Hayes Ed3 2014 CH 15

Slide 15.
Principles of Auditing: An Introduction to

International Standards on Auditing
Chapter 15 – Corporate Governance and

the Role of the Auditor
Rick Hayes, Hans Gortemaker

and Philip Wallage
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 15.2
Corporate governance discussion
Illustration 15.1 Causes of Current Discussions
Slide 15.3
The nature of corporate governance

• The board of directors sets the mission, vision,
objectives and strategy of the entity.
• Governance deals with managing as a key responsibility
of the board.
• Board’s responsibility is to design and monitor controls
that reasonably assure that objectives are met.
• The third element of Governance is supervision.
Independent supervision of management performance
and remuneration is especially crucial.
• Governance includes transparency to all stakeholders
that can be recognised.
Slide 15.4
Definitions of corporate governance

• ‘Corporate Governance is the process and structure
used to direct and manage the business and affairs
of the corporations with the objective of enhancing
shareholder value, which includes ensuring the
financial viability of the business. The process and
structure define the division of power and establish
mechanisms for achieving accountability among
shareholders, the board and management.’
• ‘The system by which companies are directed and
controlled.’ – The Cadbury Report
Slide 15.5
Stakeholders
• Corporate governance has the objective of
enhancing shareholder value. But it also take into
account the impact of decisions on other
stakeholders.
– Stakeholders are the community, the general public,
consumer groups, etc.
• The stakeholder relationships include a relationship
between the community and the firm, between
governments and firms and between community
and governments.
Slide 15.6
As the degree of trust decreases, the

demand for control, supervision and
transparency increases…
‘Trust me’
High
‘Tell me’
‘Show me’
Asia
Europe USA
Low
Low High
Transparency
Slide 15.7
Transparency
Transparency forms the backbone of good corporate
governance and requires a sophisticated system of
accounting. Such a system should:
• allow investors to assess the magnitude and timing of
future cash flows to be generated by a business;
• encourage efficient operations and maximisation of
results;
• provide an early warning of problems in meeting
objectives of the firm;
• lead to quick corrective action whenever things go bad.
Slide 15.8
Corporate governance structures

Two types:
1. Market corporate governance structure
2. Network corporate governance structure
– Market-oriented countries are more aggressive and
confrontation-seeking, while network cultures seek
consensus instead of conflict.
– In Market countries, shares are widely distributed among
individuals. In network countries, banks, insurance
companies and other institutions mainly hold shares.
As a consequence, stock exchanges play a more
important role in market-oriented countries.
– Another major difference is the two-tier separation
between the board of management and the supervisory
board in the network structure vs. one board in the market
system.
Slide 15.9
CG models – structure
Market-oriented Network-oriented
Anglo-Saxon Continental
• Shareholders (scattered • Shareholders (banks,
individuals) institutions)
• Stock exchange important • Stock exchange less
(outsider) important (insider)
• Confrontation • Consensus
• Short term horizon • Long term horizon
• Shareholder relations • Stakeholder approach
• One tier board structure • Two tier board structure
Slide 15.10
Codes of corporate governance

Codes of conduct
Combined Code
• Crises in market-based
Cromme
governance
– Great Crash of 1929
Tabaksblat
– The dot-com bubble
• Crises in regulation, self-regulation
King – Maxwell, BCCI, Polly Peck
• Combined Code
Lippens – Enron, WorldCom

• Sarbanes–Oxley; NYSE, Nasdaq
listing rule changes
Viénot
• Codes emerge with quasi-legal
status
… and more
• Governing the governors
www.ecgi.org
Slide 15.11
The Sarbanes–Oxley Act consists of 11

sections
I. – Public Company Accounting Oversight Board
II. – Auditor independence
III. – Corporate Responsibility
IV. – Enhanced Financial Disclosures
V. – Analyst Conflicts of Interest
VI. – Commission Resources and Authority
VII. – Studies and Reports
VIII. – Corporate and Criminal Fraud Accountability Act of 2002
IX. – White-Collar Crime Penalty Enhancements
X. – Corporate Tax Returns
XI. – Corporate Fraud and Accountability
Slide 15.12
European Union laws

