CASE STUDIES OF INTERNATIONAL FINANCIAL REPORT

Question 1. In current research literature, the problem between external investors and corporate managers is known as the "agency issue." Give a brief overview over the "agency theory" and its application to Corporate Governance issues. What early steps were taken at B&O to reduce the "agency" problem? What was the impact of large investment from multiple external sources on B&O, its operations, and its governance? 1.1 Agency Theory and its application to Corporate Governance issue. Agency Theory is directed towards problems that arise when a principal hires an agent to act on behalf of the principals interests. In corporate governance, the Board of Directors are an example of an Agent, while the shareholders take the role of the Principal. These principal agent problems (also known as the agency dilemma) emerge under various conditions: Principal and agent have conflicts in objectives and interests. Verifying agents performance contains costly and time-consuming elements. Principal and agent have different attitudes towards risks.

Agency Theory is particularly concerned with aligning the principals and agents interests in order to avoid conflicts and achieve efficiency. 1.2 Solutions of B&O to reduce the agency problem In order to maintain the integrity of B&O management, the company had taken early steps to resolve the problem, in the following forms: Publishing an annual statement of affairs, as required by the B&O charter, including: o Presidents letter to the shareholders. o Management report on construction progress and operation. o Treasurers report. Appointing a routine audit committee to examine B&Os financial statements quarterly to inspect the accounts and funs and to examine the vouchers. Applying a voucher system to support the companys records of financial transactions, of which all the payments had been authorized by the Board of Directors.

1.3 Impact of large investment from multiple external sources on B&O, its operations, and its governance In B&Os particular case, the company was funded by a large number of investors from mutiple sources (both inside and outside the company) and was still in need of raising its current capital. Therefore, it is important for B&O to place an emphasis on its financial management. Thereby, an audit committee were appointed to supervise its accounting records quarterly, a voucher system is established in order to verify and record transactions. The large investment funded by the public also resulted in the Government playing a crucial role in the operations of the Board and B&O in general. Particularly, the representative Patrick Macauley of City of Baltimore was appointed as an member of the Board and the Audit Committee. This means that decisions made by the Board is also partly represented by the interests of the public citizens and the government. Question 2. In Joshua's initial assessment of the B&O investment, what factors should he consider in evaluating the B&O Board of Directors'?' Which factors of a "good" Board are present, which are absent, and which factors can not be assessed because insufficient information is available? Why is evaluating the B&O Board of Directors an important first step for Joshua in his evaluation and investment decision? 2.1 Factors to consider in evaluation of the B&O Board of Directors: Size of the Board: A large number of members might represent a challenge in communication and individual contributions, while a small number of members might result in a lack of experiences and expertises. Degree of Indepence: An effective Board should balance between the number of outsiders and insiders, since this increase the independence of the Board and enable it to increase the efficiency in corporate governance. Members personal commitment and time constraints: Members of the Board must be able to ensure his/her loyalty to the benefits of the organization, as well as dilligence is making decisions. This means that members must not neglect their duties (probably in order to focus on other duties) or exploit the organization for their own purposes. Members experiences and expertises in corporate governance: This involves leadership and financial management in particular.

Integrity in Performance: The Board must be able to report its activities to shareholders in an honest and precise manner.

2.2 Evaluation of the B&O Board of Directors: Factors of a good Board: Diversity of the Board: Members contained both outsiders and insiders from various fields (banker, landowner, merchant, real-estate developer, and government representative). Experience and Expertises of the Board: Members comprised of prominent businessmen with a high level of competence in leadership and financial management. For instance, Alexander Brown, a member of the Board, is an established investment banker whose firms had previously traded with Baring Brothers & Co. Financial commitment of the Board: Majority of members own 0.33% to 1.66% shares of B&O, which reflect their own commitment to the corporation, since the corporations rise or downfall will directly affect their benefits. The City of Baltimore was also represented with 16.66% of total stock ownership shares.

Absence of other factors: Integrity in members backgrounds: Indentities of some members were not revealed, thus their commitments and expertises were questionable, and the amount of stocks they hold was unknown (George Hoffman and William Stewart). William Stewart was also appointed to the audit committee, a position which requires financial qualifications, loyalty and honesty. Communication among Board members: The information available is not sufficient to evaluate this.

