Accounting theory 2

Prepared By: Dewan Mahboob HossainPrepared By: Dewan Mahboob Hossain

Presentation on:Presentation on:Corporate GovernanceCorporate Governance

University Of Western Sydney, University Of Western Sydney, Paramatta Campus.Paramatta Campus.

Course: Accounting TheoryCourse: Accounting TheoryInstructor: Kevin Clark, CA, CPA. Instructor: Kevin Clark, CA, CPA.


Definition Definition The meaning of Corporate Governance is The meaning of Corporate Governance is

influenced by different views of different influenced by different views of different authors. authors.

For example, one group described it as a For example, one group described it as a ‘system’ by which companies are directed ‘system’ by which companies are directed and controlled (Cadbury Report, CFACG and controlled (Cadbury Report, CFACG 1992), to another group, it is concerned with 1992), to another group, it is concerned with the ‘structures and processes’ for decision the ‘structures and processes’ for decision making, accountability, control and behavior making, accountability, control and behavior at the governing body (Public Accounts and at the governing body (Public Accounts and Estimates Committee, 2002), to someone Estimates Committee, 2002), to someone corporate governance is about ‘finding ways’ corporate governance is about ‘finding ways’ to ensure effective decision making (Pound, to ensure effective decision making (Pound, 1995). 1995).


Definition (contd.)Definition (contd.)

But it should be noted that the term But it should be noted that the term corporate governance is a separate corporate governance is a separate term than ‘management’. The term term than ‘management’. The term management is highly related to the management is highly related to the day-to-day management of a day-to-day management of a company’s operations. ‘Corporate company’s operations. ‘Corporate Governance’ oversights this task of Governance’ oversights this task of management under a harmonized management under a harmonized structure. structure.


Definition (contd.) Definition (contd.)

Vittal (2000) states that corporate governance Vittal (2000) states that corporate governance calls for three factors:calls for three factors:

1. Transparency in decision-making1. Transparency in decision-making

2. Accountability which follows from transparency 2. Accountability which follows from transparency because responsibilities could be fixed easily for because responsibilities could be fixed easily for actions taken or not taken, andactions taken or not taken, and

3. The accountability is for the safeguarding of the 3. The accountability is for the safeguarding of the interests of the stakeholders and the investors in interests of the stakeholders and the investors in the organization.the organization.


Definition (contd.)Definition (contd.) Corporate governance is probably the widest Corporate governance is probably the widest

control mechanism used for efficient control mechanism used for efficient utilization of corporate resources. It can be utilization of corporate resources. It can be defined as an organizational control device, defined as an organizational control device, which is a hybrid of internal and external which is a hybrid of internal and external control mechanisms with a view to efficient control mechanisms with a view to efficient utilization of corporate resources. utilization of corporate resources.

It is the network among various corporate It is the network among various corporate players such as, shareholders, managers, players such as, shareholders, managers, employees, lenders, government, suppliers, employees, lenders, government, suppliers, and consumers for increasing the value of the and consumers for increasing the value of the firm. firm.


OECD PrinciplesOECD Principles To have a clear idea about corporate governance To have a clear idea about corporate governance

system the principles laid out by Organization of system the principles laid out by Organization of Economic Cooperation and Development (OECD) Economic Cooperation and Development (OECD) can be considered in this regard:can be considered in this regard:

1. 1. Protecting the rights of shareholders: This Protecting the rights of shareholders: This includes the right to secure ownership, full includes the right to secure ownership, full disclosures, voting rights, participation in all kind disclosures, voting rights, participation in all kind of activities in general shareholder meeting, to be of activities in general shareholder meeting, to be informed on fundamental corporate changes, to informed on fundamental corporate changes, to have access to efficiency and transparency in have access to efficiency and transparency in markets for corporate control. Bosch Committee markets for corporate control. Bosch Committee (1995) suggested that shareholders should see (1995) suggested that shareholders should see themselves as owners, not just investors.themselves as owners, not just investors.


OECD Principles (Contd.)OECD Principles (Contd.)

2. 2. Equitable treatment of shareholders:Equitable treatment of shareholders: Here Here OECD is concerned to protect the rights of the OECD is concerned to protect the rights of the minority shareholders. Corporate governance minority shareholders. Corporate governance framework should ensure the fair treatment of framework should ensure the fair treatment of all shareholders including minority and foreign all shareholders including minority and foreign shareholders. Insider trading and abusive self-shareholders. Insider trading and abusive self-dealing is explicitly prohibited. Members of the dealing is explicitly prohibited. Members of the board should disclose any material interests in board should disclose any material interests in transactions or matters influencing the transactions or matters influencing the organization.organization.



3. 3. Role of stakeholders:Role of stakeholders: OECD recognizes that OECD recognizes that in addition to shareholders there are other in addition to shareholders there are other stakeholders such as banks, bond holders, stakeholders such as banks, bond holders, regulatory authorities, suppliers and regulatory authorities, suppliers and employees who are very important in the way employees who are very important in the way in which companies perform and make in which companies perform and make decisions. Corporate governance framework decisions. Corporate governance framework should recognize the rights of stakeholders as should recognize the rights of stakeholders as established by law and encourage active established by law and encourage active cooperation between organizations and cooperation between organizations and stakeholders.stakeholders.



