1. Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 14: Comparative International Auditing and Corporate Governance

2. Chapter Topics  Recent trends in international corporate governance  International diversity in external auditing  International harmonization of auditing standards  Auditor liability and independence  Role of audit committees  Ethical issues involved in external auditing at the international level  Internal auditing issues in an international context  Audit regulation 14-2

3. Learning Objectives 1. Define corporate governance and discuss the circumstances that caused it to receive worldwide attention in recent years 2. Describe the corporate governance guidelines at the international level 3. Explain the link between auditing and corporate governance in an international context 4. Examine international diversity in external auditing 5. Describe the steps taken toward international harmonization of auditing standards 6. Discuss the issues concerning auditor liability and auditor independence 14-3

4. Learning Objectives 7. Explain the role of audit committees 8. Discuss the ethical issues involved in external auditing at the international level 9. Examine internal auditing issues in an international context 10. Describe the provisions in the Sarbanes-Oxley Act of 2002 in relation to auditing issues 14-4

5. International Trends in Corporate Governance  Recent corporate 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  Includes detailed provisions pertaining to corporate governance and auditing  These events in the U.S. are consistent with a worldwide movement to improve corporate governance and auditing 14-5

6. 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”  Make clear that the board of directors has ultimate responsibility for governance  Formed the basis of the corporate governance component of the World Bank/International Monetary Fund’s Reports on the Observance of Standardsand Codes(ROSC) 14-6

7. International Auditing and Corporate Governance OECD guidance  In 2004, revisions to the corporate governance code point out that external auditors should answer to shareholders  Highlighted the board of director’s responsibility for overseeing financial reporting  Also strengthen shareholder rights in most OECD member countries 14-7

8. International Auditing and Corporate Governance The International Federation of Accountants (IFAC) 2007 survey “Financial Reporting Supply Chain—Current Perspectives and Directions”  Positive areas include:  Increased awareness that good corporate governance counts  New codes and standard improvements in board structure  Risk management  More transparency in reporting  5 areas of concern:  Governance in name, but not spirit  Overregulation  Checklist mentality  Personal risk/liability for directors and senior management  Cost/benefit 14-8

9. International Auditing and Corporate Governance The International Federation of Accountants (IFAC) 2007 survey “Financial Reporting Supply Chain—Current Perspectives and Directions”  Proposed improvements:  Behavioral and cultural aspects of governance  Review of existing rules  Quality of directors  Better relation of remuneration to performance  Expansion of view from compliance governance to business governance 14-9

10. 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  Tightened definition of “independent” audit committee members  External auditors to report directly to audit committee  Prohibitions on certain nonaudit services by external auditors  Increased penalties for financial statement fraud  The NYSE followed suit by introducing additional listing requirements related to corporate governance 14-10

11. International Auditing and Corporate Governance Financial Reporting Council (FRC) in the U.K. published “The Audit Quality Framework” in 2008 which provides key drivers of audit quality:  The culture within an audit firm  Audit partners’ and staffs’ skills and personal qualities  Effectiveness of the audit process  Reliability and usefulness of audit reporting  Non-controllable factors affecting audit quality 14-11

12. International Auditing and Corporate Governance In their 2009 annual report Volkswagen Group in Germany said:  “Sustainable economic success can only be generated in our company if we comply with international rules and standards, because that is the only way to strengthen the trust of our customers and investors. Transparent and responsible corporate governance takes the highest priority in our daily work….” 14-12

13. International Diversity in External Auditing Background  Globalization is leading to increased importance of auditing internationally  Significant international diversity exists in various aspects of auditing  Purpose of external audits varies between countries  Environment in which auditing takes place varies  Regulation of the audit function varies  The content of audit reports also varies 14-13

14. International Diversity in External Auditing Purpose of auditing  In the U.S. and U.K., 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 14-14

15. 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 14-15

16. 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 14-16

17. 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 14-17

18. International Diversity in External Auditing Regulation of Auditors and Audit Firms  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 14-18

