External Auditing and Corporate Governance - Essay Example

Running Head: EXTERNAL AUDITING AND CORPORATE GOVERNANCE External Auditing and Corporate Governance of Table of Contents Sarbanes–Oxley Act 2 Disadvantages of External Audit 9 External Auditing and Corporate Governance Introduction This paper has been written with regards to changes that have occurred in corporate governance because of external auditing. More specifically, the paper focuses on the practice of corporate governance in the United Kingdom and the countries such as South Africa, Australia, US, India and China. Since the rules and the laws of every country and region differ from one another, there are differences in the practice of corporate governance and external auditing too. With regards to corporate governance, a huge debate is raging the world of governance these days as to how the level of trust can be improved in our communities in regards to the governance bodies of companies, aboriginal communities and charitable corporation. While there are many debates that are presently in progress, the most important ones are playing out in global communities, with other companies taking lead from there (Demb & Neubauer 2002, pp.9). By understanding the different point of views and underlying rationales can help the board of directors to develop practices and policies that improve the governance of their organization and thus improve community’s trust in the organisations leadership. (Conti & Warner 2006, pp. 12). This paper is based on good corporate governance that should be adopted by all the companies and the role of different mechanisms of corporate governance. Furthermore, evaluation of the importance of corporate governance, its pros and cons and analysis has also been discussed. Importance of Corporate Governance The process by which direction is given to the organization i known as corporate governance. With regards to this, control is implemented on the company and it is held to account. Therefore, it can be said that factors such as accountability, leadership, authority, direction, stewardship are controlled by corporate governance when control is implemented in an organization. The reason why the definition seems balanced is because it ensures that the checks and balances are employed during the process. This is the reason why it can be considered as a comprehensive definition with regards to corporate governance. The aim of implementing corporate governance is to attract the investors as well as the managers to ensure that the companies care about the profits that are generated. Moreover, it also develops a relationship between the internal governance mechanisms of the organization as well as the idea of the community with regards to corporate accounting. Therefore, corporate governance increases the confidence of the investors and to facilitate the relationship between shareholders and managers. Furthermore, corporate governance also aims to improve the functioning of the various corporate bodies. Besides all this, it also improves the board of directors to ensure transparency in situations those results in conflict between the shareholders and the managers. For instance, it is the duty of the managers to report their salaries and the operations in which they become suppliers or customers themselves. Moreover, focus is also to enhance the operations of the company to facilitate the voting rights of the shareholders. Sarbanes–Oxley Act The Act came into existence in 2002, and the other name given to it is Public Company Accounting Reform and Investor Protection Act. However, more commonly, it is known as Sarbanes–Oxley, Sarbox or SOX. This is a federal law in the US which aims to enhance the standards of all the public companies in the United States. Moreover, it also enhances the management and the public accounting firms. The Act should be implemented to ensure that good corporate governance is being practiced in the companies in the United States (Walker Review 2009, pp.10). Comparison and Evaluation of Mechanisms Numerous reasons are there which show the importance that corporate governance has attained recently. The reason why corporate mechanisms are implemented are to ensure control and also to minimize any kind of inefficiencies that occur due to different factors that serve as moral hazard. This is the reason why a third party that is known as external auditor is required to evaluate the company and also to attest the accuracy of the information which is provided by the management to the investors. The four most important mechanisms have been discussed below. 1. Role of board of directors 2. Roles of non-executive directors 3. Role of auditors, the internal audit committee, external auditors From these mechanisms, the first mechanism with regards to corporate governance is monitoring of the board of directors of the company who run it. They have the legal authority because of which they have the right to hire as well as to fire the employees who work for the company. This is done to ensure that the interests of the investors are protected. Therefore, board meetings are conducted on a regular basis to solve the problems that are identified and also to avoid such problems from occurring in the future. Executive directors posses superior knowledge and they use the knowledge during the decision making process to ensure positive outcomes. However, the directors who are non-executive have more independence; however, they cannot increase performance at all times or make corporate governance more effective. The policies that are implemented by the broad of director’s management as well as the individuals who are in the audit committee form internal control. During