2.3 Importance in evaluating the Board of Directors as first step in investment decisions: As Joshua was not familiar with B&O and its operation, but was neverthelesss interested in investing in this company, he needed to evaluate its success factors. One of the most important success factors in an organization is its management,

and thus, Joshua decided to evaluate the Board of Directors to verify their expertises, commitment and confidence in the future of this organization. The B&O venture contains serious financial risks, therefore, the decisions of the Board is deemed vital to the successful completion of the railroad. In addition, as members of the Board are mainly external investors with various connections in banking and investment, it proves these investors have a certain amount of confidence in B&O and its potential in generating profits. Thus, this is an important factor for Baring Brothers & Co. to decide whether to invest in B&O or not. Question 3. Describe the importance of the audit committee's role in B&O's survival. What essential functions did these committees perform for the B&O? How are these functions carried out today? 3.1 Importance of the audit committee in B&Os survival. In B&Os particular case, the company was funded by a large number of investors from mutiple sources (both inside and outside the company) and was still in critical need of raising its current capital. Thus, the audit committeee is appointed to oversee its accounting records and internal external, thereby satisfying its current investors, gaining the trust of potential investors and keeping its financial expenses in check. "The Audit committee refers to the governance body that is charged with oversight of the organizations audit and control functions. Although these fiduciary duties are often delegated to an audit committee of the board of directors, the (...) Practice Advisory is also intended to apply to other oversight groups with equivalent authority and responsibility, such as trustees, legislative bodies, owners of an owner-managed entity, internal control committees, or full boards of directors" (IIA Practice Advisory 2060-2 of 2004). 3.2 Essential functions performed by the audit committee. Inspect the accounts and funds of the company, examine vouchers for all expenses, and report accordingly. o Examined and reported on Treasurers Account quarterly, identified oversights in the recorded transactions. o Investigated the construction spending practices of superintendent Casper W. Wever, and reported accordingly.

Recommended possible solutions to increase internal financial control (for example, suggestion for a voucher system, suggestion for reforming organizational structure after the liquidity crisis).

3.3 Performance of audit committees functions in the modern business world. Nowadays, in the post-Enron world, audit committees functions are regulated by the Sarbanes Oxley Act of 2002, a United States federal law that set standards for general management and accounting practices in U.S public companies and organizations. The bill was the Governments reaction to a serious of major accounting scandals at Enron, Tyco International and World Com, which costs investors billion of dollars and shake their confidence in the management securities of these corporations. Question 4. What problems did the audit committee find and report? The audit committee has found minor errors as well as serious problems in its investigation, particularly: Errors in statement of account balance (9/100 instead of 19/100) (Audit report of October, 1827). Questionable 2.5% fee charged by engineers, accepted by the President. (Audit report of October, 1827). Minor errors in date (June 31st was meant to be June 30th) (Audit report of June, 1828). Questionable accounting for the discount on notes (Audit report of December, 1829). Laborers has been overpaid $1.86 by B&O (Audit report of March 31st, 1830). Postage of $54.49 for employees personal mails (thus the voucher system was suggested) (Audit report of March 31st, 1830).

The audit committee also reported on other operational issues, particularly the construction spending practices and application of the voucher systems, based on which it suggested a reorganization in order to resolve internal control issues. Question 5. Describe specific instances of internal control weaknesses at the B&O. What were the consequences? What steps were taken to strengthen the internal controls? 5.1 Specific instances of internal control weaknesses at B&O: Lack of financial planning (underestimation of railroad construction costs).

Lack of complete documentation (vouchers) and lack of work measurement system. Weak liquidity with only a fraction of equity capital being received in cash, thus in cases of short-term crisis, the organization will face serious problems of not being able to cover the costs. Lack of communication (Superintendent withholding true costs of construction from the management). Lack of a coherent, streamlined structure in duties, responsibilities and reporting authority, resulted in overlapping in authority and conflicts in responsibilities.

5.2 Consequences of the aforementioned weaknesses: Because of these weaknesses, B&O could not control its financial situation effectively, which resulted in the cash flow crisis. The superintendent Wever had requested funds freely without proper documentation or work measurement to support payment. Therefore, the payment to contractors had exceeded its contractual amounts, and the company did not have sufficient funds to cover the cash outflow. The superintendent has also been in constant conflicts with the Board of Engineers over issues such as the voucher systems, contracts and regulations. 5.3 Solutions to strengthen internal controls The audit committee has suggested a re-organization system in order to strengthen internal controls streamlining authority in reporting, duties and responsibilities and removing overlapping in responsibilities. The system removed the Board of Engineers and added the following positions: Chief Engineer. Superintendent of Construction. Auditor. Treasurer.

The re-organization scheme also tighten the organizations financial management, as incomplete vouchers will no longer be accepted, and complete vouchers will only be paid if accepted by the auditors. Question 6. What was the purpose of the voucher system? What information would be necessary in the voucher for a contractor to be paid? Why did the B&O use the voucher system, adopted from the federal government, at a time when businesses typically did not have such a formal system?

6.1 Purpose of voucher system. Voucher system is an internal financial control system which help to clarify and record details of each cash or check payments. Vouchers establish the legality of the transaction, name of the person and the amount being paid, and name of the ledger accounts on which the transaction will be recorded. 6.2 Information required for a voucher to be paid Amount being paid. Propriety of the transaction (reasons and legality). Name of the person being paid. The ledger accounts on which the transaction will be recorded (?).

