FINANCE AND ACCOUNTING - Assignment Premier

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INDEPENDENT BUSINESS ANALYSIS PROJECT

Supervisor : DR. DUNCAN WALKER

This thesis is presented in partial fulfilment of the Assessment requirements for the award of

Thesis Grade Awarded ..........….....

(To be added by Project Supervisor)

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THE ROLES AND EFFECTIVENESS OF AUDIT

COMMITTEES: A CASE STUDY OF LEHMAN BROTHERS

AND SATYAM COMPUTERS

FINANCE AND ACCOUNTING

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ABSTRACT

This thesis examined the roles and the effectiveness of ACs as provided by corporate governance codes,

in relation to corporate failures, whether the failure is as a result of the ineffectiveness of the ACs.

Given that the AC is perceived to be a means of strengthening the external financial reporting process,

and also facilitating the detection and prevention of corporate misconduct and scandals. It is believed

that many financial and governance failure the world has experienced in the recent past could

have been detected much earlier, if the ACs had been discharging their duties efficiently and

effectively. To achieve the purpose, the study provides answers to four main research questions. First,

are ACs to be blamed for audit/corporate scandals? Second, will AC prevent future audit/corporate

scandals? Third, can mandating AC improve corporate governance? And fourth, are the corporate

scandals a reflection of ineffectiveness of AC’s?

The study used secondary sourced data to investigate the roles of AC in the cases of Lehman Brothers

and Satyam corporate failures. A qualitative case study method was employed to investigate the roles

and the effectiveness of AC activities in their social, political and economic context, by identifying

and evaluating specific areas of interaction between ACs and other parties like executive

management and auditor which affect audit process.

One of the main findings of the study is that many corporate failures are associated with the

ineffectiveness of ACs, and that ACs could have prevented the occurrence of several corporate failures

if they were efficient. However, the ACs cannot be 100% blamed for the failures, This is because their

effectiveness is a subject to so many factors (independence, industry expertise, information flow,

inbuilt willingness to serve, and organizational factors), which are always lacking, and lack of any one

factor always renders the AC ineffective. Second, the study found that mandating the establishment of

ACs in corporations alone cannot improve corporate governance. This is because the cases examined

were all under mandatory regulatory requirements for the establishment of ACs but that did

prevented the occurrence of the failure. Third, lack of harsh punishment on the negligence of the ACs

members was found to be a contributing factor toward the ineffectiveness of the ACs. Fourth, the study

also revealed the need for behavioral consideration in the formation of ACs. The effectiveness of AC is

far beyond establishment and composition but rather the actual process taking place in the ACs

meetings and relation with the management in the company. Finally, it was found that ACs can only

tackle the occurrence of corporate failure when the right people are nominated into the committee,

and independent of any managerial influence.

Some of the findings are consistent, while others are contrary to previous empirical studies on

effectiveness of ACs. The study adds to the current debate on the need for improvement in the roles

played by the AC as public gatekeepers.

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ACKNOWLEDGEMENT

I am greatly indebted to my supervisor who offered a priceless supervision and support throughout

the process thank you Dr. Duncan Walker for being prompt in your response at all time that I

sought direction and guidance, I was fortunate to have you, it has been a memorable experience for

me. My gratitude also goes to our course leader who is also my personal tutor Mr. Fatau Bakare, Dr.

Williams Coffie and Dr. Abubakar Bashir for their advice and encouragement toward my academic

pursued. I also thank Prof. Mike Hynes, Sharrin Mcdowalls, Dr. Yong Wang, Dr. Lucy Zhen and the

entire staff members of the University of Wolverhampton Business School for their immeasurable

assistance in one way or the other.

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DECLARATION

This work has not previously been presented in any form to the University or to any other

institutional body, whether for assessment or other purposes. Save for any express

acknowledgements, references and / or bibliographies cited in the work, I confirm that the

intellectual content of the work is the result of my own efforts and of no other person.

It is acknowledged that the author of any project work shall own the copyright. However,

by submitting such copyright work for assessment, the author grants to the University a

perpetual royalty-free licence to do all or any of those things referred to in Section 16(i) of

the Copyright Designs & Patents Act 1988 (viz: to copy work; to issue copies to the public;

to perform or show or play the work in public; to broadcast the work or make an

adaptation of the work).

Signed …………………………………………….

Date ……………………………………………..

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CONTENTS TITLE PAGE...................................................................................................................................................................................i

ABSTRACT ..................................................................................................................................................................................... ii

ACKNOWLEDGEMENT ........................................................................................................................................................... iii

DEDICATION ................................................................................................................................................................................iv

DECLARATION ............................................................................................................................................................................. v

TABLE OF CONTENTS………………………………………………………………………………………………………………...vi

CHAPETR ONE ............................................................................................................................................................................. 1

INTRODUCTION ..................................................................................................................................................................... 1

1.0 BACKGROUNG INFORMATION ................................................................................................................................. 1

1.2 RESEARCH AIMS ............................................................................................................................................................. 2

1.3 RESEARCH QUESTIONS ............................................................................................................................................... 3

1.4 PROJECT STRUCTURE .................................................................................................................................................. 3

CHAPTER TWO ............................................................................................................................................................................ 5

LITERATURE REVIEW ......................................................................................................................................................... 5

2.0 INTRODUCTION .............................................................................................................................................................. 5

2.1 CORPORATE GOVERNACE FRAMEWORK ........................................................................................................... 5

2.1.1 DEFINITION OF CORPORATE GOVERNANCE ........................................................................................... 6

2.1.2 BOARD SUB-COMMITTEES ............................................................................................................................... 7

2.1.3 THE NOMINATION COMMITTEE .................................................................................................................... 7

2.1.4 THE REMUNERATION COMMITTEE ............................................................................................................. 8

2.1.5 UK CORPORATE GOVERNANCE APPROACH ............................................................................................. 9

2.2 LITERATURE ON AUDIT COMMITTEES ............................................................................................................ 10

2.2.1 WHY SET UP AUDIT COMMITTEE? ............................................................................................................. 10

2.2.2 ROLES OF AUDIT COMMITTEE..................................................................................................................... 12

2.2.3 EFFECTIVENESS OF AUDIT COMMITTEES ............................................................................................. 15

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2.2.4 RANGES OF AUDIT COMMITTEE ................................................................................................................. 17

2.2.5 THE NEED FOR AUDIT COMMITTEE ......................................................................................................... 18

2.2.6 WHY ARE AUDIT COMMITTEES NOT MANDATORY? ........................................................................ 20

CHAPTER THREE ..................................................................................................................................................................... 22

RESEARCH METHODOLOGY .......................................................................................................................................... 22

3.0 INTRODUCTION ........................................................................................................................................................... 22

3.1 RESEARCH APPROACH ............................................................................................................................................. 22

3.2 METHODS ....................................................................................................................................................................... 25

CHAPTER FOUR ........................................................................................................................................................................ 27

RESULTS AND EVALUATION ......................................................................................................................................... 27

4.0 INTRODUCTION ........................................................................................................................................................... 27

4.1 SATYAM COMPUTERS ............................................................................................................................................... 27

4.1.1 ANALYSIS OF AUDIT COMMITTEE OF SATYAM ................................................................................... 28

4.1.2 INDEPENDENCE OF AUDIT COMMITTEE OF SATYAM ...................................................................... 28

4.1.3 REVIEW OF FINANCIAL REPORTING PROCESS AND INTERNAL CONTROL ........................... 29

4.1.4 INFORMATION FLOW AND AUDIT COMMITTEE AUTHORITY ...................................................... 31

4.1.5 RESPONSIBILITIES FOR FRAUD DETECTION AND PREVENTION ............................................... 33

4.2 LEHMAN BROTHERS ................................................................................................................................................. 34

4.2.1 THE AUDIT COMMITTEE................................................................................................................................. 35

4.2.2 REVIEW OF FINANCIAL REPORTING PROCESS, INTERNAL CONTROL AND DISCLOSURE

REQUIREMENT ............................................................................................................................................................... 36

4.2.3 THE USE OF REPO 105 ..................................................................................................................................... 37

4.2.4 RESPONSIBILITY FOR PREDICTION PRVENTION OF FRAUDULENT ACT ................................ 38

4.2.5 AVAILABILITY OF INFORMATION AND AUDIT COMMITTEE ROLES ......................................... 40

4.3 LIMITATIONS OF THE RESEARCH ....................................................................................................................... 41

CHAPTER FIVE .......................................................................................................................................................................... 42

5.0 CONCLUSIONS AND SUMMARY OF FINDINGS ............................................................................................... 42

5.1 SUMMARY OF MAJOR FINDINGS .......................................................................................................................... 43

5.2 SCOPE FOR FURTHER RESEARCH ....................................................................................................................... 43

References: ................................................................................................................................................................................. 45

Appendices.................................................................................................................................................................................46

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CHAPETR ONE

INTRODUCTION

1.0 BACKGROUNG INFORMATION

The contemporary Audit Committees (herein AC) concept began in the late 1930’s when

the US Security and Exchange Commission (SEC) recommended that publicly held

companies form a Committee of non-officer board members that would assure the

independence, Nomination and arrangement of engagement process of external auditor

(xxxx, 2009). Afterward, the ACs played a vital role in the governing structure of public

companies (x 2005). In the last two decades ACs become a commonly used mechanism for

good corporate governance practice globally (xxxx 2004). Essentially, AC is a non-

mandatory structure used by a few corporations and has traditionally been viewed to

oversee the work of outside auditors and liaise with management on internal control and

preparation of financial report, but with limited roles on the issue (xxxx, 2005).

Following the collapse of many high profile corporations that shook the business world,

and caused shareholders, investors and public to lose confidence in many of the

stakeholders involved in governance, and the process of financial reporting. In an attempt

to restore their confidence, there have been a number of pressures, proposals and actions

taken in different countries for reforms in the corporate governance framework with

emphasis on the responsibilities and powers of ACs (xxxx, 2007). Many legislations and

corporate governance reforms have increased the responsibilities, tasks and expectations

from the ACs (xxxx 2013). The trend in ACs advancement makes it to become a common

feature of corporate governance internationally. Thus, their effectiveness becomes an issue

of concern to both researchers and regulators as it serves as a determining factor for

corporate governance success.

