CRESTA First Grade College ACFM

Unit 5 - Ethical and Governance Issues

Introduction to Ethical and Governance Issues: Fundamental Principles, Ethical
Issues in Financial Management, Agency Relationship, Transaction Cost Theory,
Governance Structures and Policies, Social and Environmental Issues, Purpose
and Content of an Integrated Report

Introduction to Ethical and Governance Issues:

Ethical and governance issues are critical aspects of corporate management and decision-
making. They revolve around the principles of responsible and accountable business practices,
transparency, fairness, and adherence to legal and ethical standards. Addressing ethical and
governance issues is essential for building trust among stakeholders, including investors,
employees, customers, and the wider community. Let's explore these concepts in more detail:

1. Ethical Issues:

Definition: Ethical issues in business involve dilemmas or situations where moral principles and
values are at stake. This encompasses decisions that affect not only the company and its
stakeholders but also the broader society.

Examples of Ethical Issues:

 Corporate Social Responsibility (CSR): Balancing financial goals with social and
environmental responsibilities.

 Employee Treatment: Fair wages, equal opportunities, and a safe working environment.

 Product Safety: Ensuring the safety and quality of products or services.

 Truth in Advertising: Providing accurate and honest information to customers.

Importance: Adhering to ethical standards is crucial for maintaining credibility, reputation, and
the trust of stakeholders. Ethical behavior contributes to sustainable business practices and
long-term success.

2. Governance Issues:

Definition: Governance refers to the system of rules, practices, and processes by which a
company is directed and controlled. It involves balancing the interests of various stakeholders
and ensuring accountability and transparency.

Examples of Governance Issues:

 Board Structure: The composition and independence of the board of directors.

 Executive Compensation: Ensuring fair and transparent compensation practices.

 Disclosure and Transparency: Providing accurate and timely information to shareholders

and the public.

 Risk Management: Effectively managing and disclosing risks associated with business
operations.

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 Importance: Good governance is fundamental to the effective management of a company
and the protection of shareholders' interests. It helps in minimizing conflicts of interest,
enhancing decision-making processes, and promoting organizational sustainability.

3. Relationship Between Ethics and Governance:

 Interconnectedness: Ethical behavior and good governance are closely intertwined. An

ethically responsible company often exhibits strong governance practices, and effective
governance mechanisms support ethical decision-making.

 Mutual Reinforcement: Ethical conduct strengthens governance by fostering trust and

stakeholder confidence. On the other hand, robust governance structures provide the
framework for ethical considerations in decision-making.

4. Legal and Regulatory Framework:

 Compliance: Companies are expected to comply with legal and regulatory requirements
related to ethics and governance. Non-compliance can lead to legal consequences, financial
penalties, and reputational damage.

 Codes of Conduct: Many organizations develop and adhere to codes of conduct that outline
ethical standards and governance principles. These codes guide employees and leadership in
making ethical decisions.

5. Evolving Landscape:

 Globalization: As businesses operate on a global scale, ethical and governance issues become
increasingly complex. Companies must navigate diverse legal systems, cultural norms, and
expectations.

 Technological Advances: The rapid pace of technological change introduces new challenges
related to data privacy, cybersecurity, and the ethical use of emerging technologies.

Addressing ethical and governance issues requires a commitment to values, transparency, and
continuous improvement. Companies that prioritize ethical behavior and strong governance are
better positioned to achieve long-term success while maintaining the trust of their stakeholders.

Fundamental Principles in Financial Management:

Financial management involves making decisions about how to acquire, allocate, and use
financial resources to achieve the goals of an organization. Several fundamental principles guide
ethical financial management:

1. Integrity:

Financial professionals should act with honesty and integrity, providing accurate and truthful
information. Integrity is fundamental to building trust with stakeholders.

2. Objectivity:

Financial decisions and reporting should be unbiased and free from conflicts of interest.
Financial professionals should prioritize the best interests of the organization and its
stakeholders.

3. Competence:

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Financial managers and professionals should possess the necessary skills, knowledge, and
expertise to perform their duties competently. Continuous professional development is
crucial.

4. Confidentiality:

Financial information is often sensitive and confidential. Financial professionals have a duty
to safeguard this information and ensure it is disclosed only to those with a legitimate need to
know.

5. Transparency:

Financial reporting should be transparent and easily understood by stakeholders. This

includes clear communication of financial performance, risks, and other relevant information.

6. Fairness:

Financial decisions should be fair and equitable. This applies to the treatment of employees,
customers, investors, and other stakeholders in financial transactions and interactions.

