The Impact of Good Corporate Governance in Internal Control - Essay Example

The Impact of Good Corporate Governance in Internal Control 1. Introduction In recent years, widespread corporate collapses and fraud, causing companies focus on corporate governance and internal auditing function, as part of the governance process, as solution to that, Whereas, in the past, it was concentrated on external auditing as solution. In addition, the level of fraud in organizations in public sector and private are increasing, therefore, the companies with good corporate governance emphasize in value in internal control and internal auditing have less likely to be in dangerous in fraud. As result, nowadays, the corporate governance has significant role to the companies to escape from failures in collapses or fraud. However, the discovery and prevention of fraud are significant challenges facing the business environment. Therefore, the ways in which companies' deals with fraud may enhance either the internal control and independent internal auditor or the need to forensic accounting. The forensic accounting is increasing in many organizations to identify situation, systems and security weaknesses by design and advise measure to reduce and limited inherent risk in organization. The Enron and WorldCom in the US corporate collapses and fraud shook the foundation of the financial system and corporate governance therefore; regulators in the U.S reform corporate governance by established the Sarbanes-Oxley act in June 2002 and Cadbury in UK, in 1992, which now combine code. This assignment will illustrate the impact of good corporate governance in internal control and internal auditing function to prevent fraud and detection. 2. Corporate governance and the prevention of fraud and detection Through the decades, the increase of the complexity of organizational activities has resulted to the increase of the difficulty of their control. In most cases, the measures established for the control of organizational activities are proved inadequate – usually because not all aspects of the firm’s environment have been taken into consideration. In practice, it has been proved that the implementation of a well-structured corporate governance framework can decrease the chances for severe organizational failures. However, a mechanism should be also established ensuring that the rules and the guidelines included in the firm’s corporate governance scheme are followed. In any case, the value of the corporate governance as a framework for preventing fraud and defection across the organization cannot be doubted. This view is analytically explained below referring primarily to the main aspects and the role of corporate governance as a strategic tool for monitoring the progress of the organization in regard to its aims and mission; at the next level, the role of corporate governance in preventing fraud is presented explaining the challenges and the benefits of the involvement of corporate governance in such activity. 2.1 Corporate governance – role and characteristics Different approaches can be used in order to explain the role of corporate governance in modern organizations. In accordance with Anand (2007) corporate governance is a framework that ‘incorporates almost every aspect of corporate life’ (Anand 2007, p.77); however, it is explained that in its common form, the corporate governance framework consists of rules that aim to protect the interests of the firm’s shareholders (Anand 2007). On the other hand, Du Plessis et al. (2010) note that the term ‘corporate governance’ can incorporate many elements; among these elements two are considered to be the most important: the promotion of the interests of the shareholders and ‘the regulation/ monitoring of the corporate conduct’ (Du Plessis et al. 2010, p.10). In other words, the corporate governance should not be regarded as just a strategic tool for protecting the interests of specific teams of organization’s stakeholders but also, and mainly, as a mechanism for ensuring the alignment of corporate strategies and activities with the existing laws and ethics – referring to the law and ethics held in the particular market in regard to the activities of corporations but also the ethics and the values of each organization. The need of flexibility as a characteristic of the corporate governance framework is made clear in ‘the Combined Code on Corporate Governance of 2003’ (Chapman 2006, p.19), the legislative framework which was used until recently in Britain for regulating the organizational activities of corporations across the country; currently, the Corporate Governance issues of corporations in UK are regulated through the Corporate Governance Code 2010. Another important aspect of corporate governance is its dependency on the corporate ownership structure. In fact, it has been proved that in firms with relatively low performance ‘the probability of disciplinary management turnover is positively correlated with stock ownership of board members, and board independence’ (Bhagat et al. 2008, p.257). In other words, corporate governance cannot be fully independent from the corporate overall framework – even if such perspective would be necessary in order for the corporate governance to have the power to prevent fraud and detection. On the other hand, Choo et al. (2007) noted that the role of corporate governance within the organizational environment – including its role in preventing fraud – can be evaluated differently in accordance with the theory used for its interpretation – reference is made to the Agency theory – related to the economic aspects of organizations – and the Stewardship theory – which aims to relate the corporate activity with the behaviour of individuals within a particular environment. Chapman (2006) notes that one of the key characteristics of corporate governance