Jessica Company - Bad Corporate Governance Practices and Weaknesses in Internal Control System - Case Study Example

Case Study: Jessica Company

Table of Contents

Question 1 - Ten examples of bad corporate governance practices in Jessica Company.3

Question 2 – Ten weaknesses in Jessica Company’s internal control system.7

Question 3 – Five factors that might increase the risk of fraud in Jessica Company.11

Question 4 – Ten recommendations for Jessica Company.15

Reference List19

• Question 1 - Ten examples of bad corporate governance practices in Jessica Company.

Examples of Bad Corporate Governance

Violation of the UK Code of Corporate Governance

Justification/

Explanation (CWG WHY?)

1. The CEO is also the chairman of the board.

Division of Responsibilities (A.2), Code Provision (A.2.1) states that the roles of chairman and CEO should not be exercised by the same person. Moreover, this code also states that the division of responsibilities between the chairman and the CEO should be clearly mentioned in writing and agreed by the board.

However, Code Provision A.3.1 states that in some exceptional case, if the board decides that the CEO should become the chairman as well, the board should consult the major shareholders in advance and should set out its reasons to shareholders at the time of the appointment and in the next annual report.

If the CEO and the chairman is the same person, it means that the company’s complete decision-making policies lie in the hands of a single person. With one incorrect decision, the company might get steered in a wrong direction. Moreover, if the CEO is the chairman of the board, the other board members may find it difficult to question and evaluate his decisions (Russell Reynolds Associates, 2012).

2. There is no internal audit department.

Audit Committee and Auditors (C.3), Code Provision (C.3.6) states that when there is no internal audit function, the audit committee should annually consider the requirement of an internal audit function and recommend the same to the board and the reasons for absence of an internal audit function should be explained in the annual report.

Without an internal audit department, the company fails to detect and prevent fraud, test internal control and monitor whether the company is complying with the policies and government regulations. This will increase the risk of fraud and other crimes within the company (Hearst Newspapers, LLC, 2016a).

3. None of the board members has any financial expertise, and the majority did not serve as board members in other companies before.

Appointments to the Board (B.2), Code Provision (B.2.2) states that the nomination committee should evaluate the balance of skills, experience, independence and knowledge and through this evaluation should describe the role and capabilities required for a particular appointment.

A board with no financial expertise may lead to poor performance of the audit committee and inaccurate information disclosure to the shareholders. Moreover, the understanding of accounting principles and financial statements will lead to better monitoring and enhanced relation with the shareholders (Guner, Malmendier and Tate, 2007).

4. The board of directors include 6 members, all executive directors except of one non-executive director who owns shares in the company

The Composition of the Board (B.1), Code Provision (B.1.2) states that at least half of the board members should comprise of non-executive directors and a smaller company should have at least two independent non-executive directors.

Only one non-executive director violates the code and it creates imbalance in the proportion of nomination committee, as according to code provision B.2.1, majority of the members of the nomination committee should be non-executive directors (Financial Reporting Council, 2016).

5. There is no clear description of role of the board or how the performance of board members is being evaluated

The Role of the Board (A.1), Code Provision (A.1.1) states that the annual report should include a statement of how the board operates and which types of decisions they can take and Evaluation (B.6), Code Provision (B.6.1) states that the board should mention in the annual report how the performance evaluation of the board, its committee and its individual directors has been conducted.

The board members are elected by the shareholders so that the board can act on behalf of their interest. If the board members do not provide clear description about their operations and their performance evaluation is not mentioned in the annual report, the shareholders might start losing trust in the company which can have a negative impact on the company (Financial Reporting Council, 2016).

6. There is also no mention of the remuneration of directors

The Level and Components of Remuneration (D.2), Code provisions (D.2.1) and (D.2.2) states that there should be a remuneration committee of at least three members who should have the responsibility for setting remuneration for all the executive directors and the chairman and maintain this information in a remuneration report.

In the remuneration report which is an integrated part of the annual report, the remuneration of directors should be mentioned in understandable language which will provide a base for the key performance indicators lined with the strategic objectives of the company. Without such information, the shareholders start losing trust on the board (Deloitte, 2014).

7. Only few members are committed to attending the board meetings

The Role of the Board (A.1), Code Provision (A.1.1) states that the board should meet regularly and sufficiently enough to discharge its duties effectively.

It is the responsibility of all the board members to meet regularly, discuss about the company’s performance and take important decisions for the betterment of the company. The shareholders have appointed the board members so that they can take important decisions regarding the company which can benefit it. If the board members are not committed in attending the board meetings, it will affect the decision-making procedure of the company. The shareholders might decide to dismiss those directors who do not attend the meeting regularly or the shareholders can even leave the company (NPGovernance, 2011).