The EU Action Plan for Company Law, pays attention
to the need for regulator response at the European level.
A 2001 comparative study concluded that the
EU should not devote time and effort for the
development of a European corporate governance
code.
Slide 15.13
European Union laws (Continued)
Slide 15.14
Best practice from a global perspective
Four elements of governance:

I. Managing including board responsibility
II. Supervision
III. Internal control
IV. Transparency.
Slide 15.15
I. Managing best practice
An important element of governance is ‘managing’

which includes the concepts of mission, strategy,
objectives and compatibility with societal
objectives.
Slide 15.16
Board responsibility
The board defines the company’s strategy,

appoints the corporate officers responsible for
managing the company and implementing this
strategy, oversees management and ensures
the quality of information provided to
shareholders and to financial markets through
the financial statements.
Slide 15.17
Certification of SEC reports by

executives
• Chief executive and financial officers of US-listed
companies have to certify annual and quarterly reports
filed with the SEC.
• Certification means that these executives reviewed the
reports and based on their knowledge there are no untrue
statement or omission of material fact, and the statements
fairly present the Company’s financial condition.
• Signing officers also certify that they evaluated the
effectiveness of disclosure controls and procedures.
• By signing they also confirm that disclosures have been
made to auditors and audit committee of all significant
deficiencies in internal control or any fraud that involves
employees with significant role in internal control.
Slide 15.18
II. Supervising best practice

• Good corporate governance requires a system of
independent supervision and active oversight of
management.
• A reduction on management influence over boards is
generally achieved by rules that ensure the independence
of non-executive members of the board or, in Continental
European countries, supervisory board members.
• According to Anglo-Saxon best practice, the board
represents the shareholders – not other constituencies,
although some countries hold that the board represents
all stakeholders.
• Appraisal of individual directors is a key element of
corporate governance including designing and approving
appropriate remuneration scheme.
Slide 15.19
Audit committees
• Since 1978, the major American stock
exchanges have required listed firms to have
audit committees comprised of independent,
outside, directors who own relatively little stock
in a firm and who are not members of management.
• They have responsibilities for monitoring
management, corporate reporting and relations
with the independent auditor.
• They meet with the internal and external auditors,
reviewing financial statements before they are issued
to the public, and, in certain circumstances, taking
action to control management.
Slide 15.20
Audit committee (Continued)

Independent directors
Audit committee members should not receive fees
other than for board service and should not be an
‘affiliated person’ of the company.
Financial expert
At least one member of its audit committee must be a
‘financial expert’ (expertise in US GAAP).
Auditor oversight
Responsible for oversight of external reporting,
internal controls and auditing, and the appointment
and compensation of the auditor.
Whistle-blower communications
Confidential and anonymous submissions by employees.
Slide 15.21
SOX: Auditor reports to audit committee

All critical accounting policies and practices in use
by the publicly listed company.
GAAP alternatives discussed with management
and any alternative preferred by the audit firm.
Other material written communications such as
management letters and unadjusted audit
differences.
Slide 15.22
III. Internal control best practice

The US Treadway Commission
Recommended that internal controls could prevent and detect fraud
and that guidelines be developed by COSO.
The Cadbury Committee in the UK
Code of Best Practice deals with internal controls as defined
by COSO.
Section 404 (SOX 404)
Requires the annual report of issuers to contain management
reports which state management responsibility for internal
control structure and procedures and give an assessment of
effectiveness.
Internal Audit Department
COSO says internal control component ‘monitoring’ includes
the contribution of an internal audit department.
Slide 15.23
SOX: Auditor report on management’s

assertion about internal controls
SOX 404 requires management reports on the
effectiveness of internal controls and the auditors
attest to management’s assertions.
For instance, PCAOB Audit Standard #5:
auditor should:
• obtain understanding of internal control and
management’s evaluation;
• evaluate design effectiveness of controls;
• test and evaluate the operating effectiveness of
controls;
• form an opinion.
Slide 15.24
Internal control
Netherland’s Corporate Governance Code II.1.5
‘As regards financial reporting risks the management