is ‘the lack of prescriptive rules’ (Chapman 2006, p.19) under the terms that each organization has to develop a corporate governance scheme that best suits to its needs, its structure and its environment (Chapman 2006). Of course, the right of the state’s authorities to control the alignment of corporate activities with the laws regulating the business activities across the country cannot be ignored or eliminating; however, the right also of the company’s shareholders to develop a corporate governance scheme that best serves their needs – in the context of existing laws – is also recognized. The potentials of shareholders to intervene in the rules of corporate governance schemes are analytically described in the study of Luo (2007); in the above study, it is noted that ‘a discipline –based governance scheme’ (Luo 2007, p.18) is available to shareholders who aim to ensure the protection of their rights and to minimize the risk for fraud. Such framework would include: ‘a) executive penalty, b) internal auditing, c) a conduct code and d) an ethics program’ (Luo 2007, p.18). The study of Luo (2007) highlights the potential role of corporate governance in protecting the interests of shareholders. In practice, such framework is used as a tool preventing fraud. This role of corporate governance is analytically explained in the section that follows. Through the issues discussed above it has been made clear that the corporate governance framework of each organization needs to be flexible ensuring its ability to be alternated following the changes in organizational environment and ownership structure. 2.2 The impact of corporate governance in internal control and internal auditing function to prevent fraud and detection The examination of the aspects of corporate governance in modern organizations – referring to the literature reviewed in the context of this study – has led to the conclusion that corporate governance can highly influence the internal control and the internal auditing function and in this way it can helps towards the prevention of fraud and detection. In regard to the relationship between the corporate governance and the internal control, a series of issues should be highlighted; the internal control of organizations refers to the monitoring of all organizational functions, being in this way a broader concept compared to the internal auditing function (Dunlop, 1998). The direct relationship between corporate governance and internal control can be identified in the definition of corporate governance included in the Corporate Governance Code 2010; in accordance with the above Code, the corporate governance can be described as ‘the system by which organizations are directed and controlled’ (The Stationery Office, UK, 2010, p.5). In other words, the internal control is one of the two key elements of corporate governance; in accordance with Solomon (2007) internal control can operate independently from corporate governance aiming to help ‘aligning the interests of managers and shareholders’ (Solomon 2007, p.150). On the other hand, internal control is not always obligatory, in terms of law, even if it is necessary for the success of organizational projects. In USA, the obligation of corporate auditors to provide certification for the development of internal control is mentioned in ‘the section 404 of the Sarbanes-Oxley Act 2002’ (Calder 2008, p.108). In UK also, ‘the Combined Code 2003 recommends that the board of directors accepts a system of internal control’ (Lee, 2007, p.38); moreover, the board of directors has to review the report on the internal control annually and inform accordingly the firm’s shareholders (Lee 2007). In accordance with the issues discussed above, internal control is a necessary element of corporate governance not only in terms of the existing laws but also in terms of the context of corporate governance – as the specific framework was described above. In accordance with Wang (2003) the impact of corporate governance on the internal control is derived from the role of corporate governance within the organizational environment; it is noted that a successful corporate governance framework needs to include provisions for the establishment and the evaluation of an effective mechanism of internal organizational control; in other words, corporate governance cannot exist without being supported by an effective internal control mechanism; in case that there is no such mechanism, then the performance of organizational activities cannot be measured and estimated – a fact that could set in risk the survival of the organization. Apart from the internal control, another organizational activity, which can be influenced by the corporate governance, is the internal auditing function. As noted above, corporate governance serves specific organizational needs; these needs set the criteria on which a firm’s corporate governance scheme will be based. Despite the fact that the structure and the elements of a corporate governance framework can be highly differentiated among organizations, still, it is necessary that the specific framework ensure ‘integrity, openness and accountability’ (Pickett 2005, p.11). In accordance with the above, the internal audit function has to be a key component of a firm’s corporate governance scheme – helping to identify those organizational activities that are opposed with the firm’s ethics and values but also with the laws regulating the business activities. Cascarino et al. (2007) refers to the historical development of internal audit in order to explain the role of the specific process within the organization but also its interaction with the corporate governance. In the study of the above researchers it is noted that internal audit has been a process developed gradually under the need for controlling the continuously increasing organizational