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CIMA BA4
Fundamentals of Ethics,
Corporate Governance and Business Law

1. Ethics 3

2. CIMA’s Code of Ethics 13

3. Corporate governance 23

4. Corporate governance – directors and the board 31

5. Internal and external audit 37

6. Error and fraud 45

7. Corporate social responsibility 51

8. Contract law 59

9. Employment law 73

10. Business organisations 85

Answers to Tests 91

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Chapter 1
ETHICS

1 Introduction
Ethics is a branch of philosophy that involves examining, categorising, justifying and
recommending concepts of right and wrong behaviour. Ethics also deals with the moral principles
that govern a person's decisions and behaviour.
Ethical standards within business have become very important and poor ethics often leads to fines,
loss of trust and falls in shareholder value.
Ethical standards for accountants are vital and represent professional accountants’ “unique selling
proposition”. What’s the point in paying an accountant unless their work is competent, honest and
impartial? It is vitally important that accountants are trusted and believed: that implies high ethical
standards.

2 Absolute v relative
There is a clear distinction between ethical theories based on absolute values and those based on
relative values

Absolute value theorists

๏ Assume that there is only one set of moral rules that are unchanging and always true.
๏ But truth in one culture must be different from the truth in another. Consider the different
truths behind Christianity and Islam.
๏ So most of the “absolute school” now accepts that each separate culture has its own truths.
๏ But, even then, some truths are international and intercultural – for example, unprovoked
murder by one person of another must surely be a basic unacceptable anti–social act,
whatever the culture, religion, geographical location.

Relative value theorists

๏ Accept that there are many moral/ethical codes each of which evolves over time and each
could be different from every other.
๏ As a result of this more open acceptance of differing codes of ethics. The relative theorists do
not believe in the “one moral truth”.
๏ They accept the need for evolution of moral codes.
๏ They accept also the idea of different races, religions, sects… having their own codes of
ethics.
๏ Auditors in one country may well accept as normal an activity by a client which would be
seen as abnormal by auditors in other countries.

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3 Schools of ethics
Those who study ethics attempt to classify the ways in which ethics lead to decisions. The
classifications are known as “ethical schools”. Summaries of the main schools are:
Teleology/utilitarianism/consequentialism holds that any action must be viewed in terms of the
consequences that the action produces: do the consequences serve some intrinsic good?
Utilitarianism proposes that one should act in such a way to produce the greatest good for the
greatest number.
Deontology, or duty bound ethics, suggests that ethics arise from the rightness or wrongness of
actions themselves, as opposed to the rightness or wrongness of the consequences of those
actions. It argues that decisions should be made considering the factors of one's duties and other's
rights
Virtue ethics, emphasises the virtues, or moral character, in contrast to the approaches that
emphasises duties or rules (deontology) or that emphasises the consequences of actions
(consequentialism). Moral character can allow a person to flourish through a life well-lived and this
state is achieved by practising the virtues. Suppose it is obvious that someone needs help. A
utilitarian will point to the fact that the consequences of doing so will maximise well-being. A
deontologist will point to the fact that in providing help the agent will be acting in accordance with
a moral rule such as “Do unto others as you would be done by”. A virtue ethicist will claim that
helping the person would be charitable and benevolent – virtues that are necessary for a live well-
lived.
Ethics in accountancy primarily uses the virtue ethics approach.

4 The consequences of poor ethics in business

Irrespective of which school of ethics you adopt, or whether you are an absolutist or relativist,
being ‘ethical’ is good for profits, particularly because most unethical behaviour will be discovered
and then the consequences are serious.
๏ An ethical organisation will suffer less from legal penalties and damages. For example, paying
employees below legal minimums is likely to give rise to fines. Under-declaring profits for tax
will lead to large penalties. Concealing the harmful side effects of a product can lead to huge
damages.
๏ An ethical approach reduces risk for investors and this will reduce the return they require.
Cheaper finance means higher profits.
๏ Better people are likely to be attracted to become employees of ethical companies.
๏ Customers might boycott and abandon unethical companies.
๏ Ethical companies will find other companies more eager to cooperate (eg a joint venture). No
one wants to be tainted by a company with a poor reputation.
๏ Ethical companies will be trusted to deliver what they promised in the way they promised.

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5 Business and professional ethics

Carrying on a business or being part of the accountancy professions means that you will be
continually faced with decisions that have ethical consequences. For example:
๏ You are a pharmaceutical company developing new drugs. How much testing should be
carried out before the drugs can be marketed? More testing might identify unwanted side-
effects, but more testing will delay treatment for people who are very ill.
๏ Your factory is old and inefficient and you are thinking of moving to new one with more
efficient use of energy, in another area of the country with better transport connections. The
factory’d carbon footprint will be reduced, but existing employees will lose their jobs.
๏ You run an airline. You transport passengers for business and leisure and to visit overseas
family members. However, airlines also cause noise and air pollution.
๏ House builders create accommodation for families, but they might build over attractive land
and displace wild-life.
๏ You are an accountant reporting to a lender on the prospects of a client. A poor report will
lead to business closure and redundancies but an optimistic report might lead to the lender
losing their investment.

6 Accountants and the public interest

The CIMA Code of Ethics states that a distinguishing mark of the accountancy profession is its
acceptance of the responsibility to act in the public interest. Therefore, a professional accountant’s
responsibility is not exclusively to satisfy the needs of an individual client or employer.
The “public” includes all users of financial information and decisions: corporate boards,
shareholders, auditors, suppliers, consumers, governments, and financial industries (e.g., banking,
insurance, legal, and investment services). It also includes citizens and taxpayers, who are affected
by the fiscal decisions of governments for public expenditure and the distribution of public
resources.
“Interest” describe the responsibilities that professional accountants have to society. Examples of
these responsibilities include:
๏ Providing sound financial and business reporting to investors and all stakeholders affected by
that reporting.
๏ Promoting the comparability of financial reporting and auditing across different countries.
๏ Reducing economic uncertainty throughout the economy.
๏ Requiring that accounting professionals apply high standards of ethical behaviour and
professional judgment.
๏ Specifying appropriate educational requirements (including continuing professional
development) and qualifications for professional accountants.
๏ Specifying regulatory and disciplinary procedures for the accountancy profession.
๏ Encouraging governments and public sector organisations to provide sound fiscal
information and decision-making.

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7 Sources of professional rules and ethics

๏ The law: Local laws must be complied with, and take precedence over other sources shown
below. However, most legal frameworks give little guidance about how accountants should
approach ethical problems.
๏ IFAC: The International Federation of Accountants develops accounting and auditing
standards that it hopes will be adopted across all countries.
๏ IESBA: The International Ethical Standards Board for Accountants (part of IFAC) develops
ethical codes and guidance.
๏ FRC: The Financial Reporting Council is the UK regulatory body which promotes good
corporate governance and reporting. It is responsible for implementing IFAC financial
reporting and auditing standards in the UK.
๏ The Conduct Committee: (previously the Professional Oversight Board) is responsible for
overseeing the FRC’s Conduct Division in its work promoting high quality corporate
reporting. Its responsibilities include overseeing:
‣ Monitoring of Recognised Supervisory and Recognised Qualifying Bodies [required if
members of accountancy bodies are to be able to carry out audits]
‣ Audit Quality Reviews
‣ Corporate reporting reviews
‣ Professional discipline
‣ Oversight of the regulation of accountants and actuaries
๏ Auditing Practices Board: The Auditing Practices Board Limited, which is part of the
Financial Reporting Council, prepares for use within the United Kingdom and the Republic of
Ireland:
‣ standards and guidance for auditing;
‣ standards and guidance for the work of reporting accountants in connection with
investment circulars; and
‣ standards and guidance for auditors’ and reporting accountants’ integrity, objectivity
and independence, with the objective of enhancing public confidence in the audit
process and the quality and relevance of audit services in the public interest
[Note CIMA members cannot audit unless they are also a member of another appropriate
body].

๏ CIMA: CIMA members must comply with local laws, local financial reporting and auditing
standards and with the CIMA Code of Ethics (based on the IESBA Code of Ethics).
The CIMA Code of Ethics is covered in detail in Chapter 2

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8 Ethical codes
Many organisations and companies are developing their own ethical codes. Areas covered can
include:
๏ Equal opportunity/discrimination
๏ Bullying
๏ Use of the internet
๏ Reporting wrong-doing
๏ Bribery
๏ Money-laundering
๏ Response to conflicts of interest

Here are extracts from Amazon’s code of ethics:

I. Compliance with Laws, Rules and Regulations

Employees must follow applicable laws, rules and regulations at all times.

II. Conflicts of Interest

…employees are expected .. to act … in the best interests of [Link]. A "conflict of interest"
exists when an employee's personal interest interferes with the best interests of [Link]. For
example, a conflict of interest may occur when an employee or a family member receives a personal
benefit as a result of the employee's position with [Link]. … the Legal Department will
consider the facts and circumstances of the situation to decide whether corrective or mitigating action
is appropriate.

III. Insider Trading Policy

Employees of the Company may not a) trade in stock or other securities while in possession of
material non-public information or b) pass on material non-public information to … or recommend to
others that they trade in stock or other securities based on material non-public information.

IV. Discrimination and Harassment

[Link] provides equal opportunity in all aspects of employment and will not tolerate any illegal
discrimination or harassment of any kind…

V. Health and Safety

[Link] provides a clean, safe and healthy work environment. Each employee has responsibility
for maintaining a safe and healthy workplace by following safety and health rules and practices and
reporting accidents…Violence and threatening behaviour are not permitted. …

VI. Price Fixing

Employees may not discuss prices or make any formal or informal agreement with any competitor
regarding prices …

VII. Bribery; Payments to Government Personnel

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Employees may not bribe anyone for any reason, whether in dealings with governments or the private
sector. ….

VIII. Record keeping, Reporting, and Financial Integrity

[Link]'s books, records, accounts and financial statements must be maintained in appropriate
detail..

IX. Questions; Reporting Violations

Employees should speak with anyone in their management chain or the Legal Department when they
have a question about the application of the Code of Conduct …The [Link] Legal Department
has developed … reporting guidelines for employees who wish to report violations of the Code of
Conduct. … [Link] will not allow retaliation against an employee for reporting misconduct by
others in good faith…Employees who violate the Code of Conduct will be subject to disciplinary
action up to and including discharge.

X. Periodic Certification

The Legal Department will designate certain employees who, based on their level of responsibility or
the nature of their work, will be required to certify periodically that they have read, understand and
complied with the Code of Conduct.

XI. Board of Directors

With respect to their service on behalf of the Company, [Link]'s Board of Directors must
comply with the relevant provisions of this Code of Conduct…

There are two approaches to formulating and applying ethical codes:

๏ Rules based
๏ Framework based
Rules based: The rules based, or compliance based, approach is based on specific checks and
punishments or sanctions. Controls are implemented by establishing checklists that employees are
required to sign-off to provide evidence that they have complied with the rules.
Framework based: The framework based, or integrity based, approach sets out guiding principles,
and creates a culture that promotes ethical sound behaviour. There are few if checklists and
compliance is based on trusting employees to ‘do the right thing’. Checklists will be high-level and
ask if the principles have been followed.
An analogy can be seen from driving a car. If a driver sees a speed camera (a control) then he or she
will slow down to ensure compliance with the speed limit and to avoid a fine. This is the rules or
compliance approach. The danger is that the driver then breaks the limit when there are no speed
cameras around.
The framework or integrity-based approach would have instilled into the driver that breaking the
speed limit is morally wrong and is dangerous. That driver will drive ethically even in the absence of
speed camera.
The rules-based approach allows organisations to design the checks it thinks are needed and can
provide evidence that employees have complied with the rules. However, it is unlikely that the
organisation can check compliance for every decision, both because of the enormous bureaucracy
that would be needed and because it is difficult to foresee every ethical dilemma. The integrity-
based approach is much more flexible but does require the organisation to extend more trust to its
employees that they have the moral discernment to act ethically.

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9 Organisational and personal values

There is no reason that an organisation’s values and the personal values of its employees will be the
same:

Organisational Personal
values values

However, unless there is some overlap there are going to be difficulties: the ethics and virtues as
perceived by employees will be at odds with what the organisation perceives and needs. Successful
organisations must get as much overlap as possible:

Organisational Personal
values values

The two sets of values can be brought towards each other by:
๏ Recruitment: try to ensure that new employees share at least some of the organisation’s
values.
๏ Training: for example courses, group discussions and role play that examine ethical dilemmas.
๏ Ethical codes: these explain how employees should act and will also set out sanctions if the
code is breached.
๏ Corporate culture: a strong emphasis from the top on how things should be done in the
organisation
The virtues and values that organisations will, in general, like to see in their employees are:
๏ Reliability: employees should do what they say they will do, both in terms of quality and in
meeting deadlines.
๏ Responsibility: employees should be willing to be accountable for their actions and decisions.
๏ Timeliness: meet deadlines. Do not have undue delays in carrying out tasks or
communicating with others.
๏ Courtesy: it is important to be courteous to others both inside and outside your organisation.
Discourtesy will generate neither friends, concessions nor more work.
๏ Respect: towards other people and their views – even if you think they are wrong.

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10 Lifelong learning
This can be defined as:

“The provision or use of learning opportunities, both formal and informal, throughout people's lives in
order to promote continuous development and improvement of the knowledge and skills needed for
employment and personal fulfilment”

It is often described as being:

๏ ongoing
๏ voluntary
๏ self-motivated.
The concept recognises that in many businesses and organisations the pace of change is now often
very fast. You only have to think about the impact of information technology and the Internet on
most businesses. Unless employees and management keep up-to-date, their organisations will
probably fail.
Within the accountancy profession is important to keep up to date when preparing reports or
giving advice. For example, developments in costing, such as activity based costing, might be more
effective in producing information on which to base reliable decisions. Obviously it is important to
keep up-to-date with tax and accounting standards. In fact, it would be unethical not to keep up to
date.
Note that is not only technical matters that change. Ethical matters also change and indeed the
changes in ethics might be backed up by changes in the law. For example, attitudes towards
bullying, discrimination, corporate social responsibility, bribery and corporate governance have all
changed markedly over the last 20 years or so. Not to keep up do date is liable to lead towards
expensive legal action.
You will see later in Chapter 2 that one of the specific ethical principles in the CIMA Code of Ethics is
that members must show professional competence and due care. That implies keeping up to date
and making use of life-long learning opportunities.

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Tests
Question 1
Which TWO of the following statements are correct?
A Teleology looks at the consequences of an actions to determine whether the action is ethical
B Deontology looks at the motives for an action to determine whether the action is ethical
C Teleology looks at the motives for an action to determine whether the action is ethical
D Deontology looks at the consequences of an action to determine whether the action is ethical

Question 2
Which of the following are likely long-term consequences of poor ethics in an organisation?
(Choose all that apply)
A Lower finance costs
B A better reputation
C Greater risk
D More customers
E Problems with regulators
F Fewer opportunities for collaboration

Question 3
A CIMA member finds that a local law requires accountants to report suspicious transactions to the
authorities. This means that the accountant has to divulge confidential information in
contravention to a general ethical duty of confidentiality.
Which duty takes precedence?
A The law takes precedence
B The accountant’s ethical code takes precedence

Question 4
What do the initials IFAC and IESBA stand for?

Question 5
What are the two approaches to establishing and administering ethical codes?

