LECTURE 7 â CORPORATE GOVERNANCE Corporate Governance ...
LECTURE 7 – CORPORATE GOVERNANCE Corporate Governance ‘a process by which the owners and creditors of an organization exert control and require accountability for the resources entrusted to the organization. The owners (stockholders) elect a board of directors to provide oversight of the organization’s activities.’ “The framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations” (ASX CGC) Primary Parties Involved in Corporate Governance Shareholders Boards of directors Audit committees of the board Management Self-regulatory accounting organisations
Other self-regulatory organisations (ASX) Regulatory agencies (ASIC) External auditors Internal auditors
The Role of Audit Committee Audit committees have oversight responsibilities. They should: o Be appraised of all significant accounting decisions made by management o Be appraised of all significant changes in accounting systems and system controls o Be involved in the engagement of the external auditor, review the audit plan and discuss the audit results with the auditor. o Have the authority to hire and fire the head of the internal audit function and set the budget for the internal audit function o Review the audit plan and discuss all significant results o Receive all regulatory audit reports (e.g. For apra) and discuss findings. Failures in Corporate Governance ASIC/CLERP 9 concerns about the auditing profession included: o Auditors were no longer willing to confront clients over questionable accounting practices. o Consulting fees were impairing auditor independence. o Accountants were using technical interpretations of Accounting Standards to push the limits Some issues that arose as a result of the audit process Analytical procedures were used inappropriately to replace direct tests of account balances. Audit firms were not thoroughly evaluating internal control and applying substantive procedures to address weaknesses in control. Audit documentation, especially related to audit planning, did not meet professional standards. Auditors ignored warning signs of fraud and other problems. Auditors were not providing sufficient warning about companies that might not continue as ‘going concerns’. Corporate Governance Regulations Corporate Law Economic Reform Program Act 2004 Also known as CLERP 9 Act Addresses audit standard setting and audit independence Financial Reporting Council (FRC) responsibilities to include: o Oversight of auditing standards setting arrangements o Reconstituting the auditing and assurance standards board as a frc body o Providing auditing standards with the force of law o Advising professional accounting bodies on issues of auditor independence o Addressing a range of other independence issues o Monitoring and reporting on company response to complying with audit-related disclosure requirements o Promoting and advising on teaching professional and business ethics o Monitoring and advising on the adequacy of accounting bodies’ disciplinary procedures.
AUASB Revision of Auditing Standards Develop high quality Australian auditing standards Use international auditing standards as a basis to develop Australian auditing standards Monitor and review auditing standards issued by other professional bodies Auditor Independence CLERP 9 amendments: o Include a statement of principle requiring auditor independence o Require auditors to make an annual declaration of independence o Strengthen restrictions on employment relations between auditors and clients o Impose new restrictions on financial relationships o Require mandatory disclosure of fees paid for categories of nas in annual report o Require a statement in annual report whether board of directors is satisfied that provision of nas is compatible with auditor independence o Make lead engagement and review partner rotation compulsory after five years o Require accountants seeking registration as company auditors to meet competency standards, abide by accepted code of ethics and complete specialist training. 8 ASX Corporate Governance Principles Foundation for management oversight Structure board to add value Promote ethical/responsible decisions Safeguard integrity of financial reporting 4.1: The board should establish an audit committee (AC). 4.2: The AC should be structured so that it: o Consists only of non-executive directors. o Consists of majority of independent directors. o Is chaired by independent chair – who is not chair of board. o Has at least 3 members. 4.3 – The AC should have a formal charter 4.4 – Coys should provide the information indicated in Guide to reporting on Principle 4.
