CHAPTER Corporate Governance and Auditing Standards LEARNING OBJECTIVES The overriding objective of this textbook is to build a foundation to analyze current professional issues and adapt audit approaches to business and eco- nomic complesities, Through studying this chapter, you will be able to: * Define the term “corporate governance,” describe recent failures in corporate gover- nance, and identify actions that the public perceived necessary to improve the quality of corporate governance. + Identify the expectations of the audit profession by major user groups and the actions these groups have taken to increase audit responsibilities + Identify management's role as the key communicator of financial and control informa- tion to stakeholders. ‘+ Identify the key responsibilities of the audit committee as the’ pity audit client of public companies. * Describe the overall audit process as a foundation for fulfilling audit responsibilities to the public. CHAPTER OVERVIEW The public accounting profession has been widely criticized during the past decade for failing to protect investor interests. While much of the aiidit profes- sion performed admirably during this time period, the failures were spectacu- lar: Enron, WorldCom, Global Crossing, and HealthSouth. However, the failures that occurred during the past decade were not solely attributable ¢o failures in the audit profession. They also represented funda- mental failures at the very heart of organization—failures of the corporate gov- femance structure, The failures in ethical standards and corporate governance continue with new issues every year. In the past few years, there have been questions about management greed associated with backdating of stock ‘options, and whether a board has enough power, time, and resources to pro- vide proper oversight of management. “The landscape for the auditing profession has changed with increased respon- sibilities, changed expectations, and greater regulatory oversight. This chapter describes the changes in audit responsibilities, describes international auditing standards, and presents a brief overview of the audit process. Corporate Governance and Auditing The financial failures of the past decade were not exclusively the fault of the public accounting profession. Rather, the failures represented fundamental break- downs in the structure of corporate governance. Nor were the failures limited to the United States. Similar failures occurred in major companies located in Italy, France, the U.K., as well as other parts of the world. Greed simply overwhelmedCorporate Governance and Auditing 35 eae) een re Wo Raa voenie Sevaiacenter ey Reporting Bis Rik and UNO erie Miiizing Libiitios all parts of the system. Thus, much of the regulation that took place in response _Uerandng Autor Resorts a Ee TED to the financial failures addressed fundamental problems in corporate gover- == nance. The auditing profession is an integral part of corporate governance. To fully understand audit responsibilities, we need to first understand the auditor's For What: role in corporate governance. financial Statements ‘According to the Code of Corporate Governance in Singapore, corporate ee aS: governance refers to: duit 2 The processes aid sesictuse by which the business and affairs of the company ae directed and managed, in order to enhance long-term shareholder value through feahancing corporate performance and accountability, while taking into account the interests of other stakeholders. However, Mak (2010)! argued that the current definition lacks three crucial ele~ ments ~ having the right people, risk management and ethical behavior. He pro- posed a more appropriate way to define corporate governance: Corporate governance rele to having people with the character, comiperencies and commitment, supported by appropriate structures and processes to diet and manage the company in an ethical manner, The objective of corporate governance is to tenance long term shareholder value through enhancing performance, accountability tnd risk management, while taking ito account the intezests of other stakeholders There are many parties involved in corporate governance. Exhibit 2.1 pro- vides a broad schematic of the overall governance process. Governance starts with the owners (shareholders) delegating responsibilities through an clected board of directors to management and, in turn, to operating units, In return Governan Peed Directors Accountability 8 Operating Se 1 2040, Mining pieces of corporate governance pure Busine Times Singapore, 20 September 201026 Chapter 2 Corporate Governance and Auditing Standacts for those responsibilities (and power), governance demands accountability back through the system to the sharcholders. The owners need accountability as to how well the resources that have been entrusted to management and the board have been used. For example, the owners want accountability on such things as: * Financial performance * Financial transparency je, the Financial statements ae clear with full disclosure and reflect the underlying economics of the company ‘+ Stewardship, including how well the company protects and manages the resources entrusted to it * Quality of internal controls ‘+ Composition of the board of directors and the nature of their activities, including information on how well management incentive systems are aligned with the share- holders’ best interests Farther, the owners want assurances that the representations made by manage- ment and the board are accurate and objectively verifiable. It is the audit function’ responsibility to meet this'broad requirement. The board has a responsibility to report on its activities, including management incentive systems, but its reports are not independently attested to by auditors, The following are the primary parties involved in corporate governance: + Stockholders * Boards of Directors * Audit committees of the Board + Management * Selfegulatory accounting organizations, e.., TCPAS * Other self-regulatory organizations, e.., Singapore Exchange ‘+ Regulatory agencies, eg., ACRA, Monetary Authority of Singapore (HAS) + Extemal auditors © Internal auditors Corporate Governance in Singapore In 2005, the Coitneil of Corporate Disclosure and Governance (CCDG) issued the Code of Corporate Governance (the “Code”). With effect from 1 September 2007, the Code came under the purview of Monetary Authority of Singapore (MAS) and Singapore Exchange (SGX). Compliance with the Code is not mandatory but companies who are listed on the SGX are required under the Singapore Exchange Listing Rules to disclose their corporate governance prac- tices and explain deviations ftom the Code in their annual reports for AGMS held from 1 January 2007 onwards. ‘The Code is divided into 4 main sections: 1. Board Matters 2, Remuneration Matters 3. Accountability and Audit 4, Communication with Shareholders ‘These 4 sections ate divided into several subsections which spell out various prin- ciples and guidelines for listed companies. Exhibit 2.2 provides a brief overview of the corporate governance disclosure that listed companies have to make in their anaual reports and also to explain their deviations from the guidelines.Enhanced Role of 27 Pues Specific