19. 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 14-19

20. 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 14-20

21. International Harmonization of Auditing Standards  The International Federation of Accountants (IFAC) develops international auditing standards  Through International Auditing and Assurance Standards Board (IAASB)  IFAC’s Forum of Firms, as well as its Compliance Committee, deal with international regulation and compliance  IFAC’s efforts at harmonization are supported by the International Organization of Securities Commissions (IOSCO) 14-21

22. International Harmonization of Auditing Standards IFAC pronouncements  A set of International Standards on Auditing consisting of nine sections has been published  Section 200 covers auditor responsibilities in conducting an audit  Section 500 deals with audit evidence  Section 700 covers audit reports  Sections 800 deals with engagements other than a standard audit  PCAOB is proposing Rule 4012 where the board would place full reliance on the inspection program of non-U.S. auditor oversight entities 14-22

23. 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.) 14-23

24. 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.) 14-24

25. 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 U.K. 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 14-25

26. Auditor Liability and Independence Limiting Auditor’s Liability  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 U.K. auditors use these, but the U.S. SEC rejects them as invalid 14-26

27. 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  Auditor independence is a subject of intense debate internationally as well as in the U.S. 14-27

28. 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  Separating consulting operations from the auditing practice  Increasing the stringency of admission criteria to the profession 14-28

29. Auditor Liability and Independence Proposals to strengthen auditor independence  A principles-based approach to auditor independence, in contrast to a lengthy set of “bright- line” rules, which would maintain some specific rules  A conceptual approach that includes no list of specific prohibitions  Focuses on the underlying aim rather than detailed prohibitions 14-29

30. Audit Committees Audit committees – United States  Committee of the board of directors responsible for financial reporting oversight  Increased attention has been paid to this topic in recent years  In the U.S., the Blue Ribbon Committee made a series of recommendations to enhance its role  Sarbanes-Oxley includes specific provisions 14-30

31. Audit Committees Audit committees – Internationally  Increasingly being seen as an important component of corporate governance  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  Also now required for publicly listed companies in Malaysia and Singapore 14-31

32. Ethical Issues in International External Auditing  Can the moral standing of the accounting profession be based on a consensus of international morals and values?  Formerly local professional fundamentals and values are now global  IFAC provides ethics education  PIOB (Public Interest Oversight Board) oversees work of IFAC committees and considered and approved revised Code of Ethics for Professional Accountants issued by the Accounting Practices Board  The revised code clarifies requirements for all professional accountants and significantly strengthens auditor independence requirements 14-32

33. Ethical Issues in International External Auditing  Walker Review into Corporate Governance of UK banks emphasizes accountability over how banks are run  Ethical codes may offer opportunities for “creative accounting”  Focus on individual benefits has led to recent corporate failures  U.S. has focused on rules of behavior rather than social norms and this is not always the best path  A more communitarian view of professional ethics may be needed 14-33

34. Internal Auditing Internal auditing – Background  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  Can enhance the effectiveness of internal controls over financial reporting  The clearest difference between external and internal auditing is the consulting function of the latter, particularly in risk management 14-34

35. Internal Auditing Internal auditing – Background  Given their complexity, multinational corporations (MNCs) are increasingly demanding risk management consulting  Internal auditors also commonly perform compliance audits, and effectiveness and efficiency audits  PCAOB’s Auditing Standard No. 5 “An Audit of Internal Control Over Financial Reporting” implements Sections 103 and 404 of the Sarbanes-Oxley Act  It must be used for all audits of internal controls no later than for fiscal years ending on or after November 15, 2007  This standard applies a principles-based approach and eliminates unnecessary procedures from the audit 14-35

36. Internal Auditing The Foreign Corrupt Practices Act (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  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 14-36

37. Sarbanes-Oxley and the Future of Auditing  Most significant legislation pertaining to financial reporting and auditing since the establishment of the SEC in the 1930s  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 14-37

38. 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 14-38

39. End of Chapter 14 14-39