Chapter 13

Corporate Governance and Audits

Corporate governance - the system by which business corporations are

directed and controlled. It is the process by which the owners and creditors
of an organization exert control and require accountability of the resources
entrusted to the organization.
Stakeholders anyone who is influenced, either directly or indirectly, by the
actions of a company
Owners want accountability on such things as:
o Financial performance
o Financial transparency
o Stewardship
o Quality of internal controls
o Composition of the board of directors and the nature of its activities

Management has always had the primary responsibility for the accuracy
and completeness of an organizations financial statements.
It is managements responsibility to:
o Choose which accounting principles best portray the economic substance
of company transactions
o Implement a system of internal control that assures completeness and
accuracy in financial reporting
o Ensure that the financial statements contain accurate and complete
disclosure
Triple-bottom-line reporting- delineates the organizations contributions to
the broader goals of society
An important aspect of governance is the independent judgement of
boards about what is in the best interests of the company and its
shareholders.
PARTIES INVOLVE IN CORPORATE GOVERNANCE and THEIR RESPECTIVE
RESPONSIBILITIES
1. Stockholders- Broad Role: Provide effective oversight through election of
board members, approval of major initiatives such as buying or selling stock,
annual reports on management compensation from the board
2. Board of Directors- Broad role: The major representative of stockholders
to ensure that the organization is run according to the organizations charter
and that there is proper accountability.
Specific activities include:
Selecting management
Reviewing management performance and determining compensation
Declaring dividends
Approving major changes
Approving corporate strategy
 Overseeing accountability activities
3. Management- Broad role: Operations and accountability. Manage the
organization effectively; provide accurate and timely accountability to
shareholders and other stakeholders
Specific activities include:
Formulating strategy and risk management
Implementing effective internal controls
Developing financial and other reports meet public, stakeholder,
and regulatory requirements
Managing and reviewing operations
Implementing an effective ethical environment
4. Audit Committees of the Board of Directors- Broad role: Provide
oversight of the internal and external audit function and the process of
preparing the annual financial statements and public reports on internal
control
Specific activities include:
Selecting the external audit firm
Approving any nonaudit work performed by the audit team
Selecting and/or approving the appointment of the Chief Audit
Executive(internal auditor)
Reviewing and approving the scope and budget of the internal function
Discussing audit findings with internal auditor and external auditor and
advising the board (and management) on specific actions that should be
taken
5. Regulators
a. Board of Accountancy- Broad Role: Set accounting and auditing
standards dictating underlying financial reporting and auditing concepts;
set the expectations of audit quality and accounting quality
Specific activities include:
Establishing accounting principles
Establishing auditing standards
Interpreting previously issued standards implementing quality control
processes to ensure audit quality
Educating members on audit and accounting requirements
b. Securities and Exchange Commission- Broad Role: Ensure the
accuracy, timeliness, and fairness of public reporting of financial and other
information for public companies
Specific activities include:
Reviewing findings with the SEC
Interacting with the FRSC in setting accounting standards
Specifying independence standards required of auditors that report on
public financial statements
Identify corporate frauds, investigate causes, and suggest remedial
actions
6. External Auditors- Broad role: Perform audits of company financial
statements to ensure that the statements are free of material misstatements
including misstatements that may be due to fraud
 Specific activities include:
Audits of public company financial statements
Audits of non-public company financial statements
Other services such as tax or consulting
7. Internal Auditors- Broad Role:Perform audits of companies for compliance
with company policies and laws, audits to evaluate the efficiency of
operations, and periodic evaluation and tests of controls
Specific activities include:
Reporting results and analyses to management(including operational
management) and audit committees
Evaluating internal controls
Corporate Governance Challenges and Failures
1. Stockholders
Focused on short-term prices
Failed to perform long-term growth analysis
Abdicated most responsibilities to management and analysts
as long as stock price increased
2. Board of Directors
Inadequate oversight of management
Approval of management compensation plans, particularly
stock options that provided perverse incentives, including
incentives to manage earnings
Directors often dominated by management
Did not spend sufficient time or have sufficient expertise to
perform duties
Continually re-priced stock options when market price
declined
3. Management
Earnings management to meet analyst expectations
Fraudulent financial reporting
Using accounting concepts
Created an environment of greed, rather than one of high
ethical conduct
4. Audit Committee of the Board of Directors
Similar to board members
Were not viewed by auditors as the audit client
5. Regulators
Inadequate enforcement of existing audit standards
Identified problems but was not sufficient resources by
Congress or the Admission to deal with the issues
6. External Auditors
Helped companies use accounting concepts to achieve earnings
objectives
Promoted personnel based on ability to sell nonaudit products
Replaced direct tests of accounting balances with inquiries , risk
analysis, and analytics
 Failed to uncover basic frauds because fundamental audit
procedures were not performed
7. Internal Auditors
Focused efforts on operational audits and assumed that
functional auditing was addressed by the external audit
function
Reported primarily to management with little reporting to the
audit committee
In some instances did not have access to the corporate
financial accounting records

