Conflicts of Interest/Independence

For management and employees: Where the independent judgment of an

employee is swayed, or might be swayed from making decisions in the organization’s best interest.

Important Issues: Usual Causes: self-interest, misunderstanding Slippery slope Inevitable...So how to manage to avoid harm Appearance is vital Guidance needed

Types of Conflict of Interest

Potential Actual

Decision Point

Non-existent Apparent Imaginary

Conflicts of interest - Causes

How might judgement be swayed … any interest, influence, loyalty, concern, emotion, or other feature tending to make judgement less reliable than normal. D&S, 9.

Self-interest - bribes, kickback, gifts, free travel, favors, special advantages or treatment, dealings with family, relatives or relations

Fraud - misappropriation of funds or property Misunderstanding - confused signals or

incentives, boss/ everybody’s doing it, cultural differences, slippery slope

Judgement Based onCommon and Conflicting Interests

Investors’ Interests

Executives’Interests

Judgements

Congruent

Self-interested

Management of Conflicts of Interest

Awareness and understanding- training Guidance and compliance - code, signoff Avoid - can’t always Additional controls:

disclosure and consultation - ethics officer+ additional approvals Chinese walls/Firewalls - confidentiality prohibition and scrutiny

International aspects, www.transparency.de

Gift or Preferential Treatment

Guidelines for Acceptance/Giving: Is it nominal or substantial? What is the intended purpose? What are the circumstances? What is the position of sensitivity of

the recipient? What is the accepted practice? What is the firm/company policy? Is it legal?

Conflicts of Interest/Independence for Professional Accountants

Mandate relies upon: Services that can be trusted by

members of the public to serve their interests

Fiduciary Responsibilities Fiduciary services

Reliance Knowledge or skill differential Important

Credibility Trust, confidence, expectations

Part of the Livent Affair:Drabinsky v. KPMG

Livent – Phantom of the Opera, Showboat, restores theatresOn Nov. 29, 1999, Drabinsky (D) sues KPMG (KC) Canada for

damages, costs and other relief for breach of contract, breach of duty of confidence, & breach of fiduciary duties D alleges KC was his accountant … tax & bus. Advice …KC

North Toronto (KCNT) Office says only personal tax KPMG Los Angeles had examined Livent books using KCNT

for tax review to give report to purchaser. Purchase goes forward. D doesn’t complain even though report not rosy. Deloitte’s audits Livent.

Purchaser believes Livent accounts mask true condition due to D

Purchaser suspends D Purchaser hires KC Downtown Toronto Office forensic unit to

investigate. Case settled, some files sealed, Drabinsky indicted in US

Discuss possible conflicts of interest

Ethical Regime - International

Guidance framework includes… IFAC Code of Ethics, CICA Independence Exposure Draft IFAC Code at www.ifac.org/Ethics/ GAAP, GAAS SOX, SEC Rules – released Nov. 19, 2002 www.sec.gov

A professional accountant must adhere to a set of rules aimed at neutrality and at protecting the public interest – s/he should not go to absolutely any lengths to serve a specific client’s interests, unless the public interest is also served

Conflict of Interest/Independence for Professional Accountants - IFAC

1. Protect the Public Interest2. Professional Service to Clients

Judgement

Integrity of Services Objectivity

IFAC Conflict of Interest/Independence

“Regardless of service or capacity, professional accountants should protect the integrity of their professional services, and maintain objectivity in their judgement.” (Sect. 1.2)

Integrity … honest, fair dealing, truthful and free of conflicts of interest (1.1)

Objectivity … a combination of impartiality, intellectual honesty and a freedom from conflicts of interest (Definitions, p. 5)

Limits to Serving Clients

SEC Proposal/Ruling…SEC Registrant Auditors “not independent whenever, during the audit and professional engagement period, the accountant:1. Has a mutual or conflicting interest with the audit client;2. Audits the accountant’s own work;3. Functions as management or an employee of the audit client; or4 Acts as an advocate for the client.” July 2000, Nov. 2000

SOX/SEC Proposal/Ruling Released Nov. 19, 2002Letters of EngagementLegalitiesPost-engagement time frame restrictions