4. 4. Ensuring disclosure and Ensuring disclosure and transparencytransparency: The OECD suggests for : The OECD suggests for provision for disclosing and provision for disclosing and communicating all material facts communicating all material facts (financial and non-financial). The (financial and non-financial). The corporate governance framework should corporate governance framework should ensure timely and accurate disclosures ensure timely and accurate disclosures on all matters regarding the organization. on all matters regarding the organization. Annual audits by independent auditors Annual audits by independent auditors are also required in this context.are also required in this context.



5. 5. Clarifying responsibilities of the Clarifying responsibilities of the board:board: The OECD is much concerned The OECD is much concerned about a board’s responsibilities for about a board’s responsibilities for protecting the company, its shareholders protecting the company, its shareholders and stakeholders. The corporate and stakeholders. The corporate governance framework should ensure governance framework should ensure the effective monitoring of management the effective monitoring of management by the board and the board’s by the board and the board’s accountability to the organization and accountability to the organization and shareholders.shareholders.


The Role of ShareholdersThe Role of Shareholders

Shareholders consist of:Shareholders consist of:

1.1. Individual shareholders andIndividual shareholders and

2.2. Institutional shareholders. Institutional shareholders.

They monitor the activities of They monitor the activities of management through direct negotiations management through direct negotiations with the management, proxy contests with the management, proxy contests and various guidelines. and various guidelines.


The Role of Shareholders (contd.)The Role of Shareholders (contd.)

According to Cadbury report (1992):According to Cadbury report (1992):

““The shareholders as owners of the company elect the The shareholders as owners of the company elect the directors to run the business on their behalf and directors to run the business on their behalf and hold them accountable for its progress. …(they) hold them accountable for its progress. …(they) have delegated many of their responsibilities as have delegated many of their responsibilities as owners to the directors who act as their stewards. It owners to the directors who act as their stewards. It is for the shareholders to challenge the directors if is for the shareholders to challenge the directors if they appear to be failing in their stewardship as they appear to be failing in their stewardship as they should use this power. While they cannot be they should use this power. While they cannot be involved in the direction of management of their involved in the direction of management of their company, they can insist on high standard of company, they can insist on high standard of governance.”governance.”


The Role of Shareholders (contd.)The Role of Shareholders (contd.) In Australia, a working group chaired by Henry Bosch In Australia, a working group chaired by Henry Bosch

(the Bosch Committee) put forward some guidelines in (the Bosch Committee) put forward some guidelines in which the followings are identified as some of the which the followings are identified as some of the rights and obligations of shareholders:rights and obligations of shareholders:

1.1. Shareholders should make themselves as informed as Shareholders should make themselves as informed as possible of the activities of the company;possible of the activities of the company;

2.2. Shareholders should see themselves as owners, not Shareholders should see themselves as owners, not just investors. Their responsibility as shareholders just investors. Their responsibility as shareholders increases with the size of their shareholdings. increases with the size of their shareholdings.

3.3. Shareholders should have made a sufficient analysis to Shareholders should have made a sufficient analysis to vote in an informed manner on all issues raised in vote in an informed manner on all issues raised in general meeting. general meeting.



4. Shareholders in companies listed on stock 4. Shareholders in companies listed on stock exchanges (other than employee shareholders) exchanges (other than employee shareholders) should not involve themselves in the company’s should not involve themselves in the company’s day to day operations. day to day operations.

5. Shareholders should take a positive interest in 5. Shareholders should take a positive interest in the composition of board of directors specially in the composition of board of directors specially in case of appointment of the non-executive case of appointment of the non-executive directors. directors.

6. Shareholders should take a positive interest in 6. Shareholders should take a positive interest in the structure of boards and, in particular, the the structure of boards and, in particular, the appointment of appropriate committees of the appointment of appropriate committees of the Board – specially the audit committee. Board – specially the audit committee.



7. Shareholders in listed companies should take a 7. Shareholders in listed companies should take a positive interest in the performance of the board positive interest in the performance of the board and should exercise their votes in the election of and should exercise their votes in the election of directors in an informed manner. directors in an informed manner.

8. Shareholders should take a positive interest in 8. Shareholders should take a positive interest in the auditor’s report and the competence of the the auditor’s report and the competence of the auditors and where appropriate, be prepared to auditors and where appropriate, be prepared to ask questions of the auditor.ask questions of the auditor.

9. Shareholders should not seek to receive price 9. Shareholders should not seek to receive price sensitive information which is not available to the sensitive information which is not available to the market generally. market generally.


The DirectorsThe Directors

All companies must have directors. The All companies must have directors. The board of directors or governing body gives board of directors or governing body gives direction and exercises judgment in setting direction and exercises judgment in setting the entity’s objectives and monitoring their the entity’s objectives and monitoring their implementation. implementation.

The board of a large public corporation The board of a large public corporation cannot manage the corporation’s day to cannot manage the corporation’s day to day business. That function must be left to day business. That function must be left to the corporate executives. the corporate executives.


The functions of the board The functions of the board according to Bosch Reportaccording to Bosch Report

1.1. Taking steps designed to protect the company’s Taking steps designed to protect the company’s financial position and its ability to meet its debts financial position and its ability to meet its debts and other obligations when they fall due. and other obligations when they fall due.

2.2. Adopting a strategic plan for the company, Adopting a strategic plan for the company, including general and specific goals and compare including general and specific goals and compare actual results with the plan;actual results with the plan;

3.3. Adopting an annual budget for the financial Adopting an annual budget for the financial performance of the company and monitoring performance of the company and monitoring results on a regular basis;results on a regular basis;

4.4. Adopting clearly defined delegations of authority Adopting clearly defined delegations of authority from the board to the CEO;from the board to the CEO;

5.5. Agreeing performance indicators with the Agreeing performance indicators with the management. management.


The functions of the board The functions of the board according to Bosch Report (contd.)according to Bosch Report (contd.)

