ACCA F8 (INT) Audit & Assurance - 2010 - Study text - Emile Woolf Publishing
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Chapter 2: Corporate governance and auditing
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The role of the auditor in corporate governance
The external auditor
The internal auditor
2 The role of the auditor in corporate governance
2.1 The external auditor
The external auditor is part of the corporate governance system.
He provides an independent check on the integrity of the financial information
prepared by the directors for the use of shareholders and other stakeholders
He may have a responsibility for forming an opinion on the extent to which the
directors have complied with specific corporate governance regulations
(accepted voluntarily or imposed on them by law).
In order to fulfil these roles, the external auditor will examine the company’s
systems and controls. However, he is not responsible for those systems or controls.
Responsibility remains with the directors and executive management.
The external auditor is also required by ISA 260 Communication of audit matters to
those charged with governance to provide management periodically with observations
arising from the audit that are significant and relevant to management’s
responsibility to oversee the financial reporting process. These observations might
include:
weaknesses in internal control found by the auditor, or
accounting policies adopted by the entity which the auditor considers
inappropriate.
In addition, all good corporate governance systems have procedures and
arrangements designed to maintain the independence of the external auditor. For
example:
the external auditor may be required to report to an audit committee, as well as
to work with the chief executive officer and finance director
the nature and extent of non-audit services provided by the audit firm may be
kept under review, to make sure that the auditor:
− has not become excessively dependent on the company and its executive
management for fee income, and
− is not in danger of becoming too familiar with the company’s management
and systems of operation
suitable procedures may be established for the discussion of contentious issues
where the auditors and the finance director/chief executive officer have strong
differences of opinion.
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2.2 The internal auditor
Senior management is responsible for putting in place a system of internal controls
that will prevent or detect errors and fraud. An internal audit function may be used
by management as a means of monitoring these systems of internal control.
An internal audit function can therefore be used to obtain assurance that the system
of internal controls is adequate and that it is functioning properly.
Companies are not required by law to have an internal audit function. However, in
the UK, listed companies are required to set up an audit committee which is
required each year to:
monitor and review the effectiveness of internal audit activities, or
where there is no internal audit function, to consider the need for an internal
audit function and make a recommendation to the board. (The reasons for not
having an internal audit function should also be explained in the annual report
and accounts.)
Other companies and entities may also choose to have an internal audit function,
because of the assurance it should provide about the adequacy of internal controls.
The role of the internal audit function is described in more detail in a later chapter.
Chapter 2: Corporate governance and auditing
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Systems of corporate governance
A voluntary or statutory approach
General principles of corporate governance
Example of a corporate governance system
The use of audit committees
3 Systems of corporate governance
3.1 A voluntary or statutory approach
Many countries now have minimum corporate governance requirements. Typically,
they are imposed only on listed companies, although smaller companies are also
encouraged to comply. (Listed companies are companies whose shares are officially
‘listed’ by the financial markets regulator and traded on a major stock market.) In
addition, some public sector organisations are also showing an increased emphasis
on corporate governance matters.
In many countries, corporate governance guidelines are based on a voluntary code
of practice rather than statutory regulation.
This is largely the case in the UK, where the Combined Code on Corporate
Governance is applied to listed companies. Although this Code does not have any
statutory force, the Listing Rules of the Financial Services Authority Stock Exchange
require listed companies to comply with every aspect of the Code or to explain their
reasons for any non-compliance. This is known as ‘comply or explain’. There are
also some statutory requirements relating to corporate governance in the UK, such
as the statutory requirement for an annual audit and a requirement for an annual
‘directors’ remuneration report’ on which the shareholders must be invited to vote.
A statutory approach to the regulation of corporate governance has been taken in
the United States, in the form of the Sarbanes-Oxley Act (2002). This was
introduced primarily as a result of the corporate failures in 2001 and 2002, including
Enron and WorldCom. (One of the requirements of the Sarbanes-Oxley Act is for the
chief executive and chief financial officer of each stock market corporation to submit
an annual report to the Securities and Exchange Commission about the adequacy of
their internal control system. This report must be supported by a formal statement
from the external auditors.)
The detailed provisions of corporate governance regulations vary from country to
country. The examiner has made it clear that you are not required to have a detailed
knowledge of the regulations in any particular country. However, you should be
aware of general principles underlying the regulation and application of best
practice in corporate governance.
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3.2 General principles of corporate governance
The five principles set out below were developed by the Organisation for Economic
Co-operation and Development (OECD). They are intended to provide a general
model of a good corporate governance system.