IFAC Code of Ethics, Nov. 2001

Duty to Society, Serve the Public Interest

ObjectivesMeet Expectations for Professionalism, Performance,

Public Interest

Basic NeedsCredibility, Professionalism, Highest Quality Services, Confidence

Fundamental PrinciplesIntegrity, Objectivity, Professional Competence and Due Care, Confidentiality, Professional Behaviour, Technical Standards

IFAC Code of Ethics

Public Interest Requirement: Responsibility to the public ... who rely on the objectivity and integrity of professional accountants to maintain the orderly functioning of commerce. (9, p.10)

Objectives involved: to work to the highest standards of

professionalism to attain the highest levels of performance and generally to meet the public interest

requirement (14, p. 11)

IFAC Code of Ethics

Four basic needs must be satisfied: credibility, professionalism, highest quality services, and confidence (14, p. 11,12)

Prerequisites or Fundamental Principles to be observed to meet objectives: Integrity Objectivity Professional competence and due care Confidentiality Professional Behaviour Technical Standards (16, p. 12,13)

IFAC Conceptual Approach to Independence

Objective: Independence of Mind & Appearance To Protect the Public Interest

Identify and EvaluateCircumstances and

Relationshipsthat createThreats To

Independence

Eliminate Threatsor

Reduce to anAcceptable Level

By Applying Safeguards

IFAC Conceptual Approach to Independence

Objective: Independence of Mind & Appearance To Protect the Public Interest

Self-InterestSelf-reviewAdvocacyFamiliarityIntimidation

Threats ToIndependence

ApplySafeguards

ProfessionLegislationRegulation

Within ClientWithin Firm

IFAC Conflict of Interest/Independence

Independence of mind - the state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgement, allowing an individual to act with integrity, and exercise objectivity and professional skepticism

Independence of appearance - the avoidance of facts and circumstances that are so significant a reasonable and informed third party, having regard knowledge of all relevant information, including any safeguards applied, would reasonably conclude a firm’s, or a member of the assurance team’s integrity, objectivity or professional skepticism had been compromised.

(Def., p. 4)

Categories of Conflict of Interest

Stakeholder categories Sphere of activity affected Examples__________________ ________________________ _____________________

Self vs others Services offered Conflicting services, shaving qualityImproper use of influence Improper purchases of client goodsMisuse of information Improper investments by relatives

Self & others Services offered Consulting and other services, and/or vs others over-involvement with management

or Directors erodes objectivity

Client vs client Services offered Serving competing clients Employer vs employer at the same time

Stakeholder Misuse of information Whistle-blowing, reporting to vs stakeholder (confidentiality) government or regulators

_____________________________________________________________________________(Source: Brooks, L.J., Business and Professional Ethics for Directors, Executives & Accountants,

South-Western, a division of Thomson Learning, 2004, Table 4.11

Frequent Conflicts of Interest

Profit vs... the Public Interest Consulting & assurance services Multi-disciplinary practices (MDPs) Fiduciary or Professional Responsibility Confidentiality Serving Multiple Clients Employees vs.... Profit and the Public

Interest Whistle-blowing & Resignation

Safeguards created by theProfession, Legislation, or Regulation

Education, training, experience requirement for entry

Continuing Education Professional standards, monitoring, and

disciplinary processes External review of firm’s quality control

system Legislation governing independence

requirements of the firmIFAC Code, 8.37

Safeguards Within the Client

Appointment of auditors ratified/approved by other than management

Client has competent staff to make managerial decisions

Policies and procedures emphasizing client’s commitment to fair financial reporting

Internal procedures to ensure objective choices in commissioning non-assurance engagements

A corporate governance structure, such as the audit committee, that provide appropriate oversight and communications regarding a firm’s services

IFAC Code, 8.38

Safeguards Within TheFirm’s Own Systems & Procedures

Leadership stressing importance of independence, and expectation of service/action in the public interest

Policies and procedures to implement and monitor control of assurance engagements

Documented independence policies regarding the identification and evaluation of threats to independence, applications of safeguards to eliminate or reduce those threats to an acceptable level

Policies and procedures to monitor and manage the reliance on revenue from a single assurance client

Using partners with separate reporting lines for the provision of non-assurance services to an assurance client

+6 other firm-wide +9 specific items IFAC Code, 8.41,2

Interesting Questions

Is it wrong for an employee to seek a special deal/ discount/benefit from being employed within a company?

