Auditing OneLecture 10

Corporate Governance

The corporate governance perspective. Driving force of governance development. Voluntary code Importance of CG Features of poor corporate governance Internal controls and corporate governance.

◦ Cadbury committee◦ Turnbull report◦ Higgs report

Sarbanes-Oxley Report◦ Purpose ◦ Aspects

Codes of Best Practice◦ OECD◦ UK Combined code

The role of audit committees The responsibility of internal control effectiveness The need for an internal audit function

Study Guide

This is a means of ensuring due and adequate control over the strategy and direction of an organisation and stewardship, use and disposition of assets – both financial and non-financial in achieving its key objectives.

“CG is about successful management of the three Rs: risk, return and reputation”. (Nobby Clarke, Former Chairman, Fosters.

“If a country does not have a reputation for strong corporate governance, capital will flow elsewhere”. (Arthur Levitt, Ex-Chairman, SEC of USA).

Thus it is the systems by which companies are directed and controlled.

Corporate Governance perspective

Good corporate governance involves risk management and internal control, accountability to stakeholders and other shareholders and conducting business in an ethical and effective way.

Corporate Governance perspective

Most corporate governance reports are based around the principles of;

Integrity, Accountability, Independence and Good management But there is disappointment on how much

these principles need to be supplemented by detailed rules.

Corporate Governance perspective

(a) Increasing internationalisation and globalisation. Investors and institutional investors began to invest outside their home countries.

(b) The differential treatment of domestic and foreign investors.

(c) Inadequate issues concerning Financial reporting.

(d) The characteristics of individual countries. Kings report emphasises the importance of qualities that are fundamental to South African culture such as collectiveness, consensus, helpfulness, fairness, consultation and religious faith.

The driving forces of governance development

(e) High profile corporate scandals. Spectacular business failures in the 80’s, 90’s, 2001 and global credit crunch commencing 2008 onwards;

(f) Gap between executive compensation and corporate performance;

(g) Competitiveness and investor confidence and attraction;

(h) The role and influence of Governments and International Agencies – USA, World Bank, OECD, COMSEEC etc and

(i) Increasing privatisation.

The driving forces of governance development

Should corporate governance guidance be in the form of principles or detailed laws.

Merits of a voluntary code; Flexibility in application – disclosure of the

extent of compliance with codes ensure shareholders are aware of a company’s arrangements.

Legislation would be burdensome and punitive to certain companies due to their size and composition of investors

Voluntary codes(principles) vs Legislation(rules)

Drawbacks of a voluntary code. Some companies do not comply freely with

voluntary codes which can adversely affect shareholders’ interests and awareness of those companies’ affairs.

The ability of shareholders to raise issues arising from non-compliance at the AGM is limited.

Voluntary codes(principles) vs Legislation(rules)

Shareholders who are not directors need assurance on;◦ How their investment is being managed◦ Whether their investment is subject to risks such as fraud.

The audit does not address these matters and is restricted to opinion on the true and fair view given by the financial statements.

Investors therefore have a knowledge gap in relation to the efficiency, effectiveness and competence of directors managing their investment, in relation to the directors’ management of risk and in relation to the viability of the company.

Importance of good corporate governance.

Shareholders need information about risks affecting their investment and how they are being managed.

Shareholders and stakeholders need assurance as to the future viability of the company.

Governments need assurance that companies’ practice good corporate governance since economic growth depends upon attracting investment especially from international investors.

Importance of good corporate governance

Domination by a single individual Lack of involvement of board Lack of adequate control function Lack of supervision Lack of independent scrutiny Lack of contact with shareholders Emphasis on short-term profitability Misleading accounts and information

Features of poor corporate governance

Cadbury committees; This committee was set up because of the

lack of confidence which was perceived in financial reporting and in the ability of external auditors to provide assurance required by the users of financial statements. The main difficulties were considered to be in the relationship between external auditors and boards of directors.

Internal controls and corporate governance

In 1999, Nigel Turnbull chaired a Committee for the Institute of Chartered Accountants in England and Wales (ICAEW), which produced a report highlighting the need for companies to demonstrate corporate responsibility to their shareholders with strong emphasis on internal controls and risks management.

The report has resulted in the study and subsequent management of risk being taken very seriously in companies throughout the developed economies.

Turnbull report

Also known as the “Review of the role and Effectiveness of Non Executive Directors Report”, was published in January 2003 at the request of the UK Chancellor and the UK Department of Trade and Industry (DTI). It sets out the measures designed to improve the structure and accountability of UK boardrooms.

After being criticized for being too harsh, a toned-down version of Higgs Report was produced by the UK Financial Reporting Council as the Combined Code on Corporate Governance.

it applies to UK companies quoted fully on the London Stock Exchange but not to those listed on Alternative Investment Market (AIM)

Higgs report

Corporate governance is in fact an umbrella term that covers a whole host of guidance and legislations including the Data Protection Act, the Computer Misuse Act and Anti-Money Laundering Legislation.

The SOX Act (2002) is probably the most prominent piece of legislation enacted so far.

Introduced in the USA in 2002, it covers corporate governance, financial reporting and auditing requirements.

