Hum and Hoo is an established audit practice in Deetown and has a large share of the audit

Section B – TWO questions ONLY to be attempted

Bob Wong was fortunate to inherit some money and decided he wanted to invest for the long term in one or more investments so he would have a higher income in retirement. He was not a specialist in accounting and had little understanding of how investments worked.

Bob studied an investment website which suggested that he needed to be aware of the level of risk in an investment and also that he needed to know what his basic attitude to risk would be. This meant he needed to decide what his risk appetite was and then select investments based on that.

When Bob studied share listings in newspapers, he noticed that they were subdivided into sectors (e.g. banks, pharmaceuticals, mining, retail). He noticed that some sectors seemed to make higher returns than others and he wanted to know why this was. One website suggested that risks also varied by sector and this was partly explained by the different business and financial risks which different sectors are exposed to.

One website said that if a potential investor wanted to know about any given company as a potential investment, the company’s most recent annual report was a good place to start. This was because, it said, the annual report contained a lot of voluntary information, in addition to the financial statements. Bob could use this information to gain an understanding of the company’s strategy and governance. The website suggested that the contents of the corporate governance section of the annual report would be particularly helpful in helping him decide whether or not to buy shares in a company.

Required:

(a) Explain ‘risk appetite’ and ‘risk awareness’, and discuss how Bob’s risk appetite might affect his choice of investments.

(8 marks) (b) Explain ‘business risk’ and ‘financial risk’ and discuss why risks might vary by sector as the website indicated. (8 marks)

(c) Distinguish, with examples, between mandatory and voluntary disclosure in annual reports, and assess the usefulness of corporate governance disclosure to Bob in selecting his investments. (9 marks)

Section A – This ONE question is compulsory and MUST be attempted

Several years ago, World Justice, a well-known charity, published a report on the activities of three major food companies in their marketing of manufactured baby foods in some of the poorer developing countries. The report, provocatively called ‘Killer Companies’, said it had evidence that the three companies were ‘aggressively mis-selling’ manufactured baby food products in these poorer countries. It was argued in the report that several problems arose with the use of these products in poorer countries which negatively affected the health of the babies, with many babies reportedly dying as a result. These problems included the use of contaminated water in the preparation of the baby food, an inability of parents to read the instructions, making up product at insufficient concentrations (thereby malnourishing the child) and aggressive selling to health facilities in those countries. Doctors often advised against the use of these products for babies because natural feeding solutions were considered safer and more beneficial in most cases.

When the ‘Killer Companies’ report was published, it was widely reported upon and received a lot of social and political attention. Two of the three companies named in ‘Killer Companies’ immediately decided to withdraw from the business but the third company, Xaxa Company (Xaxa hereafter), recognised what it believed to be an opportunity to take the market share left by the other two. It set about increasing its production capacity accordingly. When asked by journalists why Xaxa had not also withdrawn from the criticised business activity, the chief executive issued a press statement saying that it was a profitable business opportunity and, as the steward of shareholder value, he owed it to the shareholders to maximise their returns.

When it became widely known that Xaxa had decided to expand and develop its baby food business in poorer developing countries, Mothers Who Care (MWC), a national charity concerned with infant nutrition, organised a campaign against Xaxa. Strongly believing in the natural feeding of infants, MWC initially organised protests outside the Xaxa head office and also encouraged the public to boycott a wide range of Xaxa products in addition to the baby food products. MWC members started to use the phrase, ‘Xaxa kills babies’ in the hope that it would become widely adopted.

As one of the country’s largest companies and operating in many countries, Xaxa has a large issued share volume with the majority being held by institutional investors. Whilst the overall group profits remained strong, some shareholders began to feel concerned about the baby food issue. One prominent fund manager, Hugh Oublie, organised a meeting for institutional shareholders holding large volumes of Xaxa shares and 50 such institutional shareholders attended the meeting. The group became known as the ‘Oublie Group’. Although all members of the Oublie Group wanted to retain their holdings in Xaxa because of the otherwise good returns, a number of questions were framed which they decided to put to the Xaxa management:

(i) could the company explain the strategic logic of pursuing the baby food business in poorer developing countries?

(ii) was the board concerned about potential reputational damage with phrases such as ‘Xaxa kills babies’ being used widely and in the media?