6. Ensuring that systems are in place which facilitate the 6. Ensuring that systems are in place which facilitate the effective monitoring and management of the principal effective monitoring and management of the principal risks to which the company is exposed. risks to which the company is exposed.

7. Determining that the company has instituted adequate 7. Determining that the company has instituted adequate reporting systems and internal control. reporting systems and internal control.

8. Establishing and monitoring policies directed to ensure 8. Establishing and monitoring policies directed to ensure that the company complies with the law and conforms that the company complies with the law and conforms with the highest standards of financial and ethical with the highest standards of financial and ethical behavior. behavior.

9. Determining that the company accounts are in conformity 9. Determining that the company accounts are in conformity with accounting standards and are true and fair. with accounting standards and are true and fair.

10. Determining that satisfactory arrangements are in place 10. Determining that satisfactory arrangements are in place for auditing the company’s financial affairs and the scope for auditing the company’s financial affairs and the scope of external audit is adequate. of external audit is adequate.


The functions of the board The functions of the board according to Bosch Report (contd.)according to Bosch Report (contd.)

11. Selecting and recommending auditors to shareholders at 11. Selecting and recommending auditors to shareholders at general meetings;general meetings;

12. Selecting and if necessary, replacing the chief executive, 12. Selecting and if necessary, replacing the chief executive, setting an appropriate remuneration package, giving setting an appropriate remuneration package, giving guidance on the appointment and remuneration of other guidance on the appointment and remuneration of other senior management. senior management.

13. Ensuring that the company has in place a policy that 13. Ensuring that the company has in place a policy that enables it to communicate effectively with its enables it to communicate effectively with its shareholders, other stakeholders and the public generally; shareholders, other stakeholders and the public generally;

14. Adopting formal processes for the selection of new 14. Adopting formal processes for the selection of new directors and recommending them in consideration in directors and recommending them in consideration in general meetings with adequate information to allow general meetings with adequate information to allow shareholders to make informed decisions;shareholders to make informed decisions;

15. Reviewing its own processes and effectiveness and the 15. Reviewing its own processes and effectiveness and the balance of competence on the board. balance of competence on the board.


Categories of DirectorsCategories of DirectorsTwo categories of directors are generally recognized:Two categories of directors are generally recognized:1.1. Executive directors who are employees, usually Executive directors who are employees, usually

senior managers such as managing directors and senior managers such as managing directors and finance directors. In addition to their responsibilities finance directors. In addition to their responsibilities as managers, executive directors have all the same as managers, executive directors have all the same responsibilities as other members of the board. responsibilities as other members of the board. Therefore, it is important that they are of sufficient Therefore, it is important that they are of sufficient stature and security of employment to express stature and security of employment to express disagreement, if necessary, with other board disagreement, if necessary, with other board members. members.

2.2. Non-executive directors who are not employees but Non-executive directors who are not employees but bring special qualifications, experience, expertise bring special qualifications, experience, expertise and independent perspective to the board. and independent perspective to the board.


Categories of Directors (contd.)Categories of Directors (contd.)

The main functions of non-executive The main functions of non-executive directors are:directors are:

a.a. To bring independent view to the To bring independent view to the board’s deliberations;board’s deliberations;

b.b. To help the board (and the chairman) To help the board (and the chairman) provide the company with effective provide the company with effective leadership;leadership;

c.c. To foster the continuing effectiveness To foster the continuing effectiveness of executive directors and of executive directors and management. management.


Categories of Directors (contd.)Categories of Directors (contd.)

The Cadbury Report recommended that the board The Cadbury Report recommended that the board of directors should include non-executive of directors should include non-executive directors of sufficient caliber and number. On the directors of sufficient caliber and number. On the composition of sub-committees of the board, it composition of sub-committees of the board, it indicated that all boards would require a indicated that all boards would require a minimum of three non-executive directors. minimum of three non-executive directors. Further it recommended that the majority of non-Further it recommended that the majority of non-executive directors should be independent of executive directors should be independent of management and free from any business or management and free from any business or other relationship which could materially other relationship which could materially interfere with the exercise of their independent interfere with the exercise of their independent judgment. judgment.


How the Directors should act?How the Directors should act?

According to the Articles of Association of the Australian According to the Articles of Association of the Australian Institute of Company Directors, the following are the Institute of Company Directors, the following are the code of conducts of the directors:code of conducts of the directors:

1.1. A director must act honestly, in good faith and in the A director must act honestly, in good faith and in the best interest of the company;best interest of the company;

2.2. A director has a duty to use due care and diligence in A director has a duty to use due care and diligence in fulfilling the functions of the office and exercising fulfilling the functions of the office and exercising powers attached to that office.powers attached to that office.

3.3. A director must use the power of the office for a A director must use the power of the office for a proper purpose, in the best interest of the company proper purpose, in the best interest of the company as a whole. as a whole.

4.4. A director must recognize that the primary A director must recognize that the primary responsibility is to the company’s shareholders as a responsibility is to the company’s shareholders as a whole but should, where appropriate, have regard for whole but should, where appropriate, have regard for the interests of all stakeholders of the company.the interests of all stakeholders of the company.


How the Directors should act? How the Directors should act? (contd.)(contd.)