activities. Internal auditors were appointed in order to help external auditors in examining and evaluating the performance of organizational activities in regard to their alignment with existing laws and ethics. The concept of internal auditing is considered to have its roots in the nineteenth century while its differentiation in internal and external auditing – for serving the need explained above – took place in 1940s (Cascarino et al. 2007, p.4). The reference to the historical development of internal auditing is necessary in order to understand its relationship with corporate governance. On the other hand, the following issue needs to be highlighted: internal audit, as part of the corporate governance of modern firms is not always obligatory – in terms of the law that impose such context. For instance, in USA, ‘all firms listed in the New York Stock Exchange (NYSE) need to have an internal audit framework’ (Pickett et al. 2010, p.130); on the contrary, ‘in UK internal audit is not obligatory’ (Pickett et al. 2010, p.130). In other words, the existence and the elements of internal audit as an organizational function are not standardized; rather, they are depended on the standards and the ethics held in each country in regard to the activities of corporations (Aras et al 2009, p.226). The impact of the corporate governance on the internal audit function is made clear through the following facts: a) the internal audit function is designed in accordance with the organizational needs; these needs are identified and evaluated using appropriate corporate governance mechanisms, b) the internal audit function has specific requirements – referring especially to its cost; these requirements need to be addressed by examining and evaluating available organizational resources but also the organizational structure; the above elements/ sectors of the organization need to be examined and evaluated for the following reasons: b1) it is possible that the existing organizational resources (staff, technology, funds) are not adequate for supporting a particular internal audit scheme, b2) it is possible that the organization’s structure does not permit the rapid transfer of information across the organizational departments; in this case, the firm’s structure should be reviewed and changed – using the relevant rules of the firm’s corporate governance scheme (Lipman et al. 2006). In the research developed by Chen et al. (2006) it was proved that the ownership structure of firms – and thus, their corporate governance rules – could indicate the potential chances for the appearance of fraud. It is assumed that in firms with high integrated corporate governance schemes, the risk for fraud is quite low; on the other hand, successful corporate governance schemes are based on effective internal audit functions. It is concluded that, in organizations where the activities of internal auditors are effectively and adequately supported by the corporate governance rules, the risk for fraud is minimized. The above view is verified through the findings of the research developed by Lo et al. (2010); through the above research it was revealed that ‘the quality of corporate governance is important in deterring the use of manipulated transfer prices in related-party sales transactions’ (Lo et al. 2010, p.225). From another point of view, it has been proved that in firms where extremely strong shareholder interests exist, the level of quality of internal audit is low. The reason is that, in these firms, the shareholders do not adequately support the development of effective internal audit mechanism – mostly because a powerful and effective internal audit mechanism would be a threat for their interests (Lin et al. 2009). From this point of view, the corporate governance framework of a particular organization can have not just positive but also negative impact on this organization’s internal auditing function. The above issue is also highlighted in the study of Armstrong et al. (2010) where emphasis is given on the potential influence of information asymmetry on the effectiveness of internal auditing function. The corporate governance framework of each organization needs to ensure that all mechanisms ensuring the high quality of information exchanged across the organization are active. It is for this reason that the failure of organizations to provide accurate financial reports has been often related to the weaknesses of their corporate governance framework. In this context, it is suggested by Rezaee (2004) that organizations that aim to avoid the risk of financial scandals are develop corporate governance scheme which include provisions referring to all organizational functions, including ‘managerial, compliance, audit and monitoring functions’ (Rezaee 2004, p.107). 3. Corporate governance and prevention of fraud in practice – the case of Xerox The potential failure of corporate governors – CEOs and members of the board – and corporate auditors to develop effective corporate governance schemes can have severe effects on the organizational performance. This fact is made clear in the case of Xerox, a firm the financial results of which were alternated (see Figure 1) Appendix; in this way, a false impression was given on the level of the firm’s profitability. In the case of Xerox, a series of issues have been highlighted in regard to the potential effects of fraud in the financial reporting of a specific organization: a) the failure of the organization to meet the provisions of law in regard to the financial reporting can have various effects; in the case of Xerox, the SEC sued both the Corporation and KPMG, the organization which had the responsibility for the internal audit of Xerox. After evaluating the financial reports of the corporation, SEC found that the firm’s auditors had alternated the financial results of the firm at such level