Is it acceptable to hold stock in a supplier, customer, client, or other organization doing business with your company/client?

Should you snitch on a fellow worker who snorts cocaine on the job?

If an accountant learns that a client has deliberately violated building codes, should (s)he report the violation? To?

Should a secretary lie to a boss' spouse about his/her whereabouts when the boss is having an affair? What should the secretary do?

Risk Assessment /Ethics & Conflicts of Interest

Comprehensive Risk Management requires understanding the business

Risk Events Causing Drops of Over 25% Share Value,Percentage of Fortune 1000 companies, 1993-1998

Strategic ……………………………. 58%Customer demand shortfall (24) Competitive pressure (12)M & A Integration problems (7) Mis-aligned products (6)

Operational …………….31%

Cost overruns (11) Accounting irregularities (7)

Management ineffectiveness (7) Supply chain pressures (6)

Financial ………..6% [Foreign macro-eco, interest rates ]

Hazard …….0% [Lawsuits, natural disasters]Source: Mercer Management Consulting/Institute of Internal Auditors, 2001

Comprehensive Risk Management includes Ethics Risk Management

Ethics Risk Reputation SuccessReputation is important Arthur Andersen…………… survival RT Capital…………reputational capital Tylenol ……………competitive

advantageSelling trust and credibility, not pills, …

© L. Brooks

Comprehensive Risk Management depends upon the Corporate Ethical Culture

Comprehensive Risk Management utilizes both:A. Key risk factor identification & measurementB. Review of key business processes including the ethical

culture that underpins process integrity Ethical culture provides guidance for employees

about when to adhere to the Code, when actions are not covered in Code, in a grey area, or in a crisis - tools to measure ethical culture do exist

Enron’s Board failed to consider any of this!Few corporations do A, fewer do B!

Emerging Risk-oriented Decision Criteria for Directors

Criteria (New) Interests/Risks Considered

Profitability & legality …… Shareholders +

Fairness & rights …… Specific Stakeholders

Expectations Gap ………. the Public Interest

Risk Assessment - The Auditor’s Emerging Role

Why is it important?What risks are critical?

How can risks be assessed and conveyed?

Risk: Why are auditors interested?

Better achievement of strategic objectives of: the organization involved

to manage risks to reduce problems to take advantage of opportunities

the audit to assess risks likely to affect org. policies

and compliance, and operational health of the organization

to ensure significant risks examined

Traditional Audit Model vs. Business Risk Audit Models

“…the failure to detect processing errors is rarely the cause of audit problems. Rather, the major issues … are more likely to be associated with the manner in which the business entity is managed to achieve its objectives. Factors such as the business environment, governance issues and the nature of managerial control will ultimately have significance for the financial statements – their accuracy, issues of fraud and going concern.”

Developments in the Audit Methodologies of Large Accounting Firms

Lemon, Tatum & Turley, May 2000 (See www.abgweb.com)

Why Manage Risk?

More likely to achieve objectives: Identify and exploit opportunities Identify risks and avoid before problems arise Respond effectively to unexpected events Adapt and mitigate negative impacts Make good decisions quickly Preserve and enhance reputation

More complex environment Faster pace requires faster response Greater downside and upside

Ref: Managing Risk in the New Economy, CICA/AICPA, 2001

Understanding Risk

Risk is the chance of something happening that will have an impact on objectives.