The B&O applied the voucher system, which was adopted from the federal government, in order to strengthen its internal control over cash or check payments (The organization needs to disperse funds to contractors as well as other entities during the construction process as soon as possible). With the voucher system, information of each transaction will be recorded in its ledger accounts, and Question 7. How did the reorganization improve the B&O's chances of survival? The reorganization, suggested by the audit committee, has improved the internal control weaknesses of B&O by clarifying the duties, responsibilities and reporting authority within the organizations and avoid any overlapping or conflicts in duties. This is enabled by the dismissal of the Board of Engineers and replace them by the Chief Engineer and Superintendent of Construction. Other officers, auditor and treasurer, are added to the system to handle the internal accounting records. With this system, the weakness of the voucher system was improved, as the vouchers must be complete and approved by the auditor before the treasurer pays it. Therefore, B&O can increase its internal control and steer clear from short-term liquidity crisis that arose from weaknesses in financial management. Question 8. What corporate title would the "auditor" job created after the B&O 1830 reorganization carry today? Chief Financial Officer (?) Question 9. Describe why an external investor such as the House of Barings might focus on the make-up of the Board of Directors and the role it plays in governing the

corporation. Why should the audit committee's activities also be of particular interest to an external investor such as Barings? 9.1 Make-up of the Board of Directors and its role in governing the corporation The Board of Directors is absolutely important in governing a public corporation such as B&O, as they are jointly responsible for the oversight of the overall corporate governance, including financial management, human resources management, and so on. Thus, the make-up of the Board (including various backgrounds in financial management and corporate leadership) and the personal commitment of each Board member is a matter of important to Baring Brothers & Co. The Board s duties are generally defined in the Code of By(e) Laws, which may include: Establishing objectives and policies. Overseeing financial accounting procedures. Ensuring the availablity of adequate financial resources. Approving annual budgets. Accounting to the stakeholders for the organizations peformance.

Therefore, the existence of a Board is to ensure consistent management as well as coherent processes, policies, and guidance within an organization. 9.2 Audit committees activities The activities of the audit committee within the Board of an organization is still of critical importance nowadays, not only for B&O in the 19th century. The efficiency of the audit committee will determine the integrity of the corporate governance within B&O, as if certain oversight occurs, individual or group of individuals will be able to commit fraud and exploit the organization to their own interests. The audit committee also oversee proper risk management, effectiveness of internal control process, financial reporting and accounting, which are important factors for a successful venture. Question 10. Describe the purpose of an external audit. In today's business environment, who is the "client" that the auditor represents and protects in the audit examination? Why is this important issue? 10.1 Purpose of an external audit An external audit is a periodic or ad-hoc auditing process conducted by a certified accountant to supervise the accounting records of an organization. The auditor performs

trictly under the provisions of GAAP and prepares a precise report on the organizations financial position and the results of its operations. Thus, external audit represents an indepentdent, impartial view of an entitys financial standing. 10.2 Client of the auditor Nowadays, clients of the auditor are organizations (such as companies and goverments) who need to verify their financial documents in order to produce an audit report on the outcome, and the users of this information, such as shareholders, investors, government agencies, and the public. In these cases, auditor is an independent individual who perform the audit on the organizations but with the shareholders interests in mind. This is an important issue as the auditor needs to maintain his/her indepence from the company even though the company has hired the auditor to verify its financial standing. If the external auditor detects errors or fraud, it is his/her responsibility to present this to the management and reflect the information honestly in the audit report. Question 11. Comment on management's integrity as demonstrated by the B&O's President and by the Superintendent of Construction. Why should Barings be concerned about such management integrity issues? B&O suffers from criciticism and crisis because of its management integrity issues. The Superintendent of Construction was not able to justify his payments to contractors by documentation or work measurement, had constant conflicts with the Board of engineers, underestimated the construction costs and was slow in reporting the cost overruns to the Board. This resulted in the short-term liquidity crisis that jeopardized the future of B&O. The President also faced criticism as shareholders believed that he failed to take financial burden during the crisis and that he was overpaid. In this case, the shareholders doubts were due to the fact the Presidents personal salary was never clarified to the public, and the feeling that the President might pursue his personal benefits and dump the financial difficulties on the shareholders. Barings Brother are concerned about such issues as, from the viewpoint of an external investor, integrity of management is absolutely crucial. Without a proper internal control mechanisms, it is possible to the President, the Superintendent or any members of the organization to violate regulations and exploit the organizations to their own interests. With an organization that relies on multiple sources of investors like B&O,

healthy financial management is the key to winning their trust and maintain constant source of capital. Question 12. The "statement of affairs" was required by the B&O charter to be issued annually by the President to the shareholders. This practice evolved quickly into the forerunner of modern corporate annual reports, complete with financial statements. Explain how the "statement of affairs" /annual report/financial statement are important corporate governance and external control mechanisms. The statement of affairs, consisting of the annual report and financial statement, is an important control mechanisms as it reflects the overall financial standing of the organization as well as the performance of the management, and detect any possible errors or risks in the future that managers should be aware of.