5. A director must not make improper use of information acquired as a 5. A director must not make improper use of information acquired as a director;director;

6. A director must not take improper advantage of the position of director;6. A director must not take improper advantage of the position of director;7. A director must not allow personal interests, or the interests of any 7. A director must not allow personal interests, or the interests of any

associated person, to conflict with the interest of the company. associated person, to conflict with the interest of the company. 8. A director has an obligation to be independent in judgment and actions 8. A director has an obligation to be independent in judgment and actions

and to take all reasonable steps to be satisfied as to the soundness of and to take all reasonable steps to be satisfied as to the soundness of all decisions taken by the board. all decisions taken by the board.

9. Confidential information received by a director in the course of the 9. Confidential information received by a director in the course of the exercise of directorial duties remains the property of the company exercise of directorial duties remains the property of the company from which it was obtained and it is improper to disclose it, or allow it from which it was obtained and it is improper to disclose it, or allow it to be disclosed, unless that disclosure it authorized by that company, to be disclosed, unless that disclosure it authorized by that company, or the person from whom the information is provided, or is required by or the person from whom the information is provided, or is required by law.law.

10. A director should not engage in conduct likely to bring discredit upon 10. A director should not engage in conduct likely to bring discredit upon the company.the company.


Independent/ non-executive Independent/ non-executive DirectorsDirectors

The Australian Investment Managers’ Association The Australian Investment Managers’ Association defines an independent director as a director who:defines an independent director as a director who:

1.1. is not a member of management;is not a member of management;2.2. is not a substantial shareholder of the company or is not a substantial shareholder of the company or

an officer of or otherwise associated directly or an officer of or otherwise associated directly or indirectly with a substantial shareholder of the indirectly with a substantial shareholder of the company;company;

3.3. has not within the least three years been employed has not within the least three years been employed in an executive capacity by the company or any in an executive capacity by the company or any other group member or been a director after other group member or been a director after ceasing to hold any such employment; ceasing to hold any such employment;

4.4. is not a principal or a professional adviser to a is not a principal or a professional adviser to a company or another group member;company or another group member;


Independent/ non-executive Independent/ non-executive Directors (contd.)Directors (contd.)

5. is not a significant supplier or customer of the 5. is not a significant supplier or customer of the company;company;

6. has no significant contractual relationship with 6. has no significant contractual relationship with the company;the company;

7. Is free from any interest or any business or 7. Is free from any interest or any business or other relationship which could, or could other relationship which could, or could reasonably be perceived to, materially interfere reasonably be perceived to, materially interfere with the director’s ability to act with a view to the with the director’s ability to act with a view to the best interests of the company. best interests of the company.


The ChairmanThe Chairman The role of the chair in leading the board of directors, The role of the chair in leading the board of directors,

including including determining the board agendadetermining the board agenda and and obtaining contributions from other board members in obtaining contributions from other board members in the board’s deliberationsthe board’s deliberations, is crucial to ensure that the , is crucial to ensure that the board works effectively. board works effectively.

The Cadbury committee recommended that due to the The Cadbury committee recommended that due to the importance and nature of chairman’s role, it should, importance and nature of chairman’s role, it should, in principle, be separate from Chief Executive Officer in principle, be separate from Chief Executive Officer (CEO). (CEO).

A strong independent chairperson provides a check A strong independent chairperson provides a check and counterbalance to the power of CEO. and counterbalance to the power of CEO.

The Bosch Committee indicated that the combination The Bosch Committee indicated that the combination of the roles of chairperson and CEO constitute a of the roles of chairperson and CEO constitute a concentration of power that could give rise to concentration of power that could give rise to conflicts. Therefore, the roles should be separated. conflicts. Therefore, the roles should be separated.


Sub-committees of the boardSub-committees of the board

The effectiveness of the board, and particularly of The effectiveness of the board, and particularly of non-executive directors, is likely to be enhanced non-executive directors, is likely to be enhanced by the establishment of effective sub-committees. by the establishment of effective sub-committees.

Generally, three sub-committees are Generally, three sub-committees are recommended in corporate governance practices recommended in corporate governance practices and they are : audit committee, remuneration and they are : audit committee, remuneration committee and nomination committee. committee and nomination committee.

Membership of these board sub-committees is Membership of these board sub-committees is generally confined to directors and ideally they generally confined to directors and ideally they should be governed by a charter which documents should be governed by a charter which documents their responsibilities.their responsibilities.


Sub-committees of the board Sub-committees of the board (contd.)(contd.)

Further, they should report back results of Further, they should report back results of their separate meetings to the full board their separate meetings to the full board on a regular basis.on a regular basis.

The use of sub-committees gives non-The use of sub-committees gives non-executive directors a well defined area in executive directors a well defined area in which they are expected to contribute. It is which they are expected to contribute. It is expected that, the sub-committees should expected that, the sub-committees should be comprised of majority of the non-be comprised of majority of the non-executive directors. executive directors.


Audit CommitteeAudit Committee An audit committee is an important component of An audit committee is an important component of

corporate governance. corporate governance. An audit committee is a sub-committee of the board An audit committee is a sub-committee of the board

of directors, comprising a majority of of directors, comprising a majority of independent/non-executive members of the independent/non-executive members of the governing body of an entity and represents owners governing body of an entity and represents owners rather than management. rather than management.

Among other functions, it is usually assigned the Among other functions, it is usually assigned the duty of oversight of the financial reporting and duty of oversight of the financial reporting and auditing process.auditing process.

