Unit-II, Part-2

Notes

Topics:

Ethical and governance issues:

Fundamental Principles,

Ethical issues in financial management,

Agency Relationship,

Transaction Cost Theory,

Purpose and content of an integrated report

1. Fundamental Principles

i. Integrity:

Be straightforward and honest in all professional relationships

ii. Objectivity

No bias or conflict of interest influencing your business judgments

iii. Professional Competence & Due Care

Keep up your professional knowledge and skill so as to give a competent professional

service, using current developments and techniques. Act diligently and within appropriate
standards when providing professional services

iv. Confidentiality

Don't disclose any confidential information to third parties without proper and specific
authority. You can, however, if there is a legal or professional right or duty to disclose.
Obviously never use it for personal advantage of yourself or third parties

v. Professional behavior

A professional accountant should act in a manner consistent with the good reputation of the
profession. Refrain from any conduct which might bring discredit to the profession
 2. Ethical Issues in Financial Management

The ethical issues in financial management are twofold.

1. Financial managers, as agents and fiduciaries, have an obligation to manage assets
prudently and especially to avoid the use of assets for personal benefit. Thus,
managers, who have preferential access to information, should not engage in insider
trading or self-dealing. For example, management buyouts, in which a group of
managers take a public corporation private, raise the question whether people who are
paid to mind the store should seek to buy it.
2. Financial managers are called upon to make decisions that impact many different
groups, and they have an obligation in their decision making to balance some
competing interests. For example, should the decision to close a plant be made solely
with the shareholders' interests in mind or should the interests of the employees and
the local community be taken into account?

i. The prime financial objective of a company

The theory of company finance is based on the assumption that the objective of management
is tomaximise the market value of the company's shares. Specifically, the main objective of a
company should be to maximise the wealth of its ordinary shareholders. A company is
financed by ordinary shareholders, preference shareholders, loan stock holders and
otherlong-term and short-term payables. All surplus funds, however, belong to the legal
owners of the company, its ordinary shareholders. Any retained profits are undistributed
wealth of these equity shareholders.

ii. Non-financial objectives

The goal of maximising shareholder wealth implies that shareholders are the only
stakeholders of a company. In fact, the stakeholders of a company include employees,
customers, suppliers and the wider community. The formulation of the financial policy of the
firm takes into account the interests of the shareholders as a stakeholder group and the
formulation of non-financial objectives addresses the concerns of other stakeholders. We will
discuss later in this chapter the measures that companies adopt in order to address issues
related to sustainability and environmental reporting. Here we provide some other examples
of non-financial objectives. Note that these non-financial objectives could potentially limit
the achievement of financial objectives.

Non-financial objectives include:

● Ethical considerations Actions and strategies

● Welfare of employees Competitive wages and salaries, comfortable and safe working
conditions, good training and career development
 ● Welfare of management: High salaries, company cars, perks
● Welfare of society Concern for environment
● Responsibilities to customers: Providing quality products or services, fair dealing
● Responsibilities to suppliers: Not exploiting power as buyer
● Leadership in research and development: Failure to innovate may have adverse
long-term financial consequences

Most of these non-financial objectives reflect an ethical dimension of business activity.

Ethical dimensions in business

Businesses play an important role in the economic and social life of a nation. They provide
employment and tax revenues and have been responsible through research and development
for some of the greatest technological breakthroughs which have changed our everyday life.
The downside of this dominant role is abuse of power in the marketplace, disregard for the
environment, irresponsible use of depletable resources and an adverse effect on local culture
and customs. Companies like Coca-Cola, Imperial Tobacco and McDonald's have had an
impact on developing countries that transcended the economic sphere and have affected
dietary habits and ways of life.

Given the power that companies exercise, how do we measure their impact on society? How
do we assess their behaviour against some ethical norm as opposed to mere financial norms?
The answer to this question is provided by the development of business ethics as a branch of
applied morality that deals specifically with the behaviour of firms and the norms they should
follow so that their behaviour is judged as ethical.
 3. Agency Relationship

▪ The relationship between management and shareholders is sometimes referred to as

an agency relationship, in which managers act as agents for the shareholders.

▪ The goal of agency theory is to find governance structures and control mechanisms
that minimise the problem caused by the separation of ownership and control. In that
sense, agency theory is the cornerstone of the theory of corporate governance.

▪ More specifically, agency theory tries to find means for the owners to control the
managers in such a way that the managers will operate in the interest of the owners.

Agency relationship conflict

Due to following reasons, Managers may not act in the interests of the owners

a) Short-termism

The longer-term benefits of investment in research and development may be ignored

in the short-term drive to cut costs and increase profits thus putting business into the situation
of risk of the long-term prospects of the company.

If bonuses are based on short-term share performance or share options are about to
mature, managers may be tempted to make short-term decisions to boost the share price.

b) Overpriced acquisitions

Takeovers are another manifestation of the non-alignment of the interests of

shareholders and managers. So many takeovers or mergers fail to increase shareholder value.
The explanation lies in the fact that managers have motives other than shareholder value
maximisation.

c) Resistance to takeovers

The management of a company may tend to resist takeovers if they feel that their
position is threatened, even if in doing so shareholder value can be increased.