7. Compliance:

Financial professionals should comply with relevant laws, regulations, and ethical standards.
Non-compliance can lead to legal consequences and reputational damage.

Ethical Issues in Financial Management:

1. Financial Fraud:

 Issue: Manipulating financial statements, misrepresenting financial performance, or engaging

in fraudulent activities to deceive stakeholders.

 Ethical Concerns: Lack of transparency, breach of trust, and potential legal consequences.

2. Insider Trading:

 Issue: Trading securities based on material, non-public information.

 Ethical Concerns: Unfair advantage, violation of securities laws, and undermining market
integrity.

3. Excessive Executive Compensation:

 Issue: Awarding executives with compensation that may not be justified by company
performance.

 Ethical Concerns: Unfair distribution of resources, potential conflicts of interest, and

shareholder dissatisfaction.

4. Conflict of Interest:

 Issue: Personal interests of financial professionals conflicting with their professional duties.

 Ethical Concerns: Compromised objectivity, potential harm to the organization, and erosion
of trust.

5. Risk Management:

 Issue: Inadequate disclosure of risks or improper handling of risk management.

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 Ethical Concerns: Misleading stakeholders, failure to protect the interests of investors, and
potential harm to the organization.

6. Unethical Investment Practices:

 Issue: Investing in companies or activities that are socially or environmentally irresponsible.

 Ethical Concerns: Violation of ethical investing principles, reputational damage, and negative
impact on stakeholders.

7. Misleading Financial Reporting:

 Issue: Presenting financial information in a way that misrepresents the true financial health of
the organization.

 Ethical Concerns: Breach of transparency, potential fraud, and harm to stakeholders.

8. Inadequate Corporate Governance:

 Issue: Weak or ineffective governance structures that fail to provide proper oversight.

 Ethical Concerns: Lack of accountability, potential abuse of power, and increased risk of
unethical behavior.

Addressing these ethical issues in financial management requires a commitment to ethical

principles, adherence to regulatory frameworks, and the establishment of a strong ethical culture
within the organization. Companies that prioritize ethical financial management are better
positioned to build trust with stakeholders and achieve long-term success.

Agency Relationship:

The agency relationship, while designed to facilitate cooperation and delegation of tasks, can
give rise to various ethical and governance issues. These issues often stem from the potential
conflicts of interest between the principal and the agent and the challenges of ensuring that the
agent acts in the best interests of the principal. Here are some ethical and governance issues
associated with the agency relationship:

1. Conflict of Interest:

Issue: The agent may face conflicts of interest between their own interests and those of the
principal. This can lead to decisions or actions that prioritize the agent's personal gain over the
principal's best interests.

Ethical Concerns: Lack of loyalty and potential harm to the principal. The agent's fiduciary
duty to act in the principal's best interests may be compromised.

2. Moral Hazard:

Issue: The principal relies on the agent to act in their best interests, but the agent may take
risks or engage in behaviors that benefit them personally, knowing that the consequences may
be borne by the principal.

Ethical Concerns: Lack of accountability and potential harm to the principal's interests. The
agent may act in ways that are not aligned with the principal's goals.

3. Information Asymmetry:

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Issue: The agent may possess information that the principal does not have, leading to an
imbalance in knowledge. This can be exploited by the agent for personal gain.

Ethical Concerns: Lack of transparency and fairness. The principal may suffer if the agent
uses privileged information for their own advantage.

4. Overstepping Authority:

Issue: The agent may exceed the authority granted by the principal, making decisions or taking
actions that are not within the agreed-upon scope.

Ethical Concerns: Breach of trust and potential harm to the principal. The agent has a duty to
operate within the bounds of the authority granted by the principal.

5. Non-Disclosure:

Issue: The agent may fail to disclose relevant information to the principal, either intentionally
or unintentionally, affecting the principal's ability to make informed decisions.

Ethical Concerns: Lack of transparency and potential harm to the principal. The agent has a
duty to provide accurate and complete information.

6. Abuse of Power:

Issue: The agent, especially in a position of authority, may abuse their power to exploit the
principal or make decisions that primarily benefit themselves.

Ethical Concerns: Violation of the agent's duty to act in the best interests of the principal,
leading to potential harm and unfair treatment.

7. Inadequate Governance Mechanisms:

Issue: Weak governance structures may fail to provide sufficient oversight of the agent's
actions, increasing the risk of ethical lapses.