8. The accountant in the finance department

sometimes does not review his work

Financial and Business Reporting (C.1), Code Provision (C.1.1) states that the directors should explain in the annual report about their responsibility in preparing the annual reports and accounts and also state that the annual report and the accounts taken as a whole is fair, balanced, understandable and provides necessary information.

It is the right of the shareholders to obtain accurate financial information about the company. If the accountant does not review his work, it may lead to error in accounting and reporting, and this result in disclosure of inaccurate financial information to the shareholders (Hearst Newspapers, LLC, 2016b).

9. The board members met only once a year and the meeting only lasted for 50 minutes

The Role of the Board (A.1), Code Provision (A.1.1) states that the board should meet regularly and sufficiently enough to discharge its duties effectively.

If the board members do not meet regularly, they will not get updated about the company’s operations, will create a communication gap and will ultimately fail to fulfil their duties (NPGovernance, 2011).

10. The shareholders are not convinced that many of the decisions taken by the directors recently have benefitted the company

Dialogue with Shareholders (E.1), Code Provisions (E.1.1) and (E.1.2) states that the views of the shareholders should be communicated to the board as a whole and the chairman should discuss governance and strategy with the major shareholders.

The decisions taken by the directors should be beneficial to the company as well as in interest of the shareholders. If the shareholders find that the decisions are not benefiting the company, they might dismiss a director with their power or might leave the company (VentureChoice Inc., 2008).

• Question 2 – Ten weaknesses in Jessica Company’s internal control system.

Weaknesses in Jessica Company’s internal control system

Missing or weak COSO internal control component

Implications of weaknesses on Company’s success

1. The CEO is also the chairman of the board

Component: Control Activities

Element: Adequate separation of duties (COSO, 2013)

This leads to unclear division of responsibilities and provides concentrated power of running the company and the board with one single hand. This also makes the organisation’s structure complicated and difficult in reporting (Russell Reynolds Associates, 2012).

2. None of the board members has any financial expertise

Component: Control Environment

Element: Commitment to Competence (COSO, 2013)

Lack of knowledge about financial statements and accounting standards will lead to inaccurate and incomplete disclosure of financial information to the shareholders. The directors have to take certain important financial decisions regarding capital acquisition, working capital management, profit retention and many more. Without minimum financial expertise, the directors might take wrong decisions which can hamper the company’s growth (Guner, Malmendier and Tate, 2007).

3. The finance manager is also the operation manager and marketing manager.

Component: Control Activities

Element: Adequate separation of duties (COSO, 2013)

One single person cannot effectively manage three separate departments of the company. Finance, operations and marketing all are very important functions of the company, proper management of which not only enhance the performance of the company but it also helps in the company’s growth. Giving the complete responsibility of all the three functions to one single person will lead to mismanagement and complexity in the organisational structure.

4. There is only one person who is responsible for the entire IT function in the company.

Component: Control Activities

Element: Adequate separation of duties (COSO, 2013)

With technological advancements, IT has become a major functional area of every company. Responsibilities of the IT department includes recording of day-to-day information flowing from all the departments and sharing the relevant information to the company’s stakeholders. When one person is given responsibility for all these functions, it not only leads to mismanagement of information flow, but it also gives opportunity to manipulate important data. This can result in misrepresentation of information within the company.

5. There is an administration office run by two persons who are responsible for all the administrative work in the company.

Component: Control Activities

Element: Adequate separation of duties (COSO, 2013)

The administration office is considered to be the backbone of every company. It supports every departments and functions of the company. Running an administration office by only two people will lead to inter-departmental communication gap and inefficiency in operations. Although most of the administrative works are performed electronically nowadays, still some amount of paper work is still applicable. Inefficient handling of these papers may result in loss of important data and hamper the company’s daily operations. Moreover, too much work pressure will have an effect on their morale.

6. There is one small stock room for storing the company’s stock and the rest of the stock is placed outside the stock room in the corridor

Component: Control Activities

Element: Physical control over assets and records (COSO, 2013)

The company’s stock room should be big enough with sufficient space which can accommodate its entire stock. Placing the stock outside the room with no protection can damage the stock and may even lead to pilferage and theft. The company may have to incur huge loss for this reason (Ordoro, 2012).

7. There is one security guard for the stock room who has been working for the company for years

Component: Control Activities

Element: Physical control over assets and records (COSO, 2013)

The company should have at least two security guards who can work in different shifts or can work in each other’s absence. Moreover, the reliability of the security guards is an important aspect which should be considered to avoid pilferage and theft.