this process, the internal auditors implement the control procedures that serve as a corporate mechanism. It is ensured by the entity that the financial objectives of the company are attained and they comply with the rules that are formulated. Therefore, the auditors also ensure that the company follows good mechanisms with regards to corporate governance. Personnel who are hired by an organization to test the implementation of the design are the external auditors. Besides this, they also test the internal control procedures as well as reliability of financial reporting which is done. Another reason why the external auditors are hired by the company are to make sure that the information that is provided and communicated to the investors is accurate and they are not misled. WorldCom is an example that can be used to explain the situation. Accounting irregularities were exposed by Cynthia Cooper, the internal auditor of WorldCom. The figures which were presented to the investors were misleading. She was appointed to check operational auditing; however, along with her colleagues she suspected the financial transactions of the company. Investigation was conducted after this and a series of clever manipulations were revealed. The aim was to conceal $4 billon in expenses since they were not allocated properly and the accounting entries that were made were not accurate. Since the number of business failures has increased because of financial collapses, good corporate governance needs to be implemented by the company. Financial crises have occurred in East Asia and other countries which have resulted in scandals in the US. Moreover, there are reforms that have also been implemented in Europe. For this purpose, measures have also been introduced in order to enhance the corporate governance systems in the world. The issue that has arisen is with regards to the regulators and the scandals need to be addressed. Moreover, the system needs to be fixed and the root problems must be dealt with to ensure that the future issues do not occur (Friedman 2003, pp. 12). The force of trade barriers and globalization disbanding, a state’s companies’ performance can be calculated against globally set values with rising simplicity, whilst that similar states locally defended manufactured goods market. On the businesses it impacts in two ways that comprises nervousness that augments rivalry with respect to advantage in the economy. Global markets prefer stock rather than cash, and for this they have to incorporate corporate governance for the investors to be comfortable. The resulting problem is whether the recognized systems of governance and corporate finance are adequate to cope up with the alarming confronts in a globalized market. In the literature it has been frequently argued that increase in globalization augments the pressure in insider mechanism to transform or converge into an outsider mechanism. Other, on the contrary quarrel that prior differences in the economy (whether were based on dissimilar situations or past irregularities) might persist, even though when the recent economic systems have turned out to be very much alike (Gordon 2003, pp. 39). Many sectors of the states were directed by the State, prior to the privatization policy. State must form formal regulation as these industries are now in the hand of private companies. Corporations have sought the money from the public markets and have augmented the number of companies listed on stock exchange due to the privatization of these industries. Without an effective system of corporate governance, these privatized companies have not been to perform at an optimal level and have regularly been ‘tunneled’ by the insiders of the businesses. In the literature it has been usually quarreled that ‘the efficiency of the privatization is better when corporate governance is well followed with no forceful protection of investors, privatization is less probable to be successful. Since international development is increasing, the companies are also promoting good corporate governance and principles have been designed by Organization for Economic Corporation and Development to make the implementation effective. Moreover, it also ensures transparency (Denham, et.al. 2005, pp. 36). However, there are various advantages and disadvantages of mechanisms of good corporate governance that have been discussed below. Security with regards to investment is the first advantage. When the investors of the firm are the outside firms, risk of investment not materializing occurs because the managers are the ones who have control over the shareholders. However, the outside investors can secure themselves against the false facts that are provided by the companies (Craven, et.al. 2006, pp. 203). Corporate governance is essential to implement to improve the confidence of the investors in order to make them comfortable. Many cases have erupted in the companies that have not provided correct information to the investors because of which they have been misled. Besides this, corporate governance also increases valuation of firm and eases capital rising. In the absence of the protection from the outside investors, there are companies that find it difficult to raise capital. Protection is also provided to the investors through corporate governance to ensure functioning of the financial system (Drucker 2006, pp. 32). There were twenty-seven wealthiest economies around the world that were evaluated. They determine the effect that investor protection has on the ownership structures as well as corporate valuation that was conducted. Protection of the shareholders is ensured in the economy and the valuation of the assets of the company. It has further