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Chapter 2
CIMA’S CODE OF ETHICS

1 Introduction
The CIMA Code of Ethics sets out certain fundamental principles about how its members should
behave.
It also recognizes how members could be subject to certain threats that would compromise their
behaviour and suggests ways in which members can be safeguarded against the operation of
those therats.
So, the ethical framework recognises that there are:
๏ Ethical principles to be followed
๏ These are subject to risks
๏ Accountants should use safeguards to avoid or to respond to risks.
The guide applies to all members of CIMA and also to all CIMA students. It is based on IFAC’s Ethical
Code as developed and issued by IESBA, the International Ethics Standards Board for Accountants.
The code CIMA can be found here: [Link]
of-ethics-for-professional-accountants/

2 Fundamental principles
The CIMA fundamental principles are as follows:
๏ First, integrity, basically this means that members should be honest, straightforward. If they
see something is amiss, they should say so; they shouldn’t try to conceal it; they shouldn’t
‘turn a blind eye’; they shouldn’t try to be ambiguous, they should state things plainly. They
should stand up for their beliefs.
๏ Secondly, objectivity, members should be influenced by the facts and the facts only. They
must avoid bias, conflict of interest and undue influence.
๏ Third, members should exercise professional competence and due care. They must keep
themselves up-to-date with legislation and recent developments. They shouldn’t take on
work which they are not qualified for or for which they have no skills. They must be diligent,
they must be careful. This is why it is essential that accountants, once qualified, undertake
Continued Professional Development and life-long learning.
๏ Fourth, confidentiality. Members have privileged accessed to information that is highly
confidential and which might be price sensitive. That information must be held confidentially.
For example, accounting staff will see profit figures before these are released to investors.
Members should not disclose confidential information unless they have a legal or
professional duty to do so. An example of a legal duty to disclose information can arise if a
member thinks that a client or the person they are working for is involved in money
laundering. Many countries now have very strong regulations that require accountants to
report suspicions of money laundering to the authorities.

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Occasionally there might be a duty to breach confidentiality if it is in the public interest.

However, the concept of public interest is not closely defined in law and legal and
professional advice should be sought. For example, it is probably not in the public interest to
disclose if a company that is paying below minimum wages, but it probably is in the public
interest if the company were misreporting safety checks and customers were likely to be
injured as a result.
๏ Finally, members should show professional behavior. They should comply with the law and
they should avoid any actions which discredit the profession. So, for example, when they are
trying to advertise their services they shouldn’t say that other members are bad or poor. They
should confine themselves to promoting what they are good at; they shouldn’t rubbish other
professionals.

3 Threats to professional ethics

3.1 The threats

Threats to professional ethics arise from

๏ Self-interest
๏ Self review
๏ Advocacy
๏ Familiarity
๏ Intimidation.
Where such threats exist, the members must put in place safeguards that eliminate them or reduce
them to clearly insignificant levels. Safeguards apply at three levels: safeguards in the work
environment, safeguards that increase the risk of detection, and specific safeguards to deal with
particular cases. If he is unable to implement fully adequate safeguards, the accountant must not
carry out the work.

3.2 Self-interest threats

Self-interest threats are the following:

๏ Financial: For example, being promised a bonus if you sign off a dubious sales forecast.
๏ Close family, personal and business relationships are also threats. For example, if your brother
was the owner of a major supplier.
๏ Loans and guarantees from your employer or a client at unusually favourable rates.
๏ Contingent fees are obviously dangerous. A contingent fee, for example, would be where a
consulltant is paid a small fee for an optimistic cash forecast, but a small fee for a pessimistic
one.
Care should be taken to ensure that you are not exposed to these threats.

3.3 Self review threats

Self review threats arise when you attempt top check your own work. It is very difficult to be
sufficiently sceptical about having made a mistake. Furthermore any error of principle is likely to be
repeated, so reviews should be carried out by an independent person.

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3.4 Advocacy threats

Advocacy threats arise where a CIMA member or student promotes a point of view or opinion to
the extent that objectivity is compromised. An example would be where an accountant promotes
the shares in a listed company or supports the company in some sort of dispute. CIMA members
and students should take care no to overstate the case for any decision of recommendation. You
can give the facts but you mustn’t cross into giving unwarranted support.

3.5 Familiarity threats

Familiarity threats arise because of the close relationship between the accountant and client or
employer. The close relationship can arise by friendship, family or through business connections.
There is no general definition of what’s meant by ‘close relationships’, but if you were an auditor
and your brother was the Finance Director of a client firm then there probably is a close
relationship! If however the finance director was a remote cousin of yours, there might not be a
close relationship. Note that there does not have to be any family or legal relationship: friendship
can threaten independence and integrity.
If there appears to be a close relationship that would put independence at risk (or be suspected of
introducing bias), the accountant should not carry out the work.

3.6 Intimidation

The final groups of threats are intimidation threats. These can deter an accontant from acting
properly. Examples could be threatened litigation, blackmail, or there might even be physical
intimidation, though it is to be hoped that that is rare. Blackmail could be more subtly applied and
might relate back, for example, to a period where the auditor was not acting in accordance with the
required ethical standards.

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4 Independence and professional scepticism

4.1 Independence

‘Independence’ is not mentioned as an ethical principle but it is a combination of integrity and

objectivity. The accountant should stick up for what’s right, be honest and be objective. However, it
becomes difficult to be independent if, fir example, your job depends on producing a report with
favourable conclusions.

4.2 Professional scepticism

This means approaching your work with a questioning mind. It does not mean that you expect that
every piece of information you are supplied with has been deliberately falsified. On the other hand
it does not mean that you automatically believe everything you are told.
You must walk a tight-rope between belief and disbelief, being aware that we are all human and
can all be prone to:
๏ Unwarranted optimism or pessimism
๏ Making errors
๏ Misunderstanding
๏ Answering questions in a rush without really thinking about them
๏ Avoiding trouble for ourselves and colleagues
All of these frailties mean that accounting information and estimates will be, from time-to-time,
incorrect. Therefore, information needs to be checked. Certainly any information or explanations
which look odd or unfeasible needs to followed up.
Accountants should also be aware of another human frailty: dishonesty. Dishonesty also exists and
that sometimes you might be given information that deliberately misleads or covers up problems.

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5 Responses to threats to ethical principles and ethical

conflicts
Sometimes, despite attempting to avoid or reduce threats to ethical principles, CIMA members and
students can feel themselves under pressure to behave in a non-ethical manner or can be subject
to ethical conflicts.
An ethical conflict arises when a member encounters one or both of the following:
(a) Obstacles to following an appropriate course of action due to internal or external pressures.
(b) Conflicts in applying relevant professional and legal standards.
For example, a member suspects a fraud may have occurred, but reporting the suspected fraud
would violate the member’s responsibility to maintain the confidentiality of his or her employer’s
confidential information. Another example could arise when if a deposit from a client should, by
law, be placed in a separate client’s account, but is paid into the company’s ordinary account.
Once an ethical conflict is encountered, a member may be required to take steps to best achieve
compliance with the rules, fundamental principles and the law. In weighing alternative courses of
action, the member should consider factors such as the following:
๏ Relevant facts and circumstances, including applicable rules, laws, or regulations, must be
investigated.
๏ Determine the ethical issues involved.
๏ Investigate the established internal procedures.
The member should also be prepared to justify any departures from internal procedures that the
member believes were appropriate in applying the relevant rules, fundamental principles and law.
Before pursuing a course of action, the member should consider consulting with appropriate
persons within their employer.
If a conflict remains unresolved after pursuing the selected course of action, the member should
consider either consulting with other individuals for help in reaching a resolution or obtaining
advice from an appropriate professional body or legal counsel. The member also should consider
documenting the substance of the issue, the parties with whom the issue was discussed, details of
any discussions held, and any decisions made concerning the issue.
If the ethical conflict remains unresolved, the member will in all likelihood be in violation of one or
more rules or fundamental principles if he or she remains associated with the matter creating the
conflict. Accordingly, the member should consider his or her continuing relationship with the
specific assignment or employer.

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CIMA has produced an ethical checklist that can help you to navigate through these difficulties.
[Link]

CHECK ALL
POSSIBLE COURSE
YOUR FACTS
OF ACTION
and documents
– internal and
where possible
external escalation
SEEK
professional or
legal advice

IS IT ETHICAL
– have you IDENTIFY
considered the the affected
ethical issues parties
involved?

IDENTIFY REFUSE
which to remain
fundamental associated with
principles are the conflict
IS IT LEGAL?
affected

๏ Seek advice from his or her manager.

๏ If that manager is the problem, then the matter can be escalated to higher management and
the audit committee if there is one.
๏ A complaint can be made under the employer’s grievance procedures.
๏ Advice can be sought from your mentor (if there is a mentoring arrangement).
๏ Seek advice from CIMA.
๏ There might be a statutory duty to report on problems (eg money laundering).
๏ Whistle-blowing, as a last resort (See chapter 9).

5.1 Check all your facts – and document where possible

(a) Identify all relevant facts.

(b) Do not rely on word of mouth, or assumptions. Is it really your problem?
(c) Can anybody else help?

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5.2 Is it ethical – have you considered the ethical issues involved?

(a) Does it feel right?

(b) How would you feel if you saw it in a newspaper?
(c) How would you feel about your peers, friends, family knowing about it?
(d) Have you referred to the CIMA Code of Ethics?
(e) Have you referred to your internal Code of Ethics/Conduct and other internal policies?

5.3. Is it legal?

(a) Is the issue in question regulated by the law – national and international?
(b) does it comply with rules, policies, standards and contracts imposed by relevant regulators/
bodies and by your employer?

5.4. Identify which fundamental principles are affected

(a) Integrity
(b) Objectivity
(c) Professional competence and due care
(d) Confidentiality
(e) Professional behaviour

5.5 Identify the affected parties

(a) Who are the individuals, organisations and key stakeholders affected?
(b) In what way are they affected?
(c) Are there conflicts between different stakeholders?
(d) Understand the effects of non-action to the organisation, to yourself and to society.

5.6. Possible course of action – internal and external escalation

(a) Escalate internally; consider grievance procedures.

(b) Document every action you take to resolve the conflict.
(c) Escalate externally to auditor, legal advisors, professional body.

5.7. Seek professional or legal advice

(a) Your internal whistle-blowing or speak-up helpline.

(b) Legal advisors.
(c) CIMA ethics helpline: free to members and students.

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5.8. Refuse to remain associated with the conflict

(a) If resolution seems unlikely, disassociate yourself from the issue – in writing if necessary.
(b) Legal advice may be needed if this affects your employment status or if you are implicated in
any way with the issue.
As a very last resort, there is external whistle-blowing (see chapter 9)

6 CIMA’s Ethical Code and the law

By and large the law is silent on accountants’ professional ethics. There might be occasional
overlaps such as being able to sue an accontant for damage caused if work was carried out
negligently, but it has been left up to CIMA and other accounting bodies to devise and to police the
ethical code.
Note, as mentioned in Chapter 1, that if national law and ethical guides conflict, CIMA states that
the law should be followed. For example, you will see below that a CIMA ethical principle is
confidentiality. However, if tax legislation requires you to provide information to the government
about your employer’s business practices, then you must comply with the law.

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Tests
Question 1
Which of the following is/are not one of the five fundamental ethical principles of CIMA?
(Choose all that apply.)
A Honesty
B Objectivity
C Professional behaviour
D Prudence
E Confidentiality
F Professional scepticism

Question 2
Which of the following are attributes of ‘professional scepticism’?
(Choose all that apply)
A Assume everyone is trying to deceive you.
B Assume everyone tells the truth.
C Be aware that incorrect information might be given inadvertently.
D Follow up inconsistencies in information.

Question 3
CIMA has published a checklist, or pathway to guide members if they are faced with ethical
conflicts.
Place the following (incomplete) steps in the correct order.
(a) Is it ethical?
(b) Seek professional or legal advice
(c) Check your facts
(d) Identify the affected parties

Question 4
What is the ultimate step that a professional accountant should take if they cannot resolve
an ethical conflict?

Question 5
A CIMA member has been asked to prepare and check a cash-flow forecast for his/her employer.
The forecast will be sent to the company’s bank as the basis for extending the company’s overdraft.
What ethical threats might be created here?

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Chapter 3
CORPORATE GOVERNANCE

1 Why corporate governance is needed

Corporate governance is the system by which companies are directed and controlled.
The problem is that although the shareholders own companies and are known as the ‘principals’,
the day-to-day management and direction of companies is given to the Board of Directors. The
directors are the ‘agents’ of the shareholders and should act in the best interests of the
shareholders. In large companies many shareholders are relatively passive and the Board of
Directors is given more or less free rein to make whatever decisions they wish.
Auditing was instituted so that at least once a year, when the financial statements were presented
to the members of the company, the auditors would examine the financial statements and give
their opinion to the members of the company as to whether the financial statements were true and
fair. Without that assurance the members of the company really would have a little idea as to
whether or not the financial statements were worth relying on. The auditors therefore examine the
financial statements and this adds credibility to those statements so that the shareholders have a
much better idea of the performance of the directors and the company.

Appoint independent
Auditor

Measure
performance Adds credibility

Financial Statements

Prepare FS

Appoint
Shareholders Directors

Own Manage
Company

Note that shareholders appoint the independent auditors, they also appoint the directors. The
problem is, however, that once directors were appointed, shareholders often didn’t take much
further interest in what the directors were doing. Scandals such as Enron, Worldcom in the early
2000’s, and perhaps banking problems in 2008, showed that this hands-off approach was entirely
inadequate and therefore additional safeguards have been instituted to try to ensure that directors
act in the best interests of the members of the company.

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2 Corporate Governance, ethics and the law

Ethical directors should always seek to act in the best interests of thir shareholders, but often did
not. Sometimes this was deliberate so that directors could enrich themselves at the expense of the
shareholders. Somtimes it was accidental such as not understanding the risks and returns that
shareholders were happy with. Therefore, to encourage better (and more ethical) corporate
governance, most advanced economies have introduced corporate governance rules, laws and
guidelines. Some countries have taken a rules- or procedural-based approach and some a
principles- or framework-based approach (these concepts were discussed in the previous chapter).
Some countries have enshrined corporate governance in their laws whilst other rely on their stock
exchange enforcing the rules. For example:
๏ USA: The Sarbanes-Oxley Act is part of US law. A rules-based approach with the risk of crininal
prosecution if not complied with.
๏ UK: The UK Corporate Governance Code. This is not law but is a code that companies listed on
the London Stock Exchange are expected to follow. If there are serious departures from the
code, the Stock Exchange can suspend a company’s listing (ie their shares cannot be bought
or sold on the stock exchange). The stock exchange requires a ‘comply or explain’ approach:
companies have to comply with the corporate governance code or explain why they haven’t.
Explanations might not always be accepted as reasonable or acceptable.