Principles and Guldelines for Disclosure Reference Delegation of authori, by the Board to ary Board Commitee 0 Gudeine a ‘make decisions on certain board matters The number of board and board committee meetings hel inthe Guideline 14 year, 28 wel as the attendance of every hoard member at these meetings ‘The types of materia transactions that require board approval under intemal Guidetine 1.5 uldetines I Where the company considers a eirector to be independent inspite of the ulsoune 2.2 existence ofa ceatonship 2s stated in the Code thet would otherwise deemed him as non independent, the nature of the directo’ relationship and the reason for considering him as indopendent shouldbe disclosed Relationship between the Chairman and CEO where they are related to Guidetine 3.4 each otner BY ‘Composition of nominating committee Guideline 4.2 Fe Process forthe seletion and appointment of new drectors to the board Guidaine 45 Key information regarding crectors, which directors are execute, Guideline 4.6 ; non-executive or consicered by the nominating committe to be independent Process for assessing the effectivenoss ofthe Board as @ whole and the Guideline 5.1 P contribution ofeach individual dlectr tothe effectiveness ofthe Board Clear csclosure of ts remuneration pale, level and mix of emuneretion Guideline 9 paid to directors and key executives and performance ; CCompesiton of remuneration committee Guideline 9.1 Names and remuneration ofeach director. Guideline 9.2 Names and remuneration of at least the top 5 key exceuives, Guidetine 9.2 Remuneration of employees wi sro immediate family members fa drector Guideline 93 forthe CEO and whose remuneration exceed $450,000 during the year. Guldoine 9.4 Detals of employee share schemes CCompcaition of auct committon ane detals ofthe committee's acttes Guideline 12.8 Asequsey of internal contrls, Inctudingtinancial, operational and compilance Guideline 12.2 controls, and sk management systems ‘Source: Exaraced from Code of Corporate Governance 2005 Corporate Responsibility for Financial Reports Management has always had the primary responsibility for the accuracy and completeness of an organization’ financial statements. It is management's responsibility to: ‘+ Make choices on which accounting principles best portray the economic substance of company transactions = Implement a system of internal contrl that assures completeness and accuracy in financial reporting + Ensure that the financial statements, contain full and complete disclosure Enhanced Role of Audit Committees In Singapore, the Audit Committee Guidance Committee (ACGC) isued a guidebook to provide practical guidance and recommendations of best practices for audit committees of, companies listed on the Singapore Exchange. ACGC is a committee set up by the Monetary Authority of Singapore (MAS), the Accounting and Corporate Regulatory ‘Authority (ACRA) and the Singapore Exchange Led (SGX) in 2008. It is an industry-led committee, comprising of audit committee members from the business community and representatives from various groups, set up to strengthen the corporate governance prac- tices of listed companies in Singapore. The guidebook identifies the audit committees’ key28 Chapter 2 Corporate Governance and Auditing Standaeds regulatory responsibilities and addresses practical issues of concerns to audit com: mittee members of listed companies. ‘The audit committee is said to play an important role in ensuring the integrity of the financial statements through its oversight of the company’s overall financial reporting process, internal control system as well as the audit function. Therefore, the audit committee members have to ensure that the committee is made up of individuals with the appropriate qualifications to provide independent, objective and effective insight. It is important that we remember these are oversight roles; i.e.,the audit committee does not replace the CFO or divisional controllers ~ the responsibility for all these functions lies with management. ‘The audit committee must be composed of"*non-executive directors,” ie. those who are not members of management such as the CEO, CFO ete. The audit com- mittee is required to have a minimum of 3 members, of which at least wo of them should have accounting or related financial management expertise or experience. ‘Additionally, in order for the audit committee to function effectively, the commit tee should define the scope of its oversight responsibilities and how these are to be discharged. Specifically the Terms of Reference of the appointment should include * the roles and responsibility of the committee members * authority for the committee to seek independent professional advice, * provision of direct access to anyone in the organization in order to Fulfil its responsibilities, * non-executive role of the audit committee * roles of the audit committee to arbitrate between management, external and internal auditors * responsibility in fraud prevention and detection Importance of Good Governance to the Audit Good governance is important to the conduct of an audit for one very simple rea~ son: Companies with good corporate governance are les risky. These companies are less likely to engage in “financial engineering”; will usually have a code of conduct that is reinforced by actions of top management; will have independent board mem- bers who take their jobs seriously and have sufficient time and resources to perform their work; and will take the requirements of good internal control over financial reporting seriously and make a commitment to needed financial competencies. Recent empirical studies have shown that companies with good corporate gover- nance also have (2) lower costs of capital and (b) superior stock returns as compared to companies with lower levels of corporate governance. Mote and more, many audit firms are not willing to accept potential audit clients unless the clients demonstrate a strong commitment to good corporate governance. Stated simply, a public company that does not commit to good cor porate governance is too much of a risk for an audit firm. Such a company is more likely to have violations of its corporate code of conduct, is more suscep- tible to financial fraud, have a less robust internal control system, and will be more difficult to audit. Most audit firms look at thé governance issues when making decisions to become associated with, or to remain associated with, an audit client. ‘As public accounting firms continue to expand ‘their services to non-audit clients, the governance issues remain important. Even though not rendering an audit opinion, a public accounting firm cannot afford the risk of being associated with a company that has a reputation for poor governance. For example, assume that a Big 4 public accounting firm performed only internal audit work for a company with a less than reputable corporiite governance structure and manage- ment was found to have illegally backdated the exercise dates for stock options. Outside users would ask why the internal audit fonction had not looked at the risk associated with management compensation and brought it to the attention of the board, and further, seen to it that the board had taken proper action,