Comparative International Auditing and Corporate Governance Chapter 13 Comparative International Auditing and Corporate Governance

Comparative International Auditing and Corporate Governance Chapter Topics Recent trends in international corporate governance. International diversity in external auditing. Harmonization of international external auditing. Auditor liability and independence. Audit committees. International internal auditing. Audit regulation.

Comparative International Auditing and Corporate Governance Learning Objectives 1. Define corporate governance and discuss the circumstances that caused it to receive worldwide attention in recent years. 2. Explain the link between auditing and corporate governance in an international context. 3. Examine international diversity in external auditing. 4. Explain the steps take toward international harmonization of auditing standards.

Comparative International Auditing and Corporate Governance Learning Objectives 5. Demonstrate an understanding of the issues concerning auditor liability and auditor independence. 6. Explain the role of audit committees. 7. Discuss internal auditing issues in an international context. 8. Discuss the provisions in the Sarbanes-Oxley Act of 2002 in relation to auditing issues.

International Trends in Corporate Governance Recent accounting scandals, particularly those in the U.S. (e.g., Enron, WorldCom) have led to increased focus on corporate governance. The Sarbanes-Oxley Act of 2002 was a direct response to these scandals. This act includes new rules pertaining to corporate governance and auditing. These events in the U.S. are consistent with a worldwide movement to improve corporate governance and auditing. Learning Objective 1

International Auditing and Corporate Governance OECD guidance Principles of Corporate Governance (1999) provide guidance to help governments improve corporate governance within their borders. Corporate governance, “…involves a set of relationships between a company’s management, its board, its shareholders, and other stakeholders.” These principles also make clear that the board of directors has ultimate responsibility for governance. Learning Objective 2

International Auditing and Corporate Governance OECD guidance In 2004, revisions to the corporate governance code point out that external auditors should answer to shareholders. These revisions also highlight the board of directors responsibility for overseeing financial reporting. These revisions also strengthen shareholder rights in most OECD member countries. Learning Objective 2

International Auditing and Corporate Governance Sarbanes-Oxley Act of 2002 Public Company Accounting Oversight Board (PCAOB) was created to oversee the accounting profession. Certification of financial statements by CEOs and CFOs. External auditors to report directly to audit committee. Restriction on allowable non-audit work for auditors. Increased penalties for financial statement fraud. The NYSE followed suit by introducing additional listing requirements related to corporate governance. Learning Objective 2

International Diversity in External Auditing Background Globalization is leading to increased importance of auditing internationally. Significant international diversity exists in various aspects of auditing. The purpose of external audits varies between countries. The environment in which auditing takes place varies. Regulation of the audit function varies. The content of audit reports also varies. Learning Objective 3

International Diversity in External Auditing Purpose of auditing In the U.S. and UK, the purpose of the external audit is to provide assurance that the financial statements are fairly presented. In the U.S., Sarbanes-Oxley also requires audits of internal controls. Such a report provides assurance about the process of financial statement preparation. In Germany, auditors are also responsible for evaluating the report of management. Learning Objective 3

International Diversity in External Auditing Purpose of auditing International variation in the purpose of audits seems to be related to differences in corporate governance structure. The supervisory board in Germany has essentially equivalent responsibilities to a U.S. board of directors. German law includes specific regulations about the composition of the supervisory board. German supervisory boards are more broadly representative than their U.S. equivalent. Learning Objective 3

International Diversity in External Auditing Environment of auditing – Culture and history Cultures that value saving face and societal harmony are less accepting of the questioning inherent in auditing. Collectivist cultures often distrust outside auditors. Recent Chinese history of state-owned enterprises is related to explicit limits regarding application of lower-of-cost-or-market and allowance for bad debts. All of these factors can surprise auditors from a western perspective. Learning Objective 3

International Diversity in External Auditing Environment of auditing Countries with less developed financial infrastructure would need less sophisticated auditing. When banks or families are the primary source of financing, there is less demand for auditing. Common law countries tend to have a more influential auditing profession relative to code law countries. Audit quality and independence are likely to be influenced by level of rigor to join the profession and by the extent of legal liability assigned to auditors. Learning Objective 3

International Diversity in External Auditing Audit regulation Auditing in Anglo-Saxon countries has historically been self-regulated However, recent scandals have led to increased government oversight. In many other countries (e.g., Germany, China) government exercises much more control. Auditor qualifications vary significantly from country to country. Learning Objective 3

International Diversity in External Auditing Audit reports The content of audit reports varies significantly between countries, and sometimes between companies in the same country. For example, audit reports sometimes refer to local audit standards, non-local audit standards, multiple sets of audit standards, or are addressed to different audiences. The Sarbanes-Oxley Act in the U.S. includes a requirement to provide assurance on the internal controls. Learning Objective 3

International Harmonization of Auditing Standards International auditing has historically received less attention than international accounting. Recently, globalization has increased the importance of cross-national understanding of audit reports. Harmonization of international auditing standards will help increase consistency of auditing worldwide. The increased level of assurance on financial statements should result in more efficient global capital markets. The International Federation of Accountants (IFAC) develops international auditing standards. Learning Objective 4

