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The Uk Corporate Governance Framework Accounting Essay

A good governance system in an organization begins with having internal audit function. The value and the need to focus on improving strong corporate governance have increased due to a series of failure (bankruptcy and fraud) and financial scandals like earnings restatement to ensure financial reporting quality (Zeleke Belay, 2007). These corporate upheavals have driven external regulators to find ways of promoting greater accountability, disclosure and transparency. The main role of corporate governance is to restore the trust and market confidence as well; shareholders. (Carl Rosen, 2010)

It has been widely recognised that the role of the internal auditor becomes a continuing contributor in terms of developing good corporate governance practices and structure. It is said that an effective internal audit function enables the board to perform its corporate governance duties through organizational involvement, assessment, training, professional guidance and communication at all levels within the organization (Kenneth D’Silva, Jeffrey Ridley, 2007).

Audit committee, managers, internal auditors and external auditors play a critical role in effective control and appropriate leadership within the organization to act in the interest of the shareholders. To achieve results, practicing good corporate governance with clear criteria is an essential tool in an organization (Sridhar Ramamoort, 2003).

Most companies recognised and valued internal auditing and therefore, the role of internal auditors have escalated and are being relied on to contribute significantly in business improvement, strategic and operation risks. (Kenneth D’Silva, Jeffrey Ridley, 2007).

Background

The revolution of corporate governance started in the early 1990s in the United Kingdom (UK) with the Cadbury report (1992) on the financial aspects of corporate governance; with a code of best practices such as separation of the chairman and chief executive, the independence of audit committees and the practice of regularly reviewing the board’s effectiveness. Corporate governance is the relationships between managers, directors and shareholders (Cadbury report, 1992; FRC, 2012).

In UK, it is a voluntary code for listed companies in the UK, with “comply or explain” principle. Listed companies must comply with the listing rules to report on the way they complied or explain why it does not in their annual reports. The principles also apply to the internal audit function; companies that do not have internal audit function are recommended to review if there is a need for one from time to time. This will provide more transparency and accountability of the board of directors which contributed to the development of the UK corporate governance code (FRC, 2012; Keay, Andrew R, 2012).

As mention above, internal auditors plays a unique role in the governance system in terms of monitoring and identifying risk and testing of internal controls processes to ensure effectiveness or efficiency and adherence to relevant law and regulations.

The institute of internal auditing (IIA) which was established in 1941 is a guidance setting body and is currently recognise in 165 countries as a comprising mandatory criteria standards and guidelines applicable to all internal auditors for internal auditing practices (IIA, 2013).

It is essential that the board understands the importance of corporate governance and internal audit functions. The quality of corporate governance will have a profound impact on the efficiency of corporate assets use, ability to attract low-cost capital, ability to meet societal expectations and overall performance. It is said that investors are willing to pay more for a company with good corporate governance due to the fact that risk factor is reduced and believes company will perform better in the long term. With good corporate governance, internal audit work should also be performed with high standards and at appropriate level of scepticism. Further details on the standards will be discussed in section 2.1 (FRC, 2012).

Objectives

The objectives of this report were attained by analysing different literature and theoretical background of internal audit and corporate governance framework. The two case studies used in this report is an example of companies who have already experience corporate scandals. Both companies are in different industry but both failures pointed out were similar internal control and dishonesty were mainly lacking in both organizations. In this report, we will discuss on how the failure of corporate governance arises in both organization and how these failures affect the companies in different ways.

Methodology

This research is carried out based on many researchers’ works in the value of role of internal auditor in UK corporate governance framework. The factors chosen are those identified issue by the Institute of Internal Auditors (IIA) together with other related articles primarily from previous studies.

Layout

Section 1 is of this report includes introduction and background of corporate governance and internal auditing and methodology of the research.

Section 2 is literature review in view of the role of internal auditors in UK corporate governance framework and the theoretical background of corporate governance and internal auditing.

Section 3 is the case study scandal on Royal Dutch Shell and Royal bank of Scotland.

Section 4 discusses on how both companies failed to comply with the standards leading to misrepresenting the accounts.

Section 5 is what the limitations of findings and conclusions and recommendations are.