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The incessant corporate failures in recent years, such as the (Enron, Bre-X, Satyam and

Lehman Brothers) have turned the public searchlight on the ACs and raised a number of

questions on the need for more transparency in running the affairs of publicly owned

companies. The growing public pressure has placed a greater deal for emphasis on ACs role

in pursuit of effective corporate governance, because the result from the investigation of

collapsed companies indicated with clarity that almost every financial and governance

failure, the world has experienced in the recent past could have been detected much earlier

(xxxx, 2007), if the ACs had been discharging their duties efficiently and effectively.

1.2 RESEARCH AIMS

Hence, the purpose of this study is to figure out the actual role and responsibilities of ACs

and to understand the major determinants of effective discharge of ACs duties and to know

whether the effectiveness of ACs will reduce the rate of corporate collapse and enhance the

effectiveness of corporate governance. Significantly, researches/literatures on ACs in the

UK are not much, thus both the UK and the US research findings would be used in this study

to ascertain the effectiveness of ACs. This is because both the UK and the US corporate

governance systems followed the Anglo-Saxon corporate governance model (xxxxx., 2009).

The UK and the US corporate governance reforms Codes stipulated similar attributes

required of ACs to ensure effectiveness in the discharge of their duties diligently, among

which ACs must comprises of an independent directors and with at least one having recent

and relevant financial expertise. These requirements were enacted by SEC in US and FRC in

UK in line with the belief that independent directors with relevant financial expertise are

better monitors of management than the inside directors (xxxx 2014).

However, the major concern is that ACs is commonly viewed as a strong monitoring

mechanism that can make a remarkable contribution within good corporate governance

framework. With the increase in their establishment, independence and expertise, the

number of corporate failures have also increased. This questions their effectiveness and

indicates a sign that there are other factors that may play crucial role in the effectiveness of

their oversight role. The existing research carried out on ACs are mostly on establishment,

characteristics and composition of the ACs, this study will try to investigate into the

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process of ACs operations and their resultant effects on the governance process such as the

internal control system, financial reporting process and the external audit process, using a

case study of some selected high profile corporations that collapsed. However, their

financial reports revealed apparently that they are role models in terms of management

and corporate governance practice, and yet after a few months of release of such reports,

they collapsed. Although, the ACs roles in overseeing the financial reporting process has

been revisited by many corporate governance reforms in a number of countries.

This study will try to explore the unexplored research area in ACs studies, which is the role

and the effectiveness of the ACs and to contribute to the case study research approach by

illustrating the in-depth that can be derived from a case study approach, investigates the

ACs process from within the organization and to see how organizational context affect the

operational process of the ACs. The result of this study will be of immense contribution to

the study of AC nationally and internationally, it will increase more awareness to

companies within the UK on the need for effectiveness of AC, also the regulatory bodies

within and outside UK would find it very useful in terms of making further provisions and

pronouncement to strengthen the AC.

1.3 RESEARCH QUESTIONS

The research will specifically address the following research questions in view of the

changing role/ responsibilities of the ACs:

1. Are Audit committees to blame for audit/corporate scandals?

2. Will Audit Committees prevent future audit/corporate scandals?

3. Can Mandating Audit committee improve corporate governance?

4. Are the corporate scandals a reflection of ineffectiveness of Audit committees?

1.4 PROJECT STRUCTURE

This thesis is structured in the following layout:

Chapter one will contain the general overview of the research topic. In chapter two, a

review of existing literature related to ACs will be looked into from Corporate governance,

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with particular emphasis on (Nomination, Remuneration) and secondly why are ACs set up.

Thirdly, the roles of ACs and fourthly, range of ACs, fifthly the debate about effectiveness of

ACs, sixthly the debate about need for ACs, and lastly the debate about why not mandating

ACs. Chapter three will delve into the Methodology employed in the research with

references to ontology, epistemology, qualitative and quantitative and a Justification for

choosing a particular method. Chapter four will be results and evaluation with detailed

evaluation of two case studies of Lehman Brothers and Satyam and answers the research

questions, by recognizing the limitations of research and evaluate the scope for future

research. Chapter five will be Conclusions and summary of the major findings.

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CHAPTER TWO

LITERATURE REVIEW

2.0 INTRODUCTION

The literature review will be structured as follows: firstly it looks into corporate

governance, with particular emphasis on Nomination and Remuneration Committees and

secondly why ACs are set up. Thirdly the roles of ACs will be examined, fourthly the range

of ACs, fifthly the debate about effectiveness of ACs, sixthly the debate about need for ACs,

and lastly the debate about why ACs are not mandated. In each category the work will try

to investigate the roles of audit as provided by the regulatory bodies and to assess the

current levels of performance of the AC in the UK. The work will also try to uncover the

types of expertise, if any, required of AC members for effectiveness in their operations and

to identify the “knowledge gap” that might have contributed to the recent corporate

failures the world has experienced.

2.1 CORPORATE GOVERNACE FRAMEWORK

Corporate governance evolves with differing variations due to cultural, political, economic

and technological differences among nations. Establishment of corporate governance is

based on structures of ownership affected by these variations. However, in practice two

major approaches to corporate governance are identified depending on the legal system

operating in various countries of the world.

xxxx et al (2014) identified that countries that practices common law legal systems like the

UK, the US, Canada and Australia, developed a corporate governance structure that

concentrates on shareholder’s interest (returns). Mainly, the approach ensures that the

company’s management act in a way that achieves the shareholders objective. It is often

referred to as the outsider model of control as it recognizes the agency problems.

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On the other hand, countries that practice civil law legal systems such as Germany, France

and the Netherlands developed their corporate governance with a focus on the

stakeholders. This practice of corporate governance tries to balance the interest of key

players like the employees, managers, creditors, and customers (xxxx 2014, and xxxx

2014). It is often referred to as the insider model of control as it recognizes that maximum

control of the firm relies with those closer to its actual operation.

Regardless of the approach, the concept of corporate governance entails the system by

which companies are directed and controlled (xxxx, 2012). The continued growth of

companies and the prevalence of the creation of registered companies marked the starting

point for the discussion of corporate governance as ownership is separated from control of

these companies. Xxx (2010) argued that the need for corporate governance practices

became more pronounced in 1980’s as a result of the stock market crash experienced

worldwide and corporate collapse due to poor governance.

2.1.1 DEFINITION OF CORPORATE GOVERNANCE

Corporate governance is the system by which companies are directed and controlled. It is

purposely evolved to facilitate effective, entrepreneurial and prudent management that can

ensure the long-term growth of the company xxxx, 2012). One of the strongest mechanisms

used to achieve these purposes is the Board of Directors (BOD). The BOD are responsible

for the governance of the companies; their responsibilities include planning the strategic

aim of the company, ensuring leadership that will put the strategy into effect, supervising

the management of the company and reporting to shareholders on the stewardship.

Corporate governance is all about what the BOD of the company does and how the

company’s values are set. The BOD carries out its roles through subcommittees. To be

effective, these Committees must possess the utmost balance of skills, experience,

independence and knowledge of the company to help them discharge their respective roles

and responsibilities as required (xxxx, 2012).

The development and improvement of corporate governance standards in most cases

followed the occurrence of corporate governance failures that have highlighted areas of

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particular concern. The Enron/WorldCom and Pamalat failures pointed out issues with

respect to auditors, audit committee independence and deficiencies in accounting

standards. This has provided important corporate governance lessons leading to actions by

many national governments and international regulatory institutions such as IOSCO (xxxx,

2009). From the above scenario, corporate governance deficiencies may not have been

causal in failure in a strict sense. Rather, they facilitated or did not prevent practices that

resulted in poor performance. These incidences raised many questions about the

importance of corporate governance in the success of the business. These questions were

responded to in the UK through strong corporate governance recommendations in the

reports from different Committees set up by the FRC like the Higgs Committee report

(2003), the Smith Committee report (2003) and the Combined Codes updated in 2003

which incorporate the Higgs and Smith Committees recommendations. The US responded

by producing the Sarbanes Oxley Act (2002) and many other countries of the world also

engaged in initiating programmes of reform in corporate governance.

2.1.2 BOARD SUB-COMMITTEES

Every company should be headed by an effective board, which is collectively responsible

for the overall success of the company. The board appoints sub-committees and assigns

some of its role to those Committees to discharge. The Committees are used to increase

objectivity in the board against the inherent conflicts of interest in the discharge of the

board duties and responsibilities. The sub-committees are Nomination Committee,

Remuneration Committee, Risk Committee, Ethics Committee and Audit Committee.

2.1.3 THE NOMINATION COMMITTEE

Historically, directors were often appointed on the basis of personal affiliations. Because of

the vital role of board composition to effectiveness and performance, the corporate

governance reforms sought the inclusion of a Nomination Committee as one of the board

subcommittees to ensure the right people are objectively nominated into the board. The

Nomination Committee is believed to improve the effectiveness of the board through

managing its composition (xxxxx, 2006). They were criticized by activists due to the fact

that the shareholder’s voice is not meaningful in the selection process. However, recently

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the US SEC issued Rule 14a-11, which forces public companies to allow three percent of

board members to be nominated by shareholders. (xxxx, 2010).

The Nomination Committee is to evaluate the existing balance of skills, knowledge, and

experience on the board, and use it when scrutinizing a candidate for appointment. The

Committee is also involved in succession planning in the company. As with other key board

committees, the members of the Nomination Committee should be identified in the annual

report (xxxx, 2010). As a mechanism that improved the decision-making, the Nomination

Committee helps in resolving the power asymmetry between corporate boards and

management by reducing the influence of management on the selection process of new

board members. The decisions of Nomination Committees, like all other committees of the

boards (Audit Committee or Compensation Committee), are subjected to ratification by the

board as a whole (xxxx et al, 2006).

The UK Combined Codes (2008) clearly indicate there should be a formal, rigorous and

transparent procedure for the appointment of new directors to the board and states that

the appointment should be made on merit and against objective criteria. The codes provide

that the Nomination Committee should lead the process for board appointments and make

recommendations to the board, and the majority of the Committees members should be

independent non-executive directors (Para A.4.1). xxxx et al (2006) found that firms with

Nomination Committees are more likely to have a higher number of independent and

foreign directors, and a higher degree of nationality diversity.

2.1.4 THE REMUNERATION COMMITTEE

Remuneration has always been a ‘hot issue’ which attracts a lot of attentions from different

angle. The level of the Remuneration signifies the attractiveness, retention and motivation

of qualified directors required to run the company successfully. To avoid paying more than

necessary, corporate governance Codes provide for the establishment of Remuneration

Committee to structure the director’s Remuneration so as to link rewards to corporate and

individual performance. The major roles of the Committee are twofold; one is to be the

“owner” of the company’s executive and director’s compensation philosophy and program.