The auditor’s major dealing with the governing body The auditor’s major dealing with the governing body will be through audit committee, although the will be through audit committee, although the auditor will usually meet with the full governing body auditor will usually meet with the full governing body at least once per year. at least once per year.


Composition of Audit CommitteeComposition of Audit Committee

Two predominant schools of thoughts:Two predominant schools of thoughts:

The first school The first school maintains that the audit committee maintains that the audit committee should be entirely composed of non-executive should be entirely composed of non-executive directors who have no management responsibilities directors who have no management responsibilities or affiliations. It is claimed that this is the only way or affiliations. It is claimed that this is the only way to ensure the complete independence of the to ensure the complete independence of the committee in its evaluation of management and audit committee in its evaluation of management and audit representation. The NYSE requires the highest representation. The NYSE requires the highest possible standard which is that all listed companies possible standard which is that all listed companies have an audit committee composed totally of have an audit committee composed totally of independent directors. independent directors.


Composition of Audit Committee Composition of Audit Committee (contd.)(contd.)

The second school The second school claims that at the very claims that at the very least there should be one management least there should be one management representative on the committee. It would representative on the committee. It would provide a more balanced perspective to provide a more balanced perspective to the problems under committee the problems under committee investigation. The problem with this kind of investigation. The problem with this kind of structure is the potentially adverse effect structure is the potentially adverse effect that the management representative may that the management representative may have on the committee’s independence. have on the committee’s independence.


Objectives and responsibilities of Objectives and responsibilities of audit committeeaudit committee

1.1. To enhance the ability of governing body to fulfill To enhance the ability of governing body to fulfill its legal responsibilities;its legal responsibilities;

2.2. To add to the credibility and objectivity of financial To add to the credibility and objectivity of financial reports;reports;

3.3. To oversee the application of appropriate To oversee the application of appropriate accounting policies and procedures including accounting policies and procedures including appropriate disclosures;appropriate disclosures;

4.4. To establish and monitor corporate policies to To establish and monitor corporate policies to prohibit unethical, questionable or illegal prohibit unethical, questionable or illegal activities;activities;

5.5. To establish and monitor effective internal and To establish and monitor effective internal and management control;management control;

6.6. To provide a communication link between To provide a communication link between management, auditors and the governing body. management, auditors and the governing body.


Benefits of audit committeesBenefits of audit committees

An audit committee may:An audit committee may:1.1. Form part of an effective corporate governance Form part of an effective corporate governance

structure;structure;2.2. Strengthen the internal control structure and Strengthen the internal control structure and

ensure the maintenance of appropriate accounting ensure the maintenance of appropriate accounting records;records;

3.3. Support the independence of internal and external Support the independence of internal and external auditors;auditors;

4.4. Provide direct communication channel between Provide direct communication channel between management, auditor and the board;management, auditor and the board;

5.5. Improve the quality of financial disclosures and the Improve the quality of financial disclosures and the effectiveness of the audit function by providing effectiveness of the audit function by providing independent review of these functions.independent review of these functions.


Benefits of audit committees Benefits of audit committees (contd.)(contd.)

6. Act as a forum for the resolution of disagreements 6. Act as a forum for the resolution of disagreements between management and the auditors. between management and the auditors.

7. Improve the effectiveness of internal and external 7. Improve the effectiveness of internal and external auditors by providing a coordinating approach for auditors by providing a coordinating approach for audit planning.audit planning.

8. Keep the governing body fully informed about 8. Keep the governing body fully informed about accounting and auditing issues;accounting and auditing issues;

9. Increase the effectiveness of non-executive 9. Increase the effectiveness of non-executive directors;directors;

10. Provide evidence that members of the governing 10. Provide evidence that members of the governing body have exercised due care in fulfilling their body have exercised due care in fulfilling their statutory responsibilities;statutory responsibilities;


Limitations of audit committeeLimitations of audit committee

1.1. The audit committee, being only a sub-committee of The audit committee, being only a sub-committee of the governing body, may not have the power to the governing body, may not have the power to enforce its recommendations;enforce its recommendations;

2.2. Financial report users may have unrealistic Financial report users may have unrealistic expectations of audit committees;expectations of audit committees;

3.3. The establishment of an audit committee may cause The establishment of an audit committee may cause conflict within the governing body, particularly conflict within the governing body, particularly between executive and non-executive directors;between executive and non-executive directors;

4.4. The audit committee may be ineffective due to lack The audit committee may be ineffective due to lack of competent non-executive members; of competent non-executive members;

5.5. Committee members may be selected because of Committee members may be selected because of their association with the CEO or chairman of the their association with the CEO or chairman of the governing body, thus reducing perceived governing body, thus reducing perceived independence. independence.


Limitations of audit committee Limitations of audit committee (contd.)(contd.)

6.6. The presence of management in the audit The presence of management in the audit committee may inhibit open discussion and committee may inhibit open discussion and affect the independence of the committee. affect the independence of the committee.

7.7. The maintenance of an audit committee is time The maintenance of an audit committee is time consuming and costly;consuming and costly;

8.8. The responsibilities of audit committee may The responsibilities of audit committee may interrupt on those of management, creating an interrupt on those of management, creating an atmosphere of conflict and distrust. atmosphere of conflict and distrust.