(iii) would the Xaxa board consider withdrawing from the baby food business in poorer developing countries because of the alleged health impacts on children in those countries?

The company issued a statement through its investor relations department, replying that the strategic logic was based on what activities provided the most profit to shareholders regardless of the effects on other claims against the company strategy. Second, the board was not concerned with reputation risks because it believed that these were ‘temporary concerns’ which would soon be forgotten. Third, no, the board would not withdraw from the baby food market in those countries because, with the loss of two competitors, profit margins were likely to be higher and competition less. The Oublie Group expressed its dissatisfaction with this reply and said it might seek to influence the appointment of non-executive directors (NEDs) to the Xaxa board to increase the scrutiny of the executive members and their discussions on the subject.

Hugh Oublie appeared on television to say that he felt the board of Xaxa lacked balance. He said that, although profitable and a good employer in its home country, the non-executive scrutiny of company strategy had been poor for some time and the board had no meaningful sense of ethics at all. He believed that all of the executive board was dedicated to the mission to produce what he called ‘profit at any social cost’. He further believed that none of the non-executive board members was strong enough to question the strategy and raise the problem of baby food as an ethical issue. It was this lack of non-executive scrutiny which Hugh Oublie believed was a major cause of Xaxa’s unwillingness to reconsider its baby food activity. He said that he had been a long-serving observer and shareholder of Xaxa and he had noticed the company becoming more inward-looking and self-reliant in recent years. He believed this trend was very unhelpful. In addition, he expressed concerns, on behalf of the Oublie Group, about the strategic management of Xaxa and his belief that the board lacked concern for medium-term business risks brought about by the baby food marketing.

As World Justice and MWC continued their campaigns against Xaxa, some other groups became aware of the baby food situation in poorer developing countries. A television programme reported how Xaxa products were actually being used in some of the poorer countries. It claimed to confirm the problems highlighted in ‘Killer Companies’ and it highlighted a number of other Xaxa products which consumers might stop buying if they wanted to put pressure on Xaxa’s management to change their policy on baby food.

Partly in response to these pressures, the Xaxa board decided to consider two new initiatives. The first of these was to consider introducing a corporate code of ethics. By carefully drafting this and placing it prominently on its website, the board believed that it could achieve a number of favourable outcomes including improving its reputation.

The second initiative was to consider instituting a full risk audit system in response to the negative publicity it had experienced, especially from MWC, whose members were considered to be natural customers of Xaxa’s other products. Private research commissioned by Xaxa showed that the baby food business was damaging Xaxa’s reputation and possibly the willingness of some talented people to apply for jobs with the company. Political support for other company plans had also suffered, such that a recent planning application to set up a new factory by Xaxa, in a business area with no connection with baby food, had received opposition. Protestors, mainly local activists and MWC members, opposed the application with placards saying ‘Xaxa kills babies’. Because the idea of risk auditing was a new initiative for Xaxa, the board has asked a local consultancy to produce guidance on the benefits of risk audit and the benefits of an external, rather than an internal, risk audit.

Required:

(a) The underlying principles of corporate governance include transparency, judgement and reputation. Explain these three terms and assess the Xaxa board’s performance against each one. (9 marks)

(b) Explain the purposes of a corporate code of ethics and examine how the adoption of such a code might make Xaxa reconsider its marketing of baby food in poorer developing countries. (11 marks)

(c) Institutional investors are potentially influential stakeholders in a company such as Xaxa.

Required:

(i) Explain why institutional investors might attempt to intervene in the governance of a company. (ii) Discuss the reasons why the Oublie Group should attempt to intervene in the governance of Xaxa following the events described in the case.

Note: The total marks will be split equally between each part. (10 marks)

(d) Produce notes from the consulting company for the Xaxa board in response to its need for guidance on risk audit. The notes should address the following:

(i) Discuss, in the context of Xaxa, the stages in a risk audit. (8 marks)

(ii) Distinguish between internal and external risk audit, and discuss the advantages for Xaxa of an external risk audit. (8 marks)

Professional marks will be awarded in part (d) for the clarity, logical flow, style. and persuasiveness of the notes. (4 marks)

cting two towns. Route A involved cutting a channel through an area designated as being of special scientific importance because it was one of a very few suitable feeding grounds for a colony of endangered birds. The birds were considered to be an important part of the local environment with some potential influences on local ecosystems.