Timely & balanced disclosures Respect shareholder rights Recognise & manage risk Remunerate fairly & responsibly
Principle 4 – Safeguarding Integrity in Financial Reporting Members of AC are non-executive directors Committee provides advice to Board on compliance framework in accordance with Australian standards AC responsible for reviewing & recommending for Board approval the financial statements AC reviews representation letters provided to external auditors AC processes provide framework for management and external and internal auditor to review and assess the risk framework All AC members have business & financial expertise to act effectively AC reviews & approves annually overall audit strategy AC nominates external auditor to Board & appointment reviewed every 3 years. External auditor performance reviewed annually. Lead audit service partner must rotate every 5 years Ex-audit partners will not be appointed as directors AC reviews & approves annually the overall scope & plans for external audit & reviews audit reports AC involved in assessment & appointment/termination of internal auditor AC reviews overall scope, annual plans & budget for internal audit
Auditor’s Communication with Committee Auditing standards (ASA 260) require specific communications between the audit committee and the external auditor: o Auditor’s Responsibility under o Consultations with Other Accountants Generally Accepted Auditing Standards o Major Issues Discussed with o Significant Accounting Policies Management o Management Judgments and o Difficulties Encountered in Performing Accounting Estimates the Audit o Significant Audit Adjustments o Internal Audit Activities o Other Information in Annual Reports o Risk Assessment Activities o Disagreements with Management o Internal Control Evaluation. General Standards The auditor must maintain an independent mental attitude (in fact and appearance). Due professional care is to be exercised in the performance of the examination and preparation of the report. The examination is to be performed by a person or persons having adequate technical training and proficiency Fieldwork Standards The work shall be adequately planned and assistants, if any, properly supervised. A sufficient understanding of the entity and its environment, including its internal control, is to be obtained to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures Sufficient appropriate audit evidence is to be obtained through audit procedures performed to provide a reasonable basis for an opinion regarding the financial statements under examination Reporting Standards Reporting standards provide guidelines to: o Standardise the nature of audit reports o Facilitate communications with users by clearly specifying the auditor’s responsibilities o Identify and communicate all material instances in which accounting standards have not been appropriately applied o Require auditors to express an opinion on the financial report examined or indicate all substantive reasons why an opinion could not be rendered. Overview of Audit Process: a Standards-Based approach to Planning the Audit Develop an understanding with the audit client: o Scope of services to be provided o Management responsibilities o Coordination of work with client personnel o Audit fees and expectations of each party. Develop an understanding of materiality: o The audit must be planned to provide reasonable assurance that material misstatements will be detected. Develop a preliminary audit program: o Develop an understanding of the client’s business and industry o Develop an understanding of the risks the client faces and how they might affect the company’s financial statements. o Develop an understanding of management compensation plans and how those plans may motivate management actions o Develop a preliminary understanding of the client’s internal controls over financial reporting. o Build a detailed audit program on audit risk, internal control quality, accounting assertions and materiality o Develop an understanding of the client’s accounting policies and procedures o Anticipate financial statement items likely to require adjustment o Identify factors that might require modification of audit tests o Determine the type of reports to be issued.
Gathering audit evidence: testing assertions o The third standard of fieldwork requires the auditor to gather ‘sufficient, competent, evidential matter’ in order to reach a conclusion on the fairness of the financial statements. o Audit process is designed to examine assertions. o The assertions inherent in the accounting communication: Existence completeness Rights and obligations Valuation Disclosure presentation. Summarise audit evidence and reach audit conclusion o If evidence supports fair presentation, auditor moves on to other areas of investigation. o If evidence does not support fair presentation, auditor gathers more evidence. This leads to one of three states: The auditor reaches a conclusion and the client agrees to adjust the financial statements. The auditor reaches a conclusion, but the client disagrees. The auditor issues a report describing the differences in opinion. The auditor is unable to reach a conclusion and the amounts are so material, the auditor cannot render an opinion. Reach an audit conclusion and issue a report o For most engagements, the auditor will reach a conclusion that the financial statements are fairly stated and will issue an unqualified audit report. o Before issuing the report, the auditor will meet with the audit committee to discuss the audit process and the overall truth and fairness of the company’s financial reports.