Characteristics of effective audit Characteristics of effective audit committeescommittees

1.1. They are perceived to be independent and actually They are perceived to be independent and actually exercise independence in their dealings with exercise independence in their dealings with management and auditors;management and auditors;

2.2. They are composed of experienced and competent non-They are composed of experienced and competent non-executive directors;executive directors;

3.3. They are established by a resolution of the full board of They are established by a resolution of the full board of the governing body;the governing body;

4.4. They have a limited number of members;They have a limited number of members;5.5. They are given explicit objectives and terms of They are given explicit objectives and terms of

references which are subject to regular review;references which are subject to regular review;6.6. They should arrange necessary meetings at the request They should arrange necessary meetings at the request

of the auditors or management;of the auditors or management;7.7. They should circulate agendas and minutes to relevant They should circulate agendas and minutes to relevant

parties. parties.


Remuneration committeesRemuneration committees Remuneration committees are set up to review terms Remuneration committees are set up to review terms

and conditions relating to the employment of senior and conditions relating to the employment of senior management. management.

Clearly this is an area where the interests of the Clearly this is an area where the interests of the shareholders conflict with those of management. shareholders conflict with those of management.

Remuneration committees will also review the design Remuneration committees will also review the design of employee incentive schemes such as bonus of employee incentive schemes such as bonus schemes and stock option plans. schemes and stock option plans.

This has been a controversial area specially in the eyes This has been a controversial area specially in the eyes of small shareholders. of small shareholders.

Under agency theory, it is argued that in order to Under agency theory, it is argued that in order to increase shareholders’ value, it is necessary to align increase shareholders’ value, it is necessary to align the interests of management with the interests of the interests of management with the interests of shareholders. One way of achieving this is through the shareholders. One way of achieving this is through the design of appropriate remuneration committee. design of appropriate remuneration committee.


Remuneration committees (contd.)Remuneration committees (contd.) Remuneration committees provide a mechanism for Remuneration committees provide a mechanism for

the views of management and shareholders to be the views of management and shareholders to be considered by non-executive directors and therefore considered by non-executive directors and therefore assist in the development of appropriate remuneration assist in the development of appropriate remuneration structure. structure.

Perceived excess executive remuneration has been a Perceived excess executive remuneration has been a continuing source of conflict between shareholders continuing source of conflict between shareholders and managers. and managers.

According to The Australian Investment Managers’ According to The Australian Investment Managers’ Association (1997), remuneration committees should Association (1997), remuneration committees should be composed primarily of non-executive members. But be composed primarily of non-executive members. But they did not say that all the members here should be they did not say that all the members here should be non-executive. non-executive.

In contrast, UK-based Institutional Shareholders In contrast, UK-based Institutional Shareholders Committee has recommended that remuneration Committee has recommended that remuneration committees comprise only independent non-executive committees comprise only independent non-executive directors. directors.


Nomination CommitteesNomination Committees

Nomination Committees generally have two Nomination Committees generally have two main roles:main roles:

1.1. To establish the skills required of a To establish the skills required of a replacement or additional director and to replacement or additional director and to approach potential candidates.approach potential candidates.

2.2. To review, on a regular basis, the performance To review, on a regular basis, the performance of the board as a whole and the contribution of of the board as a whole and the contribution of individual members to the board. individual members to the board.


Corporate Governance and Corporate Governance and Internal ControlInternal Control

Corporate governance is related to the Corporate governance is related to the management process. management process.

Internal control is also related to many aspects Internal control is also related to many aspects of the management process. of the management process.

Effective controls, coupled with good Effective controls, coupled with good management practices, can ensure that an management practices, can ensure that an organization promptly identifies business risks, organization promptly identifies business risks, and mitigates and limits any negative and mitigates and limits any negative consequences that may result from such risks. consequences that may result from such risks.

An effective internal control structure is central An effective internal control structure is central to efficient risk management. Ineffective controls to efficient risk management. Ineffective controls result in an ineffective management process. result in an ineffective management process.


Importance of Internal controlImportance of Internal control The Cadbury Report (1992) argued that an effective The Cadbury Report (1992) argued that an effective

internal structure is the key aspect of the efficient internal structure is the key aspect of the efficient management of a company.management of a company.

The Toronto Guidelines identify managing risk as The Toronto Guidelines identify managing risk as one of the principal responsibilities of the board. one of the principal responsibilities of the board.

Thus the board needs to understand the principal Thus the board needs to understand the principal risks of all aspects of the business in which the risks of all aspects of the business in which the entity is engaged and must recognize that business entity is engaged and must recognize that business decisions require the incurrence and management decisions require the incurrence and management of risks. of risks.

The board must then achieve a proper balance The board must then achieve a proper balance between the risks incurred and the potential returns between the risks incurred and the potential returns to the shareholders. to the shareholders.


The nature of Internal Control: The COSO The nature of Internal Control: The COSO frameworkframework

The fact that internal controls are diverse The fact that internal controls are diverse and pervasive was recognized in the USA and pervasive was recognized in the USA by National Commission on Fraudulent by National Commission on Fraudulent Financial Reporting (the Treadway Financial Reporting (the Treadway Commission, 1987). Commission, 1987).

This commission had a committee called This commission had a committee called the Committee of Sponsoring the Committee of Sponsoring Organizations (COSO). It released a four-Organizations (COSO). It released a four-volume report entitled volume report entitled Internal Control-Internal Control-Integrated Framework. Integrated Framework.


The nature of Internal Control: The COSO The nature of Internal Control: The COSO framework (contd.)framework (contd.)

