Stakeholders, corporate social responsibility and ethics in financial management

A company can make a large profit by paying suppliers late, cutting safety spending and buying from a factory that uses child labour. Its shareholders may cheer for a year. Then a journalist publishes a photograph, customers leave, the government steps in and the share price falls. The lesson is that a company cannot keep making money against the wishes of everyone who has a stake in it.

This topic covers stakeholders and their conflicts, agency theory and its costs, how to reduce the agency problem, corporate social responsibility (CSR), and ethics in financial management, including codes of ethics. The previous topic covered the treasury. The next topic covers money laundering and the duties of directors. The past papers have tested stakeholders and agency conflicts in several diets.

Key terms in plain English

Syllabus check

This topic is in syllabus area A3, which covers:

• the impact of business, financial and investment decisions on the environment and stakeholders;
• agency issues and stakeholder conflicts, and ways to resolve them;
• the effect of ethical and governance issues on the management of financial resources.

CAMA 2020 and stakeholders

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.

Stakeholders and their interests

• Shareholders: a suitable return and growth in wealth. Some are long-term holders, others want quick gains.
• Directors and senior managers: careers, income and personal wealth depend on the company.
• Other employees: pay, job security and prospects, but often less influence unless they have strong union representation or scarce skills.
• Lenders: protection of their investment, so they care about the ability to pay interest and principal and want to limit further borrowing.
• Government: as regulator, as a source of tax, as a promoter of employment and sometimes as a customer.
• Customers and suppliers: quality, fair dealing and prompt payment, and some power over the company.
• Society: ethics, human rights, the environment and pollution. A poor reputation can bring new legislation or lost sales.

The power of each group depends on how far its interests fit with the others and on its ability to influence strategy.

Conflicts between stakeholders

When interests conflict, either a compromise satisfies each group partly, or the company acts for its most powerful group. In practice there is a mix. Examples:

• Directors and shareholders may want more debt because it is cheaper. Lenders want a cap, so loan agreements contain covenants that set a maximum gearing.
• The government wants tax on profits. The company wants to minimise tax.
• A company cannot maximise returns and also pay high wages.
• A company cannot maximise short-term profit and also pay for environmental protection and safe waste disposal.

The most important conflict in a large listed company is between shareholders and the board and senior managers.

Agency theory

Jensen and Meckling (1976) described the agency relationship as a contract between owners and managers, where owners hire agents to run the company and delegate decisions. A perfect contract is impossible, because managers’ decisions affect their own interests as well as the owners’. When managers put their own interests first, governance has failed.

Agency conflicts

• Moral hazard: managers take the benefits of status, such as cars and aircraft, especially when they own few shares.
• Effort level: managers work less hard than owners would, at senior and middle levels.
• Earnings retention: pay linked to company size gives managers a reason to grow the company and keep profit, not pay dividends.
• Risk aversion: managers who depend on one employer avoid risky projects that shareholders, who can diversify, would accept.
• Time horizon: managers with annual bonuses and short tenure favour short-term returns, such as accounting return on capital, over long-term share value.

Agency costs

• Monitoring costs, such as the annual report and the audit.
• The cost of poor decisions, such as overpaying for an acquisition that raises the manager’s status.
• Bonding costs, which are the costs of pay schemes that align interests, such as free shares, options and cash bonuses linked to targets.

Agency costs do not exist when owners and managers are the same people. They start when some shareholders are not directors, and are highest in large companies.

Reducing the agency problem

• Reward packages that give executives an interest in shareholder value (see the previous topic).
• A board with a majority of independent non-executive directors (Fama and Jensen, 1983), who decide matters where executives have a conflict, such as executive pay.
• Codes of corporate governance, listing rules and disclosure, which reduce the information gap.
• Monitoring, including the audit.

Corporate social responsibility

CSR is decision-making linked to ethical values and respect for people, society and the environment, as well as legal compliance. The company is a corporate citizen with a social contract: society lets it operate and in return it uses resources responsibly. Responsibilities fall in two areas: those needed to succeed and meet the law, and duties that some people think go beyond that.

Ethical frameworks often describe four layers: economic (be profitable and pursue shareholder wealth), legal (obey the law), ethical (do what is right even where the law is silent) and philanthropic (give back to the community).

Principles of CSR

1. Operate ethically and with integrity, with a recognised code of conduct.
2. Treat employees fairly and with respect: good conditions, education and training.
3. Respect basic human rights and be a responsible citizen, for example by refusing child labour and helping local schools and hospitals.
4. Sustain the environment: cut pollution, use renewable energy, recycle and run a sustainable business.