3 OECD Principles of corporate governance

The Organization of Economic Cooperation Development (OECD) has put forward some principles
of corporate governance. It is then up to countries to implement detailed laws or codes to
implement these principles.
๏ The corporate governance framework should promote transparent and fair markets, and the
efficient allocation of resources. It should be consistent with the rule of law and support
effective supervision and enforcement.
๏ The corporate governance framework should protect and facilitate the exercise of
shareholders’ rights and ensure the equitable treatment of all shareholders, including
minority and foreign shareholders. All shareholders should have the opportunity to obtain
effective redress for violation of their rights. [For example, all shareholders should have access
to the same information at the same time.]
๏ The corporate governance framework should provide sound incentives throughout the
investment chain and provide for stock markets to function in a way that contributes to good
corporate governance. [This recognises that many private investors now invest in companies
indirectly, through institutional investors such as investment trusts. So, for example, the
principles state that institutional investors acting in a fiduciary capacity should disclose their
corporate governance and voting policies with respect to their investments, including the
procedures that they have in place for deciding on the use of their voting rights.]
๏ The corporate governance framework should also recognize the rights of all stakeholders, not
just shareholders, and should encourage active cooperation between the entities and
stakeholders in creating wealth, jobs and sustainability of financially sound entities.
๏ The corporate governance framework should ensure that timely and accurate disclosure is
made on all material matters regarding the corporation, including the financial situation,
performance, ownership, and governance of the company.
๏ The corporate the corporate governance framework should ensure the strategic guidance of
the entity, effective monitoring of management by the board and the board’s accountability

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to the entity and their shareholders. [This covers requirements relating to the appointment of
board members, ethical behaviour by board members and the application of care and due
diligence]

4 IFACs main drivers for sustainable corporate success

IFAC has published an International Good Practice Guidance (IGPG) Evaluating and Improving
Governance in Organizations (IFAC, 2009) ([Link]
governance-sustainable-success). The report analyses, with the use of illustrative case studies, how
professional accountants in business support their organisations in integrating governance into the
key drivers of organisational success.
It identifies eight drivers of sustainable organisational success:

4.1 Customer and shareholder focus

๏ Understanding and satisfying customer or service-user needs.
๏ Aligning all parts of an organisation to these needs.
A customer and stakeholder focus involves ensuring that the organisation as a whole, not merely
the front-line staff, puts an understanding of customers and key stakeholder groups first. Similarly,
in the public and not-for-profit sectors, sustainable performance is strongly linked to meeting
stakeholder expectations and the quality of service delivery to their customers, clients, and society.
Irrespective of an organisation’s size, structure, or sector, a customer and stakeholder focus can be
aided by:
(a) practising good customer and stakeholder relationship management;
(b) maintaining a customer and stakeholder relations or engagement program;
(c) ensuring that all functions, including finance and accounting, are geared to supporting
customer- and stakeholder focused decisions.
Accountants can help to identify, understand and monitor groups of customers and stakeholders
to provide appropriate decision-oriented information.

4.2 Effective leadership and strategy

๏ Providing ethical and strategic leadership focused on sustainable value creation.
๏ Facilitating key performance drivers, including strong corporate values, ethical culture,
organisational structures and processes.
Professional accountants in business often participate in the key areas of strategic leadership:
strategy (what do we want to achieve?); values and attitudes (what do we stand for?); and the
business model (how do we organise to create, deliver, and capture sustainable organisational
success?).
This involves:
(a) participating in strategy and planning, providing information and analysis for strategic decision
making and maintaining strategic control and financial navigation to ensure execution of
strategy and
(b) evaluating strategic options that align with the organisation’s risk management strategy and
policies on internal control and recommending optimal strategies. It also requires setting the
right tone at the top in the organisation.

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4.3 Integrated governance, risk and control

๏ Deploying effective government structures and processes with integrated risk management
and internal control.
๏ Balancing performance and conformance in government.
Professional accountants in business can create awareness among their colleagues regarding the
importance of integrating governance, risk management, and internal control. Effective risk
management enables an organisation to exploit opportunities and take on additional risk while
staying in control and, therefore, increasing its sustainable success. With an integrated, enterprise-
wide approach to risk management and internal control, professional accountants in business also
encourage the idea that risks are viewed and managed in a more holistic way so that individual
risks are not assessed and dealt with in isolation.
Professional accountants in business are also frequently engaged in the improvement of
documentation and communication of governance, risk management, and internal control
systems.

4.4 Innovation and adaptability

๏ Innovating processes and products to improve reputation and performance.
๏ Adapting the organisation to changing circumstances.
Professional accountants can be involved in supporting each of the key stages of innovation
development, including innovation and opportunity selection, concept and design definitions,
product and service realisation, and required production and service support.

4.5 Financial management

๏ Ensuring financial leadership and strategy support sustainable value creation.
๏ Implementing good practices in areas such as tax and treasury, cost and profitability
improvement, and working capital management.
Financial management is at the core of what many professional accountants do in organisations,
such as: provision, analysis, and interpretation of financial and non-financial information to the
governing body and managers, supporting them in understanding the financial health of the
organisation and progress in delivering financial objectives, and providing the information and
analysis needed for organisational objective setting, strategy formulation, execution, and control.

4.6 People and talent management

๏ Enabling people and talent management as a strategic function.
๏ Applying talent management to the finance function so it better serves the needs of the
whole organisation.
Professional accountants should serve as promoters of integrity, transparency, and expertise. They
also deploy people and talent management strategies and policies that are focused on
determining core competencies, engaging new employees, and retaining critical staff through
robust career development—both for the finance function and the wider organisation. This
enables the organisation to continuously meet its changing needs

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4.7 Operational excellence

๏ Aligning resource allocation with strategic objectives and the drivers of shareholder and
stakeholder value
๏ Supporting decision making with timely and insightful performance analysis.
Professional accountants in in business also often use and advise on management approaches such
as the application of advanced management accounting tools, such as process analysis, strategic
and operational cost management, and throughput accounting, to make their organisations more
successful and more adaptive to changing circumstances.

4.8 Effective and transparent communication

๏ Engaging shareholders effectively to ensure that they receive relevant communications.
๏ Preparing high quality business reporting to support stakeholder understanding and
decision-making.

5 CIMA’s proposals for better reporting of corporate

governance
CIMA take the view that good corporate governance is essential to create trust and engagement
between companies and their investors, so contributing to the long-term success of the business.
However, even where a company has good corporate governance, reporting is often formulaic and
relies on standard, ‘boiler plated’ paragraphs brought together for the sake of claiming that
communication of governance issues has taken place – even though it might be very poor. CIMA
has therefore come up with practical proposals to bring corporate governance reporting ‘to life’.
[Link]
pages/Thought-leadership/Research-topics/Governance/Simple-practical-proposals-for-better-
reporting-of-corporate-governance/

The proposals are:

5.1 Tone from the top

The chairman’s view on what good governance means to him [or her] and his [or her]
company.
๏ How the chairman has met the challenge of leading the board and ensuring its effectiveness.
๏ The culture of the board and whether it is open and welcoming to effective debate and
contribution from all members, including non-executive directors.
๏ Whether the governance culture is aligned with the company’s policies and procedures, and
reinforced by a measurement and incentive system.
๏ A quick reference guide to governance activities during the year and where more information
may be found.

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5.2 How the board works as a team

๏ Showing how the company’s board is properly composed and balanced, with skill sets that
complement one another.
๏ That a range of views will be expressed in the spirit of constructive challenge, and that the
boardroom environment allows for this.

5.3 The key actions of the board and its committees

๏ What issues the board has focused its attention on.
๏ Whether the board has been focusing on the right things.
๏ How the company’s governance processes interact with the year’s key corporate events and
significant governance changes since the previous year.

5.4 Board effectiveness

๏ That there is a rigorous process in place to assess how effectively the board and its
committees are working.
๏ A balanced assessment of the effectiveness of the board and an understanding of the actions
being taken to address any underperformance.
๏ That the right issues are being discussed and that issues are kept on the agenda until
resolved.
๏ That the assessment of board and committee effectiveness is part of the linkage through
from strategy and risk to performance and reward.
๏ That matters are being addressed in a forward-looking way, so that effectiveness will improve
in the future.

5.5 Communication and engagement with shareholders

The company’s story needs to be told consistently to a broad audience. It must meet the needs of:
• Fund managers, who need to understand the business model and its shorter term returns.
• Ultimate owners such as pension funds and insurance companies, who need confidence in
management, and a longer term perspective.
• Those responsible for voting, in-house or outsourced, who need compliance data.

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Tests
Question 1
What is the name of the main act which deals with corporate governance in the USA?

Question 2
What are the five elements of CIMA’s proposals for the better reporting of corporate
governance?

Question 3
Which of the following statements are correct? (Choose all that apply.)

A Rules-based systems of corporate governance use a ‘comply or explain’ approach

B A framework-based approach and a rules-based approach are the same things.
C The UK has adopted a principles-based approach to corporate governance but the USA has
adopted a rules-based approach.
D Directors are principals, shareholders are agents
E Corporate governance can be defined as the system by which companies are directed and
controlled

Question 4
Fill in the two blanks in the sentence below:
The OECD principles of corporate governance mentions that ”… the equitable treatment of all
shareholders, including _________________ and _________________ shareholders.”

Question 5
Which organisation published an International Good Practice Guidance (IGPG) called
‘Evaluating and Improving Governance in Organisations’?

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Chapter 4
CORPORATE GOVERNANCE –
DIRECTORS AND THE BOARD

1 Introduction
You should remember from the last chapter that corporate governance is the system by which
companies are directed and controlled. Once a company grows, and certainly for listed companies,
it is the directors who are in day-to-day control. Therefore, it should not be surprising that
corporate governance codes pay great attention to the composition and activities of a company’s
board of directors.

2 Unitary and two-tier boards

Most corporate governance problems arose because of the way boards were structured and run.
There were particular dangers where a company was headed by a charismatic CEO. The word
‘charismatic’ was often used instead of more accurate descriptions such as ‘domineering’ or
‘bullying’. Often the CEO would ensure that the board was filled with directors who would offer
little resistance to the CEO’s wishes and the CEO was then able to get away with outrageous
decisions and, occastionally, robbery.
Two approaches have been taken to try to introduce some supervision to the board’s activities:
unitary boards and two-tier boards. In the European Union, the corporate governance codes in
eight countries recommend a unitary-board system and in ten countries the codes recommend a
dual-board system. In the remaining nine countries, a hybrid system applies and companies can
choose between a one or two-tier approach.

2.1 Two-tier boards

The boards are:

๏ A supervisory board: This is elected by the shareholders and is usually composed of more
experienced senior members, and employee representatives. The supervisory board is led by
a chairman and it supervises and advises the management board. The supervisory board is
particularly involved in the long-term decision making and strategic planning of the business.
It is also in charge of hiring and dismissing members of the management board.
๏ A management board: The management board will meet regularly and is in charge of the
day-to-day management of the business. It is led by a CEO (chief executive officer). Its
responsibilities are tactical issues (short term decisions), the everyday management of the
business’s transactions.

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Supervisory board: supervises the

management board and long-term
strategic decisions.

Information, Information, approval,

reports, results advice, warnings, control

Management board: tactical

decisions, day-to-day management
and organisation.

Advantages of two-tier boards Disadvantages of two-tier boards

๏ Clear separation of roles ๏ Poor information flows
๏ The supervisory board can include a ๏ Confusion ovver power and roles
wide range of stakeholders eg workers’
representatives
๏ Greater independence of discussion ๏ Slower decisions and potential
and decision making stalemates

Unitary boards
There is only one board and it appoints a mix of executive and non-executive directors. The
executive directors look after the day-to-day management of the company (like the management
board in the two-tier system); the non-executive directors warn and advise (like the supervisory
board in the two-tier system). However, all votes are taken by the single board with each executive
and non-executive director having a vote.

Advantages of unitary boards Disadvantages of unitary boards

๏ All major decision taken in one forum ๏ Less independence and separation of
duties
๏ Faster decisions as only one vote ๏ Can lacks a clear division of
needed responsibilities
๏ Close Executive/non-executive ๏ More difficult to incorporate
relations representatives of other stakeholders

๏ Effective communication and

information flow as there is only one
board

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3 The UK Corporate Governance Code

The OECD principles are put into effect in a variety of ways in different countries, but the UK
Corporate Governance Code canb be taken as an example of best practice for corporate
governance using a unitary board approach.
The full code can be accessed at:
[Link]
[Link]

The code states that the purpose of corporate governance is to facilitate:

“effective entrepreneurial and prudent management that can deliver long-term success of the
company”.
It then goes on to list the main principles of the code:

Main principles
๏ Leadership
๏ Effectiveness
๏ Accountability
๏ Remuneration
๏ Relations with shareholders

Comply or explain
The code has no force in law and is enforced on listed companies through the Stock Exchange.
Listed companies are expected ‘‘comply or explain’’ and this approach is the trademark of
corporate governance in the UK. Listed companies have to state that they have complied with the
code or else explain to shareholders why they haven’t. This allows some flexibility and non-
compliance might be acceptable in some circumstances.

Leadership
๏ Every company should be headed by an effective board which is collectively responsible for
the long- term success of the company.
๏ There should be a clear division … between the running of the board and the executive
responsi- bility for the running of the company’s business. No one individual should have
unfettered powers of decision. This means that the roles of CEO and Chairman should not be
performed by one person as that concentrates too much power in that person.
๏ The chairman is responsible for leadership of the board
๏ Non-executive directors (NEDs) must be appointed to the board and they should
constructively challenge and help develop proposals on strategy. NEDs sit in at board
meeting and have full voting rights but do not have day-to day executive or managerial
responsibility. Their function is to monitor, advise and warn the executive directors.

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Effectiveness
๏ The board should have an appropriate balance of skills, experience, independence and
knowledge. In large companies NEDs should be at least 50% of the board; in small companies
there should be at least 2 NEDs.
๏ New directors should be appointed by a Nomination Committee to ensure a formal,
rigorous and transparent procedure for their appointment. The Nomination Committee
consists of NEDs. This provision is to prevent directors appointing their friends and colleagues
to the board and ensures that the best people for the job are considered and appointed.
๏ All directors should be able to allocate sufficient time to company business.
๏ There should be induction on joining the board and a programme to update and refresh
directors’ skills and knowledge.
๏ The board should be supplied in a timely manner with necessary information.
๏ The board should undertake a formal and rigorous annual evaluation of its own performance
and that of its committees and individual directors.
๏ All directors should be submitted for re-election at regular intervals

Accountability
๏ The board should present a balanced and understandable assessment of the company’s
position and prospects.
๏ The board is responsible for determining the … significant risks …and should maintain sound
risk management and internal control systems.
๏ The board should establish formal and transparent arrangements for applying the corporate
reporting, risk management and internal control principles, and for maintaining an
appropriate relationship with the company’s auditor. This means that an Audit Committee
(NEDs again) should be established to liaise with both internal and external auditors. Before
audit committees, the finance director liaised with auditors, but this was not satisfactory
because the finance director was often the person respon- sible for accounting problems.
Therefore auditors were often reporting problems to the person who caused them. The
directors are responsible for establishing an internal control system and must review the
need for internal audit.

Remuneration
๏ Levels of remuneration should be sufficient to attract, retain and motivate directors of
sufficient quality… but avoid paying more than is necessary.
๏ A significant proportion of executive directors’remuneration should be structured so as to
link rewards to corporate and individual performance. In other words, profit related pay is
encouraged. Directors should not receive high pay irrespective of company performance.
๏ There should be a formal and transparent procedure for developing policy on executive
remuneration and for fixing the remuneration packages of individual directors. No director
should be involved in deciding his or her own remuneration. This means that a
Remuneration Committee (NEDs) should be formed to fix directors’ remuneration.

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Relations with shareholders

One of the problems with achieving good corporate was encouraging shareholders to take an
active interest in the company. Too often they did not fully participate at AGMs and would wave
through motions. This passive attitude might well have been encouraged by directors to move
power towards them and away from members.
The code therefore specifies:
๏ There should be a dialogue with shareholders based on the mutual understanding of
objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue
with shareholders takes place.
๏ The board should use the AGM to communicate with investors and to encourage their
participation.