The alternative was Route B which would involve the compulsory purchase and destruction of Eddie Krul’s farm. Mr Krul was a vocal opponent of the Route B plan. He said that he had a right to stay on the land which had been owned by his family for four generations and which he had developed into a profitable farm. The farm employed a number of local people whose jobs would be lost if Route B went through the house and land. Mr Krul threatened legal action against RDC if Route B was chosen.

An independent legal authority has determined that the compulsory purchase price of Mr Krul’s farm would be $1 million if Route B was chosen. RDC considered this a material cost, over and above other land costs, because the projected net present value (NPV) of cash flows over a ten-year period would be $5 million without buying the farm. This would reduce the NPV by $1 million if Route B was chosen.

The local government authority had given both routes provisional planning permission and offered no opinion of which it preferred. It supported infrastructure projects such as the new railway line, believing that either route would attract new income and prosperity to the region. It took the view that as an experienced railway builder, RDC would know best which to choose and how to evaluate the two options. Because it was very keen to attract the investment, it left the decision entirely to RDC. RDC selected Route A as the route to build the new line.

A local environmental pressure group, ‘Save the Birds’, was outraged at the decision to choose Route A. It criticised RDC and also the local authority for ignoring the sustainability implications of the decision. It accused the company of profiting at the expense of the environment and threatened to use ‘direct action’ to disrupt the building of the line through the birds’ feeding ground if Route A went ahead.

Required:

(a) Use Tucker’s ‘five question’ model to assess the decision to choose Route A. (10 marks)

(b) Discuss the importance to RDC of recognising all of the stakeholders in a decision such as deciding between Route A and Route B. (8 marks)

(c) Explain what a stakeholder ‘claim’ is, and critically assess the stakeholder claims of Mr Krul, the local government authority and the colony of endangered birds. (7 marks)

se in products failing the final quality checks. These checks were carried out in the QC (quality control) laboratory, which tested finished goods products before being released for sale. The product failure rate had risen from 1% of items two years ago to 4% now, and this meant an increase of hundreds of items of output a month which were not sold on to Yaya’s customers. The failed products had no value to the company once they had failed QC as the rework costs were not economic. Because the increase was gradual, it took a while for Mr Janoon to realise that the failure rate had risen.

A thorough review of the main production operation revealed nothing that might explain the increased failure and so attention was focused instead on the QC laboratory. For some years, the QC laboratory at Yaya, managed by Jane Goo, had been marginalised in the company, with its two staff working in a remote laboratory well away from other employees. Operations director Ben Janoon, who designed the internal control systems in Yaya, rarely visited the QC lab because of its remote location. He never asked for information on product failure rates to be reported to him and did not understand the science involved in the QC process. He relied on the two QC staff, Jane Goo and her assistant John Zong, both of whom did have relevant scientific qualifications.

The two QC staff considered themselves low paid. Whilst in theory they reported to Mr Janoon, in practice, they conducted their work with little contact with colleagues. The work was routine and involved testing products against a set of compliance standards. A single signature on a product compliance report was required to pass or fail in QC and these reports were then filed away with no-one else seeing them.

It was eventually established that Jane Goo had found a local buyer to pay her directly for any of Yaya’s products which had failed the QC tests. The increased failure rate had resulted from her signing products as having ‘failed QC’ when, in fact, they had passed. She kept the proceeds from the sales for herself, and also paid her assistant, John Zong, a proportion of the proceeds from the sale of the failed products.

Required:

(a) Explain typical reasons why an internal control system might be ineffective. (5 marks)

(b) Explain the internal control deficiencies that led to the increased product failures at Yaya. (10 marks)

(c) Discuss the general qualities of useful information, stating clearly how they would be of benefit to Mr Janoon, and recommend specific measures which would improve information flow from the QC lab to Mr Janoon. (10 marks)

Section B – TWO questions ONLY to be attempted

After a recent financial crisis in the country of Oland, there had been a number of high profile company failures and a general loss of confidence in business. As a result, an updated corporate governance code was proposed, with changes to address these concerns.