Sarbanes Oxley Act (SOX Act) 2002

This was the work of Senator Paul Sarbanes and Congressman Michael Oxley.

These men and their respective houses, worked together to formulate an act that would hold publicly traded companies to a higher standard and require more transparent financial reporting methods to ensure the safety of shareholders’ money.

Signed into law by Bush in July 2002, it applies to public companies in the US and those serving them such as audit committees, auditors and attorneys.

Sarbanes Oxley Act (SOX Act) 2002

The purpose of SOX Act is to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes.

To help establish investor trust, the regulations of the Sarbanes-Oxley Act are based on three principles;

Integrity, Accuracy and accountability.

Purpose of SOX Act

Company disclosure◦ Corporate responsibility◦ Enhanced financial disclosures◦ Corporate and Criminal Fraud Accountability

Auditing◦ Public Company Accounting Oversight Board

(PCAOB) Financial analysis

◦ Analysts’ Conflict of Interest (between securities analysts and investment banking)

Aspects of SOX Act

Codes of Best Practice

The OECD Principles and The UK Combined Code of Corporate Governance

The Organisation of Economic Cooperation and Development (OECD), has identified common elements underlying good corporate governance and included in “Principles of Corporate Governance”.

Principles cover; The rights of shareholders Equitable treatment of shareholders The role of stakeholders Disclosure and transparency Responsibility of the board Auditors can use these Principles to assess the

adequacy of any corporate governance regime in the absence of specific national regulations or standards

The OECD Principles

Central to the code are 5 main areas: Section 1: Companies A. DIRECTORS A.1 The Board A.2 Chairman and Chief Executive A.3 Board Balance and Independence A.4 Appointments to the Board A.5 Information and Professional Dev. A.6 Performance Evaluation A. 7 Re-election B. REMUNERATION B. 1 The Level and Make-up of Remuneration B.2 Procedure

UK Combined Code of Corporate Governance.

C. ACCOUNTABILITY AND AUDIT C.1 Financial Reporting C.2 Internal Control C.3 Audit Committee and Auditors D. RELATIONS WITH SHAREHOLDERS D.1 Dialogue with Institutional Shareholders D.2 Constructive use of AGM Section 2: Shareholders E INSTITUTIONAL SHAREHOLDERS E.1 Dialogue with Companies E.2 Evaluation of Governance Disclosures E.3 Shareholder Voting

UK Combined Code of Corporate Governance.

A.1 The Board; Every company should be headed by an

effective board, which is collectively responsible for the success of the company

A.2 Chairman and the Chief Executive There should be a clear division of

responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company’s business. No one individual should have unfettered powers of decision

A. Directors

A.3 Board balance and Independence The board should include a balance of

executive and non-executive directors (and, in particular, independent non-executive directors) such that no individual or small group of individuals can dominate the board’s decision making.

A.4 Appointments to the board There should be a formal, rigorous and

transparent procedure for the appointment of new directors to the board.

A. Directors

A.5 Information and Professional Development.

The board should be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties. All directors should receive an induction on joining the board and should regularly update and refresh their skills and knowledge

A. Directors

A.6 Performance Evaluation The board should undertake a formal and

rigorous annual evaluation of its own performance and that of its committees and individual directors.

A.7 Re-election All directors should be submitted for re-

election at regular intervals, subject to continued satisfactory performance. The board should ensure planned and progressive refreshing of the board.

A. Directors

A strengthened for the audit committee in monitoring the integrity of the company’s financial reporting, re-enforcing the independence of the external audit and reviewing the management of financial and other risks.

A. Directors

B. Remuneration

B.1 The Level and Make-up of Remuneration

Levels of Remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose. A significant proportion of directors’ remuneration should be structured so as to link rewards to corporate and individual performance.

B. Remuneration

B.2 Procedure There should be a formal and transparentprocedure for development policy on

executiveremuneration and for fixing the remunerationpackages of individual directors. No directorshould be involved in deciding his or her ownremuneration

C. Accountability and Audit

C.1 Financial Reporting The board should present a balanced andunderstandable assessment of the company’sposition and prospects.

C.2 Internal Control The board should maintain a sound system

ofinternal control to safeguard shareholders’investment and the company’s assets.

C. Accountability and Audit

C.3 Audit Committee and Auditors The board should establish formal andtransparent arrangements for considering

howthey should apply the financial reporting andinternal control principles and for maintainingan appropriate relationship with the

company’sauditors.

D. Relations with Shareholders

D.1 Dialogue with Institutional Shareholders There should be a dialogue with shareholders

based on the mutual understanding of objectives. The board as a whole has a responsibility for ensuring that a satisfactory dialogue with shareholders takes place.

D.2 Constructive use of AGM The board should use the AGM to communicate

with investors and to encourage their participation

E. Institutional ShareholdersE.1 Dialogue with Companies Institutional shareholders should enter into a

dialogue with companies based on the mutual understanding of the objectives.

E.2 Evaluation of Governance Disclosures When evaluating a company’s governancearrangements, particularly those relating to boardstructure and composition, institutional

shareholders should give due weight to all relevant factors drawn to their attention.

