TOPIC 3: CORPORATE GOVERNANCE AUDITING

CHAPTER 3

CORPORATE GOVERNANCE

It encourages transparency and accountability of those who run the companies through presentation of financial statements to stakeholders. The credibility of these financial statements is enhanced by an audit. Therefore, there is need for an audit to centre on the requirements of the users of financial statements.

 

Examples of users of audited financial statements include shareholders, directors, employees, creditors, the public, customers and government.

 

2. Principles of Corporate Governance

The key principles of corporate governance include transparency, accountability, fairness, responsibility and reputation.

Principles are the reasons why companies or institutions need corporate governance. It is therefore, important that all stakeholders in the company not only understand these principles but also believe in them.

Otherwise, if these are not understood and embraced, corporate governance cannot bring about the change and therefore, the benefits that are accrued to it. This will be true in situations where stakeholders do not understand and accept the principles but undertake corporate governance for the sake of complying with requirements.

The five principles of corporate governance are explained as follows:

2.1          Transparency

Transparency means providing information about activities, plans, actions to stakeholders that are entitled to. In good corporate governance, directors should clarify to shareowners and other key stakeholders why every material decision has been made.

This is accomplished by ensuring timely, accurate disclosure on all material matters, including the financial situation, performance, ownership and corporate governance. This does not include disclosing the company secrets.

The main reason why transparency is important is that it reduces potential conflicts between the owners of companies and the managers of those companies. Most companies are not managed by the owners. The owners simply provide capital and lose control of it in the sense that they appoint directors who in turn employ managers to run the day to day business of the company. Transparency therefore, ensures that managers show how the owners money has been used in the company. Similarly it reassures investors in the sense that they get confidence that the company has been well run.

2.2          Accountability

Accountability is about explaining how powers or authority and resources entrusted have been used. Directors should be held accountable for their decisions to shareowners, and, in certain cases, key stakeholders, submitting themselves to rigorous scrutiny.

In turn, management should also be accountable to the board. Producing financial statements and making them available to the entitled stakeholders is one way how directors and management can account for their decisions and also how they have used financial and other resources entrusted to them.

2.3         Fairness.

The Board should consider Key stakeholder views when making decisions with a sense of justice and avoidance of bias or vested interests.

The Board and management should apply fair practice in their dealings with stakeholders and adhere to the spirit not just the letter of all rules and regulations that govern the organisation. The organisation should provide effective redress for violations.

2.4         Responsibility

Responsibility means management accepting the credit or blame for governance decisions. It implies clear definition of the roles and responsibilities of the roles of senior management. To this end, directors should carry out their duties with honesty, probity and integrity. They should exercise independent judgement when making decisions.

Honest and probity relates not only to telling the truth, but also not misleading shareowners and other stakeholders. Lack of probity includes not only obvious examples of dishonesty such as taking bribes, but also reporting information in a slanted way that is designed to give an unfair impression.

Integrity can be taken as meaning someone of high moral character, who sticks to strict moral or ethical principles no matter the pressure to do otherwise. In working life, this means adhering to the highest standards of professionalism and probity. It also means straight forwardness, fair dealing and honest relationships with different people and constituents. Trust is vital in relationships and belief in the integrity of those with whom you are dealing with underpins this. Thus integrity is an underlying principle of corporate governance. All those in agency relationships should posses and exercise absolute integrity. To fail to do so breaches the relationship of trust.

Exercising independent judgement, is another key ingredient of a responsible board. Judgement means that the board making decisions that enhance the prosperity of the organization. This means that the board members must acquire a broad knowledge of business and its environment to be able to provide meaningful direction to it.

For management to be held properly responsible, organisations should ensure that procedures and structures are in place so as to minimize, or avoid completely, potential conflict of interests that could arise. In addition, there must be a system in place that allows for corrective action and penalizing mismanagement.

2.5       Reputation

Reputation defines an organisation as well as the individuals associated with that organisation. The Board must manage reputation risk. Good practices ensure a good reputation. Bad practices can destroy a reputation overnight.

Consequences of poor reputation include:

  • suppliers and customers unwillingness to deal with the organisation for fear of being victims of dishonesty;
  • inability to recruit high quality staff;
  • fall in demand because of consumer boycotts;
  • increased public relations costs because of adverse stories in the media;
  • increased compliance costs because of close attentions from regulatory bodies or external auditors; and
  • loss of market value because of a fall in investor confidence.