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Two is to provide a forum where Remuneration issues are fully and vigorously reviewed,

analyzed and acted upon (xxxx et al 2008). However, these roles vary from company to

company, and it is subject to various factors such as ownership structure, concern of

shareholders and directors capabilities.

The Combined Corporate codes (2008), states that ‘the board should establish a

Remuneration Committee which should ensure a formal and transparent procedure for

developing policy on executive Remuneration and fixing the Remuneration packages of

individual directors, and ensure no director is involved in deciding his or her own

Remuneration (Para B.2). The Committee should comprise of at least three or in the case of

small companies, two independent non-executive directors (B.2.1). As the issue of

executive Remuneration becomes increasingly complex, and drawing more public

attentions, the Committee’s job grows and become challenging. But when the Committee

get organized and stay well informed they will achieve an optimal performance (xxxxx

2008), and for transparency, the Remuneration Committee members should be identified

in the annual report; the company chairman can be a member of the Committee but should

not chair the Committee (xxxx 2010).

2.1.5 UK CORPORATE GOVERNANCE APPROACH

The UK approach is a combination of high standards of corporate governance. In

September 2009 Governance Metrics International report ranked it second in a table

showing average governance performance among companies in different countries. The

corporate governance Codes establishes good governance practices, although companies

can choose to adopt a different approach if they find it more appropriate to their prevailing

circumstances “Comply or Explain” approach. The development of the UK corporate

governance has its roots in a series of corporate failures and scandals in the late 1980s

through 1990s. The codes have undergone a series of update by FRC through a series of

Committees to meet the prevailing circumstances facing companies in the UK. In 1991 a

Committee Chaired by Adrian Cadbury was set which issued a series of recommendation-

known as the Cadbury report in 1992. It addressed the issue of relationship between

chairman and chief executive among others. In 1995, there was a recommendation from a

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separate Committee on Remuneration of directors and in 1998 the two reports were

harmonized to form what is now known as the UK corporate governance code. In 1999

guidance was issued to enrich the corporate governance Code, which assists directors to

develop risk management and internal control. Year 2003 sought the update and

incorporation of recommendations from reports on the role of non-executive directors and

the role of the audit committee. The FRC was given autonomous responsibility of

regulating the corporate governance and reporting, including publishing and maintaining

the Codes.

2.2 LITERATURE ON AUDIT COMMITTEES

An Audit Committee can be defined as a sub-committee established by the governing body

that will make arrangement for internal audit and facilitate the smooth completion of

independent audit. AC is saddled with the responsibility of enhancing the performance of

the board to fulfil its lawful responsibilities and ensure the credibility and objectivity of the

financial statements (xxxx 2004). The duties of ACs include recommendations and

appointments of the external auditors, review the company’s financial statement to ensure

it portrays the true and fair view of the company’s financial position, taking actions and

concerns raised by the external auditor, serve as intermediary between the external

auditor and the management, advice on any findings of external auditor and Internal audit

investigations (xxxxx 2010).

2.2.1 WHY SET UP AUDIT COMMITTEE?

This section explores the factors in the financial, legal and social environment that

significantly influenced the establishment of corporate AC. In Particular, the roles and

actions played by courts, security, exchange commissions and some professional

accounting bodies.

The concept of AC is not a new phenomenon, but appeared first in the late 1930’s when the

SEC and New York Stock exchange called for the establishment of ACs in public companies.

This was prompted by the case of xxxxx in 1940. Securities and Exchange Commission

(SEC) released accounting series No.19, the investigation result proposed that, to assure

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auditors independence, a Committee be selected from non-officer board members to

nominate auditors and arrange details engagement. The decision by the New York Stock

Exchange requiring all listed companies to have ACs as of June 30th 1978, made ACs an

integral part of corporate governance and a major determinant of corporate governance

effectiveness (xxxx, 1986). The increase in the formation of ACs is traceable to major court

actions like the case of Mattels’ (1971), where SEC emphasized the importance of ACs in the

need for action concerning misleading interim reporting. The Mattel’s consent was

accepted to establish an AC to ensure settlement; the court ordered that the company

established a financial control and AC who are responsible for review of financial control,

accounting procedures, and dissemination of financial statement to the public.

Since 1940, when accounting series release No.19 was issued, the SEC had continually

supported the establishment of corporate ACs. Several other court cases also required

certain corporations to establish ACs and had prescribed clearly their duties in the consent

of decree which arose from the case SEC v. Lum’s et al, the court in settling the SEC’s

allegation of manipulation and proxy fraud, ordered that a standing AC be established and

it should consist of two or more members of the board of directors who were not officers

or employees of the company. Significantly, in most cases absent of ACs was identified as a

major contributing factor to most of the allegations raised. In exception 1976, the SEC again

emphasized the need for AC as a means of deterring questionable and illegal corporate

payment and other practices. Accordingly, the commission resolves in their proceedings

the establishment of a committee comprising of independent members of the board of

directors, who are responsible for full investigation and utilization of outside auditors to

conduct the necessary detailed inquiries (xxxxx, 1986). The commission believes that

objectivity and independence will be well enhanced if the auditor deals with an AC of

independent directors or the board of directors in determining service and fees.

Most of the call and recommendation for the establishment of ACs in US and UK came as a

result of increased corporate mismanagement and scandals, which become a daily

occurrence phenomena and corporate directors, were faced with different charges, ranging

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from price fixing, bribing and maladministration. Time, resources limitations and the level

of board responsibility, intensify the kind of challenges the board are faced with. Such as:

a. Companies have increased in size, diversity and complexity

b. Directors’ knowledge limitation makes it impossible to discuss every facet of their

company’s activities.

c. The number of law suit against directors is in the increase not only because of their

actions, but also because of management actions.

d. The directors’ requirement for reasonable care in discharging their responsibilities

to shareholders received emphasis toward litigation.

In an effort to meet the challenges in their changing responsibilities as part of their roles,

the corporate board place more importance in the establishment of ACs to aid them

(Birkett, 1986).

Many organizations and association has contributed immensely toward the setting up of

ACs in US, UK and other countries of the world, either by supporting or recommendations

for the establishment based on the prevailing circumstances. In recent years the call for the

establishment and strengthening the ACs has increased as a result of increase in the

number of corporate failures around the globe, which exposed the weakness of the

corporate governance system even in the most advanced economies who embraced the

concept for so long. In responses to the call different countries accept the idea of

establishing an audit committee to form part of their board of directors as a mitigating

mechanism against corporate misconduct.

2.2.2 ROLES OF AUDIT COMMITTEE

To ascertain the roles of ACs in a broader form, a regulatory review has to be made. The

need for ACs came amid of unexpected corporate failures that stem from corporate

misconduct (xxxxx, 2005). As corporate failures become more pronounced, more attention

is drawn on the role of ACs in preventing such failures. The increased in the number of

corporate failures has increased the perceived role of ACs from being seen as a means of

strengthening the external financial reporting process to being seen as a means of detecting

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and preventing corporate misconduct and scandals. Originally, ACs is a non-mandatory

structure used by few corporations on recommendations by court as a means of settling

allegations of corporate misconduct. In recent years, a number of professional and

regulatory commissions in the US, the UK and many other countries of the world have

recommended the adoption of the concept and increased their advocacy on the expanded

roles of the ACs. Notably are the Sarbanes-Oxley Act of 2002 in the US, the report of

Australian treasury (2002), the recommendation of Smith Committee (2003) and the Higgs

review (2003) in the UK (Turley et al, 2003). Most recently, in 2008 the FRC of the UK

issued guidance on ACs which elaborates on the expanded roles of ACs, to include:

• To monitor the integrity of the financial statements of the company and any formal

announcements relating to the company’s financial performance, reviewing

significant financial reporting judgments contained in them;

• To review the company’s internal financial controls and, unless expressly addressed

by a separate board risk committee composed of independent directors or by the

board itself, the company’s internal control and risk management systems;

• To monitor and review the effectiveness of the company’s internal audit function;

• To make recommendations to the board, for it to put to the shareholders for their

approval in general meeting, in relation to the appointment of the external auditor

and to approve the remuneration and terms of engagement of the external auditor;

• To review and monitor the external auditor’s independence and objectivity and the

effectiveness of the audit process, taking into consideration relevant UK

professional and regulatory requirements;

• To develop and implement policy on the engagement of the external auditor to

supply non-audit services, taking into account relevant ethical guidance regarding

the provision of non-audit services by the external audit firm; and to report to the

board, identifying any matters in respect of which it considers that action or

improvement is needed, and making recommendations as to the steps to be taken.

The roles of ACs are based on different legislative traditions in various countries. In some

countries the roles of ACs has historically been taken care of by other bodies such as

20

supervisory boards or the board of directors. The duties of ACs include recommendation

and appointment of the External Auditors, review the company’s financial statement to

ensure it portrays the true and fair view of the company’s financial position, taking actions

and concern raised by the External Auditor, serve as intermediary between the External

Auditor and the management, advice on any findings of External Auditor and Internal audit

investigation (xxxx, 2002 xxxxx, 2010). The everyday upsurge in corporate collapse

Consequently increased the expectations of corporate AC responsibility, the

responsibilities of AC became so intensified after the two regulatory reforms of Blue

Ribbon committee’s report 1999 and the corporate and criminal Fraud Accountability Act

of 2002, which is better known as Sarbanes Oxley (SOX, 2002) (xxxx, 2005). The corporate

governance reforms in both UK and US has redefined and re-emphasized the roles,

responsibilities and expectations from the participants in financial reporting of publicly

own companies (xxxx, 2005). More emphasis is given on the roles of ACs, the ACs are faced

with the challenge of effectively overseeing the company’s financial reporting process in

entirely different corporate governance environment.