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Tests
Question 1
What are the two approaches to board structure that can be used and how does each
approach corporate governance?

Question 2
The UK Corporate Governance Code specifies three committees, mostly consisting of non-
executive directors.
What are the three committees?

Question 3
What are the five principles/sections of the UK Corporate Governance Code?

Question 4
Is the following statement true or false in relation to corporate governance?
The Chairman of the Board and the Chief Executive Officer should be different people.

Question 5
Is the following statement true or false in relation to directors?
Non-executive directors attend board meetings but are not entitled to vote.

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Chapter 5
INTERNAL AND EXTERNAL AUDIT

1 Introduction
An audit is a form of assurance, which means that:
๏ an independent expert examines
๏ specified subject matter to
๏ agreed standards
๏ that is the responsibility of one party
๏ and produces a report
๏ for a second party.
For example, in the UK once a car reaches a certain age it has to have an annual safety test to
provide assurance that the vehicle is safe to drive. That assurance is carried out as follows:
๏ An independent test centre with qualified mechanics
๏ Inspects the car
๏ Following an agreed checklist and performance criteria
๏ The car’s condition is the responsibility of the owner
๏ The car’s condition and whether it has passed or failed is communicated
๏ To the Government
In an external audit:
๏ An independent auditor
๏ Examines the financial statements
๏ Following agreed auditing standards and agrees accounting standards.
๏ The financial statements are the responsibility of the directors
๏ The condition of the financial statements (are they ‘true and fair’) is reported
๏ To shareholders (members of the company).

There are two types of audit:

๏ External: where the report goes to the members (shareholders)
๏ Internal (where the report goes to the board)
The objectives of the two types of audit are different, but many of the techniques used are similar.

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2 The need for external audit

2.1 Principal-agent relationship between shareholders and directors

As was mentioned in an earlier chapter, shareholders are the legal owners of companies. In very
small businesses, such as family businesses, the shareholders will also take part in the day to day
management of the company. However, once businesses grow, shareholders appoint directors and
managers to run their company.
Shareholders (also known as members) are the principals and directors are the agents of the
shareholders. Agents should act in the best interests of the principals so therefore, directors should
act in the best interest of shareholders. However, this can introduce conflicts of interest between
the two parties. Shareholders want large profits but the directors might want large salaries,
generous pensions and bonuses, first class travel and expensive cars.
Companies are required to produce annual financial statements (accounts) for presentation to their
shareholders. These should show how their company has got on during the year. The directors are
responsible for producing the financial accounts and there is obviously a temptation for them not
to report results accurately or fairly. For example, directors might try to overstate profits so as to
keep their jobs or to qualify for bonuses.
Therefore, independent, external auditors are appointed by the members of the company to
scrutinise objectively the financial statements and to report to the members on whether no the
financial statements show a ‘true and fair’ view of the company’s affairs and its results. Auditors’
conclusions are published as part of the financial statements in the audit report. The auditors are
therefore carrying out an assurance engagement.
In addition to the terms ‘agent’ and ‘principal’, ‘stewardship’ is sometimes used to describe the duty
that directors have to look after the interests of the shareholders.

3 What the external auditors do

3.1 Financial statements

The auditors are required to produce an audit report on a company’s financial statements. These
will have been produced from the financial records. Financial statements consist of:
๏ A statement of financial position
๏ A statement of profit or loss
๏ A statement of cash flows
๏ Notes to the financial statements
๏ A statement of movement in reserves
The audit report covers only the financial statements, not the other documents that might be
included. For example, companies also produce directors’ reports, chairman’s statements and often
graphs, forecasts and public relations material and combine these with the financial statements
and audit report into their annual report. For large companies this is often a glossy booklet
designed to impress shareholders and potential investors.
However, the audit report covers only the financial statements, not the other documents that might
be included.

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3.2 The audit report

The prime purpose of the audit report is to state whether or not the financial statements give a
true and fair view of the financial position of the company at its year end and of its performance
during the year. Sometimes a phrase such as ‘present fairly’ is used instead of ‘true and fair’
True: implies that the financial statements are factually correct, have been prepared according to
an applicable reporting framework (such as the International Financial Reporting Standards) and
that they do not contain any material misstatements that may mislead the users. Misstatements
may result from material errors or omissions in the financial statements. True also implies that the
financial statements are materially accurate.
Fair: implies that the financial statements present the information faithfully without any element of
bias and they reflect the economic substance of transactions rather than just their legal form.
Presentation is an important element of fairness.
For example:
The statement of financial position should show current assets and current liabilities separately and
in detail. Thus, the current assets and current liabilities figures might show:

Current assets
Inventory 10,000
Receivables 4,000
Cash 2,000
16,000

Current liabilities
Trade payables 12,000

This shows that the liquidity of the company is poor as suppliers expect $12,000 within the next
few weeks but, although inventory is high, there is not much coming from customers or in cash
with which to pay suppliers. Inventory can take a long time to be sold and to turn into cash.
If the presentation were as follows:
Current assets 16,000
Current liabilities 12,000
Then users might have a very wrong impression about liquidity. The current ratio is 16/12 = 1.3 and
usually anything >1 is regarded as probably satisfactory. The amounts are true (correct), but
concealing the large amount of inventory that contributes to the current assets is likely to mislead
ie not a fair presentation.

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3.3 Modified audit opinions

If the auditors cannot say that the financial statements show a true and fair view, then they will
issue a modified audit opinion explaining what the problem is.
Problems with the financial statements can arise for two reasons:
๏ There is a material misstatement in the financial statements. This means that a figure is
materially wrong or has been incorrectly presented or disclosed.
๏ The auditors have been unable to obtain sufficient appropriate audit evidence to support a
conclusion that the financial statements show a true and fair view.
These problems give rise to three types of modified opinion:
๏ Qualified: where the misstatement or lack of evidence is material, but can be isolated. These
reports usually include the phrase ‘except for [...details of the problem...] the financial
statements show a true and fair view’.
๏ Adverse: where the audit report would say that because the misstatements are so severe
(pervasive) the financial statements do NOT show a true and fair view.
๏ Disclaimer: where the auditor would say that because the lack of evidence so severe
(pervasive) they can form no opinion on the financial statements.

4 What auditors don’t do

Auditors do not:
๏ Prepare the financial statements: that is the job of the directors and their staff.
๏ Double check every transaction in the company: that would take too long and be very
expensive. Auditing is carried out on a test basis, often testing internal control system that
has been set up in the company to assess if that system should prevent or detect fraud or
error. (Internal control is further explained in Chapter 8)
๏ Manage the company.
๏ Warn shareholders that the company has made a loss: that will be shown in the financial
statements.
๏ Undertake to discover every fraud or error that might have taken place in the company:
auditors look only for material misstatements.
๏ Auditors do not provide guarantees that the financial statement are free of material fraud and
error: transactions are examined on a test basis and so there is always the risk that, even in a
properly conducted audit, an error or fraud is undiscovered.

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5 Advantages and disadvantages of an external audit

5.1 Advantages
๏ Independent scrutiny and a report on the financial statements.
๏ Greater credibility (believability) of the financial statements. This could help in raising finance.
๏ Professional expertise applied to the financial statements. Especially important when
directors and shareholders might not have financial experience.
๏ Review of the company’s internal control system (the accounting system used by the
company) and recommendations for improvement

5.2 Disadvantages
๏ Cost: auditors charge for their work
๏ Time and disruption. Auditors have to ask employees questions and have to find documents.
This distracts employees form their day-to-day tasks.
๏ A feeling of not being trusted. Auditors are always looking for independent evidence and are
reluctant to take employees’ word for anything. This can make staff feel that they are not
trusted.

6 Internal audit
6.1 Definition

An internal audit is:

‘An independent appraisal activity established within an organisation as a service to it. It is a control
which functions by examining and evaluating the adequacy and effectiveness of other controls; a
management tool which analyses the effectiveness of all parts of an entity’s operations and
management.’
(CIMA’s Management Accounting Official Terminology)

6.2 Who are the internal auditors.

๏ Usually the internal auditors are employees of the company, through it is possible to sub-
contract the function to an outside company.
๏ Ultimately, they report to the board, but often through the audit committee.
๏ Their main functions are to ensure that the company’s system of internal control adequate
and is working correctly.
๏ Although often concentrating on the operation of financial controls and the accuracy of
accounting records, they can also be given the task at looking at other areas of the business,
such as how staff are recruited to ensure that the procedures represent best practice and
comply with the law.

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6.3 Internal audit – types of assignment

๏ Transactions audit: tracing transactions through the system, often from start to finish, to see if
they are treated correctly. The ability to trace transactions backwards and forwards means
that there has to be a complete audit trail.
๏ Systems audit: an information technology or information systems audit is an examination of
the management controls within an information technology (IT) infrastructure.
๏ Risk-based audits: an internal audit which is primarily focused on the inherent risk involved in
the activities or system and provides assurance that risk is being managed by the
organisation to the defined risk appetite level.
๏ Accounting systems audit: ensuring, for example, that the proper accounting controls are
being applied consistently.
๏ Operational audits: a systematic review of effectiveness, efficiency and economy of operation.
For example, examining how customer complaints are dealt with.
๏ Value for money and best value. Usually associated with public or non-profit organisations. Its
purpose is to assess the effectiveness and efficiency of its use of public funds. For a given
amount of expenditure, what services are delivered? Are these above or below what might be
reasonably expected.?
๏ Management audits: analysis and assessment of competencies, abilities and capabilities of a
company's management in order to evaluate their effectiveness, especially with regard to the
strategic objectives and the implementation of the policies of the business.
๏ Social and environmental audits: A social and environmental audit looks at factors such as a
company's record of charitable giving, volunteer activity, energy use, recycling waste,
diversity in recruitment, non-discrimination in appointments, the standard of the work
environment, workers’ remuneration to evaluate the social and environmental impact the
company is having.
๏ Special assignments such as investigating a case of fraud
๏ Assisting the external auditors.

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7 Comparison of internal and external audit

Internal audit External audit

Reports to Management – must have a Shareholders

clear route to the board
though day-to-day reporting
to the audit committee.
Appointed by Management Shareholders

Power from Management Statute – allows external

auditors to insist on seeing all
documents and to be given
full explanations.
Employed by Company (unless outsourced) External firm
Coverage All categories of risk and Financial statements: true and
investigation fair view
Responsibility for improving A major function of internal Will report to management on
the organisation audit internal control weaknesses

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Tests
Question 1
Which of the following are NOT part of a company’s financial statements that are audited?
(Select at that are relevant)
A Statement of financial position
B Director’s report
C Notes to the financial statements
D A statement of cash flows
E Chairman’s statement

Question 2
What phrase is used in the audit report to describe the financial statements if the auditors
find they are ‘OK’?

Question 3
What are the three types of modified audit opinion?

Question 4
Complete the following table by choosing whether the description related to external or
internal auditors

Internal audit External audit

Reports to shareholders

Appointed by management

Power from statute

Covers all categories of risk
and investigation

Question 5
Which of the following statement are true in relation to external audits and external
auditors? (Choose all that all apply).
A An unmodified audit opinion means that the company is a safe investment
B Auditors should find all errors and frauds
C Auditors check transactions on a test basis
D Prepare the financial statements
E The auditors often rely on testing the internal control system

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Chapter 6
ERROR AND FRAUD

1 Introduction
All organisations keep financial records for both control, planning and performance measurement.
If errors occur in recording, using or presenting information, the organisation is likely to be harmed
and it is therefore important to try to prevent, detect and correct errors.
Fraud implies the deliberate theft of assets, under-statement of liabilities or over-statement of
results. It can cause harm to the organisation and can mislead shareholders and other stakeholders

2 Errors
Errors can be categorised as follows:

Type of error Examples

Error of 1. An invoice arrives from a supplier, but gets mislaid. There is no entry of
omission any sort into the records.
2. A receipt of cash is debited to the cash book, but not credited to sales.
3. An employee does not submit a time sheet, so no wages are paid and
no record is made of how time should be charged to projects or clients.

Errors of 1. An invoice for rent is debited to the repairs account.

commission 2. An invoice is entered twice.
3. A receipt from a customer is credited against the wrong receivables
account.
4. An account is added up and balanced off at $100 too much.

Errors of 1. A receipt of $341 from a customer is both debited to cash and credited
original entry to the customer as $431.
[Right accounts, wrong amounts.]

Errors of 1. An invoice for rent is debited to non-current assets.

principle 2. A receipt from a customer for a credit sale is debited to cash and
credited to sales.
[Principle = a posting to the completely wrong type of account.]

Compensating 1. The rent account is added up as $1,000 too much and the wages
errors account is added up as $1,000 too little.
[Two errors cancel each other out.]

Some errors will not cause the trial balance not to balance. For example, errors 1, 3, 4, 5, 6, 8, 9, 10
and 11 will NOT cause a trial balance to be out because the double entry is complete even if wrong.

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Errors that cause a trial balance to be out of balance are:

๏ One-sided errors (as in 2 and 7)
๏ Incorrect extraction of the trial balance (eg failing to include an account)

3 Fraud
Fraud can be defined as:
an intentional act involving deception to gain unjust or illegal advantage.
Fraud can happen at two levels:
๏ Fraudulent financial reporting. For example, deliberate incorrect accounting by management
to boost profits. This might be done to raise the value of the company, perhaps with the aim
of getting a high buy-out offer. Or it might be that directors’ bonuses are linked to profits and
they report fraudulently high profits to obtain higher bonuses.
๏ Misappropriation of assets. For example, the theft of cash, inventory or non-current assets.

4 Pre-requisites for fraud

Fraud requires: incentive, opportunity and attitude:

Risk factors Fraudulent financial reporting Misappropriation of assets

Incentive/motive • Profitability threatened, so • Personal financial pressure
directors ‘boost’ results • Dislike of employer
• Pressure to perform • Greed
• Incentives eg bonus linked to
profit
Opportunity • Many estimates • Cash
• Complex transactions • High value portable stock
• Dominant chief executive who • Poor IT systems
bullies staff to change amounts • Poor internal controls
• Poor internal controls
Attitude/ • Poor ethical guidance • Other people’s behaviour eg
dishonesty • Dishonesty ‘everyone over-claims expenses’
• Aggressive targets • Dislike of employer
• Poor morale • Dishonesty

We have probably all been under financial pressure and have had the opportunity to steal goods or
money from our employer. But most of us don’t because we do not possess the final condition
necessary to go through with it because we are not dishonest.

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5 Internal control and its role in preventing and detecting

fraud end errors
A good internal control system is essential to preventing and detecting fraud and error.
Internal control can be defined as:

‘The management system of controls, financial and otherwise, established in order to provide
reasonable assurance of:

(a) effective and efficient operation

(b) internal financial control
(c) compliance with laws and regulations.

Good internal control systems should make accounting records more reliable and the
occurrence of fraud and error more difficult.’
CIMA Official Terminology, 2005

The elements of an internal control system are:

๏ Control environment: The culture of the organisation as determined by top management.

Are they concerned about internal control or do they find it a nuisance? Are they proud of the
company’s records or are they sloppy?
๏ Risk assessment: What could go wrong? Where are we vulnerable? High risk implies more
controls are needed.
๏ Control procedures/activities: Detailed controls that are put in place (see later).
๏ Information and communication: Keeping an eye on results and reports to spot when
something looks wrong.
๏ Monitoring: Is the system still effective? Are people operating it as they should?
The internal control system will be fully documented so that employees know how to handle
transactions, receive authorisation, safeguard assets etc. New employees should be trained in areas
of the internal control system that are relevant to them.