8. Several hundred staff was recently made redundant as part of cost-cutting measures

Component: Control Environment

Element: Integrity and Ethical values (COSO, 2013)

Terminating staff as a measure of cost-cutting strategy is considered unethical. Maintaining the welfare of the staff is an important responsibility of every company. Some of them are afraid that they might lose their job anytime. This has resulted in reduced morale within the company. This also leads to reduced productivity, high rate of absenteeism and high employee turnover rate.

9. Jessica Company, along with other companies in its sector, was overcharging its customers

Component: Control Environment

Element: Integrity and Ethical values (COSO, 2013)

Intentionally charging higher prices from the customers for making profit is not considered ethical. This negatively affects the goodwill of the company and also reduces the customer base. Customers will tend to share negative word-of-mouth about the company.

10. The accountant in the finance department sometimes does not review his work

Component: Monitoring (COSO, 2013)

Accurately, accounting the daily transactions will help the company to evaluate its financial performance and also gives scope to identify growth opportunities. Not reviewing the accounts work can always lead to errors which will result in miscalculation of company’s transactions and funds. This will also lead to disclosure of inaccurate financial information to the company’s stakeholders (Hearst Newspapers, LLC, 2016b).

• Question 3 – Five factors that might increase the risk of fraud in Jessica Company.

Factors/circumstances increasing the risk of fraud

Categories of fraud risk factors

Type of fraud

Justification/

explanation

1. There is no internal audit department

Opportunity

Corruption in financial reporting

The internal audit department mainly involves in checking and monitoring the company’s reporting and financial statements. Absence of such department will lead the company’s management to indulge in corrupting activities by manipulating the financial statements (Hearst Newspapers, LLC, 2016a).

2. Morale within the company seems particularly low

Motive, Rationalisation

Theft, Pilferage

The company has terminated many staff before as a cost-cutting measure, which has reduced the morale of the remaining staff. With such low morale, they might attempt to steal money, company’s goods and even company’s property.

3. There is one small stock room for storing the company’s stock and the rest of the stock is placed outside the stock room in the corridor

Opportunity

Misappropriation of assets, Theft

Placing company’s stocks outside the corridor may result in severe damage of the goods. It also gives opportunity to the staff and other people to steal those stocks without the knowledge of the management (Ordoro, 2012).

4. The security guard is responsible for both keeping custody of stock and accounting for them

Opportunity, Rationalisation

Misappropriation of assets, Theft

It is not possible for one single security guard to protect the stocks and also account for them. When the security guard is off-duty or is absent for the day, the stock room remains unprotected and gives opportunity for theft. It is also mentioned that the guard is working for several years and it is found in many cases that people who have been working for many years in a particular company without any significant raise in payment, might get a rationalism to commit fraud.

5. The HR manager might not have time to check employees’ background or even ask for references from their previous employers

Motive, Opportunity

Criminal activities, Corruption

Hiring employees without a minimum background check may not only result in inappropriate recruitment, but it can also give an opportunity to potential criminals to commit crimes within the company. An employee with some criminal record might get recruited without background verification and that person can indulge in illegal activities and corruption which will affect the goodwill of the company.

• Question 4 – Ten recommendations for Jessica Company.

Recommendation

Aim

1. The board must appoint a chairman separate from the CEO.

If the CEO and the chairman of the board is the same person, it not only violates the UK Code of Corporate Governance, but it also creates complexity in organisational structure.

If these two positions are headed by two separate people, the chairman can effectively head the board in taking important strategic decisions and the CEO can head the company in efficiently performing the daily operations.

Heading the two positions by the same person also makes it difficult for the board members in reporting and evaluating the performance of the chairman (Russell Reynolds Associates, 2012).

2. There should be an internal audit department.

It is very important for a company to have an internal audit department. The internal audit function not only monitors and evaluates the financial performance of the company, but it also evaluates the company’s risk management, internal control processes and corporate governance

With an internal audit department, the management can identify whether the company is following the UK Code of Corporate Governance and what measures needs to be taken to adhere to those code provisions. Internal audit will also help to reduce the risk of fraud within the company and effectively monitor the financial reporting.

If the company continues to operate without an internal audit department, the company might have to incur losses due to improper risk management and inefficient financial reporting. The company can also get negative review from the government due to lack of corporate governance (Hearst Newspapers, LLC, 2016a).

3. There should be three separate managers for finance, operations and marketing.

If three separate managers are appointed for the three functions, it will reduce complexity in organisational structure and reporting.

The three managers can efficiently handle their respective departments. The finance manager can manage the company’s financial issues, the operations manager can handle the daily operations and production related issues and the marketing manager can manage the company’s sales and marketing related issues.