Risk Management includes the culture, processes, and structures that are directed towards the effective management of potential opportunities and adverse effects

Risk Management Process includes the systematic application of management policies, procedures, and practices to the tasks of establishing the context, identifying, analyzing, assessing, managing, monitoring, and communicating risk

Managing Risk in the New EconomyAICPA & CICA, 2001, p. 4

Integrated Risk Management

Enterprise-wide responsibility, not just by specialists

Guidance of risk champion

Based on understanding of multiple risks and the integration of risks

Ref: Enterprise Risk Management: Trends and Emerging Practices, The Institute for internal Auditors Research Foundation, 2001

Approaches to ERM

A. Key Risk Factors Assessment Identification Analysis Ranking Mitigation/planning

B. Process-control Assessment Identification of flaws, then as above

Enterprise Risk Management: Trends and Emerging Practices,The Institute of Internal Auditors Research Foundation, 2001, p. xxxi

Establishing the Risk Context

Appetite for risk depends upon: Corporate philosophy, culture and

strategic perspectives (vision, mission and values), relationships with key stakeholders, external environment, and internal environment

Capacity for risk includes: The ability to exploit opportunities, and The resilience to market setbacks and

catastrophes

Risk Management Context

.RISK MANAGEMENT APPROACH

SET OBJECTIVES…OPTIMIZATION

DETERMINEVALUES

ACCOUNTABILITY AUTHORITY

CRITERIA FOR RISK ASSESSMENT

Risk Management Values

Commitment to ethics, safety, customer service, product quality, corporate citizenship

Risk tolerance Risk limits of lenders,

creditors, shareholders

Openness to questions

Risk Assessment Criteria

Appetite and capacity for risk Policy, goals, objectives,

stakeholder interests Operational, technical, financial,

legal, social, humanitarian + Materiality Iterative

Identifying Risks

Consider both common risks & processes Internal interviewing and discussion –

brainstorming, self-assessment, SWOT analysis

External sources – comparison, discussion, benchmarking, risk consultants

Tools, diagnostics – checklists, analysis: scenarios, value chain analysis, business processes, system engineering` process mapping

Cases exist

Risk Categories - Usual

Category/Approach Sub-category Condition

Governance

Objectives

Areas of Impact Reputation

Assets

Revenues

Costs

Performance

People (Employees/Customers/Communities)

Sources of Risk Environmental

Strategic

Operational

Informational

Specific Hazards/Perils

Degree of Control/Ability To Manage

None/Little/Influence only/Great

Documentation

Risk Aspects - Ministry

Categories Sources Consequences

Environment Human Safety

Strategic Machine Reputation

Operational/Financial Medium Environment

Compliance Mission Service Delivery

Informational Management Info. Integrity

Organizational &Cultural

Privacy/Confidentiality

Criminal Activity Compliance-laws,regs

Security of assets

Analysing and Assessing Risk

A Risk Map

HighModerateLow

Low

Moderate

High

Consequence

Likelihood of Occurrence

Managing Risk in the New Economy, AICPA & CICA, 2001, p.11

Analyzing and Assessing Risks

Likelihood Consequence

Qualitative Almost certain, likely, possible, unlikely, rareNumerical scoring 1, 2, 3 and so onPercentage of volume, and so on

Insignificant, minor, moderate, major, catastrophicNumerical scoring 1, 2, 3 and so on

Quantitative Time frame hourly, daily, weekly, yearly, and so onPercentage of Volume, and so on

Dollar rangesPercentagePer capita

Managing Risk in the New Economy, AICPA & CICA, 2001, p.12

Reputation Ethics

Because of the significant relationship between Ethics and Reputation, should Ethics Risks be a separate category of risk?

An Ethics Risk exists whenever the expectations of the public are different than the action under review

Ethics Risk is an idea under developmentBy L.J. Brooks

Ethics Risk & Opportunity Identification & Assessment

Phase 1Develop aProjected,Ranked

Understandingof Stakeholder

Interests/Expectations

Identify

Rank: Urgency, Power,Legitimacy

DynamicAnalysis

Confirmation

Phase 2Compare

Activities toExpectationsto Identify

Ethics Risks &Opportunities

Performance: Inputs,Outputs,Quality

Hypernorm: Honesty, Fairness, Compassion, Integrity, Predictability, Responsibility

Reputation Driver: Trustworthiness, Credibility, Reliability, Responsibility

Phase 3Reports By

• Stakeholder Group• Product or Service

• Corporate Objective• Hypernorm Value• Reputation Driver