Literature review

During the early days, internal auditor role is only related to internal accounting control and security over assets acting as “policemen” checking and monitoring the company’s procedures and compliances with the rules. This is to assist company in producing reliable accounting information for decision-making purposes. However, internal auditor role has now expanded to be involved in operating systems, implement effective governance and controls and assess effectiveness of managements control practices and assisting in achieving company objectives and governance. They are the eyes and ears of the management, which is vital in the system of checks and balances (Deloitte, 2012). In a literature review of Sarens and De Beelde (2006) says internal auditors are currently expected to make things happen rather than waiting to respond to it.

One of the reasons leading to corporate scandals was creative accounting (for example, Shell case). Financial statements presented to stakeholders may not be in fact “true”. Dishonesty of directors plays a vital role in corporate scandals; such as knowing the accounts may not be done properly and deliberately hiding the problems from shareholder that the company is performing well. Some others says it is also due to personal greed (for example, employees at RBS Libor scandal), ethical laxity, weakness in functioning area, auditor oversight or systemic factor as a main cause of deceit (Piet Eenkhoorn, Johan Graaflandal, 1998).

The UK’s Turnbull report provides some suggestions that have to be taken into consideration when establishing internal audit function. Some factors like number of employees might indicate risks directly; with more employees complexity of payroll may increase. Some companies which indicate the boards failing to implement risk assessment and responding to risk might have simply implied the need for an internal audit department (Amanda Williams, 2012).

The likelihood of the organization not achieving its goals is highly possible if there is a major internal control failure for example in the case of Royal bank of Scotland. (Amanda Williams, 2012). 4news (2013) mention that ethical misbehaviour leads to sanctions which RBS needs to sort it out (4news, 2013).

So, without a quality activity, transparency and responsibility of the internal audit; can’t assure good corporate governance. Internal auditors often find themselves in an anomalous position in a reporting structure. Most Internal auditor report to senior management but yet are expected to review management conduct and effectiveness objectively. To prevent conflict of interest, internal auditor should report primarily and directly to the board and its audit committee rather than to senior management. (Amanda Williams, 2012).

However, there is always limitation to the effectiveness of internal audit reports; for example, they may not be privy to all sources of information throughout the company if it is not within the management structure or management cannot accept the findings. Therefore, internal auditor may face certain dilemma and criticism and hence soften the findings in report to avoid confrontation or to safeguard their positions. To protect the independency, political power should be given to the internal auditors. In view of the Libor scandals reported in myfinances.co.uk (2013), mention that IIA have drafted out a new code and is pending for further consultation which internal auditors will be given much more power to report to the chairmen rather than chief executives to maintain their independence (myfinances.co.uk, 2013)

Theory

Internal auditing

Institute of Internal Auditors (IIA, 2012) defined internal auditing role in governance processes as promoting appropriate ethics and values within the organization, ensure effectiveness and accountability, effectively communicate risk and control information appropriately and coordinating activities among the board, external and internal auditors and management in various areas.

Some of the IIA standards include in section 2110.AI standards; the function of an internal auditor should evaluate, design, implement and review on the effectiveness of the organization ethics, objectives and activities. Internal auditor helps organization in detecting and preventing fraud, testing internal control and monitor compliance with company policy and government regulation (IIA, 2012).

Internal Auditor plays like a frontline player in governance activities which includes risk-driven efforts provided for critical inputs to other governance participants, including the audit committee and management (Dana R. Hermanson, Larry E. Rittenberg. 2003).

UK corporate governance framework

Sir Adrian Cadbury defined corporate governance as the system by which companies are directed and controlled (Cadbury report, 1992). Cadbury report was particularly concerned with the low level of confidence in financial reporting and is generally believed to be the foremost cornerstone of modern corporate governance. Its findings and recommendations leading to the present day evolutions of corporate governance worldwide had quite an effect on the corporate world. The three basic principles included: openness, integrity and accountability (Jan Cattrysse, 2005).

The Cadbury Report included a number of financial aspects of corporate governance which includes the role and responsibilities of the board, consisting of executive directors and majority of independent non-executive directors; auditing and reporting of financial information to shareholders; appointment of non-executive audit committee and roles includes monitoring and reviewing effectiveness of company internal audit functions (Cadbury, 1992).