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6 Control procedures and activities

These are the procedures and measures that make up the internal control system.
๏ Segregation of duties: split up transactions so that no one person controls all of it. Having
several people involved (eg one to order goods, one to count them when received, one to
post the invoice and finally one to pay the supplier) increases the chance of errors being
found and also make fraud more difficult because employees would need to collude – and
that increases their risk of being found out.
๏ Physical: lock-up valuable assets. Keep valuable inventory in secure stores; bank cash every
night. Carry out spot checks on cash and inventory levels. Ensure all non-current assets can be
accounted for.
๏ Authorisation and approval: For example, all overtime should be authorised by an
employee’s manager; all purchasing over, say, $500 needs two authorisations. It is common to
have different authorisation limits for different management levels.
๏ Management and supervision: Managers and supervisors should manage and supervise
what employees are doing. Are they coming into work late? Do they seem to be taking
shortcuts when carrying out internal control procedures?
๏ Organisation: Ensure that duties and reporting lines are clearly defined and that everyone
knows their function and responsibilities.
๏ Arithmetic and accounting: Calculations should be independently checked. Reconciliations
(eg between balances on suppliers’ account and suppliers’ statements) should be regularly
carried out.
๏ Personnel: Recruit people of the right quality and provide training as needed.

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7 Protection against fraud

The approach to the risk of fraud should include:
๏ Prevention
๏ Detection
๏ Response
Internal control systems as set out above should go a long way towards the prevention and
detection of fraud. Internal audit also has an important part to pay as much of their time is spent
evaluating and testing the operation of internal control, carrying out spot checks and so on.
However, there is a third weapon that is available: the response of the company to fraud when it is
discovered.
The response will include establishing:
๏ How much has the fraud amounted to?
๏ Over what period was it perpetrated?
๏ How was it perpetrated?
๏ Who were the perpetrators?
๏ Who suffered losses?
๏ How can it be prevented in the future?
In addition, the company has to decide what do to with the perpetrators. Presumably they will be
dismissed. But often companies will not report the fraud to the police because this can bring
unwelcome publicity and is an admission of failings in the company’s systems.
However, a declaration that all incidents of fraud will initiate a criminal investigation by the police
can be a powerful method of preventing fraud. If potential fraudsters know that they might face a
jail sentence they will be substantially deterred from committing the fraud in the first place.

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Tests
Question 1
What are the two levels at which fraud can occur?

Question 2
What are the three requisites for fraud?

Question 3
What are the three approaches to fraud management?

Question 4
Complete the following table by choosing the category that best describes the error and
indicate if the error will cause the trial balance not to balance:

Error of Error of Error of Trial balance

omission commission principal out of
balance
An invoice from a customer
gets lost in the post

An invoice from a customer for

$541 is entered into the
bookkeeping system as $451
Repairs of $1,200 are debited
to the cost of non-current
assets instead of the repairs
account
A purchase of $240 is entered
as:
Dr Purchases 240
Dr VAT 40
CR Supplier 240

Question 5
What are the seven categories of internal control procedure that were described?

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Chapter 7
CORPORATE SOCIAL RESPONSIBILITY

1 Introduction
The function of businesses is to yield adequate returns to owners and providers of capital by
identifying and investing in promising projects. In addition to rewarding the suppliers of capital,
the projects will provide jobs and produce goods (or deliver services) that customers want.
Successful businesses will therefore cause economic prosperity – itself a virtue.
When carrying out their activities businesses, of course, must comply with the law (eg the laws to
restrict and manage pollution, or laws relating to health and safety in factories) but corporate social
responsibility (CSR) refers to going beyond what is required by the law. Increasingly, society
expects companies to assess and take responsibility for the company’s effect on the environment
and society, even if not defined by law and regulation.
CSR involves acting as a good corporate citizen, satisfying the needs of many stakeholders, and
reducing adverse effects caused by the organisation’s activities.
One definition of CSR is
‘the continuing commitment by business to behave ethically and contribute to economic
development while improving the quality of life of the workforce and their families as well as of the
local community and society at large’.
Some companies might perceive CSR as an ethical virtue; others might see it as simply being good
for business.

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2 OECD general policies

The Organisation of Economic Cooperation and Development (OECD) has issues general policies
with respect to CSR:
Enterprises should:
1. Contribute to economic, environmental and social progress with a view to achieving
sustainable development.
2. Respect the internationally recognised human rights of those affected by their activities.
3. Encourage local capacity building through close co-operation with the local community …
consistent with the need for sound commercial practice.

4. Encourage human capital formation, in particular by creating employment opportunities and

facilitating training opportunities for employees.
5. Refrain from seeking or accepting exemptions not contemplated in the statutory or
regulatory framework related to human rights, environmental, health, safety, labour, taxation,
financial incentives, or other issues.
6. Support and uphold good corporate governance principles …
7. Develop and apply effective self-regulatory practices and management systems that foster a
relationship of confidence and mutual trust between enterprises and the societies in which
they operate.
8. Promote awareness of and compliance by workers employed by multinational enterprises
with respect to company policies …
9 Refrain from discriminatory or disciplinary action against workers who make bona fide reports
to management or, as appropriate, to the competent public authorities, on practices that
contravene the law, the Guidelines or the enterprise’s policies.
10. Carry out risk-based due diligence…to identify, prevent and mitigate actual and potential
adverse impacts …
11. Avoid causing or contributing to adverse impacts …and address such impacts when they
occur.
12. Seek to prevent or mitigate an adverse impact where they have not contributed to that
impact, when the impact is nevertheless directly linked to their operations, products or
services by a business relationship.
13. Encourage, where practicable, business partners, including suppliers and sub-contractors, to
apply principles of responsible business conduct…
14. Engage with relevant stakeholders in order to provide meaningful opportunities for their
views to be taken into account in relation to planning and decision making for projects or
other activities that may significantly impact local communities.
15. Abstain from any improper involvement in local political activities.

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The OECD policies, above, can be applied to the following areas:

๏ Human rights
๏ Employment and industrial relations
๏ Environment
๏ Combating bribery, bribe solicitation and extortion
๏ Consumer interests
๏ Science and technology
๏ Competition
๏ Taxation

3 The demands of multiple stakeholders

One of the major problems that arises from trying to implement CSR in an organisation is how to
balance the competing demands of stakeholders. In most countries, as a matter of law, it is a
responsibility of the directors to maximise shareholder wealth. However, if the company decides to
go further than required by the law in reducing pollution of increasing workers’ pay, then profits
and shareholder wealth will be adversely affected. How should the requirements of these
stakeholders (employees, the local people and shareholders) be reconciled? The following matters
have to be addressed
๏ What legal right have directors to decide that a company should suddenly start spending
shareholders’ money lavishly on CSR projects picked by the directors?
๏ How do directors decide on which CSR projects money should be spent? Are they simply
spending money on areas that are of interest to them (and their spouses)?
๏ Companies spending generously on CSR reduce their profits and reduce the government’s
tax income. Perhaps the government is better placed to legislate and to spend money on
society. Governments are elected by all the people and can allocate money more logically
across many requirements.
๏ If shareholders really want to contribute more, they can make personal charitable donations
to wherever they please out of their dividends.

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4 CSR and the supply chain

As corporate social responsibility become more important to investors and other stakeholders,
businesses have realised that their supply chain and its management are areas where they are
vulnerable. Many companies are now multi-national and may off-shore production or import
materials and components from abroad. The public is becoming increasingly concerned with the
policies and ethics being applied by overseas manufacturers and suppliers as they believe that the
final product they buy might be tainted by poor practices further down the supply chain.
Examples include:
๏ Rana Plaza, Bangladesh: known structural faults caused a garment manufacturing factory to
collapse killing around 1130 workers. The factory supplied garments to retail chains such as
Primark, Benetton and Walmart.
๏ Foxconn: This company, based in China, assembles iPhones for Apple and has been the
subject of fierce criticism over working conditions.
๏ Nike: In the 1990s Nike insisted that labour conditions in its overseas contractors’ factories
were not its responsibility and that Nike could not be held responsible for the action of sub-
contractors. Nike’s sub-contractors came under attack for their workplace practices, including
the use of child labourers. Nike’s reputation was damaged, the company suffered a backlash
from incensed students, and the company saw its profits fall. The CEO of Nike took action and
began to monitor local factories and to help them to implement workplace and human
resource best practices.
Examples of areas where CSR is relevant to supply chains are:
๏ Environmental Responsibility
Companies need to monitor the environmental impact of suppliers (such as pollution,
biodiversity, use of energy, and develop a purchasing policy that aims to reduce the
environmental impact of their suppliers’ activities, goods and services (‘green buying’).
๏ Human Rights
Human rights in the supply chain, includes issues, such as: slavery, bonded, labour, child
labour, freedom of association, working conditions and wages, exploitation and non-
discrimination.
๏ Sustainability
Sustainability in a supply chain means operating now in ways that will not put at risk the well-
being of future generations. A good example can be seen in the manufacture of wooden
furniture where it is often stated that the wood has been obtained from sustainable sources
Suppliers are not simply chopping down hardwood trees in the jungle. Trees are replaced and
the supply of wood is (allegedly) managed so as not to cause irreparable damage to
ecosystems.
๏ Diversity
Supplier diversity actually refers to initiatives that aim to increase the number of suppliers
under diverse control (eg. ethnic-minority owned or women-owned). By increasing the
diversity of suppliers, buyers obtain access to a wide range of people with talent which
enables them to create valued products and services.

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5 Reporting corporate social responsibility

5.1 The triple bottom line (Elkington, 1994)

A commitment to corporate social responsibility implies a commitment to reporting about a

business' impact for good on the environment and people, as well as its financial results. The triple
bottom line is one framework for reports which include CSR impacts.
It has three sections:
๏ Financial: traditional accounting measures, such as profit.
๏ Social: the effect of business practices relating to labour and the community.
๏ Environmental: the effect of business practices on sustainability and the beneficial or harmful
effects on the environment.
(These are sometimes referred to as profit, people, planet).
Triple bottom line reporting should encourage businesses to think beyond narrow measures of
performance, such as profit. Stakeholders might support a reduction in profits if these were
balanced by improvements in environmental and social measures.
However, there are some potential problems with the approach:
๏ It is not very useful as an overall measure of business performance: quite how to you balance
or compare the results from the three parts?
๏ How should environmental and people elements be measured?
๏ There is no legal requirement to report in this format nor any standardisation that allows
companies to be compared.

5.2 The Global Reporting Initiative

[Link]
GRI is an international independent organisation that helps businesses, governments and other
organisations understand and communicate the impact of business on critical sustainability issues
such as climate change, human rights, corruption and many others.
GRI issues reporting standards grouped like the triple bottom line approach, into environmental,
social and economic standards. For example:
๏ Environmental standards: includes standards for materials, energy, water, biodiversity,
emissions.
The water standard, for example requires disclosures about:
‣ Water withdrawal by source.
‣ Water sources significantly affected by withdrawal of water.
‣ Water recycled and reused.
๏ Social standards: include standards for employment, occupational health and safety, rights
of indigenous people.
The occupational health and safety standard, for example, requires disclosures about:
‣ Workers representation in formal joint management–worker health and safety
committees.

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‣ Types of injury and rates of injury, occupational diseases, lost days, and absenteeism,
and number of work-related fatalities.
‣ Workers with high incidence or high risk of diseases related to their occupation.
‣ Health and safety topics covered in formal agreements with trade unions.
๏ Economic standards: includes standards on anti-corruption, anti-competitive behaviour
The anti-corruption standard, for example, requires disclosures about:
‣ Operations assessed for risks related to corruption.
‣ Communication and training about anti-corruption policies and procedures.
‣ Confirmed incidents of corruption and actions taken.

6 CSR and brand management

There are obvious dangers to brand strengths that can arise from poor CSR policies and
management, whether within the organisation itself or in the wider supply chain (as seen in the
Nike example above). However, there can also be marketing opportunities arising from successful
CSR policies and many companies now advertise their ambition to become carbon neutral or to
recycle a high percentage of materials.
See:
[Link]
[Link]
[Link]

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Tests
Question 1
Is the following statement true or false?
If a company buys from an independent supplier, then the company has no responsibility for how
the supplier operates.

Question 2
What are the three elements of the ‘triple bottom line’?

Question 3
What does the global reporting initiative attempt to do?

Question 4
Is the following statement true or false?
“CSR simply means being a good corporate citizen by obeying the laws with respect to the
environment, consumers, and employees.”

Question 5
Is the following statement true or false?
“Directors have a legal duty to support CSR”

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Chapter 8
CONTRACT LAW

1 What is a contract?
Definition:
A contract is an agreement, supported by consideration, made with intention to create legal
relations.
The essential elements within this definition are:
๏ Agreement. This requires:
‣ An offer
‣ Acceptance of the offer
๏ Consideration (something of value exchanged or promised)
๏ Intention to create legal relations (not just an informal arrangement)

Capacity is also needed, meaning that the parties to the contract must have the mental
capacity to enter into a legal agreement. This means that the parties must be:
๏ Over 18 (in the UK), unless the contract is for necessities.
๏ Of sound mind (including not being under the influence of alcohol or drugs).

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2 Offers
2.1 What is an offer?

An offer is made by the offeror, who will be bound by that offer if it accepted by the offeree.
Offers can be:
๏ Expressed, such as if you said to someone “I will sell you this car for $6,000.”
or
๏ Implied, such as bidding at an auction, or taking an item to a shop check-out and allowing it
to be scanned and charged to your account.
๏ Made to specific individuals (and only they can accept it)
or
๏ Made to the world at large (such as offering a reward for finding a lost item).

Note: English law, which is used as the basis for law in this paper, is often based on legal cases
which form precedents ie legal examples that are followed by judges in subsequent cases. We
illustrate the cases here to give examples of the rules, and to add some interest, but you do not
have to remember the details of the cases.

Case: Carlill v Carbolic Smoke Ball Co (1893)

The company advertised a flu remedy, the Carbolic Smoke Ball, and said that they would give
compensation if any customer caught flu despite using it.

Miss Carlill bought the product, caught flu and claimed her compensation. The manufacturers
claimed that there was no contract because the offer had been made to the world.

Held: there was an offer that Miss Carlill had accepted by using the ball. The compensation
was payable.

2.2 Invitations to treat

An offer must be distinguished from an invitation to treat. This is where one party makes it known
that they are ready to receive an offer. For example, products on supermarket shelves with prices
attached do not constitute offers: these are invitations to you to offer to buy the articles by placing
them in your basket and proceeding to the checkout. Similarly, sales adverts in catalogues,
newspapers and on the Internet are not offers: they are invitations to treat.

Case: Partridge v Crittenden (1968)

Partridge advertised the sale of wild birds. He was charged with offering birds for sale
contrary to a law protecting certain species.

Held: It was held that he was not offering birds for sale but had made an invitation to treat:
buyers would offer to buy them. He was not guilty of the alleged offence.

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2.3 Termination of offers

Offers can be terminated by:

๏ Acceptance. Once an offer has been accepted by one person it is not then available to be
accepted by another. Acceptance means that agreement has been reached.
๏ Rejection. Express rejection will terminate the offer but also any attempt to negotiate or
making a counter offer is also rejection. Note that simply asking for more information does
not count as rejection.
๏ Revocation (withdrawal) of the offer before it is accepted.
๏ Lapse. For example, the offeror had stipulated that the offer will lapse in five days if
acceptance has not been received.
๏ Death of the offeror where the offer was for personal services ie only the offeror could carry
out the contract.
๏ Failure of a condition that attached to the offer. For example, an offer to sell an item on credit
subject to satisfactory credit references.