Governance Concerns: Lack of accountability, transparency, and mechanisms to ensure

ethical conduct. Governance mechanisms should be robust to mitigate ethical risks.

8. Ineffective Monitoring:

Issue: Inadequate monitoring of the agent's activities by the principal may result in the agent
engaging in unethical behavior without detection.

Governance Concerns: Lack of control and oversight, leading to potential ethical breaches.
Effective governance requires mechanisms for monitoring and accountability.

Transaction Cost Theory (TCT) is an economic theory that explores how the costs associated
with transactions between parties impact the choice of governance structures within
organizations. TCT, developed by Nobel laureate Oliver Williamson, suggests that the choice
between various organizational forms, such as hierarchical structures or market-based
arrangements, is influenced by the transaction costs incurred in coordinating economic
activities. While TCT primarily focuses on economic efficiency, ethical and governance issues are
inherently tied to its application. Here's an exploration of Transaction Cost Theory under ethical
and governance perspectives:

1. Ethical Considerations:

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Opportunism and Moral Hazard: TCT recognizes the possibility of opportunistic behavior,
where individuals may act in their self-interest to the detriment of others. This raises ethical
concerns as opportunism can undermine trust and fairness in transactions.

Information Asymmetry: Ethical issues may arise when one party possesses more
information than the other. Lack of transparency and asymmetry can lead to situations where
one party exploits the other.

2. Governance Issues:

Choice of Governance Structures: TCT suggests that firms choose governance structures
that minimize transaction costs. However, the choice between hierarchies and markets can
have governance implications. For example, hierarchies may offer more control but can lead to
issues of power concentration.

Incomplete Contracts: TCT acknowledges the challenges of writing complete contracts that
anticipate all possible future contingencies. This can result in governance challenges as
parties may have differing expectations or interpretations.

Monitoring and Enforcement: The effectiveness of governance structures relies on the ability
to monitor and enforce contractual agreements. Incomplete monitoring or ineffective
enforcement mechanisms can lead to governance failures.

3. Role of Trust:

Trust as a Governance Mechanism: TCT recognizes trust as an important governance

mechanism. Trust can mitigate transaction costs by reducing the need for extensive contracts
and monitoring. However, ethical issues arise when trust is violated through opportunistic
behavior.

4. Relational Contracting:

Long-Term Relationships: TCT acknowledges the importance of long-term relationships in

reducing transaction costs. However, ethical considerations become crucial in maintaining
fairness and reciprocity within these relationships.

5. Externalities and Social Costs:

 Consideration of Externalities: TCT may focus primarily on the direct costs of transactions
between parties. Ethical and governance issues may emerge when there are externalities or
social costs associated with transactions that are not fully accounted for in the decision-
making process.

6. Adverse Selection and Moral Hazard:

Contracting Challenges: TCT recognizes the challenges posed by adverse selection

(asymmetric information before a transaction) and moral hazard (asymmetric information after
a transaction). Ethical governance requires addressing these challenges to ensure fair and
transparent transactions.

7. Regulatory Implications:

Government Intervention: TCT suggests that government intervention may be required when
transaction costs are high. Ethical and governance considerations come into play when
determining the appropriateness of government intervention, balancing the need for regulation
with the preservation of individual freedoms and market efficiency.

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Governance Structures and Policies:

Governance structures and policies are essential components of an organization's framework for
decision-making, accountability, and ethical conduct. These structures and policies help define
the roles and responsibilities of various stakeholders, establish mechanisms for oversight, and
ensure compliance with legal and ethical standards. Here's an overview of governance structures
and policies:

Governance Structures:

1. Board of Directors:

The board of directors is a key governance structure responsible for providing oversight and
strategic guidance to the organization. It is composed of elected or appointed individuals who
represent the interests of shareholders or stakeholders.

2. Executive Leadership:

The executive leadership team, including the CEO and other top executives, plays a crucial
role in implementing the organization's strategy and ensuring day-to-day operational
effectiveness.

3. Committees:

Board committees, such as audit committees, compensation committees, and governance

committees, are established to address specific aspects of governance in a more focused
manner. These committees often consist of board members with relevant expertise.

4. Shareholders/Owners:

Shareholders or owners of the organization have certain rights and responsibilities.

Governance structures should allow for the effective exercise of shareholder rights, including
voting on key issues and participating in important decisions.

5. Advisory Boards:

Some organizations may establish advisory boards composed of external experts who provide
advice and guidance on specific areas of the business. While advisory boards typically lack
decision-making authority, they offer valuable insights.

