Corporate Governance and Ethics - Assignment Example

Corporate Governance and Ethics [Student’s Name] [Course Title] [Instructor’s Name] 18 December 2011 Corporate Governance and Ethics Requirement 1 According to Collins and Schultz (1995), external audit refers to an evaluation of the firm’s operations, financial reporting, governance and internal controls. The main purpose of an external audit is the provision of independent assessment of internal governance and financial health of the firm without bias. An independent and external auditor is concerned with the assessment of the fairness of the financial statements of the firm. There are several purposes of having independent and external audits. Increasing the confidence of investors- Investors rely on audit reports prepared by independent and external auditors when making their investment decisions. Investors expect the independent and external auditor to make a verification of the internal control procedures, which are put in place by the company, verify the accounting methods and procedures used by the company’s accountants in the preparation of financial statements and provide an opinion on the operations of the company. In addition, investors might use independent and external auditor’s report to make an assessment of how the senior managers of the firm perform and the extent to which their actions impacts on the profitability, competitiveness and reputation of the firm. Providing an assurance to industry regulators- Industry regulators usually review independent and external audit reports when evaluating whether a company has adhered to the standards and principles of the industry. This can best be established by a party which is distinct from the company. An independent and external auditor is likely to provide audit reports that are free from bias hence a good measure that can be used by industry regulators. Helping the Government agencies to regulate- Government agencies often use reports prepared by an independent and external auditor to have a clear understanding of the operations of the firm and its adherence to laws that are applicable in their area of operations. They can also use external auditor reports as a basis for their investigations or enquiries. For example, the audit report information might be used by, say, the US Securities and Exchange Commission to commence an insider trading enquiry at a firm. Help to supplement internal audits- A company has its own internal control systems put in place. The senior managers can use external audit reports to measure the adequacy and effectiveness of the internal controls of the company. External audit report may be relied on by the internal audit department in planning, reviewing and executing annual audit programs. For example, it may allocate more resources to areas pointed as risky by external auditors. Independent and external audits support good corporate governance and ethical decision making in various ways especially by overcoming the limitations of internal control systems and procedures. This is because of the fact that there is no system which is entirely foolproof since employees in collusion can override the best controls. Notice that a critical aspect of an internal control system is the separation of duties. Individual who have the physical responsibility for assets should not also have access to accounting records (Ward and Deck, 1993). However, since these individuals are within the organization and know each other and their roles, they can agree to commit a fraudulent activity and interfere with the accounting records of the company. This can take long to be identified since they are the same individuals who are in custody of these financial records. This has the effect of defeating the overall purpose of internal control systems. An independent and external auditor is; however, distinct from the company and does his work as an independent entity. This means that eventually the external auditors’ reports will reveal the fraudulent activities of the employees of the company. Therefore, it is worth noting that the employees of the company will avoid fraudulent activities for the fear of being exposed by the external auditor. This ensures that they practice good corporate governance and uphold ethics in all their decision making processes and actions. In addition, external audits resolve the issue of cost versus benefit tradeoff. Before a decision is made to establish an internal control system, the senior managers need to satisfy themselves that the matter to be ruled on represent a significant problem and that the system will not impose cost on the many for which the benefits are few. Putting in place an internal control system is an additional cost to the company whilst the same services can be contracted to an external audit at a lower cost. Minimizing the cost to the company is a critical means of maximizing the wealth of the shareholders of the company through achieving possible value of the company. Requirement 2 Arthur Andersen was one of the big international accounting firms. It was once the accounting firm for Enron and WorldCom among others. Over the years the firm exhibited a change in the accounting profession, which resulted to financial reporting crisis in the companies it audited. These financial reporting crises were responsible for the eventual closure of Arthur Andersen. The primary focus of financial reporting is information about an enterprise performance provided by measures of earning and its components. However, the audit reports of Arthur Andersen did not meet all the levels required for conceptual framework for financial reporting. It did not fulfill the qualitative characteristics of accounting information. In the case of Enron account, it omitted entities from the financial statements. Disclosure of material information is necessary if it can have an impact on decision made. However, the meaning of materiality in an accounting context is a state of relative importance. Therefore, in deciding on the materiality of an item in terms of financial statement disclosure, Arthur Andersen should have considered whether knowledge of an entity would likely to influence the decision of users of financial statements. Even if the threshold for materiality has been left to the subjective judgment of the company preparing the financial statements, materiality should be considered not only with the value but with the nature of the entity itself (Horngren & Harrison, 2007). In the case of WorldCom, it treated costs as assets rather than expenses causing higher net income. This brought about the problem of representational faithfulness since there was no agreement between a measure and real world phenomenon that the measure is supposed to represent. A good corporate culture upholds good ethical and legal behaviour. Ethics are the principles of behaviour that help individuals to chose between what is right and wrong, good and bad in all their decision making processes and actions. A business is expected to have clear guidelines as to the code of conduct of the different stakeholders so as to reduce conflict between the relationship of the business and the stakeholders. Arthur Andersen’s corporate culture of upholding the integrity of other firms in the industry had change, for instance, it was sued for obstructing justice