Agency Costs

▪ Meaning of Agency Costs

These are the internal costs which are incurred due to competing interests of the
shareholders (principals) and management (agents).

These are the expenses associated with resolution of disagreement and managing this
relationship between principal and agents.

▪ Categories of Agency Costs:

1. Direct Costs: These are the corporate expenditure that benefit the management team
at the expense of the shareholders.

2. Indirect Costs: These are the expense that arises from monitoring the actions of the
management to keep the goals of the principals and agents aligned.

4. Transaction Cost Theory

▪ Transaction costs occur when dealing with another party.

▪ If items are made within the company itself, therefore, there are no transaction costs

▪ Transaction cost theory is part of corporate governance and agency theory. It is based
on the principle that costs will arise when you get someone else to do something for
you. For example: directors to run the business you own.

Analysing these costs can be difficult because of:

□ Bounded rationality - our limited capacity to understand business situations

□ Opportunism - actions taken in an individual’s best interests

Company will try to keep as many transaction as possible in-house in order to:
● reduce uncertainties about dealing with suppliers
● avoid high purchase prices
● manage quality
Are the transaction costs (of dealing with others and not doing the thing yourself) worth
it?
The 3 factors to take into account as to whether the transaction costs are worthwhile are:
1. Uncertainty
Do we trust the other party enough?
 o The more certain we are, the lower the transaction / agency cost

2. Frequency
how often will this be needed
o The less often, the lower the transaction/agency cost

3. Asset specificity
How unique is the item
o The more unique the item, the more worthwhile the transaction / agency cost
is.

Integrated Reporting

Integrated reporting combines financial and non-financial information. Such reporting is not
mandatory but voluntary. It is primarily aims at providers of financial capital although it
might also assist other stakeholders in decision making. It is principles based - entities may
be flexible when considering the disclosures they make which are suitable for their
circumstances. It is relevant for private and public sector entities

It aims to explain

□ how organisation creates value overtime

□ Demonstrate linkage between strategy, governance and financial performance

and Social, Environmental and Economic contexts within which it operates

Integrated reporting is designed to make visible the capitals (resources and relationships, used
and affected by the organisation ) on which the organisation depends, how the organisation
uses those capitals and its impact on them.

Capitals that are used by the business are in the form of financial capital, the human resource
capital, the social and relationship capital, Intellectual capital and manufactured capital

Purpose or Objectives of integrated reporting

▪ To improve the quality of information available to providers of financial capital

▪ To communicate everything affecting how an organisation creates value
▪ Look after the broad base of capitals and show how they depend on each other
▪ Make decisions that focus on creating value in the short, medium and long term

Principles of integrated reporting a number of guiding principles underpinning the

content and presentation of an integrated to print these principles:
 1. Strategic Focus and future orientation: The integrated reporting should provide
and insights into the strategy and how it relates to the ability to create the value in the
short medium and long term. the report should also show that how the organisation
uses and effects its various capitals
2. Connectivity of information: The integrated report should provide holistic picture
of the combination interrelationships and dependencies between the various factors
that affect the organisations ability to create value over time. This includes an analysis
of resource allocation how strategy changes when new risks and opportunities are
identified and links between the business model and the external environment
3. Stakeholder responsiveness: The integrated reporting provide the insight into
organisations relationship with stakeholders and how the organisation takes accounts
of and responds to their needs
4. Materiality: The integrated reporting should focus on the provision of information
about the matter that substantively affect the organisations’ ability to create value
over time
5. Conciseness: The integrated reporting should include sufficient contextts to
understand strategy, governance, performance and prospects without the burden of
excessive information
6. Reliability and completeness: The integrated report should include all the material
matters both positive and negative in a balanced way without material error
7. Consistency and comparability: Presentation of information on a consistent basis
overtime in a way that, if possible, enables the comparisons with the other
organisation
The ‘building blocks’ of an integrated report are:
● Guiding principles
These underpin the integrated report
They guide the content of the report and how it is presented
● Content elements
These are the key categories of information
They are a series of questions rather than a prescriptive list
Guiding Principles
1. Are you showing an insight into the future strategy..?

2. Are you showing a holistic picture of the the organisation's ability to create value over
time?
Look at the combination, inter-relatedness and dependencies between the factors that
affect this
3. Are you showing the quality of your stakeholder relationships?

4. Are you disclosing information about matters that materially affect your ability to
create value over the short, medium and long term?
5. Are you being concise?
 Not being burdened by less relevant information
6. Are you showing Reliability, completeness, consistency and comparability when
showing your own ability to create value.
Contents of integrated reporting

1. Organisational overview and external environment

What does the organisation do and what are the circumstances under which it
operates?
2. Governance

How does an organisation’s governance structure support its ability to create value in
the short, medium and long term?

3. Business model

What is the organisation’s business model?

4. Risks and opportunities

What are the specific risk and opportunities that affect the organisation’s ability to
create value over the short, medium and long term, and how is the organisation
dealing with them?

5. Strategy and resource allocation

Where does the organisation want to go and how does it intend to get there?

6. Performance

To what extent has the organisation achieved its strategic objectives for the period and
what are its outcomes in terms of effects on the capitals?

7. Outlook

What challenges and uncertainties is the organisation likely to encounter in pursuing

its strategy, and what are the potential implications for its business model and future
performance?