If the same person continues to manage the three departments, it will lead to mismanagement and hamper the company’s performance.

4. There should be at least two people involved in the IT functions.

Accurate and timely information flow in the company is very important and there should be no issues regarding software and hardware. This will ease daily operations within the company.

Two people can effectively manage all the IT related issues within the company by enhancing the flow of information within and outside the company.

Running the IT department by one person will lead to mismanagement in information flow and may even result in manipulation of data.

5. There should be at least two directors appointed with some financial expertise.

Some directors should have minimum financial knowledge for monitoring and evaluating the important financial decisions of the company.

If some directors are appointed with financial expertise, it will help the company in framing correct financial strategies and disclosure of accurate financial information to the stakeholders.

If no such directors are appointed, the company might face huge loss by taking wrong financial decisions (Guner, Malmendier and Tate, 2007).

6. All the board members should attend the board meetings regularly.

Presence of all the board members in the meeting will help the board in taking important decisions for the betterment of the company.

The directors not only can take important decisions in the meetings, but can also evaluate the current position of the company.

If all the members do not attend the meeting regularly, a communication gap is created and there will be delay in taking important strategic decisions (NPGovernance, 2011).

7. There should be a big and properly maintained room for the stocks.

A large and properly maintained room will accommodate all the company’s stocks and eliminate the risk of damage and theft.

If the stocks are kept unprotected in the corridor, it may get damaged and stolen, incurring huge loss for the company (Ordoro, 2012).

8. At least two security guards should be there to protect the stock room.

There should be minimum two security guards can work in shifts and work in absence of another.

Keeping only one security guard increases the risk of theft and also the goods can also get misplaced due to improper protection.

9. The shareholders must be convinced and happy with the company’s decisions.

It is very important that the shareholders are satisfied with the decisions and performance of the company.

If the shareholders are not convinced that the decisions taken by the directors is not benefiting the company, the shareholders might use their power to dismiss some directors or the shareholders might leave the company placing the company in a bad position.

10. The accountant must review his work.

It is very important that the accountant review his work so that there is no error in accounts and the shareholders get access to accurate financial data.

Not reviewing the accounts can also lead in recording incorrect financial transactions which may result in mismatch of accounts in financial statements (Hearst Newspapers, LLC, 2016b).

• Reference List

COSO, 2013. Internal Control – Integrated Framework. [pdf] Available at: <http://www.coso.org/documents/990025p_executive_summary_final_may20_e.pdf> [Accessed 8 July 2016]

Deloitte, 2014. Disclosure of remuneration. [pdf] Available at: <http://www2.deloitte.com/content/dam/Deloitte/za/Documents/governance-risk-compliance/ZA_DisclosureOfRemunerationAHotTopic_04042014.pdf> [Accessed 8 July 2016]

Financial Reporting Council, 2016. The UK Corporate Governance Code. [pdf] Available at: <https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/UK-Corporate-Governance-Code-April-2016.pdf> [Accessed 8 July 2016]

Guner, A.B., Malmendier, U. and Tate, G., 2007. Financial expertise of directors. Journal of Financial Economics, 1, p.2

Hearst Newspapers, LLC, 2016a. The Importance of the Internal Audit Function in a Company. [online] Available at: <http://smallbusiness.chron.com/importance-internal-audit-function-company-21496.html> [Accessed 8 July 2016]

Hearst Newspapers, LLC, 2016b. The Effects of Poor Ethics in Accounting. [online] Available at: <http://smallbusiness.chron.com/effects-poor-ethics-accounting-37750.html> [Accessed 8 July 2016]

NPGovernance, 2011. The Importance of Showing Up: Why board meeting attendance matters. [online] Available at: <https://npgovernance.wordpress.com/2011/06/18/the-importance-of-showing-up-why-board-meeting-attendance-matters/> [Accessed 8 July 2016]

Ordoro, 2012. 5 Inventory Management Techniques to Avoid Theft. [online] Available at: <https://blog.ordoro.com/2012/01/19/five-inventory-management-techniques-to-avoid-theft-of-inventory/> [Accessed 8 July 2016]

Russell Reynolds Associates, 2012. Splitting The CEO And Chairman Roles - Yes Or No? [online] Available at: <http://www.russellreynolds.com/newsroom/splitting-the-ceo-and-chairman-roles-yes-or-no> [Accessed 8 July 2016]

VentureChoice Inc., 2008. Roles of Shareholders and Directors. [online] Available at: <http://www.venturechoice.com/articles/roles_of_shareholders_and_directors.htm> [Accessed 8 July 2016]