Case: Hyde v Wrench (1840)

Hyde offered to sell his farm for £1,000. Wrench made a counter offer for £950, which Hyde
refused. Wrench then said that he would accept the £1,000 offer after all, but Hyde then
refused to sell.

Held: Hyde was entitled to refuse to sell because his offer had been terminated by the
counter-offer.

Case: Byrne v Van Tienhoven & Co (1880)

On 1 October Van Tienhoven & Co posted a letter to Byrne & Co offering to sell a product.
Byrne and Co got the letter on 11 October and telegraphed  acceptance immediately.
However, on 8 October Van Tienhoven & Co had sent another letter withdrawing their offer,
and so they refused to go through with the sale.

Held: It was held that the withdrawal of an offer is not effective until it had been successfully
communicated to the offeree. Acceptance by the offeree before they receive notice of the
revocation will be considered a valid acceptance

Note that is can be difficult to revoke an offer if it had been made to the whole world. Such
contracts are called unilateral contracts. The difficulty is in ensuring that everyone who saw the
offer also sees the revocation and also that they have not begun to carry out what was required –
which would imply acceptance of the offer. For example, someone offers a reward for finding a lost
pet, but a week later decides to withdraw that offer. In the meantime, someone has begun looking
for the pet and finds it (after the attempted withdrawal) then claims the reward. The offer of the
reward cannot be revoked with respect to the person who finds the pet.

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3 Acceptance
3.1 What is acceptance?

Acceptance must be unqualified and unconditional, otherwise it will constitute a counter-offer that
will terminate the original offer.
Acceptance can be given in writing or orally or be construed by conduct, but silence cannot
constitute acceptance. The offeree has to do something to indicate acceptance. So, if you are sent
an unsolicited item through the post you cannot be forced to pay for it if you ignore it even if you
are told that, unless the seller hears otherwise, you are deemed to have accepted it.

3.2 Communication of acceptance

The offeree must communicate acceptance to the offeror either personally or by an authorised
third party. There can be complications as to when acceptance is actually received.
๏ The postal rule: if acceptance is posted, acceptance occurs when the acceptance letter is
posted. Note that if an offer is posted, it ‘occurs’ when the letter is received by the offeree.
When a revocation is posted it ‘occurs’ when received by the offeree, provided that is before
acceptance has taken place.
๏ Telephone/fax: In general, instantaneous communication mechanisms mean that
acceptance is made when the message is received. However, if a fax had been received or
telephone message recorded outside business hours then acceptance would not be effective
until the business opened.
๏ Emails: Probably still developing, but it seems that acceptance is communicated when
received by the offeror’s email system

Case: Household Fire Insurance Co v Grant (1879)

Grant applied for shares and the letter accepting his application was posted. However, the
letter was lost in the post. Later Grant was required to pay for the shares.

Held: It was held that the contract to buy shares was formed when the acceptance letter had
been posted.

Case: Felthouse v Bindley (1862)

A man offered to buy a horse, saying to the seller that if he heard nothing by the weekend he
would consider the horse his. The horse was, however, sold instead at an auction and the
auctioneer was accused of selling a horse that had been already sold to someone else.

Held: There was no contract as the contract had not been accepted. Silence is not
acceptance.

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4 Consideration
4.1 What is consideration?

Offer and acceptance are not enough to form a contract: consideration is also needed. This means
that both sides of the contract must give or do something for the other side (or promise to do so).
The exchange of considerations could be:
๏ Money for goods
๏ Goods for goods
๏ Money for a service
๏ Money to escape an obligation etc
If the consideration is given at the time the contract is made (eg buying goods in a shop) it is
known as executed consideration. If the consideration is the promise to do something in the future
(eg agreeing to work for someone for a salary, starting in a month) it is known executory
consideration. For consideration to be valid it has to comply with a number of rules set out below.

4.2 Consideration must not be in the past

Past consideration refers to value that was promised before the contract was negotiated. So, if you
tidy an elderly neighbour’s garden and she then promises that she will then pay you $20, the
payment cannot be enforced because tidying the garden was not dependent on receiving $20. The
tidying is on the past.

Case: Re McArdle (1951)

A man moved into his deceased father’s house temporarily and repairs costing £488 were
carried out. The man and his brothers and sisters were to inherit the house equally, so the
brothers and sisters signed a document promising to reimburse £488 when the house was
sold. However, no payment was made.

Held: The repairs had been done before any agreement to share costs so there was no
enforceable contract.

4.3 Consideration must move between the parties to the contract

An action to enforce a contract or to claim damages can only be enforced by someone who has
given consideration.

Case: Tweddle v Atkinson (1861)

A couple were getting married. The two fathers each pay the couple a sum of money. Both
fathers died and the bride’s father had not paid the amount promised. The groom claimed
against the estate of the bride’s father.

Held: The claim failed because the groom was not party to the agreement and had given no
consideration: the agreement had been between the two fathers.

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4.4 Consideration must be sufficient but need not be adequate

This means that the consideration given must have some value (sufficient) but does not need to
match or be even close to the value being received (does no need to be adequate).

Case: Chappell and Co Ltd v Nestle and Co Ltd (1859)

Nestle ran a promotion in which customers could send in three chocolate bar wrappers and a
small amount of money and receive a vinyl record in exchange. For complicated copyright
reasons it had to be decided whether or not the wrappers formed part of the consideration –
even though thrown away by Nestle.

Held: It was held by the court that the wrappers were part of the consideration The wrappers
had some value to Nestle because insisting that customers enclosed them would mean that
sales would be boosted.

4.5 Carrying out a contractual or statutory duty is not consideration

Case: Collins v Godefroy (1831)

Collins was required by law to appear in court as an expert witness in a case involving
Godefroy who promised to pay Collins a sum of money for his time.

Godefroy then failed to pay.

Held: Collins had no claim. He had a legal duty to attend court so had done nothing else for
the payment promised.

4.6 Consideration cannot be illegal

Illegal consideration is an act or a promise which is considered to be against the public interest or
contrary to law.

Case: Foster v Driscoll (1929)

Foster agreed to smuggle whisky into the USA during prohibition. Payment was not made.

Held: Court the court would not enforce the contract because the consideration (ie
arranging to smuggle) was illegal.

4.7 Speciality contracts

Sometimes consideration is not needed in the formation of a valid contract. These contracts are
known as ‘speciality’ or ‘deed’ contracts, and they are made under seal. Promises under seal are
called ‘covenants’ and are enforceable even though consideration was not given.
For example, a grandparent could promise to fund a grandchild at university. This would be
unenforceable unless the promise is given in a deed, which is a formal document that requires
signatures and witnesses.

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5 Intention to enter into legal relations

For a contract to be valid there must have been an intention to enter into legal relations. Not
every agreement leads to a contract which can be enforced through the courts. For example, you
might have an agreement to meet a friend at a in a restaurant. It would be good manners to do so
but your agreement would not create a legal duty to do so. This is much more in the nature of a
social and domestic agreement and that is understood on both sides. Contract law is primarily to
do with commerce and business.
Also, if the parties can enter into an agreement marked as ‘subject to contract’ this will not be
enforceable until a formal contract is executed.

Case: Simpkins v Pays (1955)

Three women lived in the same house and regularly entered a newspaper competition, which
required the listing of eight items in order of merit. Each woman made a list, and the three
entries were submitted on one form. There was no fixed arrangement about paying the entry
fee and posting the form but the form was submitted in the defendant’s name. One of the
lines won £750, which was paid to the defendant and the plaintiff sued to recover a third
share of this.

Held: The judge held that there was evidence of an agreement to share the winnings,  and
that this was intended to be legally binding.

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6 Terms, warranties and conditions

6.1 What is a term?

A term is any provision that is part of a contract. Terms specify the details about what each party
has promised to do. Most terms are expressly agreed between the parties but there can also be
implied terms.
Terms divide into:
๏ Conditions
๏ Warranties

6.2 Conditions compared to warranties

A condition is vital to a contract and if breached will give the innocent party the right to repudiate
(terminate) the contract and to claim damages.
A warranty is less fundamental than a term. The breach of a warranty will not cause the contract to
end, but can give rise to damages.
The distinction can be a fine one as these two cases show (same year, both opera related!):

Case: Poussard v Spiers (1876)

Mme Poussard was an opera singer who contracted to perform for three months. Because of
illness she missed the opening night and the next three. Spiers replaced her with another
singer and claimed that the contract with Poussard had ended.

Held: Madame Poussard was in breach of condition because she missed the opening night
which was the most important performance because reviews of the production would be
based on this night. Spiers were entitled to end to contract.

Case: Bettini v Gye (1876)

Bettini was an opera singer who contracted to perform for three months. Because of illness he
missed a number of days of rehearsals and Gye replaced him.

Held: Missing several days of rehearsals was not vital to the contract so Bettini was in breach
of a warranty only. Gye was not entitled to end the contract.

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6.3 Implied terms

As mentioned above most terms will be expressly negotiated by the parties to the contract, but
some terms are implied by custom, fact or law.
๏ Custom. For example:

Case: Hutton v Warren (1836)

The claimant, a tenant farmer had planted seeds, but before the harvest the tenancy was
terminated. The tenant billed the landlord for the costs of seeds and the value of the labour.
The landlord refused to pay claiming that there were no terms in the contract that covered
this payment.

Held: The tenant was entitled to payment because that was the customary procedure in
tenancy terminations.

๏ Fact.
Terms implied as fact are based on the assumed intention of the parties and it is assumed that
these terms would have been included had the parties thought about it at the time.

Case: The Moorcock (1889)

A ship was moored at the defendant's wharf. When the tide went out the ship became
damaged by rocks. The claimant claimed damages from the defendant but the defendant
argued that there was no term in the contract about the condition of the river bed.

Held: The court implied a term in fact, that the river bed would be safe for mooring: it made
no sense to have the contract without such a term.

๏ Law.
For example, the law gives protection to consumers against retailers and tenants against
landlords.

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7 Misrepresentation
7.1 What is a misrepresentation?

A misrepresentation is a false statement of fact or law which induces one party to enter into a
contract.
Note the requirements. The statement must be:
๏ False.
๏ Relating to fact or law.
๏ Induces one party to enter a contract.
There are three types of misrepresentation:
๏ Innocent.
๏ Negligent.
๏ Fraudulent.
Contracts based on misrepresentations are voidable, if wished, by the innocent party – meaning
that the parties are returned to their original positions.

7.2 Fact or law

There has to be a false statement about a fact or law; a statement about future intentions is no a
misrepresentation unless there had been no intention of carrying out the action. A statement of
opinion will not be a misrepresentation unless the utterer knew the facts and ‘opinion’ was an
attempt at cover-up. Silence will not generally amount to a misrepresentation but smiles and
gestures can do.
However, there are some contracts where there is a duty of ‘utmost good faith’ (“uberrimae fidei”)
or there is a duty of good faith (fiduciary duty) where all material facts have to be disclosed. For
example, if you were taking out life insurance you have to disclose all previous health problems
even if the insurance company does not specifically ask about them.
Half-truths can be misrepresentations. Also if a statement becomes false later the change in
circumstances must be disclosed.

Case: Bissett v Wilkinson (1927)

A man buying land to use as a sheep farm asked the seller how many sheep the land would
hold. The seller had not kept sheep on the land but estimated that 2,000 sheep could be
supported. Based on this statement the land was purchased. However, the estimate turned
out to be too high and an action was brought for misrepresentation.

Held: The statement was a statement of opinion and not a statement of fact and therefore
not an actionable misrepresentation.

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Case: Edgington v Fitzmaurice (1885)

A company issued shares stating in the prospectus that the capital raised was going to be
used to expand the company. In fact, the company had cash flow problems and the money
was going to be used to pay the company’s creditors.

Held: Although the prospectus contained a statement of future intent, because the company
had no intention of using the money in this way it had made a misrepresentation.

7.3 Induces a one party to enter a contract

After establishing that a false statement of fact or law has been made, it is then necessary to show
that the statement induced one party to enter the contract. There is no misrepresentation if the
statement had been ignored, disregarded or was unknown to the party affected.

Case: Attwood v Small (1838)

A preliminary agreement was made for the purchase of an estate that generated income. The
accounts supplied by the defendant were checked by the claimant’s own accountants, who
were satisfied they were accurate, and so the claimant completed the purchase. In fact, the
accounts had exaggerated the income generated by the estate and the claimant brought an
action for misrepresentations.

Held: The claimant was unsuccessful. By getting his own experts to check the reports he had
relied on his own judgement and the work of his own experts rather than on what was said
by the defendant.

7.4 Innocent, negligent and fraudulent misrepresentations

๏ Innocent: the person making the misrepresentation believed the statement to be true.
Damages or rescission (reversal of the contract) are the remedies.

๏ Negligent: a negligent misrepresentation is a statement made without reasonable grounds

for belief in its truth.
Damages and rescission can be awarded.
๏ Fraudulent misrepresentation: where the statement is made
‣ knowing it to be false, or
‣ without belief in its truth, or
‣ recklessly, careless as to whether it be true or false
Damages and rescission are the remedies.

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8 Companies and contracts

Companies are regarded as legal persons and are able to enter into contracts in their own right. The
company can be sued and can sue under the contract.
It will be the directors who cause the company to enter contracts and sometimes there can be
limits to their authority to commit the company. Major contracts should always be authorised by
board resolution.
If a director exceeds his or her powers then that director can incur personal liability, but can be
relieved from this if the board subsequently ratifies (approves) his or her actions.
If a director’s conduct amounts to negligence, breach of duty or breach of trust, the shareholders
must ratify the director’s actions.

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Tests
Question 1
What are the four essential elements of a valid contract?

Question 2
Which two of the following statements are true?
A Consideration can be future
B Consideration can be past
C Consideration must be sufficient but need not be adequate
D Consideration must be adequate but need not be sufficient

Question 3
Which of the following is the more fundamental and vital to a contract?
A Warranty
B Condition

Question 4
Are the following statements likely to be a misrepresentation?
A “The car has been regularly serviced and has never been in an accident.” [In fact the car was
rarely serviced and had been repaired after a serious accident]
B “I think this model was one of the best made by Ford.”
[In fact, most motoring journalists though this model was poor and unreliable]

In both cases the buyers of the cars decided to buy because they were looking for a reliable
vehicle.

Question 5
Is there an enforceable contract in the following situation?
1/3/2018: Offer communicated to the buyer by telephone
5/3/2018: Buyer posts acceptance
5/3/2018: Seller revokes the offer by post

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Chapter 9
EMPLOYMENT LAW

1 Employment
An employer-employee relationship implies that there is a contract of service and the employer
controls how, when and where the work is done.
This has to be contrasted with a contract for services which is the relationship that exists between
a self-employed person and whoever is paying him or her.
There are mutual of obligations between employers and employees. For example, the employee is
obliged to work and the employer is obliged to pay wages or a salary. The employee must perform
the work personally and cannot sub-contract to someone else.

2 Employment contracts
2.1 Terms

Contract terms could be:

๏ In a written contract, or similar document like a written statement of employment.
๏ Verbally agreed.
๏ In an employee handbook.
๏ In an offer letter from the employer.
๏ Required by law (eg an employer must pay employees at least the National Minimum Wage).
In the UK employment contracts do not have to be written, but an employer must give employees
a ‘written statement of employment particulars’ if their employment contract lasts at least a month
or more. This isn’t an employment contract but will include the main conditions of employment.