The COSO report defines internal control as:The COSO report defines internal control as:

“…“…..a process, effected by an entity’s board of ..a process, effected by an entity’s board of directors, management and other personnel, directors, management and other personnel, designed to provide reasonable assurance designed to provide reasonable assurance regarding the achievement of objectives in the regarding the achievement of objectives in the following categories:following categories:Effectiveness and efficiency of operations;Effectiveness and efficiency of operations;Reliability of financial reporting; andReliability of financial reporting; andCompliance with applicable laws and Compliance with applicable laws and

regulations. “regulations. “


The nature of Internal Control: The The nature of Internal Control: The COSO framework (contd.)COSO framework (contd.)

Internal control, as defined by COSO, is Internal control, as defined by COSO, is directed toward the achievement of entity directed toward the achievement of entity objectives relating to:objectives relating to:

1.1. Effectiveness and efficiency of operations: Effectiveness and efficiency of operations: Related to performance, profitability and Related to performance, profitability and productivity. And also related to safeguarding productivity. And also related to safeguarding resources. resources.

2.2. Reliability of financial reporting: Related to the Reliability of financial reporting: Related to the preparation and dissemination of reliable preparation and dissemination of reliable financial information, safeguarding entity financial information, safeguarding entity assets and records. assets and records.

3.3. Compliance: With applicable laws and Compliance: With applicable laws and regulations to which the entity is subject. regulations to which the entity is subject.


Components of Internal ControlComponents of Internal Control To achieve these three objectives, there To achieve these three objectives, there

should be the following internal control should be the following internal control components:components:

1.1. Control environment: Setting the tone of the Control environment: Setting the tone of the organization. Influencing the control organization. Influencing the control consciousness of its people. Control consciousness of its people. Control environment factors include: integrity, ethical environment factors include: integrity, ethical values and competence of the entity’s people; values and competence of the entity’s people; management’s philosophy and operating style; management’s philosophy and operating style; the way management assigns authority and the way management assigns authority and responsibility and organizes and develops its responsibility and organizes and develops its people; and the intentions and directions people; and the intentions and directions provided by the BOD. provided by the BOD.


Components of Internal Control Components of Internal Control (contd.)(contd.)

2. Risk Assessment: Every company faces a 2. Risk Assessment: Every company faces a variety of risks from its internal and external variety of risks from its internal and external environment. Risk assessment is the environment. Risk assessment is the identification and analysis of relevant risks to identification and analysis of relevant risks to achievement of the objectives, forming a basis achievement of the objectives, forming a basis for how the risks should be managed. Because for how the risks should be managed. Because economic, industry, regulatory and operating economic, industry, regulatory and operating environment will continue to change, environment will continue to change, mechanisms are needed to identify and deal mechanisms are needed to identify and deal with specific kinds of risks associated with the with specific kinds of risks associated with the change. change.



3. Control activities: These are policies and 3. Control activities: These are policies and procedures that help ensure management procedures that help ensure management directives are carried out. They help ensure that directives are carried out. They help ensure that necessary actions are taken to address risks to necessary actions are taken to address risks to achievement of entity’s objectives. Control achievement of entity’s objectives. Control activities occur throughout the organization, at activities occur throughout the organization, at all levels and in all functions. They include a all levels and in all functions. They include a range of diversified activities such as approvals, range of diversified activities such as approvals, authorizations, verifications, reconciliations, authorizations, verifications, reconciliations, reviews of operating performance, security of reviews of operating performance, security of assets and segregations of duties. assets and segregations of duties.



4.4. Information and communication: Pertinent information Information and communication: Pertinent information must identified, captured and communicated in a form and must identified, captured and communicated in a form and timeframe that enables people to carry out their timeframe that enables people to carry out their responsibilities. responsibilities.

Information systems produce reports containing Information systems produce reports containing operational, financial, and compliance-related information, operational, financial, and compliance-related information, that make it possible to run and control the business. that make it possible to run and control the business.

They deal not only with internally generated data, They deal not only with internally generated data, but also information about external events, activities and but also information about external events, activities and conditions necessary to informed decision making. conditions necessary to informed decision making.

All personnel must receive a clear message from All personnel must receive a clear message from top management that control responsibilities must be top management that control responsibilities must be taken seriously. taken seriously.

They must understand their own role in the internal They must understand their own role in the internal control system, as well as how their individual activities control system, as well as how their individual activities relate to the works of others. relate to the works of others.



5. Monitoring: Internal control systems need 5. Monitoring: Internal control systems need to be monitored- a process that assesses to be monitored- a process that assesses the quality of system’s performance over the quality of system’s performance over time. This is accomplished through time. This is accomplished through ongoing monitoring activities, separate ongoing monitoring activities, separate evaluations or a combination of the two. evaluations or a combination of the two. Internal control deficiencies should be Internal control deficiencies should be reported upstream, with serious matters reported upstream, with serious matters reported to top management and the reported to top management and the board. board.


Role of the Auditors Role of the Auditors Auditors are perceived as upholders of the integrity of Auditors are perceived as upholders of the integrity of

financial reporting in public interest. financial reporting in public interest. Therefore, auditors are vitally interested in corporate Therefore, auditors are vitally interested in corporate

governance related issues. governance related issues. The Cadbury Report emphasizes the importance of The Cadbury Report emphasizes the importance of

financial reports. To ensure this, direct contact between financial reports. To ensure this, direct contact between the auditors, the non-executive directors and the board the auditors, the non-executive directors and the board as a whole is important. as a whole is important.

The external auditor, as an independent party with a The external auditor, as an independent party with a detailed knowledge about the entity’s financial affairs, is detailed knowledge about the entity’s financial affairs, is able to provided substantial inputs to the audit able to provided substantial inputs to the audit committee. committee.