 

  • Pillars and Codes of Corporate Governance

 

  • Pillars of corporate Governance

 

Corporate governance is built on four main cornerstones which all need to have a stable foundation in all well controlled and directed organizations. The four Corporate Governance Cornerstones are the board, management, external audit and internal audit.

 

3.1.1 Board

 

It is a body of elected or appointed members who jointly oversee the activities of a company or organization. A board’s activities are determined by the powers, duties, and responsibilities delegated to it or conferred on it by an authority outside itself, usually by shareholders. The powers, duties and responsibilities are typically detailed in the organization articles of association.

Typical duties of boards of directors include:

  • governing the organization by establishing broad policies and objectives;
  • selecting, appointing, supporting and reviewing the performance of the chief executive officer;
  • ensuring the availability of adequate financial resources;
  • approving annual budgets;
  • accounting to the stakeholders for the organization’s performance;
  • setting the salaries and compensation of company management

3.1.2 Management

It is a collection of people that implements policies and strategies of the organisation as set by the board. Management is led by a Chief executive officer or Executive director and may have other managers such as Chief Finance officer, Chief Operating Officer, Chief Commercial officer and many more. The responsibility of management is to plan, coordinate and manage all business operations to achieve corporate goals.

3.1.3 External audit

 

It is the examination of financial statements in order to provide assurance that the statements have been fairly presented. Chapter 2 explains more about external audit.

3.1.4 Internal audit

 

In order to run a company effectively, and meet their legal responsibilities, directors need assurance in a number of areas in addition to the accuracy of their published financial statements. Much of this work involves financial matters and is therefore likely to be carried out by accountants and/or auditors.

 

With company collapses at an increasing trend, often due to fraud or a failure to adequately appreciate the risks facing the business, the role of internal audit has been growing for some time. Internal audit is now seen as an almost essential element of good ‘corporate governance’, and most large companies have at least an element of internal audit activity.

 

Definition – Internal Audit is an independent, objective assurance and consulting activity designed to add value and improve an organisation’s operations.  It helps an organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.

 

Internal audit is an appraisal function that aims at providing assurance on the adequacy of internal controls. It also aims at providing recommendations to management and board on how to improve systems of control and effectiveness of various processes in an organization. Scope of internal audit therefore is wide and does not confine to financial reporting matters.

 

Since internal audit reviews the organization as a whole, it therefore, follows that various assignments can be carried out by internal audit and such engagements can be operational, financial, compliance or otherwise. Examples of assignments conducted by internal audit include Value for money audits, Environmental audits, IT audits, Fraud investigations and many more. In this chapter, the first two have been explained.

 

3.1.4.1                Value for money audit

 

Value For Money (VFM) audit could be defined as an independent assessment of the extent to which an entity operates efficiently, effectively and with due regard to economy.

 

VFM is concerned with obtaining the best possible combination of services from the least resources. Economy, efficiency and effectiveness (3Es) are the alternative ways of describing VFM.

 

The achievement of the three EEEs depends upon the existence of sound arrangements for planning, appraisal, authorization and control of the use of resources.

 

  • Economy- is concerned with obtaining resources at lowest costs.

 

  • Effectiveness- is the extent to which a programme achieves its established policy goals and objectives or other intended effects.

 

  • Efficiency is the relationship between output, in terms of goods, services or other results, and the resources used to produce them, the inputs. An efficient operation produces the maximum output for any given set of resources or alternatively, it has minimum inputs for any given quantity and quality of services provided.

 

3.1.4.2                Environmental audit

 

Definition

 

It is an audit which determines the degree of compliance with emission and pollution standards.

 

This type of audit is slowly increasing in importance due to the concern of the public and hence governments with the effect that organizations, particularly industrial, can have on the environment.

 

The method of audit is straightforward. Predetermined targets are established either voluntarily by the organization or set by government and actual outcomes are compared to the targets.

 

Eco – audit scheme

 

The European Commission (EC) has adopted a scheme for the establishment of a voluntary community environmental auditing scheme – eco-audit scheme or green audits. It is aimed at companies carrying on industrial activities.

 

A company would, under the scheme, have an environmental audit on each of its sites at regular intervals and set up a framework for acting on the audit findings. A statement would be prepared on the results of the audit which would be available for public inspection. The statement could be carried out by internal staff but would need to be validated by authorized environmental auditors.

 

Impact on annual reports

 

The Institute of Chartered Accountant of England Wales (ICAEW) in 2009 produced a report which suggests that companies should act in a number of areas to respond to the growing importance of ‘green issues’.