Before the new code was published, there was a debate in Oland society about whether corporate governance provisions should be made rules-based, or remain principles-based as had been the case in the past. One elected legislator, Martin Mung, whose constituency contained a number of the companies that had failed with resulting rises in unemployment, argued strongly that many of the corporate governance failures would not have happened if directors were legally accountable for compliance with corporate governance provisions. He said that ‘you can’t trust the markets to punish bad practice’, saying that this was what had caused the problems in the first place. He said that Oland should become a rules-based jurisdiction because the current ‘comply or explain’ was ineffective as a means of controlling corporate governance.

Mr Mung was angered by the company failures in his constituency and believed that a lack of sound corporate governance contributed to the failure of important companies and the jobs they supported. He said that he wanted the new code to make it more difficult for companies to fail.

The new code was then issued, under a principles-based approach. One added provision in the new Oland code was to recommend a reduction in the re-election period of all directors from three years to one year. The code also required that when seeking re-election, there should be ‘sufficient biographical details on each director to enable shareholders to take an informed decision’. The code explained that these measures were ‘in the interests of greater accountability’.

Required:

(a) Examine how sound corporate governance can make it more difficult for companies to fail, clearly explaining what ‘corporate governance’ means in your answer. (10 marks)

(b) Martin Mung believes that Oland should become a rules-based jurisdiction because the current ‘comply or explain’ approach is ineffective as a means of controlling corporate governance.

Required:

Explain the difference between rules-based and principles-based approaches to corporate governance regulation, and argue against Martin Mung’s belief that ‘comply or explain’ is ineffective. (8 marks)

(c) Explain what ‘accountability’ means, and discuss how the proposed new provisions for shorter re-election periods and biographical details might result in ‘greater accountability’ as the code suggests. (7 marks)

Section A – This ONE question is compulsory and MUST be attempted

P&J is a long established listed company based in Emmland, a highly developed and relatively prosperous country. For the past 60 years, P&J has been Emmland’s largest importer and processor of a product named X32, a compound used in a wide variety of building materials, protective fabrics and automotive applications. X32 is a material much valued for its heat resistance, strength and adaptability, but perhaps most of all because it is flexible and also totally fireproof. It is this last property that led to the growth of X32 use and made P&J a historically successful company and a major exporter.

X32 is mined in some of the poorest developing countries where large local communities depend heavily on X32 mining for their incomes. The incomes from the mining activities are used to support community development, including education, sanitation and health facilities in those developing countries. The X32 is then processed in dedicated X32 facilities near to the mining communities, supporting many more jobs. It is then exported to Emmland for final manufacture into finished products and distribution.

Each stage of the supply chain for X32 is dedicated only to X32 and cannot be adapted to other materials. In Emmland, P&J is the major employer in several medium-sized towns. In Aytown, for example, P&J employs 45% of the workforce and in Betown, P&J employs 3,000 people and also supports a number of local causes including a children’s nursery, an amateur football club and a number of adult education classes. In total, the company employs 15,000 people in Emmland and another 30,000 people in the various parts of the supply chain (mining and processing) in developing countries. Unlike in Emmland, where health and safety regulations are strong, there are no such regulations in most of the developing countries in which P&J operates.

Recently, some independent academic research discovered that X32 was very harmful to human health, particularly in the processing stages, causing a wide range of fatal respiratory diseases, including some that remain inactive in the body for many decades. Doctors had suspected for a while that X32 was the cause of a number of conditions that P&J employees and those working with the material had died from, but it was only when Professor Harry Kroll discovered how X32 actually attacked the body that the link was known for certain. The discovery caused a great deal of distress at P&J, and also in the industries which used X32.

The company was faced with a very difficult situation. Given that 60% of P&J’s business was concerned with X32, Professor Kroll’s findings could not be ignored. Although demand for X32 remained unaffected by Kroll’s findings in the short to medium term, the company had to consider a new legal risk from a stream of potential litigation actions against the company from employees who worked in environments containing high levels of X32 fibre, and workers in industries which used X32 in their own processes.

In order to gain some understanding of the potential value of future compensation losses, P&J took legal advice and produced two sets of figures, both describing the present value of cumulative future compensation payments through litigation against the company. These forecasts were based on financial modelling using another product of which the company was aware, which had also been found to be hazardous to health.

