External Auditors and their role in the Corporate Governance Framework

External Auditors and their role in the Corporate Governance FrameworkExternal Auditors barricade conjunctions accounts and survey to the troupe based on the accounts. Basically, the adjoin is how impertinent auditors steer these duties in effect(p)ly. Legislations, such as The Companies Act 1965, have made enceinte efforts to ensure remote auditors conduct their duties and obligations effectively. The Code of Corporate Governance in 2001 and the amendment in 2007 have further enhanced the effectiveness of audit in the interests of stockholders and shargonholders. In light of the new-fashioned scandals involving foreign auditors in the world, there is a growing concern for corporate governance globally as there is increased reliance by the stockholders and shareholders on external auditors.This study examines the role of external auditors in the corporate governance framework. The study then reviews the pecuniary scandals involving auditors occurred in the world and inve stigate the role of external auditor in the collapse of the companies.IntroductionCorporate governance is a central and dynamic aspect of business. It is very important for corporate success and hearty welfare. In the wake of Enron, HIH Insurance and other similar cases, countries around the world have reacted quickly by pre-examining similar events domestically. As a speedy solution to these corporate failures, the USA issued the Sarbanes-Oxly Act in July 2002, and in UK, the Higgs Report and the Smith Report were published in January 2003 (Solomon, 2007).Nowadays corporate governance is a globally debated topic with many characteristics (Nobel, 1998). However, the concern is whether auditors play an important role in the framework of corporate governance.Corporate GovernanceCorporate governance is the race among various(a) participants in determining the direction and performance of corporations. The main participants are the shareholders, the solicitude and the board of dire ctors.Corporate governance is the process whereby directors of a company are monitored and control conduct. on that point are two areas considered to be fundamental to corporate governance, one is supervision and monitor of management performance and the other is ensuring accountability of management to shareholders and other stakeholders (Marianne, 2009). manger now, probably the two most important basic elements of good corporate governance have been full disclosure and the presence of self-supporting directors and auditors, who each has their declare ways to confirm that the data leave behindd by the corporation are true and fairly stated. The contents of full disclosure are listed out in restrictive demands and professional pronouncements, and companies are expected to fully comply. The independence of the outside director and external auditor means the directors and auditors will have to distance themselves considerably to prove shareholders that they have conducted thei r tasks (Bavly, 2004).Role of External Auditors in Corporate GovernanceExternal auditors play a key role in the corporate governance framework. They conduct one of the most important corporate governance checks that help to monitor managements activities. The audit of financial statement makes disclosures more reliable, thus increasing confidence in the companys transparency.The role of external auditors is to make sure that Board of Directors and the management are acting responsibly towards the shareholders investment interests. By keeping objectivity, the external auditors can subjoin value to shareholders by ensuring that the companys internal controls are strong and effective. And by working with the audit committee and liaising with internal auditors, external auditors can help to facilitate a more effective oversight of the financial reporting process by the Board of Directors (Hassan, 2004).However, the audit expectations gap needs to be acknowledged, as the audit knead c an only do so much on the dissimulator. The external auditor can not be expected to find every fraud and error during an audit. In accordance with the Cadbury Report, it is important to know that the external auditors role is not to prepare the financial statements, nor to provide assurance that the data in the financial statements are correct, nor to guarantee that the company will continue as a going concern, solely the external auditors have to state in the annual report that the financial statements show a true and fair view. The Cadbury Report highlighted that there was no doubt on whether there should be an audit but quite an how the audit could be ensured to conduct effectively and objectively by the external auditors (Solomon, 2007).Auditor IndependenceExternal auditors are expected to be single-handed of the company and report on the company objectively. Actually, auditors can only play their role effectively if they are independent (Peel ODonnell, 1995). They have to conduct their tasks in the most independent and reliable manner to provide investing public with the level of assurance to make their decisions based on the financial statements.According to the Cadbury Report, auditor independence could be continueed due to the close relationship between auditors and company managers and due to the auditors intention to develop a constructive relationship with their clients. There are a number of threats to auditor independence, one of which is to provide non-audit services since non-audit services are lucrative. Auditors can obtain the contracts for non-audit services only if they maintain a good relationship with the management.The Cadbury Report stressed that a balance is needed to be achieved in such way that external auditors will work with, not against, company management, but in doing so they need to serve shareholders. This is a difficult path. The easiest way to ensure this balance being attained is suggested to establish audit committees and develop effective accounting standards.The Cadbury Report recommended all companies to establish audit committees. Audit