Corporate Governance and Ethics - Literature review Example

Corporate Governance and Ethics Name Course Name and Code Instructor’s Name Date Introduction Corporate governance is an important aspect of businesses that entails the processes and mechanisms that are used to manage such corporations (Samantha & Das 2009). In other words, corporate governance is a system that includes the processes, rights and controls that are formulated by stakeholders of a business corporation/body for the purpose of management that is aimed at protecting the stakeholders’ interests (Samanta & Das 2009). Further, corporate governance is done both internally and externally since the stakeholders of any business entity include internal members such as employees and the management and external members such as customers, auditors and the communities around the business premises among others. A further definition by Samanta & Das (2009) is that corporate governance is the process by which investors and stakeholders manage the financial affairs of a company with the aim of cutting down the cost of running the company. This therefore calls for regular auditing of the financial sector to be aware of the company’s financial performance. Therefore, auditing is a very vital process in corporate governance as it ensures transparency in the financial affairs of any business entity. Benson (n.d) indicates that an auditor is primarily charged with the duty of giving the best opinion on a client’s financial performance after getting the right financial information, which is only obtained, through conducting an audit. For auditing to be effective in ensuring good corporate governance practices are adopted in a company, it is important that the auditors are independent in that they should not have any shares or be involved in non-audit services of the company. In addition, auditors can be both internal and external where internal auditors are part of a company’s audit committee whereas external auditors are not part of a company but are contracted by the company to liaise with the company’s audit committee. 1. Role of auditors in corporate governance and business ethics Auditors have the power to detect the faults in a company’s management system and can only do this effectively if they are not attached to any of the company’s affairs (Krishna n.d). In other words, auditors have to be independent to report the company’s affairs without biasness. Krishna (n.d) also indicates that auditors have a great role to play in corporate governance through honestly reporting on the company’s affairs especially financial performance. Auditors are also expected to ensure that they maintain a company’s integrity through transparency in their audit services to ensure good corporate governance. Moreover, auditors act as the eyes of a company’s shareholders and stakeholders and hence are mandated with the duty of detecting the company’s shortcomings and report them as they are to enable the stakeholders and shareholders take the right corrective measures. As Krishna (n.d) puts it, auditors “must act as the guardian of the company’s financial integrity.” In addition, research has shown that conducting internal audits improves the detection of fraud in organizations and that organizations with internal audit groups are more likely to detect fraud than those that have outsourced it to external auditors (Coram, Ferguson & Moroney n.d). According to Low (2002) as discussed in Krishna (n.d), independent audits are more effective and are a very important part of corporate governance since they ensure that the company performs its operations as per the legal requirements. This means that audits are used in identifying any misconduct of any employee of the company and bring it to the knowledge of all stakeholders so that the right decisions are made. Furthermore, audit reports are used by investors in deciding whether they will invest in the company or not. Therefore, it is important that auditors carry out an effective audit process to report things as they are as the information they provide is vital in stakeholders’ decision making. An independent audit process also ensures accountability in any business entity, which is an important component of corporate governance (Krishna n.d). Accountability entails step by step reporting on the use of a company’s resources especially the financial resources. In accounting for the use of company’s resources, honesty is a value that comes in handy since it is through this value that a clear report is tabled. Accountability also goes hand in hand with transparency since it is through being accountable that transparency comes to being. It is therefore important that any business entity contract an external auditor who does not have any ‘strings attached’ with the company so that all audits are objective. The main shortcoming with internal audits is that the auditors are part of the company and hence they may not report any faults they see in the management. It is also clear that internal auditors may be threatened by their seniors if they point out their shortcomings. Additionally, it can be argued that internal audits may overlook some faults in the company’s system since they are part of the company and hence will produce a biased audit report that can mislead stakeholders. The above statements prove that external and independent audits are more effective in ensuring corporate governance. 