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2.2 Written statement of employment particulars

A written statement can be made up of more than one document but the principal statement will
include
๏ The employer’s name.
๏ The employee’s name, job title or a description of work and start date.
๏ How much and how often an employee will get paid.
๏ Hours of work (including weekend and shift work details).
๏ Holiday entitlement.
๏ Sick pay entitlements and arrangements.
๏ Where an employee will be working.
๏ How long a temporary job is expected to last.
๏ The end date of a fixed-term contract.
๏ Notice periods.
๏ Collective agreements ie agreements negotiated with trade unions.
๏ Pension contributions and entitlements.
๏ To whom go to with a grievance.
๏ How to complain about how a grievance, disciplinary or dismissal decisions.

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2.2 Implied terms

๏ The duty to maintain mutual trust and confidence
This implies a duty on the part of an employer not “conduct itself in a manner calculated or
likely to destroy or seriously damage the relationship of trust and confidence between the
parties”. It is a duty to act rationally and not so perversely that no reasonable employer would
act in such a way.
๏ Fidelity
This requires the employee to serve the employer faithfully. It is implied in all employment
contracts and means that an employee may not act against the interests of the employer. It
becomes particularly relevant if the employee is thinking about leaving and working for a
competitor (obviously the employee could take confidential information with him or her), or
setting up a competing business (where poaching customers of the old employer might be
attempted).
๏ Not to steal from the employer
Not a surprising implied term!
๏ Employees should obey their employees
Employees should obey their employees in respect of lawful and reasonable orders.
๏ Reasonable care and skill
Employees must exercise reasonable care and skill. The level required will depend on the
experience and qualifications of the employee.
๏ Safe working environment
Employers are required to provide a safe working environment for their employees.
๏ Something necessary to do the job
For example, a delivery van driver must have a driving licence.
๏ Duty to provide work
While there is generally no duty for an employer to provide work for its employees, such an
obligation does arise if the employee must be allowed to work to maintain his or her skills or
public profile.
๏ References
There is no duty to supply these but if they are supplied there is a requirement for them to be
accurate.

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3 Workplace policies and procedures

3.1 Anti-discrimination legislation

There is now equal opportunity legislation in many European states aimed at anti-discrimination
with respect to employment, whether it’s engaging people, promoting them or paying them.
Anti-discrimination laws can relate to:
๏ race,
๏ sex,
๏ disability,
๏ religion,
๏ sexual orientation,
๏ age
Equal opportunities legislation identifies three types of illegal behaviour:
๏ Direct discrimination. An example of this would be if you advertised for a salesman. That is
direct discrimination because you are asking only for male applicants or male employee.
๏ Indirect discrimination is more subtle and indeed often employers fall into this trap
inadvertently. An example of rather obvious indirect discrimination would be if you
advertised for a salesperson but then stipulated that that person had be two meters tall with
a large, black beard. Most courts would assume that this would favour male applicants.
Stipulating height minimums would probably be an example of indirect sex discrimination
because men are, on average, taller than women.
๏ Victimisation. This is where someone has complained about discrimination and then later on
within the workplace they are treated poorly or otherwise discriminated against because they
complained.

3.2 Diversity

Diversity of employment is ensuring that the composition of the workforce reflects the population
as a whole. There are sound reasons for diversity.
๏ You’re likely to attract a wider range of candidates if you are known as an employer who
embraces diversity. Diversity means more than diversity in race or sexual diversity; it can also
mean offering people part-time work or allowing them to work from home. If you can offer
part-time work or home working you may well get additional good candidates worthy of
consideration. So why reduce the field by putting unnecessary restrictions?
๏ A diverse workforce brings a variety of skills. If you employ people just like yourself, you’ll
probably get skills just like yours.
๏ The diverse workforce might better reflect customers and clients so your customers and
clients are likely to feel more comfortable.
๏ You may be able claim the moral high ground by having a diverse workforce and this of itself
may be attractive to customers, clients, and potential employees.

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3.3 Bribery and corruption

Improper payments of cash or gifts to third parties can be described as:

๏ Bribery: payments to induce someone to do something they shouldn’t do. For example, to
induce the person to award you a contract when you were neither the cheapest or best
supplier. Note that small amounts of entertainment and low-value gifts are allowed.
๏ Facilitation payments: payments to induce someone to do something they should be doing
anyhow. For example, payments to customs officers to inspect goods quickly. In the UK
facilitation payments are regarded as bribes under the Bribery Act 2010
A company will not commit the offence of failing to prevent bribery if it can show that it had
‘adequate procedures’ in place to prevent bribery. What counts as ‘adequate procedures’ will
depend on the bribery risks faced. If, having assessed the position, a company believes that there is
a risk of bribery then, if it wants to rely on the defence, the procedures adopted should be
proportionate to that risk.
Conflicts of interest can also be included in this section. For example, if your brother is the sales
manager of a supplier to you company there is an obvious risk that you will place orders with your
brother’s company even if it is not the most suitable supplier.
It would be normal to include anti-bribery regulations as a term in an employment contract.

3.4 Whistle-blowing

Whistleblowing is defined as “making a disclosure that is in the public interest”.

Many frauds are known about or suspected by people who are not involved in the dishonesty. The
challenge for management is to encourage these ‘innocent’ people to speak out and to
demonstrate that it is very much in their own interest to do so. Reporting mechanisms are a very
important element of risk management and fraud deterrence.
There can be many conflicting emotions influencing the potential ‘whistle-blower’:
๏ working group/family loyalties
๏ intimidation
๏ fear of consequences
๏ suspicion rather than proof.
The organisation’s anti-fraud culture and reporting processes can be a major influence on the
whistle-blower, as it is often fear of the consequences that has the impact. To the whistle-blower
the impact of speaking out can be traumatic, ranging from being dismissed to being shunned by
other employees. Confidential reporting mechanism might help.

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In the UK, whistle-blowers (employees, trainees, agency workers) are protected by law if they
report:
๏ a criminal offence, eg fraud
๏ someone’s health and safety is in danger
๏ risk or actual damage to the environment
๏ a miscarriage of justice
๏ the company is breaking the law, eg doesn’t have the right insurance
๏ you believe someone is covering up wrongdoing
Personal grievances (eg bullying, harassment, discrimination) aren’t covered by whistleblowing
law, unless your particular case is in the public interest.
To enjoy legal protection, disclosures by whistle-blowers must actually be in the public interest.
Therefore, in order to be protected by the law the whistle-blower must:
๏ Have made the disclosure in good faith – in other words you must be disclosing the
information because it is in the public interest and is clearly wrong.
๏ Reasonably believe that the information is substantially true.
๏ Reasonably believe you are making the disclosure to the right prescribed person.

3.5 Money laundering

Definition:
A process whereby the proceeds of criminal activity are converted into assets appearing to have a
legitimate origin.
For example, the illegal funds could be the result of drug-dealing, prostitution or people-trafficking.
There are three stages in money laundering:
๏ Placement of the illegal monies into a legitimate business activity. Businesses generating
cash are often used because the illegal money can be paid in and described as sales. Tax will
be paid on it, but that’s a small price to pay for making the cash appear legitimate. However,
there is a danger that this will be spotted so therefore the next stage is also carried out.
๏ Layering – the transfer of money from place to place to conceal its source. This often involves
passing the money through several countries and many bank accounts.
๏ Integration to make it appear that the money, after its travels, is legitimate.
In the UK and many other countries there is a duty to report suspicions about money laundering to
the financial authorities or to the police. There can also be sanctions against ‘tipping off’ the
perpetrators by, for example, telling them that you have reported them.

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3.6 Social media

Social media such as Twitter and Facebook have become important marketing and communication
tools. Marketing is to outside entities but communication can both inside and outside the
organisation.
You will be aware of phenomena such as ‘trolling’ where offensive, rude or sarcastic remarks are
made - often under the cover of anonymity. Even email exchanges can become offensive because
there is a tendency to answer immediately without full thought or a period of time in which to cool
down.
One employee bullying another using social media can be very costly to the employer if the bullied
employee can show that bullying occurred and that the employer took no steps to prevent it.
Offensive remarks made directly to customers are obviously bad news, but employees should also
be careful about remarks and pictures they post on their Facebook accounts as careless privacy
settings can let customers, suppliers, competitors and other employees have access.
Organisations must ensure that they have policies in place governing employees’ use of social
media – not only because of the damage it can cause but because employees might spend too
long on various applications rather than getting on with their work.

4 Data protection
4.1 Introduction

Huge amounts of data about employees, customers and suppliers can now be easily stored on IT
systems. This has the following implications:
๏ Is the data correct and up-to-date?
๏ Is it held safely?
๏ What damage could be caused if the system was ‘hacked’ so that others could access it?
๏ Is the data relevant to the decisions being made using it?
Data and IT are now recognised and major strategic resources, and like all major assets must be
protected and used properly.

4.2 Viruses, hacking, backups and disaster plans

All machines and the network should use anti-virus software and firewalls to prevent hacking or
loss or corruption of data. Employees should be trained about the dangers of downloading
material (particularly unsolicited material) from the Internet and using USB sticks that can pass
viruses from machine to machine.
Data should be regularly backed up and the copies kept securely at a separate location. If the
company is very IT dependent it should have a disaster recovery plan that will allow processing to
resume quickly even if their IT system has been destroyed, eg by flood, fire or act of terrorism.

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4.3 Data Protection Act

Many countries now have data protection legislation to safeguard the use of personal data. In the
UK, it is the Data Protection Act 1998 and this implements an EU directive and lays down the
following principles (shared in the legislation of many countries):
๏ Data shall be processed fairly and lawfully.
๏ It can be obtained for only one or more specified and lawful purposes.
๏ It mustn’t be excessive to what’s required.
๏ It must be accurate and kept up-to-date.
๏ It mustn’t be kept for longer than necessary.
๏ Personal data shall be processed only in accordance with the rights of data subjects. The data
subject is a person about whom the data is held and that person has certain rights. For
example, they have a right to see the data and they have a right to insist that it’s corrected.
The people holding the data have to register with a government body and there they have to
say what data is held, why it is held and to whom it might be supplied.
๏ Appropriate measures shall be taken against unauthorised and unlawful processing and also
care has to be taken over the accidental loss or damage to personal data.
๏ Personal data must not be transferred to a country or territory outside the European
Economic Area unless there is similar legislation giving similar protection in that area.

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5 Health and safety

Health and safety legislation imposes duties on both employers and on employees.

5.1 Health and safety – employer’s duties

๏ Work practices and the work environment must be safe and healthy.
๏ The plant and equipment should be maintained to the necessary standard.
๏ There should be information, instructions, training and supervision so people know how to
work the machinery and that safe working practices are adopted.
๏ People should know that there is a health and safety policy.
๏ People should be aware of the organisation’s safety policy.
๏ Employers must carry out risk assessments, thinking ahead, identifying risks, seeing to what
extent those risks need to be worried about, and providing training, guidance, and protection
as necessary.
๏ Note there is a requirement to share hazards and risk information with others.
๏ You have to identify employees who are particularly at risk.
๏ You must employ competent safety and health advisors.
๏ Within the organisation there will be a safety representative from the employee side, and
probably a safety committee which meets regularly to consider health and safety matters.

5.2 Health and safety – employees’ duties

๏ They have to take reasonable care of themselves and others and for example these duties
could be breached by employees playing practical jokes with their colleagues.
๏ They must allow the employer to carry out the duties in relation to safety. They mustn’t
interfere intentionally or recklessly with machinery for example by taking off guards from
machine.
๏ They must inform the employer of any situation which they think is a danger. For example, if
an employee sees that a machine has deteriorated and is now perhaps dangerous they have a
duty to inform their employer.
๏ They have to use equipment properly, making use of all the safety features that it may
incorporate.

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5.3 Health and safety policy

Some companies establish and publish a health and safety policy. This will usually have the
following sections:
๏ First, a statement of the principles.
๏ There will then be a section on certain procedures, perhaps relating to fire safety procedures.
๏ They may emphasise how important it is to comply with the law, and in some cases state
what is necessary to comply with the law.
๏ There may be a section on the detailed instructions about operating machinery.
๏ A section dealing with the training requirements, and perhaps the qualifications needed to
ensure that health and safety policies are properly implemented.

6 Disciplinary procedures, employment protection and

termination
6.1 Disciplinary procedures

These may be needed to address issues of both misconduct (such as poor time-keeping or health
and safety breaches) and poor performance. It is important for disciplinary procedures to be
handled properly because otherwise, if they lead to dismissal, it is likely that employment tribunals
will find the dismissal unfair.
Initially there will be an informal talk with the employee and that might be enough to correct
performance.
If that doesn’t product results, then there should be a verbal warning. This can be informal (not
entered on the employee’s record), or formal (entered on the employee’s record).
If improvements are still not made (and in some cases time must be given for this) then there will
be:
๏ First written warning
๏ Second (final) written warning
๏ Suspension/demotion/dismissal
Some acts, termed gross misconduct, are so serious that they may justify dismissal without initial
warnings. But a fair disciplinary process should always be followed, before dismissing for gross
misconduct. A fair disciplinary procedure will follow the following steps:
๏ Establish the facts. It is important to carry out investigations of potential disciplinary matters
promptly to establish the facts of the case. This might require an investigatory meeting with
the employee before proceeding to any disciplinary hearing. In others cases the investigation
stage will be the collection of evidence by the employer for use at any disciplinary hearing.
๏ Inform the employee. If there is a disciplinary case to answer, the employee should be
notified of this in writing with enough information about the alleged misconduct or poor
performance allow the employee to prepare a response at a disciplinary meeting. The
notification should also give details of the time and venue for the meeting and advise the
employee of their right to be accompanied at the meeting.
๏ Hold the disciplinary meeting. This should be held without unreasonable delay whilst
allowing the employee reasonable time to prepare their case. The employer should explain

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the problem and go through the evidence that has been gathered. The employee should be
allowed to answer any allegations that have been made and to ask questions, present
evidence and call relevant witnesses.
Workers have a statutory right to be accompanied by a companion where the disciplinary meeting
could result in:
๏ a formal warning being issued; or
๏ the taking of some other disciplinary action; or
๏ the confirmation of a warning or some other disciplinary action (appeal hearings)
Decide on action. After the meeting decide whether or not disciplinary or any other action is
required and inform the employee in writing.
Appeals. If an employee feels that disciplinary action taken against them is unjust they should
appeal against the decision. Appeals should be heard without unreasonable delay and should be
dealt with impartially and wherever possible, by a manager who has not previously been involved
in the case. Workers have a statutory right to be accompanied at appeal hearings.

6.2 Employment protection and the termination of employment

The law increasingly gives employees protection. Health and safety was one aspect of that, as are
the laws governing equal opportunities. Here we deal with the termination of employment.
Employment can be ended in three ways:
๏ Retirement
๏ Resignation
๏ Dismissal.
There are three forms of dismissal:
๏ Termination by the employer (sacking)
๏ Ending a fixed term contract without renewal
๏ Constructive dismissal. This is where the employer’s behaviour entitles the employee to
presume he or she has been dismissed.
Wrongful dismissal is when the dismissal breaches the contract of employment, for example, not
giving the employee the agreed amount of notice. A more serious problem is unfair dismissal, a
part of the law that gives the employee some protection as it is assumed that dismissal is unfair
unless the employer can prove it to have been fair.
Dismissal is fair is:
๏ It is caused by redundancy (and selection of redundant employees is fair).
๏ Non-capability: the employee is incapable of doing the job despite training.
๏ Legal restrictions: such as a driver losing his or her driving licence.
๏ Misconduct: provided suitable warning have been given. Gross misconduct (eg hitting a
customer!) can be grounds for instant dismissal.
๏ Other substantial reasons: for example, the sales director is married to the sales director of a
rival.