The OECD Principles state that a corporate governance framework should achieve
the following objectives:
(1) Protect shareholders’ rights, such as voting rights and the right to transfer
ownership in shares.
(2) Ensure the equitable treatment of all shareholders, including minority and
foreign shareholders. All shareholders should have the opportunity to obtain
effective redress for any violation of their rights.
(3) Recognise the rights of stakeholders as established by law and encourage
active co-operation between corporations and stakeholders in creating wealth,
jobs, and the sustainability of financially secure enterprises.
(4) Ensure that timely and accurate disclosure is made on all material matters
regarding the corporation, including the financial situation, performance,
ownership, and governance of the company.
(5) Ensure the strategic guidance of the company, the effective monitoring of
management by the board, and the board’s accountability to the company and
the shareholders. This includes ensuring:
− the integrity of the corporation’s accounting and financial reporting
systems, including the independent audit
− that appropriate systems of control are in place, in particular, systems for
monitoring risk, financial control, and compliance with the law.
Items (4) and (5) above have the greatest relevance to audit and assurance.
3.3 Example of a corporate governance system
Although, as stated above, you are not required to have a detailed knowledge of the
regulations in any particular country, it is useful to see how the above principles are
reflected in a specific corporate governance system. The main principles of the UK’s
Combined Code are therefore set out below by way of an example of a current
corporate governance system. The principles have been expanded upon where they
are of particular relevance to external auditors.
Directors
(1) Every company should be headed by an effective board, which is collectively
responsible for the success of the company
(2) There should be a clear division of responsibilities between the running of the
board (the chairman) and the running of the company’s business (the chief
executive)
(3) The board should include a balance of executive and non-executive directors.
(4) There should be a formal procedure for appointing new directors to the board.
Chapter 2: Corporate governance and auditing
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(5) The board should be provided with timely information to enable it to
discharge its duties.
(6) The board should undertake a formal annual evaluation of its own
performance and that of its committees and individual directors.
(7) All directors should be submitted for re-election at regular intervals, subject to
continued satisfactory performance.
Remuneration
(1) Levels of remuneration should be sufficient to attract, retain and motivate
directors, but should not be more than is necessary.
(2) There should be a formal procedure for fixing directors’ remuneration. No
director should be involved in deciding their own remuneration.
Accountability and audit
(1) The board should present a balanced assessment of the company’s position
and prospects.
[In the annual report, both the directors and the auditors must explain their
respective responsibilities.]
(2) The board should maintain a sound system of internal control to safeguard the
company’s assets.
[At least annually, the board should conduct a review of the effectiveness of
the internal controls and should report to shareholders that they have done
so.]
(3) The board should maintain an appropriate relationship with the company’s
auditors.
[The topic of establishing an audit committee is covered below.]
Relations with shareholders
(1) There should be a dialogue with shareholders based on the mutual
understanding of objectives.
(2) The board should use the AGM to communicate with investors and encourage
their participation.
Example
Mrs Smith is both Chief Executive Officer (CEO) and Chairman of your client. The
board of directors consist of five executive and two non ‐executive directors. Board
salaries are set by Mrs Smith based on her assessment of all the board members,
includingherself,andnottheiractualperformance
.
Required
Explainwhyyourclientdoesnotmeetinternationalcodesofcorporategovernance,
whythismaycauseaproblemforthecompany,andrecommendchanges.
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Answer
ChiefExecutiveOfficer(CEO)andChairman
Why codes are not met: Mrs Smith is both CEO and Chairman of the company.
Good principles of corporate governance state that the person responsible for
running the company (the CEO) and the person responsible for controlling the
board(thechairman)shouldbedifferent
people.
Whyaproblem:Thisistoensurethatnooneindividualhasunrestrictedpowersof
decision.
Recommendation: That Mrs Smith is either the CEO or the Chairman and that a
secondindividualisappointedto the otherposttoensurethatMrs Smith does not
havetoomuchpower.
Compositionofboard
Why codes are not met: The current board ratio of executive to non‐executive
directorsis5:2.
Whyaproblem:Thismeansthattheexecutivedirectorscandominatethe
board proceedings. Corporate governance codes suggest that there should be a
balanceofexecutiveandnon‐executivedirectors
sothiscannothappen.
Recommendation: That the number of executive and non‐executive directors is
equaltohelpensurenoonegroupdominatestheboard.Thiswillmeanappointing
morenon‐executivedirectors.
Boardremuneration
Whycodesarenotmet:BoardremunerationissetbyMrsSmith.