2. The rise and fall of Arthur Andersen Arthur Andersen LLP was an audit company that was established in Chicago in the year 1913 by Arthur Andersen and a partner named Clarence Delany (Benson n.d). The company grew to become one of the biggest audit companies in the United States, a success that was attributed to its corporate culture that was based on the values of trust, integrity and ethics (Benson n.d). For a long time, the company practiced auditor independence, which earned it a very good reputation that was based on integrity. However, this later changed when the company started offering consulting services to companies including their audit clients. The company’s consulting department became more profitable than the audit department and hence the management started focusing on making profits through these non-audit services (Benson n.d, Krishna n.d). With time, Arthur Andersen started focusing more on its growth through making profits in consulting services hence compromising the quality of the company’s audit services (Benson n.d). The corporate culture of this audit firm changed and started focusing more on recruiting and retaining big clients who were mostly getting consulting services from Arthur Andersen (Benson, n.d). This decision in turn affected the independence of the audits performed by this company since the same clients audited were also receiving consulting services. This mix of business activities led to conflict of interest since the company’s corporate culture changed and started focusing more on the growth and making of huge profits through offering consulting services. Further, Arthur Andersen’s auditors started providing sub-standard audit services but it was difficult for the clients to question these practices since they were also relying on the consulting services of the company (Benson n.d). Moreover, the organizational culture changed from that of teamwork to that of competition and self-centeredness due to the split of the company’s consulting and audit departments into two independent units (Benson n.d). The employees from both units were only interested in achieving more profits, which was the criteria for promotion hence togetherness and team spirit were not encouraged in the company. Therefore, due to the scramble for promotion by the employees, the quality of audits was overlooked and this later led to the collapse of Arthur Andersen due to scandals from its clients. The audit mistakes of Arthur Andersen led to the bankruptcy and collapse of some of its clients that included Enron, the Baptist Foundation of Arizona, Sunbeam Corporation and HIH Insurance Ltd. In the case of Enron, for instance, Arthur Andersen offered both audit and consulting services to this client, an act that led to conflict of interests. In addition the independence of the auditors was affected which in turn led to loss of confidence in financial reporting (Krishna n.d, Samanta & Das 2009). What contributed much to the scandal was that Arthur Andersen did not report the fraud committed by the management to both the stockholders and stakeholders (Krishna n.d, Samanta & Das 2009). The example of Enron shows that Arthur Andersen had compromised its values of truth and trust so as not to severe its relationship with the management (Enron’s management). By not relaying the truth to the stakeholders and shareholders, the auditors were abusing the code of corporate governance. The change of corporate culture to that of inferior auditing led to the collapse of Arthur Andersen. The mixing of business services led to conflict of interests as the company was more concerned with making profits through providing consulting services and hence overlooked the provision of audit services. Benson (n.d) has outlined several shortcomings in the corporate culture of Arthur Andersen that led to its collapse in 2002. Firstly, the company was more concerned with its growth in profits and did not care about the progress its clients. Secondly, the company did not monitor its audit team so as to establish whether it was performing the audits as per the set standards and it was also clear that the audit team was very secretive of its affairs. Thirdly, the company’s partners had limited involvement in the decision making process of the company affairs and hence had little or no say in the company affairs. Lastly, it was evident that Arthur Andersen had started hiring untrained auditors who provided poor audit services to clients (Benson n.d). 3. Sarbanes-Oxley Act of 2002 The Sarbanes-Oxley Act of 2002 was established in 2002 with consent from both republicans and democrats with the aim of restoring stakeholders’ confidence in financial auditing (Ferrel & Fraedrich 2008). after the scandals of most companies and especially that of Enron due to financial audits failures, stakeholders held the belief that all audit firms, company directors and boards had come up with a deceptive culture that was aimed at defrauding them (Ferrel & Fraedrich 2008). Therefore, it was important that strict measures to be put in place so as to correct this failure and encourage investors and other stakeholders to invest more and have confidence that their savings are safe. It is a requirement by the Sarbanes-Oxley Act of 2002 that there be a Public Company