FEE (2012), identified the differences between countries in relation to the roles of ACs to

be mainly on:

a. The extent of exceptions applied to establish ACs

b. Whether the minimum numbers of ACs is specified or not. i.e the number of

independent members of ACs differ from one country to the other.

c. Whether the chair of the board can be chair of the AC or not

d. Whether remuneration policies for members of ACs are developed

e. To what extent the auditor attends meetings of ACs

Because of the differences in corporate governance Codes between countries, some of the

differences in ACs are likely to remain (FEE, 2012). Despite the differences between

countries, the roles of the ACs might still be similar. Recent corporate governance reforms

in the UK by regulatory bodies which broadly redefined the roles and responsibilities of

stakeholders in public corporations. Most notably, the reforms emphasizes more on AC,

21

which is commonly viewed as monitoring mechanism created to ensure confidence in the

integrity of an organizations process and procedure relating to internal control and

corporate financial reporting.

2.2.3 EFFECTIVENESS OF AUDIT COMMITTEES

In number of cases, an accusation finger has been pointed at ACs, in the event of financial

failures of companies. The question is, are these fingers pointed in the right direction. Most

of the responsibilities of the failures rest with the management who are unwilling to

present a clear looks of the procedures and the rationale behind most of their deals. While

they lacked the access to information that will allow them have better understanding of the

situation, the ACs are sometimes at a fault of not being inquisitive on a matter of concern

for more details (xxxxx, 2005). The growing public pressure has placed a greater deal for

emphasis on ACs roles in pursuit of effective corporate governance. xxxxx (2013), states

that ACs are failing to deliver on their responsibility whenever an organization suffers a

catastrophic failure or even significant risk that could have been prevented. Xxxx (2006)

also found that ACs in most cases are rarely utilized as management control tools, they are

rather used as compliance to SOX and the SEC requirement. Accordingly, xxxx et al (2010)

state that most of the ACs rely heavily on the information provided by the CEO and CFO

who are the suppose person the ACs is expected to provide oversight to protect

shareholders. Unless the ACs has effective and independent information source, it

effectiveness is not guaranteed (xxxx, 2013).

However, a significant number of prior research established that the mere formation of AC

in organization result in substantial benefits. For example xxxxx et al (1999) found that the

presence of AC is significant factor in enhancing third party perception of auditor

independence. xxxxx (1996) concluded that firms with ACs are associated with fewer

shareholder lawsuits alleging fraud, fewer quarterly earnings restatements, fewer SEC

enforcement actions, fewer illegal acts and fewer instances of audit turnover when there is

an auditor-client disagreement. Similarly, xxxxx (2006) found that ACs are associated with

higher quality audit. However, these findings are in conflict with the result from xxxx

22

(1996) which concluded that the presence of AC has no significant effect on the likelihood

of financial statement fraud and that interaction of the AC with board does not impact on

the likelihood of financial statement fraud. It was further suggest that the board

composition is more likely to constrain fraud in an organization than AC. This finding

correspond to the findings of xxxx et al (2005) who conclude that it is the board that

effectively constrain abnormal earning not the AC, And xxxxx (2007) who determines that

the mere presence of AC does not reduce the occurrence of errors and non-compliance

qualifications.

However, it has been observed recently that ACs comprising of independent and

knowledgeable directors with right information is in the right position to ask management

the right question to determine whether the company’s management is sufficiently

managing risk as identified by Blue ribbon committee report as one of the ACs best

practice. The most important and reliable source of information to ACs as pointed out by

xxxx (2013) are the employee whistleblowers, lower level executive and the external

auditor, although communication from employees to ACs requires the employees to

acknowledge the misconduct or the risk attached to it, also they need to be motivated to

reveal the information directly to the ACs. Although, In some cases, the ACs do not act on

the information disclose to them by the individual whistleblowers due to their relationship

with the management of the company and negligence of duties as enshrined in corporate

governance Codes (xxxx, 2013). An example of such situation could be found in the case of

Enron. Where Sherron Watkins wrote a letter to Enron chairman Kenneth Lay, disclosing

his personal fear about what is happening in the company by saying “I am incredibly

nervous that we will implode in a wave of accounting scandals”, the Chairman then push

the matter to inside counsel to administer and investigate Watkins’ complaint, in place of

employing the service of independent counsel to investigate on the matter. The inside

counsel then take the matter to the regular outside counsel of the company who received

substantial legal fees from Enron, to carry out the investigation. After a short investigation,

the regular counsel gave Enron a report that generally found no substance in Watkins’

complaint. After the Enron’s bankruptcy, a separate investigation was carried out by an

23

independent board committee, using a different counsel and found a significant substance

to Watkins’ complaint (xxxxet al, 2002 pp 34-35). For effectiveness, the whistle blowing

system should be well administered by the companies with oversight from the ACs, and it

presence should be well known to all and sundry in the organization. The ACs should

consider any complaint by whistleblowers and relate to the auditor any matter concerning

the financial reporting process (xxxx., 2008).

xxxx (2013) suggested that a new behavioural approach to corporate governance focusing

on the psychological aspects of human being inside organization need to be evolve in order

to reduce the emergence of corporate scandals in the near future. This suggestion came

after a careful examination of eight cases of corporate scandals where xxxx et al, (2006),

conclude that the root cause of the failures were: 1) poor strategic decision; 2)over-

expansion and ill-judged acquisition; 3) dominant CEOs; 4) greed, hubris and a desire for

power; 5) failure of internal control and ineffective boards. Furthermore, xxxxx (2013),

observed that ACs members acknowledge with accuracy the degree of change in

management incentives, although it’s not all the Committee members that believed that the

change in incentives result in change in management behaviour. It is concluded that the

effects of both trust and incentives on ACs decision to support management versus the

External Auditor are affected by the perception of the intent to deceive (Rose et al., 2010).

However, identifying the perceive intent to deceive and trust in human being call for the

inculcation of psychological knowledge into the main stream of governance activities. By

combining both the existing approach to corporate governance with a new behavioural

approach which focus on human factor, stakeholders confidence will be restored to expect

good corporate governance.

2.2.4 RANGES OF AUDIT COMMITTEE

Corporate governance Codes differences between countries, makes the practices of ACs

varies world over. Some countries mandate the establishment of the ACs by law, Example

Canada, Australia, Singapore and Thailand. Others are mandated by regulatory bodies,

Example Bangladesh, Malaysia and US. But in the UK audit committees’ establishment are

encourage by Codes of best practice, in many countries of the world ACs are not mandated

24

nor encourage by any Code, it is at the discretion of the firm to appoints or not to appoints,

therefore the operation of ACs differs in certain respect. xxxxx (2004) observed that ACs do

not operate in a vacuum and their operation and effect cannot be adequately examined

without regard to the institutional and organizational context in which they function and

the power relation which are intrinsic to that context. The underlying corporate culture

affects the operation of ACs. Generally, ACs are expected to operate the same irrespective of

the organization. But it is observed that there exists some significant difference between

the ACs activities in private and public sector. External financial reporting functions are

performed by higher proportion of private than public sector ACs, also in the cases of

reviewing public statements with regard to financial issues, a greater proportion of private

than public sector ACs perform the function. The only external financial reporting functions

carried out by a greater proportion of ACs in public sector is reviewing the entity’s entire

annual account (xxxx 1998). This is due to the absence of written ACs charter, despite the

express requirement of the ACs activities in most of the corporate governance Codes.

Turley and Zaman (2007) observed that organizational culture affect the operation of AC’s,

most significant effect of AC on corporate governance in certain instances occur outside the

formal settings and process.

2.2.5 THE NEED FOR AUDIT COMMITTEE

An AC is a sub-committee established by the governing body that will make arrangement

for internal audit and facilitate the smooth completion of independent audit. Audit

Committee is saddled with the responsibility of enhancing the performance of the board to

fulfil its lawful responsibilities and ensure the credibility and objectivity of the financial

statements (xxxxx, 2004). The duties of ACs includes recommendation and appointment of

the External Auditors, review the company’s financial statement to ensure it portrays the

true and fair view of the company’s financial position, taking actions and concerns raised

by the External Auditor, serve as intermediary between the External Auditor and the

management, advice on any findings of External Auditor and Internal audit investigation

(xxxx, 2010). The function of an AC is generally seen as assisting the Board in providing an

independent review of the effectiveness of the financial reporting process, internal control

25

and risk management system of the company, overseeing the audit process and performing

other duties and responsibilities as assigned by the Board, the Board has full responsibility

and authority for the management and supervision of the business. The AC does not take

over these functions but will report and make recommendations to the full Board on

matters pertaining to its work and findings (xxxx, 2002).

The continued changes in business environment, and increase in complexities of modern

day corporations increase the need for the establishment of ACs to enhance the governance

process of those corporations. Similarly, the growth and increase in corporate activities

result in increased risk and responsibilities of corporate directors, the need to reduce the

risk further increase the need for an AC as the means of reducing such risk. Consequently,

AC became an addition to the corporate practice (xxxxet al, 1977 in xxx, 1986). As more

interest group evolve with keen interest on the activities of corporations, the AC is viewed

as watchdog for the distance interest group who has no direct access to what is happening

in those corporations. Those who argue on the need for ACs emphasize that AC ensures

good relationships between directors, investors and auditors. AC also helps in the

discharge of accountability and directors execution of their responsibilities. ACs influences

power relations between accountability and auditing (xxxx, 2004).

ACs are often perceived as an effective mechanism reducing agency cost, ACs are expected

to monitor the reliability of the company’s accounting processes and compliance with

relevant corporate legal and ethical standards which includes maintenance and prevention

of fraud controls (xxx 2004 and xxxx, 2004). However, many research on the ACs effect on

corporate governance revealed that it is not all of these perceived potentials were achieved

by adoption of AC concept, rather in some cases the ACs aides the perpetration of most of

the corporate scandal the world witness either deliberately or out of non-commitment to

their duties as prescribed in the governance Codes, like the cases of Enron in 2001 and

number of scandals involving large US companies such as world.com and global crossing

(xxxx, 2009).

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2.2.6 WHY ARE AUDIT COMMITTEES NOT MANDATORY?

Audit Committee is becoming a top issue in the discourse of corporate governance because

of it perceived role in the corporate monitoring, the concept has gain wide acceptance as a

monitoring tool and a deterrent against the management and enhance the work of external

auditor. In the past two decades, the persistent corporate failure has generated many

concerns among academicians and regulators regarding establishing ACs, either to

mandate the establishment or not due to increasing expectation on the ACs. According to

xxxx (2014), those advocating the non-mandatory AC argued that, requiring a complete

independent on AC and enforcement of mandatory rules would create a significant

financial cost, adding that the risk of financial misstatements and accounting fraud is

negligible in their country; therefore, it is a country specific problem. The Institute of

Chartered Accountants of New Zealand states that, a mandatory approach for small market

would channel limited resources on compliance rather than value creating strategy,

therefore mandatory approach is not appropriate for New Zealand market given there is no

evidence of financial misreporting in New Zealand to compare with the magnitude in some

advance economies like Australia and U.S (xxxx 2014). Furthermore, empirical evidences

on firms that adopted a high quality AC in New Zealand shows no evidence that best

practice AC improved financial reporting quality, it is also found that no evidence that best

practice AC were associated with lower audit fees (Rainsbury and Bradbury, 2009).