Audit Contribution to Corporate Governance Quality & credibility of financial statements o Audit quality – function of firm’s reputation & strength of monitoring o Quality will be manifested by: 1. Financial information reflecting economic reality 2. Information credible (based on reputation of auditor) Review of internal control structure o Quality of IC crucial to corporate governance in 3 ways: 1. Assists in producing reliable F/R data 2. Ensures resources are used efficiently, effectively & safeguarded. 3. Assist in compliance with laws & regulations
TUTORIAL QUESTIONS Revision Questions Question 2.3 In what ways has the board of directors been responsible for corporate governance failures? Question 2.18 An audit committee should be composed of outside or non-executive directors. Define ‘outside directors’ within the context of an audit committee. How does the existence of an audit committee affect the auditor’s independence? Explain. Question 2.24 What are the audit committee’s versus the board of director responsibilities over financial reporting and internal control? Discussion and Research Questions Question 2.50 Public accounting serves an important role in corporate governance. REQUIRED: a) Describe the role that external auditing fills in promoting good corporate governance. b) What were the major criticisms of the public accounting profession as contributors to failures in corporate governance? c) Identify three items that constituted a ‘gap’ in user expectations and auditor performance associated with corporate governance failures? d) Auditors have been described as ‘public watchdogs’. What does the term public watch dog convey regarding the responsibility of the external auditor to the public. Question 2.57 Ray, the owner of a small company, asked Holmes, a qualified accountant to conduct an audit of the company’s records. Ray told Holmes that the audit must be completed in time to submit an audited financial report to a bank as part of a loan application. Holmes immediately accepted the engagement and agreed to provide an auditor’s opinion within three weeks. Ray agreed to pay Holmes a fixed fee plus a bonus if the loan was granted. Holmes hired two accounting students to conduct the audit and spent several hours telling them exactly what to do. Holmes told the students not to spend time reviewing internal controls but insisted they concentrate on proving the mathematical accuracy of the ledger accounts and to summarise the data in the accounting records to support Ray’s financial report. The students followed Holmes’ instructions and after two weeks, gave Holmes the financial report which did not include notes to the financial statements because the company did not have any unusual transactions. Holmes received the statements and prepared an unqualified auditor’s report. The report however, did not refer to accounting standards. REQUIRED: Briefly describe each of the relevant auditing standards in this case and indicate how the action(s) of Holmes resulted in a failure to comply with each standard.
Question 2.63 Audits of financial reports are designed to test the correctness of account balances. REQUIRED: a) A construction company shows the following assets on the balance sheet: Construction equipment 1 278 000 Accumulated depreciation 386 000 Leased equipment – construction 550 000 Explain the difference in the three accounts and the underlying accounting treatments. b) Is the equipment held by the company comparatively old or new? Explain. c) Develop an audit procedure to determine that all leased equipment that should have been capitalised during the year was actually capitalised (as opposed to being treated as a lease expense)? d) The construction equipment account shows that the company purchased approximated $400 000 of new equipment this year. Identify an audit procedure that will determine whether the equipment account was properly accounted for during the year. e) Assuming the auditor determines the debits to construction equipment were proper during the year, what other information does the auditor need to know in order to ensure that the construction equipment, net of depreciation, is properly reflected on the balance sheet? f)
How can an auditor determine that the client was assigned an appropriate useful life to the equipment and has depreciated it accurately?
Other self-regulatory organisations (ASX) Regulatory agencies (ASIC) External auditors Internal auditors
The Role of Audit Committee Audit committees have oversight responsibilities. They should: o Be appraised of all significant accounting decisions made by management o Be appraised of all significant changes in accounting systems and system controls o Be involved in the engagement of the external auditor, review the audit plan and discuss the audit results with the auditor. o Have the authority to hire and fire the head of the internal audit function and set the budget for the internal audit function o Review the audit plan and discuss all significant results o Receive all regulatory audit reports (e.g. For apra) and discuss findings. Failures in Corporate Governance ASIC/CLERP 9 concerns about the auditing profession included: o Auditors were no longer willing to confront clients over questionable accounting practices. o Consulting fees were impairing auditor independence. o Accountants were using technical interpretations of Accounting Standards to push the limits Some issues that arose as a result of the audit process Analytical procedures were used inappropriately to replace direct tests of account balances. Audit firms were not thoroughly evaluating internal control and applying substantive procedures to address weaknesses in control. Audit documentation, especially related to audit planning, did not meet professional standards. Auditors ignored warning signs of fraud and other problems. Auditors were not providing sufficient warning about companies that might not continue as ‘going concerns’. Corporate Governance Regulations Corporate Law Economic Reform Program Act 2004 Also known as CLERP 9 Act Addresses audit standard setting and audit independence Financial Reporting Council (FRC) responsibilities to include: o Oversight of auditing standards setting arrangements o Reconstituting the auditing and assurance standards board as a frc body o Providing auditing standards with the force of law o Advising professional accounting bodies on issues of auditor independence o Addressing a range of other independence issues o Monitoring and reporting on company response to complying with audit-related disclosure requirements o Promoting and advising on teaching professional and business ethics o Monitoring and advising on the adequacy of accounting bodies’ disciplinary procedures.