Accounting Oversight Board that is charged with the responsibility of monitoring all accounting firms that perform audits on public corporations (Ferrel & Fraedrich 2008). This body is also mandated to formulate and implement standards and rules for auditors in accounting firms. The act also mandates this board to investigate and discipline any auditors who violate the set standards and rules (Ferrel & Fraedrich 2008). Furthermore, through this act, accounting firms are prohibited from providing both auditing and accounting services to the same clients unless they have permission from the clients’ audit committee so as to prevent conflict of interests (Ferrel & Fraedrich 2008). More emphasis has also been placed on the length of time that auditors should serve a particular client. Ferrel & Fraedrich (2008), summarize the key provisions of this act as outlined below: All CEOs and CFOs should certify their companies’ financial statements before they are released to the public The members of the corporate audit committees should be independent of the company’s interests; that they should not have any possessions in the company shares. Corporations are not allowed to loan officers as well as board members All codes of ethics for senior management should be registered with the SEC Company attorneys should report any misconduct to top managers as well as the board of directors and if they fail to take the right corrective measures then the attorney should quit Financial securities analysts must certify that their recommendations are based on objective reports People who disclose wrongdoings to authorities should be granted protection from harm by those he has reported Mutual fund managers should be transparent so as to ensure that investors are aware of the affairs of the decision making process Any mail/wire fraud receives a ten-year penalty Auditors should be rotated from one account to another from time to time with senior auditors not being allowed to work in one account for more than five years whereas other auditors are not allowed to exceed seven years in one account. The Sarbanes-Oxley Act of 2002 has managed to renew investor confidence in financial auditing. It has also managed to make companies’ top management to be more accountable to employees, investors, communities and society at large (Ferrel & Fraedrich 2008). Additionally, there has been improved information flow from stock analysts and rating agencies to the public. Moreover, Ferrel & Fraedrich (2008) indicate that this act has introduced strict penalties for top management, auditors and board members who go against the provisions of the act. Conclusion From the above discussion, it is evident that corporate governance is an important component of any business entity. It is also evident that auditing is very vital in good corporate governance. Auditing can be done by both internal and external auditors who are expected to report on the financial performance of the company objectively. Auditors act as the eyes of all stakeholders and any information they provide helps the stakeholders in the decision-making process of the company. Dishonesty and lack of integrity in any audit process leads to collapse of large business entities as the false information leads to misguided decision making. Such an example is the collapse of large companies such as Enron due to sub-standard audits performed by the Arthur Andersen, a large audit company that collapsed in 2002 due to corporate governance scandals. People lost confidence in financial auditing due to the scandals arising in auditing firms worldwide. However, this confidence and trust was restored when both the republicans and democrats established the Sarbanes-Oxley Act of 2002 so as to foresee all the auditing activities of public corporations. This act provides more strict rules and regulations on all audit firms and ensures that severe disciplinary actions are taken against any offenders. References Benson, D. n.d, Arthur Andersen: Questionable accounting practices. Broadly, D. 2006. Auditing and its role in corporate governance. Hong Kong: Deloitte Touche Tohmatsu. Coram, P, Ferguson, C. & Moroney, R. n.d. The importance of internal audit in fraud detection, viewed 5th January 2012, aaahq.org/audit/midyear/.../Coram_TheImportanceOfInternalAudit.p... Federation of European Accountants. 2009. Discussion paper for auditor’s role regarding providing assurance on corporate governance statements. FEE, Bruxelles. Ferrell, O.C & Fraedrich, J. 2008. Business ethics: Ethical decision making and cases, 7th ed. London: Cengage Learning. Imhoff, E.A. 2003. Accounting quality, auditing and corporate governance. Accounting Horizons, pp. 117-128, Viewed 5th January 2011, www.bus.iastate.edu/aclem/592/SS03/Imhoff.pdf Krishnan, L. n.d. The role of auditors in the context of corporate governance. Viewed 5th January 2012, www.utar.edu.my Samanta, N., & Das, T. 2009. Role of auditors in corporate governance. Viewed 5th January 2012, SSRN: http://ssrn.com/abstract=1487050 Smith, N.C., & Michelle, Q. 2004. From grace to disgrace: the rise & fall of Arthur Andersen. Journal of Business Ethics Education, vol. 1, no. 1, pp. 91-130. United Nations. 2006. United Nations Conference on Trade and Development: Guidance on good practices in corporate governance disclosure, United Nations. New York and Geneva. Read More