The external auditor should also assist the audit The external auditor should also assist the audit committee by informing it of any developments such as committee by informing it of any developments such as legislative changes or new accounting standards. legislative changes or new accounting standards.


Role of the Auditors (contd.)Role of the Auditors (contd.) The external auditor’s roles and responsibilities in The external auditor’s roles and responsibilities in

relation to effective interaction with an effective relation to effective interaction with an effective audit committee include the following:audit committee include the following:

1.1. Ensuring that information regarding the planning Ensuring that information regarding the planning of audit (e.g., scope, materiality etc.) is of audit (e.g., scope, materiality etc.) is communicated to the audit committees on time;communicated to the audit committees on time;

2.2. Communicating to the committee the Communicating to the committee the responsibilities of auditors according to auditing responsibilities of auditors according to auditing standards and legal mandates. standards and legal mandates.

3.3. Communicating to the committee matters which, Communicating to the committee matters which, in auditor’s judgment, represent significant in auditor’s judgment, represent significant deficiencies in the design or operation of the deficiencies in the design or operation of the internal control structure. internal control structure.


Role of the Auditors (contd.)Role of the Auditors (contd.)4. 4. Informing audit committee of any major issues which Informing audit committee of any major issues which

were discussed with the management in connection were discussed with the management in connection with the appointment of the auditors;with the appointment of the auditors;

5. Informing the audit committee of any serious difficulties 5. Informing the audit committee of any serious difficulties encountered in the performance of the audit;encountered in the performance of the audit;

6. Informing the audit committee about any significant 6. Informing the audit committee about any significant errors, problems of weaknesses revealed by the audit errors, problems of weaknesses revealed by the audit or areas of significant disagreement with the or areas of significant disagreement with the management, the corrective actions taken and their management, the corrective actions taken and their current status. current status.

7. Asking the audit committee if there are any other 7. Asking the audit committee if there are any other matters of which the auditor should be aware. matters of which the auditor should be aware.

8. Documenting in the working papers significant matters 8. Documenting in the working papers significant matters communicated to the audit committee.communicated to the audit committee.

9. Responding in an appropriate manner to reasonable 9. Responding in an appropriate manner to reasonable audit committee questions. audit committee questions.


Internal Auditor’s ResponsibilitiesInternal Auditor’s Responsibilities

The role of internal auditors may vary between The role of internal auditors may vary between different situations and companies: it could different situations and companies: it could include financial, compliance or performance include financial, compliance or performance audit. audit.

An effective internal audit function should An effective internal audit function should evaluate and monitor the adequacy and evaluate and monitor the adequacy and effectiveness of the internal control structure. effectiveness of the internal control structure.

An internal audit program may assist in risk An internal audit program may assist in risk assessment and management.assessment and management.

It is important for the internal auditors to have It is important for the internal auditors to have direct access to the audit committee. direct access to the audit committee.


Internal Auditor’s Responsibilities Internal Auditor’s Responsibilities (contd.)(contd.)

The audit committee should:The audit committee should:1.1. Monitor the scope of the work of internal Monitor the scope of the work of internal

audit; andaudit; and2.2. Review the reports issued. Review the reports issued.

This can be achieved by having the head of This can be achieved by having the head of the internal audit function attend the internal audit function attend meetings with the audit committee. meetings with the audit committee.



The audit committee can play an important role The audit committee can play an important role in ensuring that the internal audit function is in ensuring that the internal audit function is effective by addressing such issues as:effective by addressing such issues as:

1.1. The level of resources allocated to the internal The level of resources allocated to the internal audit;audit;

2.2. The scope of the authority of internal audit;The scope of the authority of internal audit;3.3. The appropriateness of the internal audit The appropriateness of the internal audit

program and reporting line;program and reporting line;4.4. The quality and timeliness of its reports;The quality and timeliness of its reports;5.5. The extent to which management reacts to the The extent to which management reacts to the

matters raised by internal audit. matters raised by internal audit.



The audit committee can also The audit committee can also provide an effective means of provide an effective means of formalizing and coordinating the formalizing and coordinating the working relationship between working relationship between internal and external auditors. internal and external auditors.



Internal auditors should provide the audit committee Internal auditors should provide the audit committee with the following:with the following:

1.1. A copy of formal audit plan, including internal A copy of formal audit plan, including internal audit’s objectives, work schedules, staffing audit’s objectives, work schedules, staffing requirements, budget and description of any requirements, budget and description of any limitations placed on internal audit’s scope of work.limitations placed on internal audit’s scope of work.

2.2. Details of the internal audit staff structure, including Details of the internal audit staff structure, including staff skills, experience and qualifications. staff skills, experience and qualifications.

3.3. Activity reports highlighting significant findings and Activity reports highlighting significant findings and recommendations, particularly in relation to the recommendations, particularly in relation to the entity’s risk management, and identifying any lack of entity’s risk management, and identifying any lack of action by managementaction by management. .



4. Major variances from the internal audit 4. Major variances from the internal audit department’s work schedules and department’s work schedules and budgets;budgets;

5. Advice on the coordination of internal 5. Advice on the coordination of internal audit plan with the external audit plan;audit plan with the external audit plan;

6. Activity reports on any major frauds or 6. Activity reports on any major frauds or conflict of interest. conflict of interest.

7. Any other information requested by the 7. Any other information requested by the audit committee. audit committee.


Accounting theory 2

Documents

dewan mahboob

corporate

internal audit

internal control

internal auditors

cadbury report

corporate

internal control