The finance director (FD), Hannah Yin, informed the P&J board that the company could not survive if the worst-case scenario was realised. She said that the actual outcome depended upon the proportion of people affected, the period that the illness lay undetected in the body, the control measures which were put in place to reduce the exposure of employees and users to X32, and society’s perception of X32 as a material. She estimated that losses at least the size of the best case scenario were very likely to occur and would cause a manageable but highly damaging level of losses.

The worst case scenario was far less likely but would make it impossible for the company to survive. Although profitable, P&J had been highly geared for several years and it was thought unlikely that its banks would lend it any further funds. Hannah Yin explained that this would limit the company’s options when dealing with the risk. She also said that the company had little by way of retained earnings.

Chief executive officer, Laszlo Ho, commissioned a study to see whether the health risk to P&J workers could be managed with extra internal controls relating to safety measures to eliminate or reduce exposure to X32 dust. The confidential report said that it would be very difficult to manage X32 dust in the three stages of the supply chain unless the facilities were redesigned and rebuilt completely, and unless independent breathing apparatus was issued to all people coming into contact with X32 at any stage. FD Hannah Yin calculated that a full refit of all of the company’s mines, processing and manufacturing plants (which Mr Ho called ‘Plan A’) was simply not affordable given the current market price of X32 and the current costs of production. Laszlo Ho then proposed the idea of a partial refit of the Aytown and Betown plants because, being in Emmland, they were more visible to investors and most other stakeholders.

Mr Ho reasoned that this partial refit (which he called ‘Plan B’) would enable the company to claim it was making progress on improving internal controls relating to safety measures whilst managing current costs and ‘waiting to see’ how the market for X32 fared in the longer term. Under Plan B, no changes would be made to limit exposure to X32 in the company’s operations in developing countries.

Hannah Yin, a qualified accountant, was trusted by shareholders because of her performance in the role of FD over several years. Because she would be believed by shareholders, Mr Ho offered to substantially increase her share options if she would report only the ‘best case’ scenario to shareholders and report ‘Plan B’ as evidence of the company’s social responsibility. She accepted Mr Ho’s offer and reported to shareholders as he had suggested. She also said that the company was aware of Professor Kroll’s research but argued that the findings were not conclusive and also not considered a serious risk to P&J’s future success.

Eventually, through speaking to an anonymous company source, a financial journalist discovered the whole story and felt that the public, and P&J’s shareholders in particular, would want to know about the events and the decisions that had been taken in P&J. He decided to write an article for his magazine, Investors in Companies, on what he had discovered.

Required:

(a) Define ‘social footprint’ and describe, from the case, four potential social implications of Professor Kroll’s discovery about the health risks of X32. (10 marks)

(b) Describe what ‘risk diversification’ means and explain why diversifying the risk related to the potential claims against the use of X32 would be very difficult for P&J. (10 marks)

(c) As an accountant, Hannah Yin is bound by the IFAC fundamental principles of professionalism.

Required:

Criticise the professional and ethical behaviour of Hannah Yin, clearly identifying the fundamental principles of professionalism she has failed to meet. (9 marks)

(d) Writing as the journalist who discovered the story, draft a short article for the magazine Investors in Companies. You may assume the magazine has an educated readership. Your article should achieve the following:

(i) Distinguish between strategic and operational risk and explain why Professor Kroll’s findings are a strategic risk to P&J; (8 marks)

(ii) Discuss the board’s responsibilities for internal control in P&J and criticise Mr Ho’s decision to choose Plan B. (9 marks)

Professional marks will be awarded in part (d) for the structure, logical flow, persuasiveness and tone of the article. (4 marks)

nce 1920. The current chief executive, Mr Gustav Lum, is the great grandson of the company’s founder and has himself been in post as CEO since 1998. Because the Lum family wanted to maintain a high degree of control, they operated a two-tier board structure: four members of the Lum family comprised the supervisory board and the other eight non-family directors comprised the operating board.

Despite being quite a large company with 5,000 employees, Lum Co never had any non-executive directors because they were not required in privately-owned companies in the country in which Lum Co was situated.

The four members of the Lum family valued the control of the supervisory board to ensure that the full Lum family’s wishes (being the only shareholders) were carried out. This also enabled decisions to be made quickly, without the need to take everything before a meeting of the full board.