However, as vast majority of research indicates that AC provides ample benefits to the

governance of corporations. In Australia after the collapse of high flying companies, the

ASX mandate the establishment of AC’s in 2003 to top 500 companies listed in the S&P/ASX

under ASX listing rule 12.70. while non-top 500 were not mandate to have AC’s as they are

not under the listing rule 12.70, rather they are subject to ASX listing rule 4.10.3 which

provide either to have an AC’s or to explain why AC is not justifiable to them. (xxxx, 2011).

The argument is that in as much as AC’s is important to one group of companies, it must be

important to another group too in all ramifications. For example, a company’s performance

may improve in a given year to move to top 500 and in the following year when met with

unfavourable market situation moves back to top 300, which means the structure of their

27

AC must be fluctuating year in year out, in essence it does not make any difference

mandating or not mandating.

Similarly, in 2003, Japanese amended corporate Codes give large companies the option to

adopt or not to adopt the USA style of AC. The companies that choose to adopt the USA style

are required to establish the AC, while those companies who choose not to adopt US style

are place on the conventional Japanese corporate governance, which does not require them

to establish an AC (xxxxx, 2005). This indicates that the corporate governance framework

in most cases determines mandating or not mandating ACs. After the passage of Sarbanes

Oxley many countries that adopted the Sarbanes Oxley Codes mandated the establishment

of AC’s on certain categories of listed companies while others did not, but has instituted

new rules that mandates the use of AC’s in certain circumstances. However, xxxx (2010),

state that the number of countries mandating the establishment of AC recently has increase

(see appendices 1 for the list of countries).

CHAPTER THREE

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RESEARCH METHODOLOGY

3.0 INTRODUCTION

This Chapter explores the procedural framework within which this research is conducted.

The Chapter will discuss the research approach, the methods employed and the rationale

behind the selection of the approach and methods in the conduct of the research.

Research is a diligent and systematic inquiry or investigation into a subject in order to

discover or revise facts. While, methodology described and approach to the investigation

which may be transform into research programme about answering unanswered

questions. Therefore, a good research method could be developed by careful understanding

of philosophical literatures which gives a philosophical solution to a question of “Why

Research”. Developing the philosophical perspective requires a choice between two

different dimensional views of scientific approach to research, that involves either a

subjective or an objective approach to research. And the origin of these two major

approaches is traced from the several core assumptions concerning the ontology (reality),

epistemology (knowledge), and finally the methodology (xxxxx, 2004).

3.1 RESEARCH APPROACH

Debates and arguments are much in recent years within many of the social sciences field in

relation to merits of quantitative and qualitative strategies of research (objective and

subjective) strategies of research. The decision to adopt one among the two by individual

researcher vary considerably, some researchers sees the two strategies as entirely separate

and opposite having varying philosophical positions existing between them. While others

see to mix the two in their research is the best alternative (xxxxx, 1998, 2010 and Johnson

and xxxxx, 2004). However, xxxx (2002) warns that such a suggestion underestimate the

legitimacy that are related with the choice of methods, where quantitative approach is

viewed as more scientific and ‘objective’, qualitative approach is always viewed as

‘subjective’.

The advocate of Quantitative research approach developed assumptions that are

commonly called positivist philosophy. This approach to social science research developed

29

from the natural sciences, where it is believed that social observation should be treated as

an entity as the same way that scientist treats physical phenomena. They further argue that

observer is separate from the entities that are subject of the observation and maintain that

social science inquiry should be objective (xxxx, 2004). On the contrary, the advocate of the

Qualitative research approach (also called constructivist and interpretivists) reject the

assumption of the positivists approach. They argue that researchers cannot distance

themselves from; what is being observed, the study’s subject matter or the methods of

study. They maintain that the researcher is characterized by in built biasness reflected by

their background, status, interest, values and resources (xxxx, 2004). Therefore, they argue

for the superiority of constructivism, idealism, relativism, humanism and sometimes

postmodernism. It is also believed that multiple constructed realities abound, that time-and

context-free generalizations are neither desirable nor possible, that is also impossible to

differentiate In total the causes and effects and that logic flows from specific to general, and

that the knower and the known cannot be separated because the subjective knower is the

only sources of reality (xxxx, 2004).

Both side of the argument view their paradigms as the ideal for research, and that

qualitative and quantitative research approach, including their associate methods cannot

and should not be combined. Positivists approach is face with increasing critics as being

inappropriate approach to the study of social science phenomena. Saying the success

recorded by the objectivism approach in natural sciences research has not been repeated in

the social science research due to its significant weakness. These critics identify that

subjectivism is more related to the study of social science due to the complexity of the

social science research (study that involves human beings). They argue that the

researchers that employed a nominal ontology and its accompanying epistemology realize

more explanatory success (xxxxx, 2004). However, subjectivist approach is not without its

own weakness and critics, it is observed by its critics that it is unable to replace objectivist

approach and so it is condemn as an alternative to objectivist approach. Although,

subjectivist argue that there are many equal version of reality and each version of it is

personal and community-specific, therefore each version of reality cannot be compared as

30

it is viewed as good as the other. Moreover, xxxxx (1997) pointed out that because of the

absent of absolute basis for scientific knowledge, theories are incommensurable, hence a

given theory cannot be held as more valid than the other.

It is noted by researchers that the heated debate between critics and proponent of both

approaches that argument on ontology and epistemology cannot end in any philosophical

solution, because there is no right or wrong philosophical stance. In this regards,

xxxxx(1997) stated that many of the present realists and empiricist are pragmatics, they do

not disturb themselves about the ontology and the epistemology but about the particular

problem they face from their theories and investigation, and argue that there is no basis for

advocating any view as unequivocally correct conception of the relationship between

philosophy and social science, as the philosophy itself is a matter of philosophical dispute.

Therefore, the decision to choose among the two approaches depends on the aims of the

research and the kind of research questions. This study will tries to explore the unexplored

research area in ACs studies, which are the roles and the effectiveness of the ACs by

investigating the ACs process from within the organization. To do that, qualitative

approach is appropriate as it can describe events, persons and phenomena scientifically

without the use of numerical data as against the quantitative approach which requires data

to be analyzed in terms of numbers (xxxxx, 2002). Both are useful and valid, however

qualitative is more concerned with collection and analysis of information in many forms,

mostly non numeric. It tends to focus on exploring as much details as possible, and aim to

achieve ‘depth’ rather than ‘Breath’, as the researcher gains an insider’s view of the field,

because of the researcher’s close involvement and that allows the researcher to find issues

that are often missed by the quantitative approach. On the other hand, quantitative is

mostly concerned with collecting and analyzing data in numeric form with the aides of

statistical techniques which allows sophisticated analysis. Although, because of complexity

of human beings it is difficult to treat them as matters in natural sciences, and so social

sciences research of this nature required the use of qualitative approach because it can

suggest possible relationships, causes, effect and dynamic process of an event (xxxx, 2002).

31

Research is a systematic investigation to find answers to problem. Scientifically,

quantitative research methods are employed in an attempt to establish general laws or

principles. The naturalistic or qualitative approach to research gives more credence to

subjective experience of individuals, which focus on individual case rather than general

law-making (xxxx, 2002). Whilst quantitative research may be mostly used for testing

theory it can also be used for exploring an area and generating hypotheses and theory.

Similarly qualitative research can be used for testing hypotheses and theories even though

it is mostly used for theory generation.

3.2 METHODS

To understand how and why a company is committed to fraudulent financial reporting and

the role of ACs in that regard, therefore a qualitative case study approach to research is

needed for several reasons as advocated by xxxx (2007) to use a bottom-up approach in

qualitative research by inductive process. The study reviewed Secondary data from data

banks, and analyzed the details as they relates to the roles of AC’s in the failure of the

selected companies (Lehman and Satyam). A case study allows for deep understanding of a

situation (xxxxx, 2007). The researcher employed a qualitative case study method to

investigate the roles and effectiveness of ACs in the failed companies, using several data

sources, including available public information, academic journals, public legal findings and

reports of investigation committees. According to xxx (2014), a case study method does not

seek to control any variables; it looks at case in its natural context and can be undertaken

by using any approach (a positivists or interpretivist). After the investigations carried out

by the Examiners in the failure of Lehman Brothers and the investigations of serious fraud

investigation office (SFIO) and Central Bureau of investigation (CBI) in the case of Satyam,

many source documents become available publicly which provided rich real-time pictures

of what happened in the companies, which the researcher would not otherwise have access

in the case of most research project. However, the observable phenomena that can be

found in the documented cases using the evidence from investigation agencies and the

confession in press articles (such as managers’ quotes and the analyses of Journalists). they

are not academic sources but research based evidence showed that “press has fulfil the role

32

of watchdog or monitors for accounting frauds by undertaking original investigation from

other intermediary sources (auditor, analyst and lawsuit), and rebroadcast it to public.

Hence, the use of some reputable press articles and publications (financial times, wall

street journal, CNN-IBN, business outlook) to examine the corporate scandals and the roles

played by the established gatekeepers.

The case study is a multiple one looking at the two largest fraud cases in India and USA,

involving Satyam computer services (labelled as “India’s Enron”) by Indian media and Case

of Lehman Brother plc (term as the largest corporate scandal in the history of USA). The

used of multiple case studies is often considered more compelling, and the overall study is

therefore regarded as being more appealing as it gives a researcher the room to consider

multiple experiments as against single case study (xxxx, 2014). Both the cases involved

fraud and manipulation of financial statements which was perpetrated by the top

management for a long period without being spotted by the established monitoring

mechanism. Different research method has been employed in the study of ACs; in this study

Case study appear to be appropriate to study how ACs operates in their social, political and

economic context. xxxx (2004), states that qualitative research method using case studies

provide significant potential for researching ACs activities in the organizational and

institutional context in which they operate, adding that cases may allow identification of

specific areas of interaction between ACs and other parties like executive management and

auditor which affect audit process.