 

It is recommended that the annual report should contain details of:

 

  • The company’s environmental policy and objectives;
  • The impact of the business on the environment;
  • The extent to which the company complies with external requirements;
  • Identity of director with environmental responsibility.

 

External auditors need to be aware of contingent liabilities that may require disclosure because of the consequences of damage caused to the environment. The auditor may view many of these liabilities as too remote to be included within the financial statements. Therefore it may be appropriate to have additional environmental audit reports.

 

3.1.5    Comparison between external audit and internal audit

 

External audit is the activity carried on by the auditor when he/she verifies accounting data; determines the accuracy and reliability of accounting statements and reports on them. This activity is carried out by an independent person.

 

Internal audit is an independent appraisal function established by the board of an organization for the review of the internal control system as a service to the organization.  It objectively examines, evaluates and reports on the adequacy of internal control as a contribution to the proper, economic, efficient and effective use of resources.  It is mainly done by employees of the firm and thus independence is not always easy to achieve. However, independent audit firms provide such services.

 

3.1.6  Similarities between external audit and internal audit

 

Both external audit and internal audit are interested in the following.

 

  • An effective system of internal control.

 

  • A continuous effective operation of internal control system.

 

  • Safeguarding of assets of a business.

 

  • An adequate accounting system which complies with the  Companies Act and which provides basis for producing accounts in true and fair terms.

 

  • Adequate management information flow.

 

  • Compliance with statutory and regulatory requirements.

 

In addition both external audit and internal audit use similar methods of approach.  The similar methods are:

 

  • Examination of the system of internal check, for both soundness in design and effectiveness in operation.

 

  • Examination and checking of accounting records and statements.

 

  • Verification of assets and liabilities.

 

  • Observation, inquiry, and the making of statistical comparisons and             accounting ratio measurements.

 

3.1.7 Differences between external audit and internal audit

 

External audit Internal audit
 Work is laid down by statute  Work is determined by management
 The        auditor             must             be independent  The auditor is an employee and may not be independent
 The auditor is interested in the truth and fairness of the financial statements in terms of statutory obligation  The auditor is interested in appraising the efficiency of the system of internal control and management information systems.
 The auditor is paid on a fee

basis

 The auditor is paid on salary basis
 The auditor has responsibility to shareholders and sometimes to other users of accounts  The auditor is answerable only either to management or board of directors
  The auditor is appointed by shareholders  The auditor is appointed by management or board

 

3.1.8       How external auditor cooperates with internal auditor

 

The wide experience of the external auditor may be of assistance to the internal auditor.  On the other hand the internal auditor’s intimate acquaintance with the business concerned may be of help to the external auditor.

 

External auditor and internal auditor may cooperate in the following ways.

 

  • They can agree which aspects of work to be carried out only by internal auditor or together with the external auditor.
  • The external auditor may accept work done by the internal auditor, for example, confirmation of customer accounts, verification of assets and audit schedules prepared by the internal auditor.

 

 

3.2 Codes of corporate governance

 

The need to improve corporate governance came to prominence in the United Kingdom (UK) in the 1980s, following the high profile collapses of a number of large companies (Maxwell, Polly Peck, etc).  Poor standards of corporate governance had led to insufficient controls being in place to prevent wrongdoing in the United States of America (US) in the 1990s, as demonstrated by the collapses at Enron and WorldCom.

 

As a result of the challenges in UK and US corporate governance scholars saw the need to produce guidelines to assist in operating and controlling companies. The guidelines are in forms of codes of best practice.

 

Some of the recent codes of corporate governance are:

  • Malawi code of corporate governance
  • King report of South Africa
  • Combined code of UK

 

 

End of Chapter Question 

 

Question One:

 

You are in charge of the internal audit department of ZX Ltd, a rapidly expanding company. Turnover has increased by about 20% per annum for the last five years, to the current level of K50 million. Net profits are also high, with an acceptable return being provided for the shareholders.

 

The internal audit department was established last year to assist the board of directors in their control of the company and prepare for possible listing on the stock exchange. The managing director is keen to follow the principles of good corporate governance with respect to internal audit. However, he is also aware that the other board members do not have complete knowledge of corporate governance and detailed knowledge of International Standards on Audit.

 

Required:

  1. Explain what you understand by corporate governance and its pillars in a company. 10 Marks
  2. Explain how the internal audit department can assist the board of directors fulfill their obligations under the principle of good corporate governance.10 Marks

Total  20 Marks

 

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