Starting in 2008, the two tiers of the board met in joint sessions to discuss a flotation (issuing public shares on the stock market) of 80% of the company. The issue of the family losing control was raised by the CEO’s brother, Mr Crispin Lum. He said that if the company became listed, the Lum family would lose the freedom to manage the company as they wished, including supporting their own long-held values and beliefs. These values, he said, were managing for the long term and adopting a paternalistic management style. Other directors said that the new listing rules that would apply to the board, including compliance with the stock market’s corporate governance codes of practice, would be expensive and difficult to introduce.

The flotation went ahead in 2011. In order to comply with the new listing rules, Lum Co took on a number of non-executive directors (NEDs) and formed a unitary board. A number of problems arose around this time with NEDs feeling frustrated at the culture and management style. in Lum Co, whilst the Lum family members found it difficult to make the transition to managing a public company with a unitary board. Gustav Lum said that it was very different from managing the company when it was privately owned by the Lum family. The human resources manager said that an effective induction programme for NEDs and some relevant continuing professional development (CPD) for existing executives might help to address the problems.

Required:

(a) Compare the typical governance arrangements between a family business and a listed company, and assess Crispin’s view that the Lum family will ‘lose the freedom to manage the company as they wish’ after the flotation. (10 marks)

(b) Assess the benefits of introducing an induction programme for the new NEDs, and requiring continual professional development (CPD) for the existing executives at Lum Co after its flotation. (8 marks)

(c) Distinguish between unitary and two-tier boards, and discuss the difficulties that the Lum family might encounter when introducing a unitary board. (7 marks)

her for several years and, as well as being work colleagues, are personal friends with each other. At Jojo it is customary for the performance of all student accountants to be appraised after their first year of a training contract using a range of criteria including examination success, technical ability and professionalism. Three levels of outcome are possible:

1. ‘Good’, allowing students to continue with no issues;

2. ‘Some concerns’, meaning students are counselled and then allowed to continue; and,

3. ‘Poor’, where students are dismissed from the audit practice.

The appraisal committee is comprised of three people: managing partner Jack Hu, the training manager (both of whom are professional accountants) and the person responsible for human resources. The committee receives confidential reports on each student and makes decisions based on the views of relevant engagement partners and also exam results. It is normally the training manager who makes the recommendation and in most cases his appraisal is agreed and then acted upon accordingly. Because the appraisals are confidential between the student and the firm, the list of students and their appraisal categories are not publicised within the firm.

When the 2010 intake was being appraised last year, one student was appraised by the training manager as ‘poor’ but was not dismissed. Polly Shah was unpopular among other students because she was considered lazy and technically weak. She also failed a number of her exams. Other students who were appraised as ‘poor’ were dismissed, but Polly received a brief counselling session from Jack Hu and then returned to her duties. Polly stayed for another year and then, having failed more exams, left Jojo to pursue other career interests outside accounting.

Polly’s departure triggered some discussion amongst Jojo’s partners as to why she had been retained when other poor performers had not. It later emerged that Jack Hu was a close friend of Polly’s parents and had enjoyed free holidays in the Shah family’s villa for several years. Because he was the managing partner, Mr Hu was able to insist on retaining Polly, despite the objections of the training manager and the human resources representative, although the training manager was reported to be furious at the decision to retain Polly.

Required:

(a) Define ‘conflict of interest’ and assess the consequences of Jack Hu’s behaviour after Polly Shah’s appraisal. (10 marks)

(b) Describe four ethical safeguards that could be used in Jojo to prevent a recurrence of the events like those described in the case. (8 marks)

(c) The case raises issues of the importance of senior management performance measurement. In a public company, this refers to directors, and in a privately-owned partnership like Jojo, it refers to partners. The managing partner (Mr Hu’s position) is equivalent to the role of chief executive.

Required:

Explain the typical criteria used in the performance measurement of individual directors and discuss the reasons why individual performance measurement of partners may be difficult to implement at Jojo. (7 marks)

Section B – TWO questions ONLY to be attempted

John Louse, the recently retired chief executive of Zogs Company, a major listed company, was giving a speech reflecting on his career and some of the aspects of governance he supported and others of which he was critical. In particular, he believed that board committees were mainly ineffective. A lot of the ineffectiveness, he said, was due to the lack of independence of many non-executive directors (NEDs). He believed that it was not enough just to have the required number of non-executive directors; they must also be ‘truly independent’ of the executive board. It was his opinion that it was not enough to have no material financial connection with a company for independence: he believed that in order to be truly independent, NEDs should come from outside the industry and have no previous contact with any of the current executive directors.