AUASB Revision of Auditing Standards Develop high quality Australian auditing standards Use international auditing standards as a basis to develop Australian auditing standards Monitor and review auditing standards issued by other professional bodies Auditor Independence CLERP 9 amendments: o Include a statement of principle requiring auditor independence o Require auditors to make an annual declaration of independence o Strengthen restrictions on employment relations between auditors and clients o Impose new restrictions on financial relationships o Require mandatory disclosure of fees paid for categories of nas in annual report o Require a statement in annual report whether board of directors is satisfied that provision of nas is compatible with auditor independence o Make lead engagement and review partner rotation compulsory after five years o Require accountants seeking registration as company auditors to meet competency standards, abide by accepted code of ethics and complete specialist training. 8 ASX Corporate Governance Principles Foundation for management oversight Structure board to add value Promote ethical/responsible decisions Safeguard integrity of financial reporting 4.1: The board should establish an audit committee (AC). 4.2: The AC should be structured so that it: o Consists only of non-executive directors. o Consists of majority of independent directors. o Is chaired by independent chair – who is not chair of board. o Has at least 3 members. 4.3 – The AC should have a formal charter 4.4 – Coys should provide the information indicated in Guide to reporting on Principle 4.
Timely & balanced disclosures Respect shareholder rights Recognise & manage risk Remunerate fairly & responsibly
Principle 4 – Safeguarding Integrity in Financial Reporting Members of AC are non-executive directors Committee provides advice to Board on compliance framework in accordance with Australian standards AC responsible for reviewing & recommending for Board approval the financial statements AC reviews representation letters provided to external auditors AC processes provide framework for management and external and internal auditor to review and assess the risk framework All AC members have business & financial expertise to act effectively AC reviews & approves annually overall audit strategy AC nominates external auditor to Board & appointment reviewed every 3 years. External auditor performance reviewed annually. Lead audit service partner must rotate every 5 years Ex-audit partners will not be appointed as directors AC reviews & approves annually the overall scope & plans for external audit & reviews audit reports AC involved in assessment & appointment/termination of internal auditor AC reviews overall scope, annual plans & budget for internal audit
Auditor’s Communication with Committee Auditing standards (ASA 260) require specific communications between the audit committee and the external auditor: o Auditor’s Responsibility under o Consultations with Other Accountants Generally Accepted Auditing Standards o Major Issues Discussed with o Significant Accounting Policies Management o Management Judgments and o Difficulties Encountered in Performing Accounting Estimates the Audit o Significant Audit Adjustments o Internal Audit Activities o Other Information in Annual Reports o Risk Assessment Activities o Disagreements with Management o Internal Control Evaluation. General Standards The auditor must maintain an independent mental attitude (in fact and appearance). Due professional care is to be exercised in the performance of the examination and preparation of the report. The examination is to be performed by a person or persons having adequate technical training and proficiency Fieldwork Standards The work shall be adequately planned and assistants, if any, properly supervised. A sufficient understanding of the entity and its environment, including its internal control, is to be obtained to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures Sufficient appropriate audit evidence is to be obtained through audit procedures performed to provide a reasonable basis for an opinion regarding the financial statements under examination Reporting Standards Reporting standards provide guidelines to: o Standardise the nature of audit reports o Facilitate communications with users by clearly specifying the auditor’s responsibilities o Identify and communicate all material instances in which accounting standards have not been appropriately applied o Require auditors to express an opinion on the financial report examined or indicate all substantive reasons why an opinion could not be rendered. Overview of Audit Process: a Standards-Based approach to Planning the Audit Develop an understanding with the audit client: o Scope of services to be provided o Management responsibilities o Coordination of work with client personnel o Audit fees and expectations of each party. Develop an understanding of materiality: o The audit must be planned to provide reasonable assurance that material misstatements will be detected. Develop a preliminary audit program: o Develop an understanding of the client’s business and industry o Develop an understanding of the risks the client faces and how they might affect the company’s financial statements. o Develop an understanding of management compensation plans and how those plans may motivate management actions o Develop a preliminary understanding of the client’s internal controls over financial reporting. o Build a detailed audit program on audit risk, internal control quality, accounting assertions and materiality o Develop an understanding of the client’s accounting policies and procedures o Anticipate financial statement items likely to require adjustment o Identify factors that might require modification of audit tests o Determine the type of reports to be issued.