Turnbull report (September 1999) has the most significant implications on corporate governance and also on internal auditing recommending important guidelines which includes the following. Listed companies are expected to have a sound system of internal control to safeguard shareholders’ investment and company’s assets. Management needs to review effectiveness of internal control on an annual basis. Business risk should be evaluated regularly. Board is responsible for internal control and the need for internal audit department needs to be kept under review (FRC, 2005).

In view of the corporate scandals one cannot help but wonder how long this ‘comply or explain’ principle will still last. There seems to be a growing demand for ‘compliance’ and less interest in the ‘explanation’. Surely, the more emphasis is being placed on compliance, the more need for control and for independent audits in general. Only compliance provides proper assurance for good corporate governance.

Case studies

Introduction of company

The Royal Dutch Shell has been around for more than a century they are now the second largest oil exploration and production company in the world in terms of revenue. Shell headquarters is in Netherlands with its registered office in London, United Kingdom. Shell is a global group of energy and petrochemical companies aiming to meet the energy needs of society in an economically, socially and environmentally viable now and in future. (Shell, 2013)

Corporate scandal of Shell

In 2004 Shell announced that it financial statements overstated its oil reserves resulting a huge reclassification of 4.47 billion (approximately twenty-three per cent of previously report prove reserves) barrels of oil in April 2004 which originally reported as proven oil and gas reserves in 2002. In February 2005, approximately 1.37 billion barrels of oil were removed which was originally reported as proved reserves in 2003. Financial statements were restated accordingly. Reserves are an oil company's most valuable asset, and any reclassification into less certain categories is a major concern for investors (ICMR, 2005). It was uncovered by an external auditor, Ryder Scott instead of Shell’s group reserve auditor which Shell has mention in 2004 annual report that there was a lack of appropriate resources and confusion or roles and responsibilities with respect to the group reserves coordinator and auditor (Shell annual report, 2004)

Introduction of company

The Royal Bank of Scotland group PLC (RBS) was founded in 1727 is headquartered in Edinburgh, the United Kingdom. It provides banking and financial products to personal, commercial, corporate and institutional customer worldwide. RBS has around 700 branches mainly in Scotland and throughout England and Wales. (RBS, 2013)

Corporate scandal of RBS

London interbank offered rate (Libor) is an international benchmark for which banks are required to use to monitor financial transactions between other banks and customers. The scandal was uncovered in 2012 by U.S. Commodity Futures Trading Commission (CFTC) when it was found that a number of banks like Barclay, UBS and RBS have been fixing the interest rate during the financial crisis as a means of making higher profits under the nose of their internal auditors. It was found that twenty-one employees have been manipulating the Libor rate particularly Yen and Swiss Franc Libor submission from 2006 and up until 2010. RBS employees have submitted false data on interest rates to benefit its trading positions. Despite five internal audits was done by RBS group internal auditor the manipulation of submission was failed to detect by them. They even mention that adequate systems and controls were in place; if it is then why wasn’t it reported earlier. The internal auditors were under fire from regulators for failing to spot on the manipulation of Libor interest rate and should report directly to company board and having sufficient resources to do so (Reuters, 2013).

Application of theory

Dechow, et al. (1995) find that firms with weak corporate governance are more likely to manipulate earnings. If the internal audit department is to be effective in providing assurance it needs to be: sufficiently resourced, both financially and in terms of qualified, experienced staff; well organised, so that it has well developed work practices; and independent and objective (IIA, 2013). Agrawal and Chadha (2005) find that the probability of restating earnings is lower when boards and audit committees have financial expertise.

Shell

According to IIA standards, internal auditor should be someone who is qualified and has experience; however this is not the case for Shell. A retired Shell engineer was acting as Group Reserve Auditor to perform this function which he was an experience engineer but he does not have adequate training or expertise on how to conduct his works and the rules and standards on which his opinions should be based. He reported to the management of Shell’s exploration and production division which were the same people he audited (David Gwilliam, et al. 2009) which clearly shows a conflict of interest (Stephen J. Korotash. 2004).

