CHAPTER 16 Auditing and corporate governance. Contents Corporate governance Independent directors Chairman of the board and chief executive officer

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts

CHAPTER 16Auditing and corporate

governance


Contents Corporate governance Independent directors Chairman of the board and chief executive

officer Institutional shareholders Statutory audit Issues in international audit Audit independence Internal control and risk management Audit committee


Corporate governance

Agency problem: the owners of a business (principals) need means to ensure that those whom they appointed to run the business (agents) do so in a way that matches with shareholders’ needs

Agency problem has been broadened out into the concept of corporate governance


Corporate governance (cont.)

Increased emphasis on the effectiveness and accountability of corporate boards of directors

Extending the shareholder perspective to wider stakeholder concerns


Corporate governance regimes

Governance regimes are heavily influenced by the institutional environment

Stakeholder model (Continental Europe) versus shareholder model (Anglo-Saxon environment) of corporate governance

Tendency towards convergence on the issue of effectiveness and accountability of corporate boards


Reporting on internal control

An effective system of internal control is seen as crucial for good goverance

Reporting on the effectiveness of internal control as a governance requirement

COSO Framework is considered to offer an established set of control criteria to assess the effectiveness of internal control

US Sarbanes-Oxley Act of 2002


US Sarbanes-Oxley Act

Each annual report filed with the SEC has to include an internal control report Management’s responsibility for establishing

adequate internal control over financial reporting

Management’s assessment of its effectiveness The independent auditors must attest to

and report on the assessments made by company management


Independent directors Independent directors are non-

executive directors who attend board meetings on a regular basis and monitor corporate behaviour

A (unitary) board should include a significant portion of independent directors

In a dual-board system, the supervisory board exercises oversight over what executive directors in the management board are doing


Independent directors (cont.)

Independent directors should be free of personal or business ties with the company

They are increasingly asked to participate in subcommittees to deal with particular tasks Remunertaion committee Audit committee


Chairman of the board

Most corporate governance codes recommend a clear division of responsibilities at the top between the chairman of the board and the CEO Ensures a balance of power and

authority Less acute in a dual-board system


Institutional shareholders

Financial institutions (banks, insurance companies, fund managers, pension funds, etc.) with large shareholdings

Institutional shareholders increasingly pressure companies to sign up to codes of conduct


Statutory audit The independent auditor’s assurance plays a

central role in corporate governance Auditing (multinational) group accounts is

more complicated than individual accounts, as subsidiaries are working in different legal environments and involves intra-group reconciliations. Moreover, it adds time pressure

The auditor of group accounts is responsible for any error in the group audit, even if such an error has arisen because of a mistake by the auditor of a subsidiary


International audit Multinationals tend to have an exclusive

auditor (large audit firm) for all their subsidiaries

The conduct of an international audit is usually guided by the set of international auditing rules put out by the International Federation of Accountants (IFAC)

The audit report should specify what auditing rules have been followed by the auditor


Audit independence The value of an audit depends partly upon

the technical skills of the auditor and partly upon his independence and ethical qualities

Independence issues: Restrictions on the type of non-audit services

that an auditor is allowed to provide to audit clients

Employment of former audit firm employees by the audit client

Periodic audit partner rotation Limits to the audit appointment


Internal control and risk management

Effective risk management should enable companies to take risks with more confidence and in a rational and informed manner

Those charged with corporate governance are expected to systematically identify, evaluate and respond to company risks

COSO’s Enterprise Risk Management – Integrated Framework (2004)


Enterprise risk management -Definition

“Enterprise risk management is a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.”

Source: COSO, Enterprise Risk Management – Integrated Framework, 2004


Enterprise risk management COSO sees internal control as a subset of

risk management Other risk management devices include

transferring risk to third parties, risk-sharing, contingency planning and consciously excluding activities deemed too risky

Risk disclosure requirements may empower shareholders to use disclosures to bring companies to adopt more elaborate risk management standards


Audit committee Independence is an essential quality for

audit committee members The audit committee should provide a

quasi-independent forum where those concerned with checking the effectiveness and quality of the company’s accounting and control should be able to meet and discuss with shareholder representatives (independent directors) and raise issues of concern


Audit committee roles

Oversee of the financial reporting process

Monitor the effectiveness of the system of internal control (and possibly of the enterprise risk management system)

Act as an intermediary between the board of directors and the external auditors (and possibly internal auditors as well)

Documents

CHAPTER 16 Auditing and corporate governance. Contents Corporate governance Independent directors Chairman of the board and chief executive officer