33

CHAPTER FOUR

RESULTS AND EVALUATION

4.0 INTRODUCTION

The cases of corporate scandals involving two major companies in USA and India (Lehman

Brothers and Satyam computers) are analyzed in an attempt to assess the roles and the

effectiveness of ACs in the face of the corporate failures.

4.1 SATYAM COMPUTERS

At the time of this study the case company (Satyam) has been acquired by Tech Mahindra

and renamed to “Mahindra Satyam”. SATYAM was a rising star in the Indian outsource IT

industry, the company was incorporated by two brothers Mr. B Rama and Mr. B Ramalinga

Raju on 24th June 1987 as a private limited company with only 20 employees with

headquarters at Hyderabad, to provide software development and consultancy services to

large corporations. The company grew rapidly and converted to public company in 1991.

SATYAM growth as global business makes it to be seen as the “India’s growing success”. In

the year 1997, SATYAM was chosen by the Switzerland based world economic forum and

world link magazine as one of the India’s most remarkable and rapidly growing

entrepreneurial companies (xxxxx, 2010). SATYAM was listed on the New York stock

exchange and extranet, its network covers 67 countries across the world.

The company employed 40,000 IT professionals across its development centres in the

world. The company provides services to over 654 global companies among which 185 are

fortunes 500 corporations. In 2003, SATYAM became provider of IT services to World Bank

and entered into a long term contract with World Bank. SATYAM won a number of awards

for innovation, corporate governance and accountability. The last was in September, 2008

when SATYAM received an award from world council for corporate governance “A global

peacock award” for global excellence in corporate accountability (xxxxx, 2009, xxxx, 2010

and xxxx, 2013).

34

The company turned from being India’s IT Empire, the fourth largest company with high

profile customers to nation’s biggest corporate scandals in the living memory of India

(xxxx, 2010) following the confession of its chairman and founder Mr. Raju of a committed

fraud to the tune of $1.47 billion. The confession of Mr. Raju came at the middle of

resistance by the SATYAM investors on the announced management decision to used $1.6

billion on a bid to acquire two MAYTAS companies (MAYTAS infrastructures ltd and

MAYTAS properties) to deploy the purported cash available for the benefit of investors.

The resistance of the investors forced the chairman to reverse his decision within 12 hours.

Another big shocker to the company came when World Bank announced on 23rd December,

2008 that they have barred SATYAM from business with them for eight years and on 7th

January, 2009 Mr. Raju resigned.

4.1.1 ANALYSIS OF AUDIT COMMITTEE OF SATYAM

AC is expected to monitor the integrity of the company’s financial reporting procedures and

internal controls. The AC is also expected to select, retain, oversee and evaluate the

company’s external auditor, as recommended by stock exchange board of India (SEBI)

listing agreement and the New York stock exchange (NYSE). The AC at SATYAM existed but

seems not be active.

4.1.2 INDEPENDENCE OF AUDIT COMMITTEE OF SATYAM

The board of directors is the highest decision making body in the company established with

responsibility for ensuring that requisite system of control of the company’s business and

its records are established in accordance with the provisions of the company Act 1958 (as

amended) regulations made thereunder and in accordance with best accounting practices

(xxxx, 2007).

In his confession letter Mr. Raju states “None of the board members, Past or present, had any

knowledge of the situation in which the company is placed. Even business leaders and senior

executives in the company, such as Ram Mynampati, Subu D, T.R Anand, Keshab Panda,

Virender Agarwal, A.S. Murthy, Hari S.V Krishnan Vijay Prasad, Manish Mehta, Murali V,

Sriram Papani. Kiran Kavale, Joe Lagioia, Ravindra Panumetsa, Jayaraman and Prabhakar

35

Gupta are unaware of the real situation as against the books of accounts. None of my or

Managing Director’s immediate or extended family members has any idea about these issues”

(xxxx, 2013).

Evidence from the confession letter of the chairman and reports of investigation agencies

like SFIO and CBI on SATYAM scandals reveals SATYAM board was composed of ‘chairman-

friendly directors’. Each of the board member was there on the personal invitation of the

chairman, as against the regulatory requirement for nomination of independent directors.

This correspond with the findings of xxxxx (2013) which examine the roles of directors

appointed from the same social network with the CEOs and found that the social ties has a

negative effect on variables that ensure their oversight quality, however, social ties formed

through ‘Advice networks’ do not hinder the quality of AC oversight. Again, xxx (2014) also

states that the friendships “have a negative impact on corporate financial integrity,

fostering earnings manipulation, low levels of audit effort, concealment of financial

distress, and cover-ups of internal control weakness.” This confirm the findings of xxxx

(2010) that the ties between the top management of SATYAM and the board members did

not allowed them to know what was happening in the company.

4.1.3 REVIEW OF FINANCIAL REPORTING PROCESS AND INTERNAL CONTROL

The AC of every company has the responsibility to review and monitor the integrity of

company’s financial reporting procedure and internal control under both legal and

regulatory requirement. Legally, an independent director owes the shareholders the duty

of good faith and duty of care. However, they are not expected to display extraordinary care

but that much which a man of ordinary prudence would take his case (xxxxx, 2010).

Similarly, the AC is designed to act as an independent voice on the board of directors with

regard to audit and corporate governance issues and is seen as valuable asset, particularly

with respect to maintaining the independence and integrity of internal audit function (xxxx,

2008). “Central Bureau of investigation (CBI) findings on diversion of SATYAM funds abroad,

have identify three suspicious foreign bank accounts in US, which were held in the name of

three different individuals. About rupees 60 crore belonging to SATYAM were channelized into

those accounts bearing non-Indian names, and the transaction was not found in the books of

36

SATYAM. Also the CBI report states that a whistleblower (Hyderabad origin UK National

settled in London) contacted CBI and informed the investigation agency that there are six

bank accounts and fictitious firms that Mr. Raju floated in London had served their purpose

and were liquidated long before the scam came to light. They were started in 1999 and closed

down just before the listing of SATYAM’s ADRs on New York Stock Exchange in May 2001”

(xxxx, 2010). Neither the AC nor the independent auditor came across it, they failed to be

inquisitive in their respective duties, while paragraph 13 of ISA emphasized that no matter

the auditors experience with a particular clients, they should maintain an attitude of

professional cautions. In other word, they should consider that fraud is always possible and

that they need to take into account (xxxx, 2008).

However, the level of fraud perpetrated by Mr. Raju and associate in SATYAM scandals

clearly demonstrated how AC duties and responsibilities were violated despite the eminent

personalities sitting in the AC of the company. This confirms the claim of xxxx (2006) who

said that if AC actually performed their duties well, they could enhance the transparency of

company and re-established the public trust in the stock market. With their qualification

and experience, commitment to critical issues about the company is highly expected and it

is incumbent upon all the AC members to be inquisitive and ask important questions more

than once.

“Serious fraud investigation office (SFIO) findings revealed that SATYAM was deeply involved

in making false disclosure to the stock exchange. The company used the name of Chintalapati

Srinivasa amongst its directors, friends and relatives list till December 31, 2008 at the stock

exchange. In reality Mr. Chintalapati was a director form 1990 till Jan 23, 2003 and held the

position of executive director only till 31 August 2000. It was further found that the company,

in its annual account for the year 2002-03, had reported certain extra ordinary items, which

on deduction would have brought the company under losses. False fully, SATYAM activities

displayed an EPS of Rs 9.77 per share, which on correction stands at (-) 1.93 per share. The

reported EPS was used to move up the share price of SATYAM at the stock market”. (xxxx,

2010)

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The core of the AC members is to understand important financial-reporting issues and

development affecting the company, take a close look at the management key activities and

bring in a personal history of business judgement and ethical standard and skill to the their

task which some time book cannot provide (xxxxx, 2011). However, when members of

management or those charged with governance responsibility comprise of the group who

perpetrate the fraud and irregularities like the case of SATYAM, it is more likely that it will

go undetected by the company’s internal control system and the auditors, because they

have greater scope to override controls and conceal fraud (xxxxx 2004). It is on record that

Howard Sherma, chief executive of GovernanceMetrics International, a corporate

governance rating services, said his firm gave a warning report to its clients in December

2006 that “SATYAM’s AC had no members who qualified as expert in audit-committee

financial practices. He said his view was based on US Securities and Exchange Commission

expectation. SATYAM is listed in both US and India; therefore it is subjected to both US and

Indian securities law. GovernanceMetrics evaluate the shares in MSCI Emerging Market Index

in which SATYAM shares are included” Sherma further added that “No one can claim that

having a recognized accounting expert on AC would have prevented or uncovered the fraud.

But certainly it would have reduced the risk” (xxxx, 2009). Contrary to that, there are

number of research findings which indicate that accounting expertise is associated with

better financial reporting outcomes. For example xxxx (2007), Krishna and Visvanathan

(2008), However, a well planned and executed fraud always involves collusion and is

complex in nature, and may remain undetected for a considerable period of time when

commensurate with relax and uncommitted gatekeepers (xxxx 2004).

4.1.4 INFORMATION FLOW AND AUDIT COMMITTEE AUTHORITY

By authority, an AC should have clear right to seek information, makes decision and carry

out its prescribed duties, the conduct of AC members are designed to ensure that all of

them are kept informed about what is going on and that control is exercised over the

executive management, the AC has a set of overriding duties to exercise for control to be

effective (xxxx, 2005). The presence of AC most often gives a notion that the system of

corporate governance is adequate when in actual sense it is not.

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According to SFIO findings an ex-senior executive of the company Jose Abraham blew the

whistle on the scam of SATYAM. In an e-mail dated December 18, 2008, Jose Abraham sent his

findings to an independent director of the company Mr. KG Palepu, who then forward the mail

to Mr. M Rammohan Rao, who is the chairman of the AC of the company. The chairman also

forwarded same to other members of the committee, the statutory auditor Mr. S

Gopalakrishna and the chairman Mr. Raju (xxxx, 2010).