International Harmonization of Auditing Standards IFAC The International Auditing and Assurance Standards Board (IIASB) is the entity that develops international auditing standards. IFAC’s Forum of Firms and Compliance committee deal with international regulation and compliance. IFAC’s efforts at harmonization are supported by the International Organization of Securities Commissions (IOSCO). Learning Objective 4

International Harmonization of Auditing Standards IFAC pronouncements A set of International Standards on Auditing consisting of nine sections have been published. Section 200 covers auditor responsibilities in conducting an audit. Section 500 deals with audit evidence. Section 700 covers audit reports. Sections 800 and 900 deal with engagements other than a standard audit. Learning Objective 4

Auditor Liability and Independence Auditor liability -- Background Auditors are subject to civil liability, criminal liability, and professional sanctions. Civil liability can result from breach of contract or civil duty (e.g., negligence). Criminal liability can result from criminal conduct (e.g., fraud). Professional sanctions can result from violation of the rules of a professional body. The potential for legal liability varies internationally and is highly significant in some countries (e.g., the U.S.). Learning Objective 5

Auditor Liability and Independence Auditor liability – Recent events Andersen, a big five firm, was effectively put out of business by a criminal conviction, later overturned, in connection with its Enron audit. One remaining big four firm, PricewaterhouseCoopers, suggested to UK authorities that auditors are in a legally untenable position. A 1998 German court decision resulted in auditors being liable to third parties for the first time in that country. Learning Objective 5

Auditor Liability and Independence Auditor liability – Possible reforms Several solutions to limiting auditor liability exist in order to limit potential damage to firms. Change of ownership structure to limit or eliminate joint and several liability. Proportionate liability that limits auditor liability to the proportion for which they are deemed responsible. Statutory caps to limit damages. Disclaimer of liability to avoid unintended liability. Some UK auditors use these, the U.S. SEC rejects them as invalid. Learning Objective 5

Auditor Liability and Independence Auditor Independence -- Background Independence is a fundamental principle of auditing. Auditors in the U.S. are required to adhere to a detailed set of independence rules. The SEC has additional rules for auditors of public companies. An SEC report in 2000 cited numerous violations by big five auditors. Auditor independence is a subject of intense debate internationally as well as in the U.S. Learning Objective 5

Auditor Liability and Independence Proposals to strengthen auditor independence Involvement of stockholders in auditor appointment. Restrictions or prohibitions of certain consulting activities. Increased regulatory oversight. Increased involvement by the board of directors and audit committee. Mandatory rotation of audit firms or engagement partners. Learning Objective 5

Auditor Liability and Independence Proposals to strengthen auditor independence Separating consulting operations from the auditing practice. Increasing the stringency of admission criteria to the profession. A principles-based approach to auditor independence, in contrast to a lengthy set of “bright-line” rules. This approach maintains some specific rules. A conceptual approach similar to the above but that includes no list of specific prohibitions. Learning Objective 5

Audit Committees Audit committees – United States The audit committee is a committee of the board of directors responsible for financial reporting oversight. Beginning in the 1990s, increased attention has been paid to this topic. In the U.S., the Blue Ribbon Committee made a series of recommendations to enhance the role of the audit committee. Sarbanes-Oxley includes specific provisions related to audit committees. Learning Objective 6

Audit Committees Audit committees – Internationally Audit committees are increasingly being seen as an important component of corporate governance. There is wide acceptance globally that the auditor works for the audit committee. Australia, for example, requires listed companies to have audit committees composed completely of outside directors. Audit committees are also no required for listed companies in Malaysia and Singapore. Learning Objective 6

Internal Auditing Internal auditing -- Background Internal auditing is “an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations.” The SEC requires an internal audit function of public companies. Internal audit can enhance the effectiveness of internal controls over financial reporting. Learning Objective 7

Internal Auditing Internal auditing -- Background The clearest difference between external and internal auditing is the consulting function of the latter, particularly risk management. Given their complexity, multinational corporations (MNCs) are increasingly demanding risk management consulting. Internal auditors also commonly perform compliance audits, and effectiveness and efficiency audits. Learning Objective 7

Internal Auditing The Foreign Corrupt Practices Act Foreign Corrupt Practices Act of 1977 (FCPA) requires companies to maintain effective internal controls and not pay bribes. The logic is that effective internal controls over financial reporting will mitigate the risk of bribe payments. This legislation was a reaction to the discovery, in the 1970s, that many U.S. companies did pay bribes. Enforcement of the FCPA has resulted in large fines against major U.S. companies. Learning Objective 7

Sarbanes-Oxley and the Future of Auditing Sarbanes-Oxley is the most significant legislation pertaining to financial reporting, and auditing, since the establishment of the SEC in the 1930s. The act has had an observable impact on business, one example of which is the increase in financial expertise on audit committees. Companies have spent significant resources enhancing internal controls. On a more negative note, many financial executives are experiencing increased stress due to Sarbanes-Oxley. Learning Objective 8

Sarbanes-Oxley and the Future of Auditing Other international audit issues There is increased demand for internet-based financial reporting and the related assurance. Continuous assurance on real-time information. Increased competition in the audit market. Increased exposure of international audit firms. The risk that increases in litigation will lead to more of a checklist approach to auditing. The enhanced partnership between external auditors, internal auditors, and audit committees. Learning Objective 8