Relationship between Corporate Governance and Risk to

the Auditor
Good governance is important to the conduct of an audit for one very simple
reason: companies with good corporate governance are less risky to audit.
These companies generally have the following characteristics:
Are less likely to engage in financial engineering;
Have a code of conduct that is reinforced by actions of top management;
Have independent board members who take their jobs seriously and have
sufficient time and resources to perform their work;
Take the requirements of good internal control over financial reporting
seriously; and
Make a commitment to financial competencies needed.

Recall that stockholders and other stakeholders want disclosures from management
that are accurate and objectively verification. The auditor is in a much better
position to provide accurate verification when the governance mechanisms, such as
the board and the audit committee, adhere to and embrace fundamental principles
of good governance.

Responsibility for Finding Fraud

Who should be primarily responsible?

Auditors are not guarantors of the success or failure of a business strategy. Financial
and other officers of an enterprise that is the people who penetrate the fraud-
are primarily responsible for the fraud and the resulting third party losses; owner-
managers who are in contact or who actively work in the business might also be
responsible.
External Auditors Responsibility
Auditor s should be held secondarily responsible if they failed to follow the PSAs
when auditing the enterprise and they did not exercise reasonable professional
judgement when:
 Planning the audit
Designing the audit procedures; and
Evaluating the audit findings

Audit Committee
One of the characteristics of good and effective corporate governance is the
creation of an audit committee which will oversee the accounting and financial
processing of the company and the financial statements audit. SEC Memorandum
#6 requires that audit committees for public companies shall be composed of at
least three directors who shall preferably have accounting and finance backgrounds.

Audit Committee Oversight Responsibilities

a. Assist the Board in the performance of oversight
b. Provide oversight over Managements activities in managing credit, maker,
liquidity, etc.
c. Perform oversight functions over the corporation s internal and external
auditors
d. Review the annual audit plan
e. Discuss with the external auditor the nature, scope and expenses of the audit
f. Organize an internal audit department
g. Monitor and evaluate the adequacy and effectiveness of the corporations
internal control system
h. Review the reports submitted by the internal and external auditors
i. Review the quarterly, half-year and annual financial statements
j. Coordinate, monitor and facilitate compliance with laws, rules and regulations
k. Evaluate and determine the non audit work
l. Establish and identify the reporting line of the Internal Auditor

Summary of Principles of Good Corporate Governance and Best

Practice Recommendations
A company should:
1. Lay solid foundations for management and oversight
2. Structure the board to add value
3. Promote ethical and responsible decision- making
4. Safeguard integrity in financial reporting
5. Make timely and balanced disclosure
6. Respect the rights of shareholders
7. Recognize and manage risk
8. Encourage enhanced performance
9. Remunerate fairly and responsibly
10.Recognize the legitimate interests of stakeholders