E.3 Shareholders Voting Institutional shareholders have a

responsibility to make considered use of their votes.

E. Institutional Shareholders

The auditors’ reporting role in relation to corporate governance Auditors should include a description of

their responsibilities in the normal annual audit report

The provisions of the combined code under (iii) Accountability and audit above (except the going concern statement) should be reviewed and they should be stated as being subject to the auditors’ review in the audit report.

The auditor should state they are only required to report on the results of the review if directors have not complied, either by non-disclosure or directors’ statements are inconsistent with the auditors’ knowledge of the company.

The auditors’ reporting role in relation to corporate governance

Auditors are not expected to assess whether all risks are satisfactorily addressed by the internal controls, nor form an opinion on the effectiveness of the company’s corporate governance procedures, nor its risk and control procedures. This fact should be stated in the auditors’ report.

The auditors’ reporting role in relation to corporate governance

“We review whether the Corporate Governance Statement reflects the company’s compliance with the nine provisions of the 2003 FRC Combined Code specified for our review by the Listing Rules of the Financial Service Authority, and we report if it does not. We are not required to consider whether the Board’s statements on internal control cover all the risks and controls, or to form an opinion on the effectiveness of the company’s corporate governance procedures or its risk and control procedures.”

Illustrative wording of review of corporate governance statements.

Audit committeesStructure, roles, benefits and limitations

The establishment of an effective audit committee is an important part of good corporate governance principles.

An audit committee comprises non-executive directors who should be independent of the company.

Audit Committees

The detailed role of the audit committee varies from company to company and country to country, but could include the review of the following;

The company’s strategy The company’s performance Company’s commercial policies The acquisition and deployment of resources Making key appointments Establishing corporate standards of conduct Reviewing the company’s accounting policies.

Roles of audit committee.

Company’s compliance with the Combined Code including the directors’ statement on internal financial control effectiveness

Company’s risk management systems Appointing, removing the auditors and fixing auditors’

remuneration Review auditors management letter and response from

management Review scope and quality of ext. auditors work Consider other services of external auditors for conflict of

interest Work of internal audit and control systems Implement and review ad hoc investigations Compliance with laws and regulations

Roles of audit committee.

For stakeholders; Increased confidence in the credibility of

financial reports and improvement in the quality of financial reporting.

For the external auditors; Buffer between auditors and executive

directors thus reducing executive pressure and increasing auditor independence.

Channel of communication between and an impartial forum in the event of disagreement arising and for raising issues of concern

Benefits of audit committees

For all interested parties; Committee can create a climate of

discipline and control, reducing the opportunity for fraud.

It can strengthen the position of the internal audit function by providing a greater degree of independence from management

Benefits of audit committees

Selection of non-executive directors is difficult

Review of strategy and commercial policies of executives may be seen as having a stifling effect on their entrepreneurial activities

Findings are rarely made public and their effectiveness is difficult to assess

Limitations/drawbacks of audit committees

Internal financial control effectiveness

Importance, responsibilities of directors and auditors, the need for internal audit

function

Internal control system encompasses the policies, processes, tasks, behaviours and other aspects of a company which together;

Facilitate effectiveness and efficient operation to respond to business, operational, financial, compliance and other risks to achieve company objectives and safeguard assets.

Ensure the quality of internal and external reporting. This requires maintenance of proper records and processes that generate a flow of timely, relevant and reliable info.

Ensure compliance with applicable laws and regulations and internal policies with respect to conduct of business.

Importance of control and risk management

Directors should; Have a defined process for the review Regularly review internal control reports Consider key risks and how they have been

managed. Consider the adequacy of remedial action Consider the adequacy of monitoring Conduct an annual assessment of risks and the

effectiveness of internal control Make a statement on this process in the annual

report

Responsibilities of directors

Auditor should assess whether the directors’ summary of the process of reviewing the effectiveness of the control system is supported by the documentation prepared by the directors

Enquiries should be made of the directors and a review made of the statement made by the directors and the supporting documentation

Auditors are not expected to assess whether all risks and controls have been reviewed nor whether the risks are satisfactorily addressed by the internal controls, nor form an opinion on the effectiveness of the co.s corporate governance procedures, nor its risk and control procedures – this fact should be stated in the auditors’ report

Auditors responsibilities

If the auditor have any reservations, they should recommend specifically on them in the auditors’ report in an emphasis of matter paragraph following the unqualified opnion on the financial statements

Auditors responsibilities

The Combined Code emphasis the consideration of key risks and their management.

The traditional audit function covers the assessment of internal control systems are arising from the company’s operational activities – eg risk of bankruptcy, of non-compliance with law and regulations, of bad publicity etc.

Assessing the need for an internal audit function

The directors in consequence should consider the establishment of an internal audit function (where none exists) to assist in the formulation of a risk management strategy:

The identification of risks in relation to specific systems governing, for example, break contracts by large customers, operational risks arising from shortages in raw materials, compliance with health and safety laws etc

The controls of risks- eg staff training in risk awareness,

The monitoring of risks.

Auditors responsibilities