Whyaproblem:
Thisprocessbreachesprinciplesofgoodgovernancebecause the
remuneration structure is not transparent and Mrs Smith sets her own pay. Mrs
Smithcould easily be setting remuneration levels based on her own judgements
without anyobjective criteria. Remuneration should also be linked to performance,
toencourageahighstandardofwork.
Recommendation: That a remuneration committee is established comprising three
non‐executive directors. This committee would set remuneration levels for the
board, taking into account current salary levels and the performance of board
members.
3.4 The use of audit committees
An audit committee is a sub-committee of the board of directors. The role of the
audit committee is to carry out some delegated functions in connection with the
external audit and internal audit, and to report and make recommendations to the
main board of directors.
The requirement for an audit committee varies between countries. In the European
Union, all listed companies are required to establish an audit committee.
In the UK’s Combined Code, these arrangements are fulfilled by establishing an
audit committee consisting entirely of independent non-executive directors. The
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audit committee provides a counter-balance to the working relationship between
the external auditors and the executive management of the company.
By having a requirement for the external auditor to have certain dealings with the
audit committee, it should be possible to:
reduce the dependence of the auditors on the executive management (in
particular the chief executive officer and finance director)
monitor the independence of the auditors
provide assurance to the board that the auditors are performing their tasks to a
suitable standard.
Functions of an audit committee
The functions of an audit committee may include the following tasks and
responsibilities:
To monitor the integrity of the financial statements, and to review any
significant financial reporting judgements that have been used in the
preparation of the statements.
To review the adequacy of the company’s internal financial controls, and
possibly also its other internal controls (compliance controls and operational
controls).
To monitor the effectiveness of the internal audit function in the company.
To make recommendations to the board about the appointment, re-appointment
or removal of the external auditors, for submission to a vote by the shareholders.
To approve the remuneration and terms of engagement of the external auditors.
To monitor the independence and objectivity of the external auditors and the
effectiveness of the audit process.
To review and implement a policy on the employment of the external auditors to
provide non-audit services to the company, so that the policy maintains the
objectivity and independence of the auditors in their audit work.
The audit committee does not remove the need for the executive management to
work directly with the external auditors. However, it provides an important extra
channel of communication with the external auditors, to ensure that they fulfil their
responsibilities properly.
Benefits and disadvantages of an audit committee
The existence of an audit committee should:
increase user confidence in the credibility of financial information published by
the company
assist directors in meeting their responsibilities
strengthen the independence of the external auditors by providing a point of
liaison for them
lead to better communication between the external auditors and the board of
directors.
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However, there are disadvantages, such as:
the additional cost (and time) involved in having an audit committee
the creation of a ‘two-tier’ board of directors: those directors closely involved in
the preparation of the financial statements and the annual audit, and those who
are not involved
fear amongst executive directors that the aim of the audit committee is to ‘catch
them out’
placing an excessive burden on those non-executive directors who are members
of the audit committee.
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Paper F8 (INT)
Audit and assurance
CHAPTER
3
The statutory audit
Contents
1 The regulatory framework
2 International Standards on Auditing (ISAs)
3 Advantages and limitations of statutory audits
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The regulatory framework
The requirement for an external audit
Eligibility to act as an external auditor
Appointment of auditors
Resignation of auditors
Removal of auditors
Rights and duties of auditors
1 The regulatory framework
The detailed statutory regulation of auditing and the audit profession varies from
country to country. General principles of regulation are described in this chapter.
These give an indication of the broad nature of the regulations that apply in most
countries.
1.1 The requirement for an external audit
In most countries there is a legal requirement for listed and other large companies to
have an external audit of their published financial statements. This requirement is
imposed by law in order to protect the shareholders.
However, in smaller ‘family’ companies, where the shareholders are also the
directors, the requirement for assurance in the form of an external audit is much less
important.
As a consequence, many countries have a small company audit exemption. This
exempts small companies from the need for an annual statutory audit. For example,
in the UK, companies are exempted from the requirement to have an external audit
if their annual revenue does not exceed £6.5 million and their assets as shown in
their balance sheet/statement of financial position do not exceed £3.26 million.
1.2 Eligibility to act as an external auditor
Self-regulation by the audit profession
Eligibility to act as an external auditor is usually determined by membership of an
appropriate ‘regulatory body’, such as the ACCA.
The role of such regulatory bodies normally includes the following:
Offering professional qualifications for auditors, to provide evidence that
auditors possess a minimum level of technical competence.
Establishing procedures to ensure that the professional competence of auditors
is maintained. This includes matters such as:
− ensuring that audits are performed only by ‘fit and proper’ persons, who act
with professional integrity