In relation to risk committees, he said that in his experience, the company’s risk committee had never stopped any risk affecting the company and because of this, he questioned its value. He said that the risk committee was ‘always asking for more information, which was inconvenient’ and had such a ‘gloomy and pessimistic’ approach to its task. He asked, ‘why can’t risk committees just get on with stopping risk, and also stop making inconvenient demands on company management? Do they think middle managers have nothing else to do?’ He viewed all material risks as external risks and so the risk committee should be looking outwards and not inwards.

Since retiring from Zogs, Mr Louse had taken up a non-executive directorship of SmallCo, a smaller private company in his town. In a meeting with Alan Ng, the new chief executive of Zogs, Mr Ng said that whilst risk management systems were vital in large companies like Zogs, fewer risk controls were needed in smaller companies like SmallCo.

Required:

(a) Define ‘independence’ in the context of corporate governance and critically evaluate Mr Louse’s comment that greater independence of non-executive directors is important in increasing the effectiveness of board committees. (8 marks)

(b) Describe the roles of a risk committee and criticise Mr Louse’s understanding of the risk committee in Zogs Company. (9 marks)

(c) Assess whether risk committees and risk mitigation systems are more important in larger companies, like Zogs, than in smaller companies like SmallCo. (8 marks)

Section A – This ONE question is compulsory and MUST be attempted

Hayho is a large international company with direct investments in 65 countries. It is a manufacturer of high technology products, with each Hayho factory typically employing over 3,000 people. Hayho factories also support local supply chains employing many more people so each Hayho plant is considered a vital part of the regional economy in which it is located.

Several years ago, Hayho was widely criticised for its operations in Arrland, a developing country with an oppressive and undemocratic government. Investigative journalists produced material showing the poor conditions of workers, and pollution around the Hayho factories in Arrland. They also showed evidence suggesting that Hayho had paid bribes to the Arrland government so that local opposition to the Hayho operation could be forcefully stopped. After this episode, the company became very sensitive to criticism of its operations in developing countries. A press statement at the time said that Hayho, in future, would always uphold the highest standards of integrity, human rights and environmental protection whilst at the same time ‘responsibly’ supporting developing countries by providing jobs and opportunities to enable greater social and economic development.

The board of Hayho is now deciding between two possible large new investments, both directly employing about 3,000 people. Both options have a number of advantages and disadvantages and Mr Woo, Hayho’s finance director, has recently made clear that only one can be chosen at this stage. The two options are of similar investment value and are referred to as the ‘Jayland option’ and the ‘Pealand option’.

The ‘Jayland option’ is to build a new large factory in Jayland and to recruit a completely new local workforce to work in it. Jayland is a developing country with few environmental and labour regulations. It has a poorly developed education and training system, and is generally considered to be undemocratic. Its president, Mr Popo, has been in office since he seized power in a military coup 30 years ago. Human rights organisations say that he maintains order by abusing the rights of the people and cruelly suppressing any dissent against him. In early exploratory talks between Hayho and the Jayland government, Hayho was given assurances that it could pursue its activities with little regulation from the government as long as the Jayland president, Mr Popo, received a personal annual ‘royalty’ (effectively a bribe) for allowing Hayho to operate in his country.

Finance director Mr Woo said that some stakeholders would probably criticise Hayho, perhaps in the international media, for investing in Jayland. Hayho may be accused of supporting the dictatorship of Mr Popo in that country, especially if the ‘royalty’ was ever discovered. Mr Woo calculated that the NPV (net present value) of projected pretax returns of the Jayland option over a ten-year period was $2 billion but that there was also a risk of potential political instability in Jayland during the lifetime of the investment.