According to IIA (2013) standards 1210, internal auditor must possess the knowledge, skill and other competencies needed to perform their individual responsibilities (IIA, 2013). Which in this case, Shell failed to conform to applicable regulations including not conforming to the requirements of SEC guidance Rule 4-10 in a number of significant ways (Stephen J. Korotash. 2004).

Shell structured its organization with two boards and a Committee of Managing Directors which resulted in lower accountability. Absence of clearly defined roles and responsibilities of the top management made misrepresentation easier. (David Gwilliam, et al. 2009).

The lack of effective internal controls over the reserves estimation and reporting processes. As mention in section 2 literature review, creative accounting scandals happened due to the desirableness in creating and maintaining strong appearance of financial statements. Shell established their reserve figure was deficient both in terms of over-optimism and in failing to comply with SEC rules and interpretative guidance (Stephen J. Korotash. 2004).

Conclusion

An internal review of the governance structure of the group was carried out in 2004 whereby, they merge two parent companies Royal Dutch Petroleum and Shell Transport and trading company into single new parent company. The management have concluded that in order to win back investor confidence, ensure greater transparency and avoid accounting failures was to overhaul its corporate governance system (Shell, 2004). Shell’s decentralized system required an effective internal reserves audit function. (David Gwilliam, et al. 2009.)

RBS

One of the many roles of internal auditor is supposed to alert company about potential risks and ensure risk is report to company’s leadership. However, it does seem to be in the case of RBS scandal leading to manipulation of submission of Libor.

An internal audit report gave RBS bank Libor setting as a clean bill of health was misleading for the stakeholders (Telegraphy, 2013). RBS failed to comply with internal control with the guidelines mention in Turnbull report (FRC, 2005) and violation of U.S. Commodity Futures Trading Commission (CFTC) several acts leading to the failure of RBS. Some of the guidelines and act which include Turnbull report (2005) mention that internal review should cover all material controls, including financial, operational and compliance controls and risk management systems and the act of CFTC (2011) section 6a rules covering market manipulation and fraud and section 9a (CFTC, 2001) commodity exchange act and etc.

The CFTC reported (2013) that RBS has lack of internal controls, failure to implement controls for making Libor submission which allows conflict of interest to happen in the organization. No equate training, systems, controls, policies governing the procedure for making Libor submissions. RBS Group internal auditor has also mention that there was a lack of discussion of strategy and risk and hence, failed to identify the risk and preventing it from happening (Risk Business, 2008; CFCT, 2013)

Conclusion

This scandal has cause RBS operating expenses fell by £859 million and headcount fell by 9,600. More importantly, losing the shareholders and public confidence in RBS; they will have to rebuild the trust all over again (RBS annual report, 2012)

CFTC (2013) report mentions that conducting of internal audit of samples of its submission should be done periodically every six months to verify the integrity and reliability of the process. RBS must now implement better internal controls and write up clear submission procedures and policies on interest rates including Libor in order to ensure that any submissions are reliable (CFCT, 2013).

As mention in section 2.1 literature review, in response to Libor corporate scandal; a new consultation document designed to avoid a repeat of the Libor and other mis-selling scandals is being launched in February 2013 by the Institute of Internal Auditors (IIA) (myfinances.co.uk, 2013).

Conclusions

Internal auditor plays an important role in corporate governance in an organization to overcome financial crisis, restoring stakeholders’ confidence for the future. When shareholders and the public lose the confidence in the company, it will take much more efforts in regaining it back. Having independence, qualified with integrity auditor is fundamental to a company good governance practices and with the required resources from the board members and audit committee.

The evidence presented in this paper based on study of two major corporate cause celebres provides at best muted support for the viewpoint that seeking to reinforce the existing corporate governance structure along the lines advocated in the UK will necessarily act to prevent any such future failure of corporate governance.

Limitations

The limitations with this topic was, there was ample literature available for corporate governance and that it is very difficult to select appropriate ones however, not very much on roles of internal auditor in corporate governance. As this assignment focus is on the Role of internal auditor particularly in UK governance, there is limited number of case study for this topic; moreover one of the case study of RBS is a very recent case in 2012 therefore not much literature has been covered.

Word count: 3396

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