Gathering audit evidence: testing assertions o The third standard of fieldwork requires the auditor to gather ‘sufficient, competent, evidential matter’ in order to reach a conclusion on the fairness of the financial statements. o Audit process is designed to examine assertions. o The assertions inherent in the accounting communication: Existence completeness Rights and obligations Valuation Disclosure presentation. Summarise audit evidence and reach audit conclusion o If evidence supports fair presentation, auditor moves on to other areas of investigation. o If evidence does not support fair presentation, auditor gathers more evidence. This leads to one of three states: The auditor reaches a conclusion and the client agrees to adjust the financial statements. The auditor reaches a conclusion, but the client disagrees. The auditor issues a report describing the differences in opinion. The auditor is unable to reach a conclusion and the amounts are so material, the auditor cannot render an opinion. Reach an audit conclusion and issue a report o For most engagements, the auditor will reach a conclusion that the financial statements are fairly stated and will issue an unqualified audit report. o Before issuing the report, the auditor will meet with the audit committee to discuss the audit process and the overall truth and fairness of the company’s financial reports.
Audit Contribution to Corporate Governance Quality & credibility of financial statements o Audit quality – function of firm’s reputation & strength of monitoring o Quality will be manifested by: 1. Financial information reflecting economic reality 2. Information credible (based on reputation of auditor) Review of internal control structure o Quality of IC crucial to corporate governance in 3 ways: 1. Assists in producing reliable F/R data 2. Ensures resources are used efficiently, effectively & safeguarded. 3. Assist in compliance with laws & regulations
TUTORIAL QUESTIONS Revision Questions Question 2.3 In what ways has the board of directors been responsible for corporate governance failures? Question 2.18 An audit committee should be composed of outside or non-executive directors. Define ‘outside directors’ within the context of an audit committee. How does the existence of an audit committee affect the auditor’s independence? Explain. Question 2.24 What are the audit committee’s versus the board of director responsibilities over financial reporting and internal control? Discussion and Research Questions Question 2.50 Public accounting serves an important role in corporate governance. REQUIRED: a) Describe the role that external auditing fills in promoting good corporate governance. b) What were the major criticisms of the public accounting profession as contributors to failures in corporate governance? c) Identify three items that constituted a ‘gap’ in user expectations and auditor performance associated with corporate governance failures? d) Auditors have been described as ‘public watchdogs’. What does the term public watch dog convey regarding the responsibility of the external auditor to the public. Question 2.57 Ray, the owner of a small company, asked Holmes, a qualified accountant to conduct an audit of the company’s records. Ray told Holmes that the audit must be completed in time to submit an audited financial report to a bank as part of a loan application. Holmes immediately accepted the engagement and agreed to provide an auditor’s opinion within three weeks. Ray agreed to pay Holmes a fixed fee plus a bonus if the loan was granted. Holmes hired two accounting students to conduct the audit and spent several hours telling them exactly what to do. Holmes told the students not to spend time reviewing internal controls but insisted they concentrate on proving the mathematical accuracy of the ledger accounts and to summarise the data in the accounting records to support Ray’s financial report. The students followed Holmes’ instructions and after two weeks, gave Holmes the financial report which did not include notes to the financial statements because the company did not have any unusual transactions. Holmes received the statements and prepared an unqualified auditor’s report. The report however, did not refer to accounting standards. REQUIRED: Briefly describe each of the relevant auditing standards in this case and indicate how the action(s) of Holmes resulted in a failure to comply with each standard.
Question 2.63 Audits of financial reports are designed to test the correctness of account balances. REQUIRED: a) A construction company shows the following assets on the balance sheet: Construction equipment 1 278 000 Accumulated depreciation 386 000 Leased equipment – construction 550 000 Explain the difference in the three accounts and the underlying accounting treatments. b) Is the equipment held by the company comparatively old or new? Explain. c) Develop an audit procedure to determine that all leased equipment that should have been capitalised during the year was actually capitalised (as opposed to being treated as a lease expense)? d) The construction equipment account shows that the company purchased approximated $400 000 of new equipment this year. Identify an audit procedure that will determine whether the equipment account was properly accounted for during the year. e) Assuming the auditor determines the debits to construction equipment were proper during the year, what other information does the auditor need to know in order to ensure that the construction equipment, net of depreciation, is properly reflected on the balance sheet? f)
How can an auditor determine that the client was assigned an appropriate useful life to the equipment and has depreciated it accurately?
