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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. Effective governance includes systems, process and controls that promote ethics, values, performance, accountability, risk communication, coordination and communication among the board, external and internal auditors and management (Gramling et al, 2004)
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.
Most companies recognised and valued internal auditing as making an independent contribution to corporate governance practices in their organisations especially in the area of risk management, governance and control. The expectations of the role of internal auditor have increased and are being relied on to contribute significantly.
According to Cadbury report (1992), corporate governance is the system by which companies are directed and controlled. It is the relationships between managers, directors and shareholders. UK Corporate Governance code is a voluntary code for listed companies in the UK which was first published in 1992, 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. It will provide more transparency and accountability of the board of directors which contributed to the development of the UK corporate governance code (Keay, Andrew R, 2012).
Corporate governance includes the law, regulations, listing rules and practices that enable the organization to perform efficiently and generating profit but yet meeting both legal obligations and society expectations.
It is essential that the board understands the importance of corporate governance. 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. Investor is prepared to pay more for a company with good corporate governance because investor believes that the company will perform better in the future and risk is reduced.
During the early days internal auditor role is only related to internal accounting control and security over assets. However, internal auditor role has now expanded to be involved in operating systems and the achievement of firms' objectives and governing. Traditionally the internal auditors were acting as 'policemen' that check and monitor the company's procedures and level of compliances with the rules (Skinner and Spira, 2003).
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.
This research is carried out based on many researchers' works in the value of internal auditing 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.
Section 1 is of this report includes introduction 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.
Ibrahim El' Sayed Ebaid (2011, pg, 171-183) says traditionally, the internal audit function was designed to safeguard firm's assets and assist in producing reliable accounting information for decision-making purposes. Now, the role of auditor has expanded to implement effective governance and controls; and assess the effectiveness of management's control practices. They are the eyes and ears of the management, which is vital in the system of checks and balances (Deloitte, 2010). 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.
Piet Eenkhoorn, Johan Graafland (1998) mention that one of the reasons leading to corporate scandals was creative accounting (for example, Shell). Financial statements presented to stakeholders may not be in fact "true". Dishonesty of directors plays a vital role in corporate scandals; it can be in many ways 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).
UK corporate governance stresses the importance of strengthening financial controls and accountability of the boards of directors to shareholders. The Combined Code also recommends that non-executive directors should be independent, underlining the important role that the non-executive directors play in contributing to and enhancing corporate governance (Gramling et al, 2004).
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 RBS (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. A dilemma, 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).
Internal audit is vital for an organization's governance mechanisms. Institute of Internal Auditors (IIA, 2012) defines 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.
The standards are also to measure at board level; the effectiveness of internal auditing practices in organisations of all sizes and sectors in many countries. IIA frameworks include definition of internal auditing, codes of ethics, attributable, performance and implementation standards, practice advisories and position (Kenneth D'Silva, Jeffrey Ridley, 2007).
Some of the IIA standards includes 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 both governance activities which are monitoring of risks and providing assurance regarding controls. The internal auditor's risk-driven efforts provide critical inputs to other governance participants, including the audit committee and management. n To enhance organization effectiveness or efficiency, internal auditor may spend some time on consulting or operational oriented work. (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 'perceived' 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 of the board; auditing and reporting of financial information to shareholders. The report was structured in a manner that organisations can easily follow it. The Cadbury report Section 4 deals with the structure of board, and there should be executive directors and independent non-executive directors. Section 4.11 explains the purpose of having non-executive directors. The responsibilities of directors which are mentioned in section 4.28. Internal control is discussed in section 4.31 provide guidance on keeping records of accounts and reducing the chance of fraud. Section 4.33 explains about Audit committee and their relationship with the board members and the appointment of external auditors (Cadbury Report, 1992).
The UK Corporate governance framework sets out the requirements relating to the composition and functions of the audit committee. Management must monitor the financial reporting process; monitor the effectiveness of the company's internal control, internal audit, and risk management systems. Where there is no internal audit function, the audit committee should consider annually whether there is a need for an internal audit function and make a recommendation to the board. Where there is no internal audit function, the reasons for the absence of such a function should be explained in the relevant section of the annual report.
Turnbull report (September 1999) has the most significant implications on corporate governance and also on internal auditing recommending a few 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 - Governance Problem
Introduction of company
The Royal Dutch Shell has been around for more than a century and is still surviving very strongly as 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).
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. A scandal was uncovered 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. It was found that twenty employees of RBS had been manipulating the Libor rate specially Japanese Yen and Swiss Franc Libor submission from 2006 and up until 2010, after the U.S Commodity future trading commission investigations into the bank's conduct had already begun. The U.S. Commodity Futures Trading Commission (CFTC) says RBS submitted false data on interest rates to benefit its trading positions.
The financial services agency (FSA) found that one trader approached colleagues responsible for setting these interest rates and these 'submitters' manipulate the rate to rig bets made by the trader on complex financial instruments known as derivatives. RBS bank's failed to stop this wrongdoing, which persisted for four years, showed 'serious deficiencies' in its 'internal controls' (CFTC, 2013).
RBS was fined £390million by US and UK regulators for manipulating a key global interest rate.
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)
Shell: No segregation of duties and inadequate training
Agrawal and Chadha (2005) find that the probability of restating earnings is lower when boards and audit committees have financial expertise.
In the case of Shell, a retired Shell engineer acting as Group Reserve Auditor was engaged 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.
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 failure of Shell's internal reserves estimation and reporting guidelines to conform to applicable regulations. 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).
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 - lack of internal control
Failure to comply internal control with the guidelines mention in Turnbull report (FRC, 2005) leads to the failure of RBS. Turnbull report (2005) mention that review should cover all material controls, including financial, operational and compliance controls and risk management systems.
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.
Mr Hester told the Commission that an internal audit report that gave the bank's Libor-setting process a clean bill of health was "misleading", the group had subsequently taken "disciplinary action" against some of those involved and insisted the document did not amount to a "conspiracy" (Telegraphy, 2013)
The financial authority services (2013) and US Commodity Futures Trading Commission mention that RBS sought to manipulate Libor in order to improve the profitability of its trading books. RBS failed to adequately supervise its trading desks and traders. By allowing derivatives traders and submitters to share a desk, the CFTC said this made it much easier for RBS to engage in Libor manipulations. RBS Group internal auditor has 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)
CFTC (2013) report also 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).
Internal auditor plays an important role in corporate governance in an organization to overcome financial crisis, restoring stakeholders confidence for the future. 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.
Internal auditors are (generally) employed by the company they are reporting on and are often managed as part of the finance function. They will therefore have to report upon the effectiveness of financial systems that they form a part of. It is therefore difficult for internal audit to remain truly objective. However, acceptable levels of independence can be achieved through one, or more, of the following strategies: Reporting channels separate from the management of the main financial reporting function, such as an audit committee; Reviews of internal audit work by managers independent of the function under scrutiny; and Outsourcing the internal audit function to a professional third party
The increase in costs is already with organization in terms of increased expenditure on internal audit and burgeoning fees for audit firms (primarily linked to advice on internal control) and non-executive directors.
Limitations of Auditor
The reporting systems structure whereby, the chief internal auditor reports to the finance director. This limits the effectiveness of the internal audit reports as the finance director will also be responsible for some of the financial systems that the internal auditor is reporting on. Similarly, the chief internal auditor may soften or limit criticism in reports to avoid confrontation with the finance director. To ensure independence, the internal audit should report to an audit committee.
One of the major problem realised with this topic was, there was ample amount of literature available and that it is very difficult to select the most appropriate one. But problem was solved by concentrating on academic literature, which is mentioned in brief in this assignment.