This is similar to Enron case where Sherron Watkins reported a concern but the AC did

nothing over it (xxxx et al, 2002 pp 34-35). This signifies the height of lack of commitment

to ensuring the whistle blower system operate effectively in the company by both the

management and the AC (xxxxx 2013), Mr. Abraham only got the courage to blew the

whistle when he became an ex-officer of the company. The whistle blower system as

suggested by xxxxx (2013) is one of the primary sources of authentic information for the

AC, but in most cases management of companies do not support the establishment of that

system. In this regards, it is clear that the AC of SATYAM had no clue to what happened, as

mentioned by Ved Jain, President of the Institute of Chartered Accountants of India “the AC

seems to be sleeping.”(xxxxx, 2009),

Again, the AC authority on the independent auditor was stampeded by the management of

SATYAM; investigation show that “the auditor price Waterhouse partners Gopalakrishna and

Srinivas Talluri audited the account of SATYAM for eight years till the accounting fraud came

to light”. If the AC had exercised it authority on the selection, recommendation and

appointment of the independent auditor and the rotation of the office, it could be said the

story of SATYAM could have been different. This is similar to the findings of xxxx et al

(2010), that despite the attention received by the concept of AC from academic literatures

and by regulators in different countries, some companies experiences suggest that AC are

typically ineffective and are lacking the sufficient power to be strong governance

mechanism. Similarly, xxxxx (2013), states that ACs are failing to deliver on their

responsibility whenever an organization suffers a catastrophic failure or even significant

risk that could have been prevented. In this case, because of the auditor’s long standing

relation with the management, they became ineffective to figure out and report to AC the

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gray areas in the financial statement for a long period of time, and it is so glaring that AC

and the auditors could have stop the occurrence of the fraud long before it became worse.

The whistle blower system that should be strengthening by the AC was inexistence. And the

very few employees with good conscience occasionally report their worries on the

irregularities going on but the AC committee refused to act on their report.

4.1.5 RESPONSIBILITIES FOR FRAUD DETECTION AND PREVENTION

Categorically, the functions of SATYAM’s AC included “oversight of the company’s financial

reporting process and disclosure of financial information to ensure that the financial

statement are correct, sufficient and credible” and “Reviewing with the management,

performance of statutory and internal auditors and adequacy of the internal control

systems” (Company’s Annual report 2008 in xxxxx, 2009). However, evidence has shown

that if the AC had discharged it function as required by SEBI, it could have been a different

story to be told about SATYAM. A number of events have posed the need for AC’s deep

involvement to unearth the actual picture and to be able to detect and prevent the

eventualities.

For example, in terms of disclosure the AC committee did not ensure the correctness,

sufficiency and credibility of SATYAM financial statement. Firstly, there exist a lawsuit in

Texas US, initiated since 2007, which require huge amount in compensation and

punishment for damages; it had not been reported to SEBI or the SEC (xxxx, 2009). This is

an event of serious non-disclosure of material facts. Secondly, SATYAM lost one of its

branch cases in London also not reported (xxxx, 2009). This clearly violates both the

provision of SEBI and New York SEC on disclosure obligations. The third incidence relates

to the World Bank ban on SATYAM for providing “improper benefits to bank staff,” which is

related to bribery, however, the bank did not report it to the company AC for an action to

be taken for good governance. This confirms the findings of xxxx et al. (2008) which shows

that firms with less active AC are indeed less likely to identify ineffective internal controls.

Similarly, decision to spend the entire cash reserve of the company on a related party

transaction at a gross overvaluation required the AC to make a thorough investigation on

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the matter, but it was clear that the AC did not carry out any tangible investigation before

accepting the decision by the board. “Investigation has found that Maytas properties valued

at $1.3 billion which was said to have 6,800 acres of ‘Land ‘ under development, only 100

acres could be verified. Also, the promoters of Maytas infrastructures claimed to owned only

35% at the time of bid, but CNBC a business channel revealed that the promoters were

holding as much as 85%, all of which the SATYAM AC has no knowledge of it while it is part of

their functions to get to the root of such transactions”. Coincidentally, this correspond with

the findings of xxxxx (2013) which conclude that when directors are appointed from the

same social ties with CEOs, the social ties have a negative effect on variables that ensure

their oversight quality. In the end it renders the AC inefficient and not being able to ask any

serious question and easily get convinced with silly answers.

4.2 LEHMAN BROTHERS

Lehman Brothers had started as a small general store at Montgomery, Alabama in 1844.

Henry Lehman, an immigrant from Rimpar, Germany, founded it. It was established as a

small shop selling groceries, dry goods and utensils to the local cotton farmers. In the year

1850, his two brothers, Emmanuel and Mayer, joined him in the business, and they jointly

named the business LEHMAN BROTHERS. However, Lehman Brothers metamorphose from

general merchandising business to a commodities broker that bought and sold cotton for

planters living around Montgomery, Alabama. In 1858, they opened a New York office,

concentrating their operation in the New York office gave them the chance to spearhead

the formation of the New York cotton exchange in 1870. The first commodities futures

trading venture. Mayer Lehman was appointed to it first board of directors.

During depression in 1930’s, Lehman was the first firm to come up with a new method of

financing known as the private placement when companies were unable to raise capital. An

innovative idea then, the private placement nowadays becomes a standard financing

technique. The economic expansion of 1950’s which was driven by electronic and

computer technology, Lehman Brothers was deeply involved in the investment

opportunities in the sector, and engaged in underwriting digital equipment corporation’s

first public offering. In the 1960’s and 1970’s the firm expanded its tentacles, when U.S

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companies expanded internationally, to increase its presence globally by opening offices in

Europe and Asia. In 1980’s Lehman Brothers acted as an advisor on several large U.S and

cross -border transactions, Lehman Brothers also take part in the new market as a result of

computer boom by backing companies like Intel, the company that introduced the world’s

first microprocessor to raised fund.

In 1984, Lehman Brothers was acquired by American Express and merged with its retail

brokerage Shearson to form Shearson Lehman Brothers. Soon after that American Express

pulled out in 1993, Lehman Brothers once again became known solely as Lehman Brothers.

While the firm prospered over the years, it has content with ample challenges over the

years, especially the shortage of capital when American Express pulled out in1994. In 2000,

Lehman celebrated its 150th anniversary, however despite its ability to survive through the

challenges; the collapse of the US housing market ultimately brought it to its knees in 2008,

as its involvement in the subprime mortgage turned disastrous. Lehman was the fourth

largest US investment bank at the time of its collapse, with 25,000 employees worldwide. It

was the largest victim of the US subprime financial crisis that collapsed the global financial

markets in 2008. On 15 September 2008, Lehman filed for Chapter 11 bankruptcy, with

$639 billion in assets and $619 billion in debt, which makes it the biggest in history (HBS,

2014)

4.2.1 THE AUDIT COMMITTEE

The AC of Lehman Brothers existed for some time, due to the long-standing institutional

practice in the company, Consistent with the Sarbanes Oxley provision, the AC reports on

their roles in the annual account of Lehman Brothers.

4.2.2 REVIEW OF FINANCIAL REPORTING PROCESS, INTERNAL CONTROL AND

DISCLOSURE REQUIREMENT

“We continue to be committed to industry best practices with respect to corporate

governance. Our Board of Directors consists of ten members. With the exception of our CEO,

all of our directors are independent. The audit, nominating, and corporate governance,

finance and risk, and compensation and benefit committee are exclusively composed of

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independent directors. The AC includes a financial expert as defined in the SEC’s rules. The

board holds regularly scheduled executive session in which non-management directors meet

independently of management. The board and all its committees each conduct a self-

evaluation at annually. Last year, overall director attendance at board and committee

meetings was 96%. We have an orientation program for new directors. Our corporate

governance guidelines also contemplate continuing director education arranged by the

company. Our Code of ethics is published in our website. We have designed our internal

control environment to put appropriate risk mitigants in place. We have a global head of risk

management and a global risk management division, which is independent. The company’s

management assessed the effectiveness of our internal controls. Based on our assessment, we

believe that the company’s internal controls are effective over financial reporting.

Independent auditors have also considered these controls effective. We also sponsor several

share-based employees’ incentives.” (Lehman Brothers Annual Report 2007 in Da Silveira

2013).

Above is an excerpt from the Annual Report of Lehman Brothers a few months before it

collapse, which portrays how robust the company is in adherence to Sarbanes Oxley

provisions and good corporate governance practice. But sufficient evidence contradicts the

assertion of the company’s management for being adherence to best governance practice

as observed by xxxx (2010), that Lehman was bankrupt right before September 2008. This

make legal expert to believed that Lehman executives deliberately manipulated

information in the statements, and the auditors and AC purposely closed their eyes to these

balance sheet manipulations as early as 2000’s (xxxx, 2011). Especially in the use of Repo,

significantly Lehman used Repo 105, and failed to disclose it to the government, rating

agencies, investors, and the board of directors. It is believed that the auditor and the AC

were aware of the situation, and sufficient evidence from the bank examiner’s report

findings indicates a breach of fiduciary duties. However, the report states clearly that the

board of directors was unaware of Lehman’s Repo 105 program and transactions (page

945).

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This could be because the management has over powered the board or lack industry

knowledge from the part of the board and AC members as found by Cohen et al (2008) that

AC members with industry expertise are likely to have superior ability for understanding,

interpreting and assessing the quality of financial reports than members with no industry

expertise. However, when the top management takes control of the board agenda, the AC

might not be able to get right information to discharge it oversight duties (xxxxx et al,

2009). And this reveals the inability of the AC to act on behalf of the board as a sub-

committee of the board responsible to the board for reviewing the system of control over

the company’s business.

4.2.3 THE USE OF REPO 105

Repo is a financial instrument used by financial institutions routinely to transfer securities

under short-term arrangement to finance immediate liquidity needs. On who to control the

transfer asset FAS 140 provided that it should be treated as a financing arrangement or

sale (xxx, 2011 and xxxxx, 2013). Although, Repo 105 was in line with American accounting

standards, it purpose in Lehman was to deceive and they used techniques to reduced it

reported leverage substantially (xxxx, 2011). And it is observed that financial statement

fraud techniques vary by industry. In technology companies, the identified techniques are

in revenue recognition, while financial services sector’s fraud techniques relate to

misappropriation of asset (xxx, 2000). This is again confirmed by xxxxx et al (2010a) that

AC members with strong industry expertise would have sufficient knowledge to assess the

business activities and risk to be able to evaluate the appropriateness of the use of

accounting methods and whether estimate are realistic, leading to higher quality financial

reporting.

Lehman reported having over twenty operating committees to review risk decisions as

they claim “Risk management is one of the core competencies of the firm” (xxxxx, 2010).