been added that the countries that provide effective protection to the minority shareholders also have a higher valuation. Moreover, the bargaining power of the company also strengthens and this attracts foreign investment. Bargaining power of the developing nations in order to pull foreign investment or to attain long-standing growth efforts in rising markets and transitional economy systems is strengthened by corporate governance. Companies comply with the statute law and regulation in the countries where stock markets are quite active, they are therefore unable to achieve swift growth but they also have access to external finances. Maintaining a good system of corporate governance is not merely to attract the foreign investment for long lasting but also to widen the locally held investment markets by pulling the institutional investors and local capital markets and also motivating them to offer long term funds that would be vital for growth (Coffee 2001, pp. 127). The mechanism of the corporate governance also promotes the corporate social responsibility. Corporate governance also highlights the issue of social responsibility and deals with the initiative of admiring the cultural surroundings. Corporate governance, in summary has insinuations further than corporations investors, comprising employees of company, creditors, clients and community and even the country’s complete financial system. In addition the system also offers with alternate choices for investments – Firms would have to find alternate way to finance themselves in the absence of corporate governance, for instance, bank financing or internal financing, Nevertheless, these have their pros as well as cons (Franks & Mayer 2003, 23). However, there are also some disadvantages of mechanisms of corporate governance that include cost of monitoring. The shareholders need to have one voice and opinion in order to get the things implemented. Only this would enable their voice to have the real weight. Therefore, the individuals must have a collective vision. Moreover, the companies can be corrupted easily. Therefore, government insight is required by the companies because they can get corrupt easily. Corruption is not good for the interest of the company and also for the shareholders who invest in the company. One more problem that occurs because of the mechanisms of corporate governance is with regards to the companies owned by families. This strategy works well only when the shareholders and the board members make the decisions with regards to the objectives with regards to the interest of the company. WorldCom did not opt for this because they did not want to allocate any cost for the purpose of monitoring. This was because the company was hiding the real facts from the customers (Coase 2001, pp. 23). External Audit External Audit is conducted by an independent professional who examines whether the records of the financial statements are in accordance with the specified laws, rules and regulations. An annual audit is a vital element of the checks and a balance required and is one of the keystones of corporate governance. General public, agencies of the Government and investors rely on the external auditor to provide and unbiased and independent audit report. The statute defines the format of reporting of audit report which of course varies according to jurisdictions of different states, the method of appointing auditors and their qualifications. It is mandatory that the external auditor should be a member of one the recognised professional accountancy body. Certified Public Accountants are the soul authorized private type of external auditors who may execute audits and give their opinions on the entity’s financial statements. In the UK, ICAEW or ACCA members may perform this role and in the other countries like India and China Chartered Accountants serve this function. Sarbanes-Oxley Act, in the US has strictly imposed requirements on external auditors to evaluate internal control while conducting the audits of public companies listed on the stock exchange Advantages of External Audit 1. External Auditors are also known as the watch dogs who find out errors which might have been committed purposely or unknowingly. 2. Regular audit is quite useful in getting the independent opinion about the condition of the company. 3. External Auditors observe the highest level of business and professional ethics and in particular they work in independence and are not biased. 4. External Auditors are competent and are well versed with the International Accounting and regulatory standards. Disadvantages of External Audit 1. Private and confidential information is required by the auditors which might include internal employee salaries and client billing records etc. 2. Fees of auditors is also an issue, usually the fees of the external auditors are quite high. 3. External Auditors provide report on the historical information. Impact of External Audit on Corporate Governance External auditors play a vital corporate governance role in Asia, UK, US and South Africa. When the ownership structure signals the agency conflicts, the firms then prefer hiring name-brand auditors for auditing their company’s financial statements. More specifically, the auditors from the Big 4 firms are hired when firms perceive entrenchment issues, detained by the level of voting rights of the major shareholders are intense. Weak evidence also enlightens that the choice of the auditor is linked with the inducement arrangement outcome calculated by the domineering shareholders’ cash flow rights. Additionally, these kind of links between agency conflicts and auditors choice are seen amongst firms that are regular equity issuers