for destroying documents that were related to Enron. This attracted a heavy court fine that resulted to financial problems in the company. In addition, Arthur Andersen was the accountant for Harken Energy when it bought unprofitable spectrum 7 which had many debts and gave a generous stock option, which led to poor financial health of the company. Furthermore, Arthur Andersen allowed ethical and illegal behavior in the company. An ethical and illegal financial practice may occur if there is an insider trading. A member of the audit committee sold his shares at a huge profit since he knew that the stock price for Harken Energy was inflated and were expected to fall. This resulted to Harken making a huge loss and its stock price dropped by 20%. Such activities as insider trading have no beneficial economic or financial purpose and it can be argued that they have a negative impact on shareholders wealth. Due to these scandals some of Arthur Andersen’s loyal clients cancelled their clients and other clients followed suit. This led to its eventual downfall as a result of fall in business since its customers had lost trust in its accounting services and ethical standards of behaviour. In an effort to regain trust from its clients Arthur Andersen fired the auditor who was in charge of the Enron account. The company destroyed the documents that were incriminating; however, it was later revealed that Arthur Andersen was not forthright about its executive involvement. This means that Arthur Andersen was not being honest about its dealings, which heightened suspicion to its clients leading to loss of trust with the company. Investors, when analyzing the firm will consider the risk inherent in the firm’s operation and the quality and reliability of reported earning among other factors. Inaccurate financial reporting is misleading to the investors, which means that any decision made in reliance to such reports will also be misleading. This means that the risk of loss to investors will be correspondingly high. Requirement 3 Sarbanes-Oxley Act of 2002 was enacted to reflect the response to series of business scandals, bankruptcies and pension losses. The aim of the legislation is the improvement of corporate governance of firms, which requires that all members of the audit committee are independent and are given authority to hire independent advisors and counsel. In addition, the Act prohibits firm’s auditors from doing certain services that are non-audit for that firm. In other words, the act of congress intended to bring reform to corporate accountability and stewardship in response to corporate scandals. The provisions of the act include I. Established the public company accounting oversight board II. Required external auditors to report directly to the audit committee of the company III. Prohibits external auditors from providing other services which may compromise independence. The objectives of financial reporting and financial statements are derived from the needs of the external users of accounting information. Over the years, numerous organizations, committees and interested individuals have developed and published their own conceptual framework, but no single framework has been universally accepted and relied on in practice. Due to these differences in practice there is need to harmonize the audit reports. Otherwise, the investors and creditors to the company may question the truth and lose trust in the financial reports of the company. The report from an external auditor indicates whether the business being audited has prepared its financial statements in an acceptable manner so that they can be compared with the previous years’ statement and to some extent with the statements of other enterprises. The accounting principle must be developed in relation to the stated objective of financial reporting and financial statements (Warren, 2009). Sarbanes-Oxley Act of 2002 attempts to restore truth and trust in financial reporting by ensuring that the conceptual framework for financial reporting are adhered to. It ensures that the objective of financial reporting and financial statements are met through the establishment of the public company accounting oversight board. The board achieves this by ensuring that financial reports provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions. The information therein should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. It also restores truth and trust in financial reporting by helping present and potential investors and creditors and other users in assessing the amount, timing and certainty of prospective cash receipts from dividends or interests and the proceeds from the sales, redemption or maturity of securities or loans. The public company accounting oversight board restores truth and trust in financial reporting by ensuring that financial reporting provide information about the economic resources of an enterprise, the claim to those resources and the effect of transactions, events and circumstances that change resources and claims to those resources. Furthermore, the board ensures that financial reporting provide information about an enterprise financial performance during a period. This regains trust from investors and creditors since they often keep information about the past to help in assessing the future prospects of an enterprise. In addition, the board attempts to restore truth and trust in financial reporting by ensuring that there is provision of information about how an enterprise obtain and spend cash, about its borrowing, about its capital transactions including cash dividends and other distributions of enterprise resources to owners and about other factors that may affect the liquidity or solvency of the enterprise. The Act has a provision that prohibits external auditors from providing other services which may compromise independence. The role of an external auditor is to investigate all the internal operations of the company he is auditing. If an external auditor offers other services to the company he is auditing, it means he will be accountable to other party within the organization with respect to that task. This will have the effect of compromising independence of the auditor to act in his capacity as an auditor. However, the move by the Act to prohibit such services ensures that the auditor is independent in his auditing services and gives his independent view about the company hence restore truth and trust in financial reporting. The Act requires external auditors to report directly to the audit committee of the company. This has been successful because the external auditor is not required to report to an individual. It is difficult for the external auditor to collude with the entire committee than an individual and committee fraudulent activities that are damaging to the company. References Collins, A. and Schultz, N., 1995. A critical examination of the AICPA code of professional conduct. Journal of business ethics, 14(1), pp.31-41. Horngren, C. T., & Harrison, W. T., 2007. Accounting.7th ed. Upper Saddle River, NJ: Pearson Prentice Hall. Ward, S. and Deck, A., 1993. Certified public accountants: Ethical perception skills and attitudes on ethics education. Journal of business ethics, 12, pp.601-610. Warren, R., 2009. Governmental Accounting Made Easy. New Jersey: John Wiley and Sons. Read More