The ‘Pealand option’ is to buy an existing plant in Pealand which would then be refurbished to facilitate the manufacture of Hayho products. This would involve ‘inheriting’ the workforce of the previous owners. Pealand is a ‘new democracy’, and a transitional economy, having gained its independence ten years ago. In an attempt to purge the corrupt business practices associated with its past, the Pealand government has become very thorough in ensuring that all inward investments, including Hayho’s factory purchase, meet exacting and demanding standards of environmental protection and work conditions. Mr Woo, the finance director, said that the NPV of projected pre-tax returns over a ten-year period was $1 billion for the Pealand option but that the risk of political instability in Pealand was negligible. Both of the returns, the forecast $2 billion for Jayland and the $1 billion for Pealand, were considered to be acceptable in principle.

Mr Woo also said that there were issues with the two options relating to the effectiveness of necessary internal controls. Whichever option was chosen (Jayland or Pealand), it would be necessary to establish internal controls to enable accurate and timely reporting of production and cost data back to head office. So a number of systems would need to be put in place to support the production itself. One staff member, Emily Baa, who had previously worked in Jayland for another company, gave her opinion to the board about some of the issues that Hayho might encounter if it chose the Jayland option. She said that Jayland was very under developed until relatively recently and explained how the national culture was unfamiliar with modern business practice and behaviour. She said that property security may be a problem and that there was a potential risk to assets there. She also said that, in her opinion, there was a lack of some key job skills among the potential workforce in Jayland such as quality control and accounting skills. She explained that quality control skills would be necessary to ensure product specifications were met and that accounting skills would be necessary for the provision of internal and external reporting. As a manufacturer of very technologically advanced products, a number of stringent international product standards applied to Hayho products wherever in the world they were produced.

Meanwhile, news that Hayho was considering a large investment in Jayland leaked out to the press. In response, Hayho’s chief executive, Helen Duomo received two letters. The first was from a prominent international human rights lobbying organisation called ‘Watching Business’ (WB). In the letter, the lobby group said that because of its ‘terrible track record’ in Arrland and elsewhere, Hayho was being carefully monitored for its ‘unethical business practices’. WB said its interest in Hayho’s activities had been rekindled since it had received intelligence about the possible investment in Jayland and warned Mrs Duomo not to make the investment because it would provide credibility for the ‘brutal dictatorship’ of Mr Popo.

Whilst Mrs Duomo, known for her forthright manner, would normally dismiss threats from groups of this type, she knew that WB had a lot of support among senior politicians and legislators in many parts of the world. She believed that WB could achieve some power through mobilising public opinion through effective use of mass media, such as newspapers and television. WB was also respected as a research organisation and its advice was often sought by politicians and trade organisations.

Mrs Duomo said she was frustrated whenever anybody got in the way of her accountability to the Hayho shareholders, but that some interests could not be ignored because of their potential to influence. WB fell into this category.

The second letter she received was from the head of Quark Investments, Hayho’s single biggest institutional shareholder. The letter sought to remind Mrs Duomo that the Hayho board was employed by its shareholders and that Mrs Duomo should be determined and resolute in maximising shareholder returns. The letter encouraged the board not to be diverted by ‘well meaning but misinformed outsiders concerned with things that were actually none of their business’.

Aware that she had to manage two competing demands placed on her, Mrs Duomo sought advice from Emily Baa, who had experience of life in Jayland. So she asked Emily Baa to prepare some notes for the next board meeting to clarify whom the board of Hayho was actually accountable to and how it might respond to the letter from WB.

Required: (a) Explain ‘risk appetite’ and demonstrate how different risk appetites might affect the selection of investments between Jayland and Pealand. (6 marks)

(b) Use the AAA (American Accounting Association) seven-step model to examine the ethical decision whether to select the Jayland option or the Pealand option. (14 marks)

(c) Describe the general purposes of an internal control system and, based on Emily Baa’s views, assess the main internal control challenges that Hayho might encounter if it chose the Jayland option. (12 marks)

(d) Prepare briefing notes from Emily Baa to prepare chief executive of Hayho, Helen Duomo, for the board meeting as requested in the case. The notes should cover the following:

(i) A discussion of the meaning of accountability at Hayho and of how the Mendelow framework can be used to predict the influence of the Watching Business pressure group; (7 marks)

(ii) A brief explanation of the agency relationship between the board of Hayho and Quark Investments, and advice on why the demands from Watching Business should be carefully considered. (7 marks)

Professional marks will be awarded in part (d) for the clarity, flow, persuasiveness and structure of the briefing notes. (4 marks)