and is seen less in firm that are less equity issuers. Therefore firms when planning to hire Big 4 auditors should also consider the trade-off amongst the advantages from augmenting the capital and the expenses of forfeiting profits from opaqueness. Based on the research it has also been found that the Big 4 auditors also take into consideration when charging audit fee and audit report decision, the agency conflicts, which eventually supports the research that the external audit in the UK, US, South Africa and Asia plays a vital corporate governance role. Corporate governance is a vital monitoring system and its main objective is to resolve the agency problem by linking the interest of management with the interest of investors and not to directly improve the performance of the company. Ghoshal & Moran (2006) also emphasised upon the efficiency of corporate governance as a screening system. Corporate governance also on the other hand reduces the ability of management to manage the income. Another vital monitoring system is the external audit which also aligns the interest of shareholders and management and in turn reduces the latent for opportunistic directors‟ performance. Auditors hold great responsibility for audit report containing reliable information related to the financials of the company when the audit committee’s role is mainly formal, though the symbolic efforts of the committee can lead to efficient questioning of the management. Management’s ability to manage the earning is reduced to quite an extent when the monitoring is being carried out by an independent and high quality external auditor. Moreover, external audit and corporate governance consequently aid the shareholders by supporting the goals of management with the goals of investors, thus increasing the integrity of the financial reporting process and reliability of the information in the financial statements. Addressing the Problem Primary objective of this study is to investigate the impact of external auditing on corporate governance. Then environment of UK differs from Australia and US in several ways that could influence the conclusion of this study. For instance, International Financial Reporting Standards rather than local standards of accounting are mandatory in the UK as accepted by other countries of the EU council. (Regulation (EC) No. 1606/2002). Whereas in the US and Canada Generally Accepted Accounting Principles are followed. Companies in the UK, US and Asia are also exposed to different listing requirements and recommendations of the corporate governance. Coase (2001), in his cultural and sociological studies has found that although the UK, US and Australia are similar in many respects, there exists many of the organizational difference that cannot be overlooked. In relation to the recommendations given by the corporate governance, there are numerous differences in composition and structure of boards, compensation levels of the executives and functions of the audit committee. Not merely the corporate governance recommendations but also the concept of managing the income is dissimilar amongst the states. It is argued by Ghoshal & Moran (2006) that the managers in the US manage the earning better than the managers in the UK and Australia. The mixed finding on the relationship between independence of auditor and management of earning was solely due to overlooking the role of corporate governance. In addition the audit committee also play an important role in the earnings management and monitoring the audit and non-audit service fees being paid to the auditors. Ultimately, this study gives clear evidence of the impact of external audit on corporate governance and identifies the main aspect of a company’s external audit and corporate governance that can satisfy the agency costs being imposed on the investors by professional opportunism in the managing of income. These are mentioned below. 1. Autonomy of the BOD, autonomous chairman, autonomous audit committee and autonomous nomination committee 2. Large BOD, dedicated Non-Executive directors and expert audit committee 3. An autonomous auditor specialised in the operating sector 4. Size of the firm, its cash flows and performance Conclusion It can therefore, be concluded that external auditing has played a major role in changing corporate governance in the UK and other countries that include South Africa, Australia, US, India and China. This is mainly because of various factors that have already been discussed above. The most important mechanism with regards to good corporate governance is the role that the board directors have in the company. This is mainly because of the legal authority which enables them to hire and fire the employees, and to protect the interests of the investors. Besides this, the board of directors also conduct boards meetings regularly to ensure that the potential problems are identified and ways of avoiding these problems are formulated. Moreover, nowadays since the companies worldwide are now known to everyone and any negative aspect that is linked with it will create a lot of insult. Therefore, implementation of good corporate governance is equally important for which external auditing also needs to be taken care of. WorldCom failed because it did not comply with the proper style of management and more importantly, it did not reveal the real facts to the investors because of which the investors were fooled. Moreover, external auditing is also involved here as the accounting figures showed to them were wrong and their relations with the Wall Street were also amiable because of which the investors could not make out what the real truth was. 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