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Sir Adrian Cadbury, who chaired the U.K's Committee on the Financial Aspects of Corporate Governance which reported in 1992, stated that corporate governance was " the system by which companies are directed and controlled" (Cadbury Report 1992, page 15). This definition is sufficient but clearly conveys the importance of controls in the company. Corporate governance, the process whereby directors of a company are monitored and controlled, involves decision making, accountability and monitoring.
Two aspects which are considered to be fundamental to corporate governance are:
Supervision and monitoring of management performance (the enterprise aspect) and
Ensuring accountability of management to shareholders and other stakeholders (the accountability aspect).
Enron, Parmalat, WorldCom, HIH - these corporate failures and accounting scandals shook the foundations of investor confidence in the transparency, integrity and accountability of corporations and capital markets.
There has also been public disquiet about the role professional auditors and audit firms have played in these corporate scandals. There have been disastrous repercussions of the above, many of which have assumed epic proportions: reputations both of key individuals and organizations are in ruins, jobs have been lost, and pension funds have been wiped out. The damage, both economic and social, has been incalculable, and the implications are far-reaching for corporate management, company directors, audit firms and the investing public.
An array of factors contributed to these events, but one thing is for certain -the billions of dollars in corporate value lost was due in significant part to unscrupulous management and boards of directors that failed to meet their responsibilities. The accounting profession, including auditors, also played a major role in these events. While the story behind these corporate failures is always complex, a lack of ethical behaviour by many individuals is a big part of it.
Role of auditors
For the audit profession, these developments have again highlighted the gap between public expectations and the reality of the role of the auditor. With Enron in particular, the public perception was that the auditor should have acted as a control on unscrupulous management practices. The conclusion reached by many members of the public (and parliamentarians) was that the auditors failed in this responsibility because their independence from the management of Enron was compromised. While it is by no means as simple as that, the audit profession must acknowledge and address these types of perceptions, or indeed facts, if it is to restore trust in both the capital markets and itself.
Corporate governance involves decision making, accountability, and monitoring.
Decisions require relevant and reliable information.
Accountability involves measuring, reporting, and transparency.
Monitoring involves systems and feedback.
The auditor does not have direct corporate governance responsibility but rather provides a check on the information aspects of the governance system.
Three key themes have emerged from lessons learned from various corporate collapses and these are:
emphasis on "substance of the transaction" rather than legal form,
the management of risk
Since the management of risk is considered to have the greatest impact and significance in the fields of regulation and corporate governance, auditors are to play a major play.
The financial audit remains an important aspect of corporate governance that makes management accountable to shareholders for its stewardship of a company.
"The quality of reported financial information, however, is influenced not simply by the quality of accounting standards, but also by other institutional factors [corporate governance, the legal system, and the existence and enforcement of laws governing investor protection and disclosure standards] that affect the demand for and the supply of financial information
At this point it is pertinent to mention that it is not the regulator alone who can bring about effective corporate governance; the auditors play a key role in meeting the objective. In order for audit committees to fulfill their role as watchdogs over the financial reporting process, members of the audit committee need to receive important information about the company's business activities and the proper accounting for those activities. This implies that any good audit is a function of good accounts and good accounts come from full disclosures which clearly show the financial health of the company.
Auditor's primary role is to check whether the financial information given to investors is reliable. To meet its obligations to shareholders, the Board must ensure that it receives relevant and reliable information. Auditor assists the Board in achieving that goal. There must be open and frank dialogue between the auditors and the board.
However, the role of auditors is to ensure whether Board of Directors and the management are acting responsibly towards the shareholders' investment interests i.e. no leakages are taking place on the investment side; no wastages on the expenditure side and is there propriety of the expenditure or not.
The biggest challenge ahead for auditors is to identify how ethical behaviour can be - and be seen to be - restored, as it is this that will be the basis for the reconstruction of public trust in the profession and in the practice of auditing. Regulators are increasingly taking an interest in the activities of auditors evidenced by:
Regulation of the relationship between the auditors and the company (independence and freedom from conflicts)
Public inspections of audit firms (quality control systems within the firm and appropriateness of audit work
It is imperative that the auditor is perceived to be independent of the client. For instance, SOX adopts a rules-driven approach setting out prohibited services and requiring preapproval by audit committee of non-audit services
Auditing and accounting rules have evolved to a quantitative rule of thumb for materiality when the qualitative factors often speak volumes about the financial condition of the company as well as management's integrity. Ethical behaviour is not simply conforming to legal and professional rules; it is a state of mind, the following of unwritten principles, a culture of 'doing the right thing'.
For e.g. Asian Financial Crisis in the late 1990s revealed the vulnerability of economies to structural weaknesses in governance systems. It has become evident that prudent management and sound code of ethics could have prevented the economic meltdown in the Newly Industrialized Countries (NICs)
The cost of accounting and audit failures is immense in terms of skepticism about the auditors and the companies, in terms of litigation against the auditors and the companies and in terms of the survival of the auditors and the companies
Corporate governance, business ethics and effective compliance management are increasingly critical to an organization's reputation and success. To regain public trust, safeguard reputation and grow market share, all organizations need to embed ethics and compliance into their culture and core business processes. They also need a mechanism so that they can be seen by the public at large to have these processes working effectively.
A framework and process for corporate governance, business ethics and compliance management that weaves together a 'top-down' approach to managing accountability with 'bottom-up' compliance processes is a large step in the right direction.
External auditors can impact the risk taking incentives of management through an appropriate application of accounting policies. However, it is also important to ensure that rules (in the event of a breach of accounting polices) are correspondingly enforced. The external auditor's responsibilities and the audit committee's role in corporate governance are fundamental complements in helping to achieve the desired aims of corporate governance. Safeguards are necessary to ensure that the external auditor's expertise is maximized. In conclusion, good corporate governance is largely the result of a sound internal monitoring system, an effective regulatory environment and adequate disclosure requirements. The significance of mandatory compliance with laws and regulations through a strict monitoring and regulatory system is crucial. Even though external auditors play a vital role in corporate governance, through their involvement and their examination of financial statement and accounting policies, it must be emphasized that they alone cannot promote effective governance. The ultimate success or failure of an organization's code of conduct and business ethics program will rest upon the values and culture created by the board of directors or leadership team, and ultimately embraced by all its people