board states in the annual report that the internal risk
management and control systems provide a reasonable
assurance that the financial reporting does not contain
any errors of material importance and that the risk
management and control systems worked properly in
the year under review. The management board shall
provide clear substantiation of this.’
1
Process 1
and
Slide 15.25
IV. Best practice: transparency
• Elements of transparency include timely

disclosure of reliable, adequate and relevant
information for decision making.
• Investors want clear, reliable and internationally
comparable information about enterprises.
Slide 15.26
Introduction of a new business

reporting model
Current Reporting Model Future Reporting Model
Shareholder focus Stakeholder focus
Paper-based reporting Web-based reporting
Standardised information Customised information (relevant information for
decision making)
Periodic reporting Continuous (online, real-time)
Distribution of information Dialogue (i.e. a two-way communication)
Financial information Integrated reporting (based on relevant value
drivers)
Illustration 15.5 Current and Future Business Reporting Models
Slide 15.27
International Integrated Reporting Council (IIRC)

Integrated Reporting Framework
Slide 15.28
How is integrated reporting different?

Thinking: Disconnected Integrated

Stewardship: Financial capital All forms of capital

Focus: Past, financial Past and future, connected,
 strategic
Timeframe: Short term Short, medium and long term

Trust: Narrow disclosures Greater transparency

Adaptive: Rule bound Responsive to individual
 circumstances
Concise: Long and complex Concise and material

Technology Paper based Technology enabled
enabled: 
Supplementary material
Slide 15.29
Corporate governance and the role of

the auditor
The external auditor plays a central role in good
corporate governance. Their core role is to:
• audit financial statements and other
(financial) reporting
• attest internal control statements
• review or attest of corporate governance
statements.
Slide 15.30
According to the UK corporate code

• The audit committee should have primary
responsibility for making a recommendation on the
appointment, reappointment and removal of the
external auditors.
• (Public) companies should put the external audit
contract out to tender at least every ten years.
• If the board does not accept the audit committee’s
recommendation, it should include in the annual
report, a statement explaining the recommendation
and should set out reasons why the board has
taken a different position.
Slide 15.31
Audit profession and corporate governance
The audit profession not only plays a significant

role in corporate governance, but is also forced to
look after its own corporate governance structure.
There are also government monitors of the audit
profession like the US PCAOB.
Slide 15.32
Duties of the PCAOB are:

Register public accounting firms that prepare audit
reports for issuers.
Establish or adopt rules: auditing, quality control, ethics,
independence, as related to preparation of audit
reports.
Conduct investigations of and disciplinary proceedings
involving registered public accounting firms.
Establish auditing standards.
Establish quality control standards. Quality control
standards could include rules to require monitoring
professional ethics and independence.
Slide 15.33
EU directive on statutory audit
EU Directive set out a new structure for audit and

corporate governance in the following areas:
• Qualifications to be a statutory auditor
• Characteristics of a statutory auditor
• Performance standards
• Transparent information about statutory auditors
• Independent quality assurance (QA).
Slide 15.34
EU directive on statutory audit

(Continued)
• Annual transparency report: Audit firms of public interest entities
must publish on their Web sites an annual transparency report that
includes: a description of the governance structure of the audit
firm, a description of its internal quality control system, and a
statement on the effectiveness of its functioning by its governing
board.
• Mandatory audit partner rotation: The key audit partner is to
rotate within a maximum period of seven years after the date of
appointment.
• A cooling-off period of two years: The key audit partner who
carries out the statutory audit is not allowed to take up a key
management position in the audited entity before two years have
elapsed from their resignation.
Slide 15.35
Summary of the proposed key requirements of the new

EU legislation on Statutory Audits as per May 2014
The key requirements of the new legislation are:

Public Interest Entities (PIEs)
• The Regulation affects the statutory audits of PIEs.
• The PIE definition captures all EU entities, irrespective of size that
(i) have securities listed on a regulated market, are (ii) credit institutions or
(iii) insurance undertakings. Member States may also expand the PIE definition
to include other entities.
The European Commission is empowered to adopt ISAs within the EU.
Auditor reporting to shareholders
• The Regulation contains expanded auditor reporting requirements aimed at
enhancing investors’ understanding of the audit process including critical
judgements made during the audit.
Slide 15.36

(Continued)
Mandatory Firm Rotation (MFR)

• Every company that falls within the PIE definition is required to rotate their auditors
after a ten year period and Member States are allowed to adopt a shorter period.
• The Regulation also grants Member States the option to allow PIEs to extend the
rotation period to (i) a maximum of 20 years if a public tender takes place on expiry of
the 10 year period or (ii) to a maximum of 24 years where a joint auditor is appointed.
• Non-EU groups that have an EU based PIE in their group structure will be required to
rotate the auditors of those subsidiaries.
Audit Committees
• Audit Committee approval is required for all permissible non-audit services after having
assessed the threats and safeguards to auditor independence. Audit committees may
also issue guidelines regarding the provision of tax and valuation services if a Member
State exercises its option to permit these.
• The Regulation requires a written report by the statutory auditor to the Audit
Committee.
Slide 15.37

(Continued)
Restrictions on Non-Audit Services (NAS) to audited entities

• The Regulation contains a list of services which the statutory auditor of a
PIE and all members of the statutory auditor’s network are prohibited from
providing to PIE’s.
• The NAS prohibitions include, inter alia, tax compliance, tax advice,
corporate finance and valuation services.
• The prohibitions extend to the financial year immediately preceding the
appointment of the statutory auditor with regard to designing and
implementing internal control or risk procedures related to the preparation
and/or control of financial information or designing and implementing financial
information technology systems.
• Permissible NAS are ‘capped’ if they exceed 70% of the statutory audit fee.
• Member States have the option to add to the list of prohibited NAS and apply
a cap that is lower than 70%.
Slide 15.38
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Slide 15.

Principles of Auditing: An Introduction to

Chapter 15 – Corporate Governance and

Rick Hayes, Hans Gortemaker

Corporate governance discussion

Illustration 15.1 Causes of Current Discussions

The nature of corporate governance

Definitions of corporate governance

As the degree of trust decreases, the

Corporate governance structures

Codes of corporate governance

Lippens – Enron, WorldCom

The Sarbanes–Oxley Act consists of 11

European Union laws

European Union laws (Continued)

Best practice from a global perspective

Four elements of governance:

I. Managing best practice

An important element of governance is ‘managing’

The board defines the company’s strategy,

Certification of SEC reports by

II. Supervising best practice

Audit committee (Continued)

SOX: Auditor reports to audit committee

III. Internal control best practice

SOX: Auditor report on management’s

‘As regards financial reporting risks the management

IV. Best practice: transparency

• Elements of transparency include timely

Introduction of a new business

Shareholder focus Stakeholder focus

Paper-based reporting Web-based reporting

Standardised information Customised information (relevant information for

Periodic reporting Continuous (online, real-time)

Distribution of information Dialogue (i.e. a two-way communication)

Financial information Integrated reporting (based on relevant value

Illustration 15.5 Current and Future Business Reporting Models

International Integrated Reporting Council (IIRC)

How is integrated reporting different?

Corporate governance and the role of

According to the UK corporate code

Audit profession and corporate governance

The audit profession not only plays a significant

Duties of the PCAOB are:

EU directive on statutory audit

EU Directive set out a new structure for audit and

EU directive on statutory audit

Summary of the proposed key requirements of the new

The key requirements of the new legislation are:

Summary of the proposed key requirements of the new

Mandatory Firm Rotation (MFR)

Summary of the proposed key requirements of the new

Restrictions on Non-Audit Services (NAS) to audited entities

Thank you for your attention

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