6. Internal Control Systems:

Internal control mechanisms are implemented to safeguard assets, ensure accurate financial
reporting, and promote compliance with laws and regulations. These controls can include
segregation of duties, approval processes, and regular internal audits.

Governance Policies:

1. Code of Conduct and Ethics:

A code of conduct outlines the ethical principles and standards that employees, executives,
and other stakeholders are expected to follow. It helps guide decision-making and behavior
within the organization.

2. Whistleblower Policies:

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Whistleblower policies provide a mechanism for employees to report unethical or illegal
activities within the organization while protecting them from retaliation. These policies
encourage transparency and accountability.

3. Anti-Corruption Policies:

Organizations often implement anti-corruption policies to prevent bribery and corrupt

practices. These policies align with legal requirements and promote ethical behavior in
business dealings.

4. Conflict of Interest Policies:

Conflict of interest policies address situations where individuals' personal interests may
conflict with their responsibilities to the organization. They outline disclosure requirements
and mechanisms for managing conflicts.

5. Data Governance Policies:

With the increasing importance of data, organizations establish data governance policies to
ensure the proper collection, storage, processing, and protection of data. These policies
address privacy, security, and compliance considerations.

6. Risk Management Policies:

Risk management policies define how the organization identifies, assesses, and mitigates
risks. They establish processes for risk oversight and reporting to ensure that the organization
operates within acceptable risk tolerances.

7. Compliance Policies:

Compliance policies detail the organization's commitment to complying with relevant laws,
regulations, and industry standards. They guide employees in understanding and adhering to
legal requirements.

8. Environmental, Social, and Governance (ESG) Policies:

ESG policies reflect an organization's commitment to environmental sustainability, social

responsibility, and good governance practices. They address issues such as environmental
impact, social equity, and diversity.

9. Information Security Policies:

Information security policies outline measures to protect the organization's information

assets from unauthorized access, disclosure, alteration, and destruction. They are crucial for
safeguarding sensitive data.

10. Communication and Disclosure Policies:

Policies related to communication and disclosure guide how the organization communicates
with stakeholders, including shareholders, employees, customers, and the public. They ensure
transparency and consistent messaging.

Social and Environmental Issues:

Social and environmental issues encompass a wide range of challenges and concerns that affect
societies, communities, and the natural world. These issues are complex, interconnected, and
often have significant implications for the well-being of individuals, the sustainability of

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ecosystems, and the overall health of the planet. Here is an overview of key social and
environmental issues:

Social Issues:

1. Poverty:

Persistent poverty and income inequality can lead to social disparities, limited access to
education and healthcare, and reduced overall quality of life.

2. Education Disparities:

Unequal access to quality education can perpetuate social inequalities and limit opportunities
for personal and professional growth.

3. Healthcare Disparities:

Disparities in healthcare access and quality contribute to differences in health outcomes

among various socio-economic groups.

4. Unemployment and Underemployment:

Lack of job opportunities or stable employment can lead to economic insecurity, social unrest,
and reduced community well-being.

5. Discrimination and Inequality:

Discrimination based on race, gender, ethnicity, sexual orientation, and other factors can
contribute to social tensions and hinder societal progress.

6. Gender Inequality:

Unequal opportunities and treatment based on gender contribute to disparities in education,

employment, and overall well-being.

7. Social Justice:

Issues related to social justice involve fair and equitable treatment for all individuals,
addressing systemic injustices, and promoting equal rights.

8. Access to Basic Needs:

Limited access to clean water, sanitation, nutritious food, and adequate housing remains a
challenge in many parts of the world.

9. Human Rights Violations:

Violations of human rights, including issues such as forced labor, human trafficking, and
political repression, pose significant social challenges.

10. Mental Health:

Stigmatization, lack of awareness, and insufficient resources for mental health contribute to
the global mental health crisis.

Environmental Issues:

1. Climate Change:

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The warming of the Earth's climate, primarily due to human activities, poses severe risks to
ecosystems, weather patterns, and global sea levels.

2. Deforestation:

The clearing of forests for agriculture, logging, and other purposes contributes to habitat loss,
biodiversity decline, and increased carbon emissions.

3. Loss of Biodiversity:

Habitat destruction, pollution, climate change, and overexploitation of resources lead to a loss
of biodiversity, threatening ecosystems and their ability to support life.

4. Air and Water Pollution:

Industrial activities, waste disposal, and agricultural practices contribute to the pollution of
air and water, affecting human health and ecosystems.

5. Resource Depletion:

Over-extraction of natural resources, such as fossil fuels, minerals, and water, can deplete
finite resources and harm ecosystems.