Ultimately, the risk management structure appeared to be ineffective and dysfunctional as

they were disregarded in most cases of risk assessment (xxxxx, 2009, xxxxx, 2010, and

xxxxx, 2013). From all account, it appeared that “the top management wilfully certified the

accuracy of financial statement knowing they were inappropriate, and an accounting scandal

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was in making and the Sarbanes Oxley Act was violated”. This is because of the

ineffectiveness of the instituted watchdog due to power relation existing between the AC

and the management as observed by Turnbull (2004), that AC have not been working and

cannot be relied upon to protect investors unless they become a separate board elected by

investors on democratic rather than a plutocratic basis. AC is increasingly failing to deliver

on their responsibilities due to lack of risk awareness system in most of the organizations

(xxxx, 2013).

4.2.4 RESPONSIBILITY FOR PREDICTION PRVENTION OF FRAUDULENT ACT

AC is delegated with the responsibility of overseeing the financial reporting process of

companies as a subcommittee under the board of directors. In the case of Lehman the

discharge of these duties is lacking as claimed by xxxxx (2011) that warning signs were

apparently visible to detect the possibility for the bankruptcy of the firm, arguing that the

auditors and the AC ignored the statement of cash flows in their analysis as examination of

the statement revealed that “Although Lehman Brothers had $7.286 billion in cash and cash

equivalents on November 30, 2007, an analysis of its cash flows signal a major dysfunctions in

working capital management. Specifically, this is shocking for financial instruments: over a

three year period, they generated net negative cash flows of $161.657 billion.” The inability to

predict the catastrophe the firm faced by analysis clearly indicates that the AC either did

not understand the statement or were blind folded by superficial performance, which did

not allowed them to be inquisitive on a matter of concerns for more details (xxxxx, 2005).

Although, it is not the primary roles of the AC to detect a fraud, but it is expected the

auditors and AC working together should discover frauds or errors, which are material to

the financial statement (xxxx2004), the AC’s first priority should be to make sure financial

projection are sound (xxxxx et al, 2009). But that appeared to be lacking in the case of

Lehman brothers. Conclusively, xxxxx (2013) state that the net negative cash flows signal a

deficiency which could have been prevented, nevertheless, the AC and the auditors failed to

recognize the lack of correlation between the statement of cash flows with balance sheet

and income statements. More so, the 2005-2007 statement of cash flows of Lehman gave a

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clear prediction of the coming bankruptcy, which was completely detectable by careful

examination. xxxxx (2011) enumerated the signs for the distress in the cash flows

statement to include:

i. “Chronic inability to generate cash from operating activities

ii. Massive and systematic investment in working capital items and even more

intensive investment in financial tools and instrument.

iii. Systematic use of external financing to offset operating deficit, in which mainly

included long-term debt.

iv. Steady deterioration of cash flows over three years leading to crisis.

These were enough warnings for disaster appearing in the near future; the top

management were aware as members of Lehman tax department, maintain that they were

also aware of the trouble ahead (xxxxx, 2009). The system of bonuses in the investment-

banking sector has been identified as contributing factor toward substantial risk taking,

and some firms had limited understanding and control over their potential balance sheet

and liquidity needs that most of the allege fraud activities were undertaken by top

management members who want to look like an exceptional traders and achieve a higher

bonuses. The AC needs to better understand the behaviour and risks that a company’s

incentive plans encourage and whether such risks are appropriate (xxxx, 2009). In this

regard, xxxxx et al (2010) mention that in 2006, Lehman made a deliberate decision in

pursuing a higher-growth business strategy, by switching from low a low-risk brokerage

model to capital-intensive banking model, where they buy and stored asset, which

primarily should have been moved to the third party. All these were pre-warnings posed to

the monitoring mechanism (AC) to predict their probable consequences.

4.2.5 AVAILABILITY OF INFORMATION AND AUDIT COMMITTEE ROLES

According to xxxxx (2013), the effectiveness of AC can only be guaranteed when there is an

effective and independent source of information, the ability of the AC to obtain information

independent of the CEO and the CFO is crucial for effective oversight. The AC of Lehman

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Brothers were not well informed on what was going on with Lehman, as the Examiner’s

report found that “sufficient evidence show that Mr. Matthew Lee forwarded a whistle-blower

letter to the independent auditors apposite to Lehman Repo 105 activities and reporting on

$50 billion in the second quarter 2008, but the auditors failed to informed the AC of Lee’s

allegations, while they were aware that the financial information may be materially

misleading because of the failure to disclose the effect of the Lehman Repo 105” (Examiners

report volume 3 p.1033). Although, the AC make an effort during a meeting with the

internal and external auditors by requesting the external auditor to assist with the

investigation into the allegations made by Lee, the external auditor refused to informed the

AC about the Repo 105 claims by Lee, even though the AC asked to be told about each

allegations (xxxx, 2013).

The Actions of the external auditors and lawyers are clear negligence of duties, as both are

in the best position to assist in the evasion of ‘good faith’ obligations of an investment bank

and has a burden of protecting the public from ‘shams transactions (xxx, 2010). Evidence

also showed that “In the first quarter of 2008, while other investment bank were reporting

massive losses from written-downs heavy commercial and residential real estate holdings,

Lehman reported a profit by manipulating it equally troubled real estate portfolios comprised

of $25 billion in prime.” (xxxx, 2013). According to xxxx (2011) Lehman engaged in creative

and deceitful accounting practice, which temporarily removed securities and troubled

liabilities from Lehman balance sheet, recording the transactions as sales while reporting

quarterly financial result to public. The AC was unable to questions that due to cover up by

the management of the company and they lack information from other sources. In most

cases, as identified by xxxx et al (2009) that the management may take over the agenda

setting process like the case of (Enron, WorldCom and Hollinger) where the senior

management took control of the agenda and were able to control the flow of information to

the board and the AC. Beasley concluded that “information timeliness can be an important

issue and may reduce the ceremonial role played by AC.” This confirm the explanation of

xxxxx et al (2005), who said that information asymmetry always exist in the board and the

independent directors are always on the unprivileged side of this asymmetry.

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4.3 LIMITATIONS OF THE RESEARCH

Limitations of the study is that, it is solely based on secondary data without the inclusion of

primary data, which could have been used to gather the experience of the ACs members

through interaction, interviews and questionnaire. However, the nature of regulations

guiding the release of vital information from companies in the UK makes it difficult for the

researcher to use the primary data, despite it important as a source of information for

social science research of this nature. The use of only two case studies might not give the

required insight to understand the roles and the effectiveness of AC within the

organizational and institutional context. Therefore, the findings are either inconclusive or

limited. Time constraint is identified as limitation on the side of the researcher as case

study research is time consuming and require in depth investigation into the matter of

study before concluding. The study would have been appropriate and insightful if it was

conducted using both primary and secondary data, from existing companies. In that, it can

give the present view of ACs activities as against the information from the collapse

companies.

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CHAPTER FIVE

5.0 CONCLUSIONS AND SUMMARY OF FINDINGS

As outlined in chapter one, this thesis examined the roles and effectiveness of AC in the face

of incessant corporate failures; Chapter four discussed the roles and effectiveness of AC

from the perspective of two major failed companies. Over the past 7 decades, the AC

concept is receiving a considerable attention and growing from a committee saddled with

the responsibility of Nominating and arranging the engagement process of independent

auditors to a Committee now responsible for overseeing the integrity of the financial

statements of company, the review of the company’s internal financial control and

monitoring and reviewing the effectiveness of the company’s internal audit function. As

business environment is continuously changing and business risks are increasing, so did

the roles, responsibilities and challenges facing AC grew, especially in the wake of

corporate failures such as Enron, WorldCom, Pamalat, and Madoff.

The attention of regulators and academicians turned on the AC roles in the aftermath of the

2008 subprime crisis, seeking the way out to improve activities of the governance

mechanism and ensure investor’s confidence resurface on corporations. In most of the

corporate failures, the AC is being accused of not discharging their duties as required and

they are associated with the corporate failures. However, the roles of the AC is a

challenging one and it depend on so many factors to be discharged effectively as identified

by researchers (Independent, industry expertise, information flow, and inbuilt willingness

to serve by AC members), and the absence of any of such factors most often renders the AC

ineffective.

This study concludes that in most cases Companies report conformity with regulations by

having an AC that appears effective but is not actually effective in substance. However, the

presence of AC has enhanced the quality of financial reporting and affected the potential

threat of fraud to a certain degree. But lacks of industry specific expertise cripple the effort

of the AC.

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5.1 SUMMARY OF MAJOR FINDINGS

After evaluating the result, the study reveals the following key findings;

In both case scenarios, the perpetrated fraud could have been prevented if the ACs were

proactive in the discharge of their duties, because the signals existed long before the

occurrence of the failures. However, lack of information, which should have been supplied

by the auditors and whittles blower prevented the AC from predicting the looming failures

facing the companies. It is also found that the readily available information at the disposal

of the AC is the one provided by the management whom the AC is to monitor, however, it

was suggested by xxxxx (2013) that the effectiveness of AC can only be guaranteed when

there exist and effective and independent source of information.

The study also found that effectiveness of AC is not determined by either mandatory or

voluntary AC, as in both cases AC establishment is a mandatory requirement. All that is

needed is the understanding of the sector specifics risks associated with the company,

which is lacking by the AC members. Lack of harsh punishment on the negligence of AC

members also contributes to the laxness of the AC in the discharge of their duties. The

concept of AC entirely failed to recognized behavioural aspect of human being in the

formation of AC, while certain personality trait could not be ignored.

5.2 SCOPE FOR FURTHER RESEARCH

The findings of this study open further scope for research, as many areas need to be

studied and investigated for detail understanding of the actual process involved in AC

activities and the determinants of their effectiveness. Further research should include (i)

consideration on the AC behaviour to find what exactly is happening in the ACs meetings.

(ii) The research should investigate whether after appointment into the ACs, the

independent director continues to remain independent or not. (iii) Further studies should

theorize a concept that will ensure a continue training for ACs members on their roles and

the resultant effect of not doing their duties. (iv)Focus on the enhancement of information

flow between auditors and ACs. Therefore, a longitudinal case study method will suit this

study, as it can give an in depth information required to understand exactly how ACs

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behave, to be able to come up with a way out on how to improve the activities of the ACs.

The research could also be undertaking using a case study combined with survey method,

several benefits of case studies can be realized through open-ended questions and semi-

structured interviews and other methods of survey data collection.