that ‘an overstatement of $3bn resulted’ (BBC News, 2002), b) in the case of fraud in corporations, the potential responsibility of partners and employees is examined and penalties are imposed accordingly; in Xerox, the research of SEC on the firm’s financial reporting processes revealed that four partners of the firm were involved in the specific activity; for this reason, these partners were sued – along with KPMG – for ‘the damaged caused to the firm’s shareholders but also to its international affiliates’ (Accountancy, 2003), c) if a corporation is found to have been involved in fraud of various forms – including the provision of false financial reports – then the cooperation with the governmental authorities is necessary in order for a fair arrangement to be made; in any case, the firm’s auditors and any of its partners who participated in the specific activity need to admit their responsibility. In the case of Xerox, the persons who were involved in the fraud refused to admit their responsibility; the specific practice led the members of SEC to the decision to impose on the firm an extremely high penalty – actually, a fine of $10 million was imposed on Xerox because of the accounting fraud in which the firm’s auditors and certain of its partners were involved (CCN Money, 2002); d) through the case of Xerox it was made clear – as in also other similar cases worldwide – that shareholders are not always aware of the decisions of corporate managers; especially regarding the accuracy of a firm’s financial result, the risk for potential failures is high especially when internal auditing function is not appropriately monitored; usually, that corporate managers and internal auditors have not the intension of causing damage on the firm; rather, they seek to improve the firm’s image in its market aiming to attract more investors; however, the regulations referring to the specific activity – accounting fraud – are clear and are not related with the intentions of the persons involved in these activities (U.S Securities and Exchange Commission, 2003). In the case of Xerox it was proved that the particular accounting fraud was committed by the internal auditors in cooperation with the firm’s partners – certain of them; it can be assumed that the specific action was initiated by a firm partner who aimed to secure his position in the organization; this issue is highlighted in the study of Fich et al (2007) where it is noted that fraud in corporations is often initiated by ‘fraud affiliated directors’ (Fich et al. 2007, p.306) who aim to secure their position and the power of control within the specific organization. 4. Conclusion The examination of the forms and the effects of corporate governance in modern organizations led to a series of important conclusions: a) the access of shareholders to the financial results of the corporation in which they participate is not always easy; in fact, even when relevant information is provided, the accuracy of the data involved is difficult to be checked, b) the power of internal auditors and CEOs in regard to the development of internal audit should be reviewed; a mechanism should exist in each corporation for monitoring the activities developed in the context of the internal auditing function; the lack of control of the reports submitted by the internal auditors can result to severe damages – referring to the fines imposed by the authorities in cases that an accounting fraud is identified in the financial reports submitted, c) the framework developed in countries worldwide regarding the protection of investors from accounting fraud is not satisfactory; a first weakness of the existing framework regarding the accounting obligations of corporations is the lack of mechanism for checking the financial reports submitted by the firms’ internal auditors; in fact, it seems that the relevant reports can be submitted directly to the relevant authorities – their examination by external auditors and their verification is a rather typical process which, quite often, is not developed successfully. In any case, corporate governance has been proved as having the power to impact the internal control and the internal auditing function – for the reasons presented above. However, this relationship along corporate governance, the internal control and the internal auditing function has not led to the increase of the prevention of fraud and prevention. Rather, it seems that the corporate governance framework is used as a vehicle for identifying the firms’ strengths and weaknesses and proceed to forms of accounting fraud that are difficult to be traced. The above view is supported by the fact that the number of firms where accounting frauds are identified is extremely low compared to the number of firms that are actually involved in accounting fraud activities. References A. Books Anand, S. (2007) Essentials of Corporate Governance. John Wiley and Sons Aras, G., Crowther, D. (2009) Global perspectives on corporate governance and CSR. Gower Publishing Calder, A. 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Online Sources Accountancy (2003) U.S. sues KPMG for fraud over Xerox accounting, available from http://www.accountancy.com.pk/newsprac.asp?newsid=167 BBC News, 2002, SEC charges Xerox with fraud, available from http://news.bbc.co.uk/2/hi/business/1924604.stm Dobin, B. (2010) Workers Charged In $4M Xerox Forklift Fraud, available from, http://www.manufacturing.net/News-Workers-Charged-In-4M-Xerox-Forklift-Fraud-061110.aspx CNN Money, 2002, Xerox charged with fraud, available from http://money.cnn.com/2002/04/11/technology/xerox_fraud/ U.S Securities and Exchange Commission, 2003, XEROX, available from http://www.sec.gov/news/press/2003-70.htm Appendix Figure 1 – actual and false increase of profits in Xerox (source: http://news.bbc.co.uk/2/hi/business/1924604.stm) Read More