6. Waste Management:

Improper disposal of waste, including plastic pollution, electronic waste, and hazardous
materials, poses environmental and health risks.

7. Natural Disasters:

Increasing frequency and intensity of natural disasters, such as hurricanes, floods, and
wildfires, are exacerbated by climate change and pose threats to communities.

8. Oceans and Fisheries:

Overfishing, pollution, and climate change impact marine ecosystems, threatening fish stocks
and the livelihoods of communities dependent on fisheries.

9. Land Degradation:

Unsustainable agricultural practices, deforestation, and urbanization contribute to the

degradation of arable land and soil fertility.

10. Environmental Injustice:

Some communities, often marginalized or economically disadvantaged, disproportionately bear

the burden of environmental degradation and pollution.

An integrated report is a comprehensive document that provides a holistic view of an

organization's performance, combining financial and non-financial information to give
stakeholders a clear understanding of how the organization creates value over time. The purpose
and content of an integrated report are shaped by the concept of integrated reporting, which
seeks to promote a more integrated and cohesive approach to corporate reporting. Here are the
key aspects:

Purpose of an Integrated Report:

1. Holistic View of Performance:

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The primary purpose of an integrated report is to provide stakeholders with a holistic and
integrated view of the organization's performance. This goes beyond traditional financial
reporting to include environmental, social, and governance (ESG) factors.

2. Value Creation:

Integrated reporting aims to articulate how an organization creates value over the short,
medium, and long term. It recognizes that value is not solely financial but encompasses
various forms of capital, including financial, human, social, and natural capital.

3. Stakeholder Communication:

The report serves as a communication tool to engage and inform stakeholders. By presenting a
broader perspective on the organization's performance, it fosters transparency and trust
among investors, customers, employees, and other interested parties.

4. Long-Term Sustainability:

Integrated reporting encourages organizations to consider and report on factors that

contribute to their long-term sustainability. This includes environmental stewardship, social
responsibility, and effective governance practices.

5. Decision-Making Support:

The report is designed to assist stakeholders in making informed decisions. Investors, in

particular, benefit from a more comprehensive understanding of the organization's business
model, strategy, risks, and opportunities.

6. Alignment with Global Reporting Frameworks:

Integrated reporting aligns with various global reporting frameworks, including the
International Integrated Reporting Council (IIRC) Framework. This alignment facilitates
consistency and comparability in reporting practices.

Content of an Integrated Report:

1. Strategic Overview:

An integrated report typically includes a strategic overview that outlines the organization's
purpose, mission, vision, and key strategic objectives. This section provides context for
understanding the organization's activities.

2. Business Model:

A clear explanation of the organization's business model is provided, describing how it creates
and sustains value across various forms of capital. This helps stakeholders understand the
key drivers of the organization's success.

3. Governance Structure:

Information about the organization's governance structure, including the composition of the
board, governance processes, and risk management practices, is included. This section
demonstrates how the organization is managed and overseen.

4. Financial Performance:

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While financial performance is a part of the integrated report, it goes beyond traditional
financial statements. The report considers financial capital alongside other forms of capital,
providing a more comprehensive financial perspective.

5. Stakeholder Engagement:

Integrated reports often discuss how the organization engages with its stakeholders, seeking
their input and feedback. This reflects a commitment to a more inclusive and transparent
approach to decision-making.

6. Environmental and Social Performance:

Detailed information on environmental and social performance is a key component. This

includes the organization's environmental impact, social initiatives, and contributions to
sustainable development.

7. Risks and Opportunities:

An analysis of risks and opportunities is provided, addressing both short-term and long-term
factors that could impact the organization's ability to create value. This helps stakeholders
understand the challenges and uncertainties the organization faces.

8. Outcomes and Impacts:

Reporting on the outcomes and impacts of the organization's activities is essential. This
includes positive and negative effects on various forms of capital, such as environmental
conservation, community well-being, and economic development.

9. Future Outlook:

The report often includes a discussion of the organization's future outlook, outlining its
strategic direction, plans for innovation, and the steps it is taking to ensure long-term
sustainability.

10. Assurance and Verification:

Some organizations choose to include information on the assurance or verification processes

undertaken to enhance the credibility of the report. This may involve external audits or third-
party reviews.

By integrating financial and non-financial information, an integrated report provides a more

complete and interconnected picture of an organization's performance. This approach aligns
with the growing recognition that sustainable and responsible business practices contribute to
long-term success and value creation.

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