Corporate governance relates to the structure by which companies are monitored and controlled. From the enterprise aspect, supervision and monitoring of management performance is considered whereas from the accountability aspect, ensuring the best interest of the shareholders and other stakeholders is considered to be fundamental to corporate governance. The first part will consider the contribution of external audit and internal audit to corporate governance. Subsequent section will illustrate the barriers to that contribution and how those barriers might be overcome.
The contribution of external audit and internal audit to the Corporate Governance
Corporate governance is the system under which companies are organized, financed and operated. The aims of corporate governance are included performance, which is the provision of strategic direction to ensure that objectives are achieved and conformance, which is the identification of management risks and the provision of assurance to ensure the organisation's resources are used responsibly.
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The primary objective of corporate governance is transparent management of the company. It ensures that the board of director responsible for monitoring and managing the risk and the external auditors remain independent and free from influence of the company. It also addresses other issues like business ethics and corporate social responsibility.
The purpose of having corporate governance is to motivate managers to keep the promises they make to investors. Good corporate governance, then, is increased levels of confidence and transparency in company activities by achieving the goals that are in the interest of the company and its shareholders. However, bad governance can be defined as promise-breaking behavior.
By 1999, the IIA Inc. had revised the definition of internal auditing, "Internal auditing helps an organisation to achieve its objectives by bringing a systematic approach to evaluate and contribute to the improvement of risk management, control and governance processes." According to Okafor and Ibadin (2009), "the internal audit performs a critical role in improving corporate governance in companies." An effective internal audit function is able to help the board to discharge its governance responsibilities. Internal auditing and corporate governance is considered as a matter of major public concern.
The contribution of internal auditing to corporate governance is described by indicating the relationship between internal audit and key elements of corporate governance. Rezaee (1996) explained that "the internal auditors in nowadays business environment are provided a wider range of information which is concerning the organisation's financial, operational and compliance activities. Their intention is to improve effectiveness, efficiency, and economy of management performance and activities. The company should focus on all cornerstones of corporate governance and in particular the internal audit function to achieve the quality of governance.
The internal auditing contributes to corporate governance by assessing the scope and effectiveness of the systems established by management to identify and monitor the risks arising from the organisation's activities. According to Rezaee and Lander (1993), "the internal auditing provides information that related to any fraudulent activities or irregularities." It will conduct the company's annual report and report the results to the audit committee. Sawyer (2003) describes "the internal auditing will encourage audit committee to review its activities and practises periodically to ensure that its activities are constituent with leading practises."
On the other hand, "external audit is also regarded as an important cornerstone of corporate governance, with respect to align the interests of managers and shareholders and reduce the potential for opportunistic managers' behavior." (Adamec et al.& Davidson et al., 2005)
Corporate governance resolves the problems which arise from the principal-agent relationship. As Turnbull (2000) notes, "agency theory can simply conclude that the value of the organisation's shares cannot be maximised because managers possess discretions, which allow them to expropriate value to themselves." However, the external auditor's involvement could contribute to corporate governance efforts in addressing the agency problem. The external auditor would help to encourage the managers become more accountable. Through an appropriate application of accounting policies, creative accounting practices and hyper inflation of figures are discouraged by the external auditor. For those managers or directors who intentionally inflate or manipulate the accounting figures and financial statements would impose penalties, for example, by reducing such managers or directors' annual bonuses or even pensions.
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"An improvement of corporate governance in Europe, in the aftermath of Enron would require the involvement of external auditors." (Hopt, 2007) According to Abbott (2007), "outsourcing the company's routine internal audit activities to external auditors not only constitutes a threat to external auditor's independence but could also generate disagreements relating to financial reporting and internal control issues between the external auditor and management."
In order to strengthen the mechanisms of corporate governance, the internal and external auditors should be mutually support and cooperate. (Gramling and Myers, 2003).
The barriers to the contribution of the external and internal audit
The corporate frauds such as Enron and other recent audit failures have highlighted the importance of auditor independence as a global issue. According to Mautz and Sharaf (1961), "auditor independence is a cornerstone of the auditing profession, and a crucial element in the statutory corporate reporting process." An auditor is expected to be free from undue influence which may affect his own opinion about the state of affairs of his client's business. The auditor is required to be independent and also be seen to be independent by stakeholders of the company he is reporting on.
Dictionary of International Accounting Terms (2001) defines "audit independence as an individual who should have no personal or financial involvement with a client." Louwers et al. (2007) defines "independence as a mental attitude and physical appearance which the auditor would not influenced by others in judgment and decision making." However, Whittington & Pany (2004) concluded that "auditor independence is relative and not absolute. Commonly there are five threats to auditor independence are identified. These are self-interest, self-review, advocacy, familiarity and intimidation threat." (Cosserat, 2004)
The elements that give rise to these threats include tenure, rendering of non audit services, ability of managers to influence the compensation of auditors, size of the audit and strength of audit committee. Other factors included large size of audit fees, highly competitive audit service market, and non existence of audit committees.
Different researchers have recognised the auditor independence also as an ethical issue. Mednick (1990) stated that "there should be more emphasis on developing professional ethics in order to overcome the problems related to auditor independence." Ethics are important to the auditors because it helps the auditors to decide the concept of right and wrong and how to react in difficult situations. Therefore, codes of ethics are relatively important as rules in the accounting profession.
On the one hand, external auditors need to evaluate the internal auditors' functions such as the internal auditors' competence, objectivity, and work performance when conducting an independent audit for a large company who has an internal audit staff. The effective independent audit is to provide adequate lines of communication between the internal and external auditors.
This aspect is extremely important because of the working team relationship that must exist. If it does not exist, it is likely that this aspect can significantly influence many audit decisions made by the external auditors. Thus, because of the nature of this relationship, communication problems can affect the outcome of an effective and efficient independent audit.
The internal audit has moved from being an extension of financial control, focussing on financial accounts and the operation of routine internal financial controls in many companies. The external auditor's responsibilities role in corporate governance is fundamental complements in helping to achieve the desired aims of corporate governance. It expressed that financial information is important to the growth of any economy. There have been some of the corporate scandals happened over the years and this has raised questions about the independence of the auditor in the discharge of his statutory function. The way to improve the communication between internal and external auditors is to recognize the barriers that may cause problems. Various training and educational efforts can be offered once the problems have been identified.