CSR fits the stakeholder view of governance. Profit maximisation with no regard for social and environmental duties is not acceptable. A company that promotes its ethics is exposed to reputation risk, for example if a foreign supplier is found to use forced or child labour. Public concern about the environment is rising, and companies that ignore it risk damage to their name and, over time, lost sales and profit.

Some companies use CSR statements only to improve public relations.

Ethics in financial management

Business ethics covers honesty and integrity (more than staying within the law), concern for stakeholders, respect for human rights, concern for the environment and social responsibility to communities. Financial managers must notice ethical issues in the advice they give.

Codes of ethics

A code of ethics is issued by the board and guides every employee. It works only if directors and senior managers are seen to follow it. Companies adopt codes for three reasons that build on each other:

• compliance (obeying laws and public expectations)
• stakeholder relations (trust through openness and transparency)
• a value-based organisation (an ethical culture, which may help long-term success, though this is opinion and not proof)

Global companies find it hard to apply one code in every culture, and codes often focus on the home country.

A typical code has general statements and sections on each stakeholder group:

• employees (human rights, equal opportunity, no harassment, health and safety, privacy, rules on gifts and bribes)
• customers (fair dealing, product safety, honest advertising, privacy)
• competitors (fair dealing and no industrial spying)
• shareholders (trust through disclosure)

It states that local law must be obeyed and that breaches bring discipline.

In the exam you are more likely to be asked to comment on a practical dilemma than to describe a code, but a code is a useful practical suggestion.

The rules in more depth

Why shareholders are not the only group that matters

Shareholders are paid last. If lenders, staff, customers or the government turn against the company, there may be nothing left for the shareholders. So long-term wealth depends on keeping the other groups content.

Why directors’ pay schemes can backfire

A bonus tied to one year’s profit rewards cuts in training, maintenance and research. A share option rewards a rise in price, including rises that managers did not cause. Schemes need several measures and a long horizon.

Why CSR can be justified by wealth maximisation

Good staff relations, a good reputation and fewer fines can raise profit and lower risk. Where CSR costs money, the board must decide how far to go, and should be honest with shareholders about it.

Effect on analysis

In the exam, name each stakeholder, state its interest, say who has the power, and propose a compromise.

Worked examples

1. Current gearing.
   150 ÷ (150 + 300) = 33.3%.
2. The maximum total debt D satisfies D ÷ (D + 300) = 0.40, so D = 0.40D + 120, and 0.60D = 120, so D = ₦200m.
3. The company can borrow only ₦50m more (200 − 150) without breaching the covenant.
4. To raise more, the directors must negotiate with the lender or issue equity. This shows lenders restricting the choice of shareholders and directors.

1. Overpayment = 520 − 400 = ₦120m.
2. If the market agrees with the valuer, shareholders lose about ₦120m of value. This is an agency cost from a poor decision.
3. Controls: board approval by independent directors, an independent valuation, and pay that does not depend only on size.

1. Stakeholders affected: children and families (human rights), customers and the public (trust), shareholders (reputation and cost), employees and the government.
2. Risk: if the story is published, the company suffers reputation risk and may lose sales.
3. Action: investigate and audit the supplier, require compliance with the code, change supplier if it does not comply, and tell stakeholders what was done. The extra 4% is a cost of protecting long-term value.

How to score full marks

• Name each stakeholder in the scenario and state its interest.
• Identify the conflict and say who is more powerful.
• For agency questions, name the conflict (moral hazard, effort, retention, risk, time) and link it to the facts.
• Give remedies: pay schemes, independent directors, codes, monitoring.
• Discuss both views of CSR and reputation risk.
• Apply ethics to the dilemma and recommend an action.

Common mistakes in the exam

• Treating shareholders as the only stakeholder.
• Listing agency problems without applying them to the case.
• Writing about shareholder wealth for a public body.
• Ignoring lenders’ covenants when advising on gearing.
• Saying that CSR is always a cost with no benefit.
• Describing a code of ethics in theory when the question asks for a practical recommendation.

Quick revision

• Stakeholders: shareholders, directors, employees, lenders, government, customers, suppliers, society.
• Main conflict: shareholders against managers (agency).
• Agency conflicts: moral hazard, effort, retention, risk aversion, time horizon.
• Agency costs: monitoring, poor decisions, bonding.
• Remedies: performance pay, independent non-executive directors, codes, audit.
• CSR: ethics, fair staff treatment, human rights and community, environment. Risk: reputation.
• CAMA 2020: ss. 305, 306, 308, 404(7).

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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