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Dismissal is automatically unfair if it is because of:

๏ Pregnancy.
๏ Membership of a trade union.
๏ Carrying out health and safety procedures.
๏ Insisting on employment contracts and payslips.
Disputes about dismissal can be heard by an employment tribunal (effectively a court). If the
tribunal finds for the employee, then there are three possible remedies:
Reinstatement. The employer gives the employee the old job back. However, you’ll understand
that usually the old job won’t be available anymore because it will have been given to somebody
else.
Re-engagement. The employee is given a job comparable to the old one. Of course, there might
not be a suitable job and again you’ll realise by this stage of events the employee and the employer
probably aren’t on best terms anyhow.
Compensation. This is by far the most common remedy and sometimes the compensation can be
very high if it’s found that the employer has acted very badly.

Tests
Question 1
Which one of the following is true?
A Employment means a contract for service
B Employment means a contract for services

Question 2
What does the implied term ‘fidelity’ mean?

Question 3
What are the three types of illegal behaviour identified in anti-discrimination legislation?

Question 4
What is the distinction between ‘bribes’ and ‘facilitation’ payments?

Question 5
What are the three ways in which employment can end?

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Chapter 10
BUSINESS ORGANISATIONS

1 Types of business organisation

1.1 Introduction

The common legal structures are:

๏ Sole traders
๏ Partnerships
๏ Limited companies (incorporated entities)

1.2 Sole traders

Most businesses start life with a sole trader structure. This means that a person simply begins to
trade with very little formality. There is no legal distinction between what the business owns or
owes and what its owner owns or owes. This means that the owner has unlimited liability for the
debts of the business. If the business fails, people owed money by it can pursue the owner’s
personal assets.
The owner puts capital into the business, the business trades and the owner can take out profits as
drawings. The owner pays income tax on the profits made by the business.
The business assets, including goodwill can be sold to a new owner but, strictly, this means that the
original business has ceased and a new on starts with the new owner. A sole trader business
automatically comes to an end if the sole trader dies. The business may still have a value – stock,
buildings, equipment and goodwill, but the business itself will legally cease. The business assets
will form part of the sole trader’s estate and pass on to beneficiaries under the terms of the will.

1.3 Partnerships

If two or more people trade together with a view to profit, then a partnership is formed. Each
partner will contribute agreed amounts of capital and profits are shared according to whatever
agreement has been made between them. Each partner has unlimited liability for the debts of the
business.
As with sole traders, tax on partnership profits is paid by the business owners through their income
tax.
Unless provision is made in the partnership agreement, the partnership will cease on the death of a
partner and the deceased partner’s estate becomes entitled to their share of the business. The
remaining partners will have to pay the deceased partner’s estate the value of the deceased’s share.
Many countries now allow the formation of limited liability partnerships which operate like
partnerships, but which also offer the partners limited liability for the business’s debts.

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1.4 Limited companies

Limited companies require more formality to establish. They have to be registered with the
relevant government organisations (in the UK, The Registrar of Companies). The most common
type of company is one limited by shares. This means that shareholders’ liability is limited to the
value of their shares. Note that the liability of a limited company for its debts is unlimited: it is the
liability of the shareholders that is limited.
Limited companies (or incorporated bodies) are known as ‘legal persons’ (or ‘persona at law’). They
have a legal existence that is separate from their owners. In particular they can:
๏ Own property in their own name
๏ Be liable for their own debts
๏ Sue and be sued
๏ Face criminal charges (eg if an employee were injured)
๏ Pay their own tax (corporation tax).
Many large limited companies are listed (or quoted) on stock exchanges where their shares can be
freely bought and sold by investors. A listed companies’ shares have a share price that depends on
supply and demand for those shares. Typically, these prices vary frequently and the latest prices
can be seen in the financial press or on the internet. This lets investors see immediately what their
shares are worth.
Shareholders can receive a share of the company’s profits if the company directors decide that the
company should pay a dividend. Dividends are defined as a payment per share owned. The
shareholders will also benefit if the value of their shares increase so that they make a profit when
the shares are sold.
Usually limited companies are profit-seeking, but don’t have to be. For example, a charity or school
could use this legal structure.

2 Advantages and disadvantages of the limited company

format
2.1 Advantages of the limited company
๏ Tax: From time to time there are tax benefits. The corporation tax rate is often lower than
income tax rates to attract businesses into the economy. Shareholders are taxed only on
dividends paid out. Many shareholder-directors pay themselves a small salary and large
dividends and this arrangement can save tax.
๏ Limited liability: the personal wealth of investors is protected because their liability is
limited.
๏ Succession: because companies have a separate legal existence they can continue in
perpetuity even as shareholders change or die.
๏ Easy transfer of shares: ownership is represented by shares and these can be bought and
sold in small quantities allowing very wide ownership.
๏ Professional: some people claim that limited companies project a more professional
impression than a sole traders can. It can look as though they have more substance.
๏ Raising finance: if a limited company does well it can be listed on a stock exchange and it
then has potential access to a huge amount of funding from a wide range of investors.

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2.2 Disadvantages of the limited company

๏ Formalities: there are initial formalities in setting up a company – though these can be
relatively minor. In the UK most people would buy an ‘off the shelf’ company (ie one already
incorporated), install themselves as shareholders and directors, change its name, pay in some
capital and start trading. In the UK it can all be done within a day or so. If the off-the-shelf
route is not taken then considerable expertise is needed to ensure that the company
documentation is properly drafted and is all in order.
Thereafter, financial statements (accounts) and returns have to be filed annually with the
appropriate government department. Once a company becomes large enough it will have to
have an annual audit by an independent auditor who hope to be able to state that the
company’s financial statements show a ‘true and fair view’ ie that the accounts are ‘OK’.
Audits can be costly.
๏ Separate tax calculations: corporation tax has to be calculated according to corporation tax
legislation.
๏ Publicity: because the financial statements have to be filed with the appropriate government
department they can be inspected by the public, so profits and other information cannot be
kept confidential.

3 The company’s constitution

A company’s constitution (the rules governing its existence and governance) is set out in the
Memorandum of Association and in the Articles of Association.

3.1 The memorandum of association

Typically, this document will contain information such as:

๏ Company name.
๏ Date of incorporation.
๏ Type of company - eg limited by shares.
๏ The statute under which the company is registered.
๏ Names and signatures of all subscribers (the original shareholders).
๏ Limited liability of shareholders.

Any person or corporate body that adds their name to the memorandum during the company
formation process will immediately become a member (shareholder) of that company. Details of all
members are registered with Companies House and displayed on the central public register, which
is available to everyone online.

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3.2 The articles of association

Most companies adopt model articles (ie standard articles) but the articles can vary from company
to company. The Articles are primarily to do with the internal matters of the company: rights and
duties of shareholders and directors.
The contents of the model articles include the following matters:
๏ Directors’ powers, responsibilities, decision making (eg how many have to be present at a
meeting to make decisions), appointment and removal.
๏ Shares: types of share, transfer of shares, rights to dividends, procedures for declaring
dividends.
๏ Power to capitalise profits
๏ Decision making by shareholders: attendance, speaking and voting at general meetings;
proxy votes.
๏ Administrative matters: means of communication to be used, director’s indemnity and
insurance.

4 Public and private companies

A private company cannot offer shares to the public. It has no minimum capital requirement and
might have only one director. In the UK they are designated by having ‘Ltd’ (meaning limited
liability) after their names.
A public company can offer shares to the public. There are minimum capital requirements and
there must be at least two directors and a company secretary (who can be a director). In the UK
they are designated by having ‘Plc’ (Public Limited Company) after their names. If they meet the
stock exchange listing requirements, public limited companies can be listed (quoted) on a stock
exchange)
Note that the term ‘public’ is often, wrongly used to mean ‘listed’. Listed companies have to be
public companies, but public companies do not have to be listed.

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5 The corporate veil

It was explained above that limited companies have a separate legal existence and that their
actions and liabilities are separate from those of the shareholders and directors. A company might
be sued if it causes damage, but the shareholders won’t be because the company is the guilty
party. The company might be pursued by creditors, but the creditors cannot chase the
shareholders or directors for amounts owed by the company.

Case: Salomon v Salomon (1897)

Salomon formed a limited company to take over his business. He was the majority
shareholder but also lent money to the company as a secured creditor. The company failed.
Salomon’s debt was safe because it was secured on company assets but there was nothing
left for the unsecured creditors who then attempted to claim their money from Salomon,
asserting that Salomon and the company were one.

Held: Salomon and his company were separate. The unsecured creditors could claim from the
company but not from Salomon personally.

Case: Macaura v Northern Life Assurance (1925)

Macaura owned a forestry company. He insured the timber against fire, but in his own name.
The forest was destroyed by fire and the insurance company refused to pay out.

Held: To insure an asset you must have an insurable interest in the asset (eg ownership).
Macaura owned shares in the forestry company; the forestry company owned the trees.
Macaura therefore did not have an insurable interest in the trees because he did not own
them, so the insurance company did not have to pay out.

The distinction between the company and its owners is sometimes called the ‘veil of incorporation’.
However, the veil of incorporation can be lifted (or pierced) in some situations. This means
disregarding the separate personality of a company and occurs when the court applies an
exception to the rule in Salomon v. Salomon.
For example:

Case: Gilford Motor Co v Horne (1933)

Horne was an employee who, in his employment contract, had agreed not to compete with
his employer, Gilford Motor Co. Horne left and formed a company and caused his company to
compete. He claimed that he had not broken his agreement because it was the company (a
separate legal entity) not him who was competing.

Held: An injunction to stop the competition was granted because incorporation should not
be used to evade legal responsibilities.

The veil of incorporation is to be lifted only in circumstances where incorporation is being used to
give protection from improper behaviour and so the company is being used as a front.

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Under s.214 of the Insolvency Act 1986, where a company is being wound up, if at some point
before the winding up of the company began a director knew or ought to have concluded that
there was no reasonable prospect that the company would avoid failure, the liquidator can apply
to the court for the director to be made liable for company debts.
A prudent, responsible director will not generally be made liable simply because the company has
failed, but directors who ignore the company’s situation and continue to trade once the situation
was hopeless could find themselves liable under this section for the company’s debts.

Tests
Question 1
Which TWO of the following are true in respect of a limited liability company?
A The company has unlimited liability for its debts
B The company has limited liability for its debts
C The shareholders have unlimited liability for the company’s debts
D The shareholders have limited liability for the company’s debts

Question 2
What are the two documents that make up a company’s constitution?

Question 3
What is mean by the ‘veil of incorporation’ and in what circumstances can it be ‘lifted’?

Question 4
When a company makes profits, who is taxed on those profits: the company or the
shareholders?

Question 5
Which of a sole traders or a limited company’s affairs are more public?

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ANSWERS TO TESTS

Chapter 1
1 A, B
2 C, E, F
3 A
4 IFAC = International Federation of Accountants;
IESBA = International Ethics Standards Board for Accountants
5 (1) Rules/compliance/procedural based codes.
(2) Framework/integrity/principles based codes

Chapter 2
1 A: the principle is Integrity, not honesty
D: important but not an ethical principle
F: important but not an ethical principle
2 C, D
3 Check your facts – is it ethical – identify the affected parties – seek professional or legal advice
4 Withdraw from the conflict.
5 Self-interest (the company might fail and the accountant’s job disappear if the forecast is not
optimistic).
Self-review – the accountant has to check his/her own work.
Possible intimidation depending on the pressure from management
Possibly familiarity as the accountant will be relying on estimates produced by colleagues
such as the sales team.

Chapter 3
1 The Sarbanes-Oxley Act
2 Tone from the top, how the board works as a team, key actions of the board and its
committees, board effectiveness, communication with shareholders.
3 C, E
4 Minority, foreign
5 IFAC

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Chapter 4
1 Two-tier; unitary. Twe-tier has a supervisory and management board; unitary has non-
executive direstors on the single board.
2 Nomination committee, audit committee, remuneration committee.
3 Leadership, effectiveness, accountability, remuneration, relations with shareholders
4 True
5 False

Chapter 5
1 B, E
2 True and fair (or fairly present)
3 Qualified, adverse and disclaimer
4

Internal audit External audit

Reports to shareholders X

Appointed by management X

Power from statute X

Covers all categories of risk and investigation X

5 C, E

Chapter 6
1 Financial statement fraud; misapporpriation of assets
2 Motive/incentive, opportunity, attitude/dishonesty
3 Prevention, detection, response

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Error of Error of Error of Trial

omission commission principal balance
out of
balance
An invoice from a customer gets X
lost in the post
An invoice from a customer for X
$541 is entered into the
bookkeeping system as $451
Repairs of $1,200 are debited to X
the cost of non-current assets
instead of the repairs account
A purchase of $240 is entered as: X X
• Dr Purchases 240
• Dr VAT 40
• CR Supplier $240

๏ Segregation of duties
๏ Physical
๏ Authorisation and approval
๏ Management and supervision
๏ Organisation
๏ Arithmetic and accounting
๏ Personnel

Chapter 7
1 False. There might be no legal responsibility but the behaviour of suppliers can taint
companys buying from them and buyers can therefore bring pressure to bear on their
suppliers to behave better,
2 Profit, people, planet or profit, social, environmental.
3 GRI is an international independent organisation that helps businesses, governments and
other organisations understand and communicate the impact of business on critical
sustainability issues such as climate change, human rights, corruption and many others.
4 False. CSR means going further than the law prescribes.
5 False. Directors’ legal duty is to maximise shareholder wealth.

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Chapter 8
1 Offer, acceptance, consideration, intention to create legal relations. (You could also mention
‘capacity’)
2 A, C
3 B
4 A – Probably a misrepresentation because the statement is one of fact and is untrue.
B– Because the statement was an opinion of the seller it is probably not a misrepresentation
provided it was honestly held.
5 Yes. The offer has been communicated instantly by phone. Acceptance is on 5/3/2018 (date
of posting). Revocation is not effective until received (presumed after 5/3/2018).

Chapter 9
1 A
2 Fidelity requires the employee to serve the employer faithfully. It is implied into all
employment contracts and means that an employee may not act against the interests of the
employer. It becomes particularly relevant if the employee is thinking about leaving and
working for a competitor, or setting up a competing business.
3 Direct discrimination, indirect discrimination and victimisation.
4 Bribery: payments to induce someone to do something they shouldn’t do.
Facilitation payments: payments to induce someone to do something they should be doing
anyhow.
5 Retirement, resignation and dismissal

Chapter 10
1 A, D
2 The Memorandum of Association; The Articles of Association.
3 The veil of incorporation is the distinction between the company and its owners. The veil of
incorporation is to be lifted only in circumstances where incorporation is being used to give
protection from improper behaviour so that the company is being used as a front.
4 The company is taxed on its profits through corporation tax.
5 Limited companies have to file their financial statements and other information with the
Registrar of Companies where the information can be inspected by the public. Sole trader’s
financial affairs can be kept much more private.

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