committees serve as representative of shareholder interests. They are not only responsible for monitoring financial reporting process to support good corporate governance, they are also considered to be able to ensure an appropriate relationship exists between the external auditor and the management whose financial statements are being audited (Hassan, 2004). The Smith Report issued in 2003 highlighted that the audit committee needs to be proactive and raise the concern with directors rather than brush them under the carpet. The Report also stressed that all members of audit committee should be independent non-executive directors. Companys annual reports should disclose detailed discipline on the role and responsibilities of their audit committee.Lessons from Financial Scandals4.1 Collapse of EnronEnron, the energy trading company based on Texas is the first scandal shaking up the auditing profession. It has led to a crisis to the confidence on auditors and the reliability of financial reporting (Holm Laursen, 2007). The audit fictitious character and the independence of external auditors were questioned. In this case, Enrons audit and accounting function were fraudulent. Arthur Andersen, the auditor of Enron, has been involved in Enrons fraudulent accounting and auditing. Failure of the audit function is one of the key factors contributing to the companys collapse.Enron created The Raptors, four special purpose entities (SPEs). SPEs are accomplished in order that a company can form a adjunction venture with other interested parties to conduct a specific deed. This transaction will not subject the other parties to the trys more generally associated with the companys operations. U.S Generally Accepted Accounting Principles (GAPP) allows companies to record the gains and losses of SPEs without reporting their assets and liabilities in certain instances. In this way, Enron avoided adding more than $1 billion debt to its balance shred without consolidating certain SPEs (Jenkins, 2003). But the problems are, when the losses of these entities quickly rose into billions of dollars, these entities were brought into the core financial statements. It then became clear that Enron itself had great losses. The corporations stock price dropped sharply, and the company went into bankruptcy in December 2001 (Brown, 2005).Examples of Enrons devious accounting exist widely in the corporation. The company recorded profits, for example, from a joint venture with Blockbuster Video that was never materialized (The Economist, 7 February 2002). In 2002, Enron restated its accounts, which is actually a process that reduced reported profits by $600 million (The Economist, 6 December 2001). In fact, the process resulted in a cumulative profit decrease of $591 million and a rise in debt of $628 million for the financial statements fr om 1997 to 2000. The divergence between the profit figures was generally attributed to the earlier omission of three off-balance sheet entities. Such profit inflation enabled the company to raise its earnings per share (EPS).The company not only manipulated the accounting figures to inflate the earnings, but it also was found to remove substantial amounts of debt from its accounts by setting up a number of off-balance sheet entities. Such special purpose entities can be intentd to hide a companys liabilities from the balance sheet, in order to make the financial statements look much better than they really are (The Economist, 2 May 2002). It means substantial number of liabilities did not have to be disclosed on Enrons financial statements, because they were mainly attributed to another legal entity.All these issues raise the question, why did Enrons auditor allow this type of activity? This is because the conflicts of interest exist between the external auditor and the managemen t.Conflicts of sakeConflicts of interest are a frequent problem in the audit profession. Although independent fitting of external auditors by companys shareholders is regularly replaced by subjective appointment by the company management, the auditor is all too often appreciated to the companys senior management.Further, conflicts of interest arise from interactive functions of audit and consultancy. Arthur Andersen has been blamed to apply leisurely standards in their audits because of conflict of interest over the subatantial consulting fees collected from Enron. In 2000, Andersen collected $25 million for auditing Enrons books in addition to $27 million for consulting services. In 2001, Arthur Anderson gain US$55 million for provision of non-audit services (Brown, 2005). Although Arthur Andersen reported on the companys accounts, they did not report fraud to the shareholders. This is because the fraud was committed by the management. Kenneth Lay, the Chief executive Officer (CE O) from Feb 1986 until Feb 2001, took home US$ 152 million although the company was facing a loss. If Andersen were to report, they probably will not be appointed in the following historic period or be engaged in non-audit services (Krishnan, L, 2009).Especially, close relationships are established over time between companies and their external auditors. It can again affect independent judgment and impact on the auditing function. In this case, there are regular exchanges of employees within Enron from Arthur Anderson. Such conflicts of interest affect the corporate governance function. heartbreaking conflicts of interest have also arisen among members of Enrons internal audit committee, which causes the internal audit committee did not perform its functions of internal control and of checking the external auditing function. For example, Lord Wakeham, a member of the audit committee, was at the same time having a consulting contract with Enron (The Economist, 7February2002). This s hows that people in responsible positions should have detected fraudulent activities if they were independent. Enrons board of directors was tranquil of a number of members who have been shown to be willing to conduct fraudulent activity. It is also because the non-executive directors were compromised by conflicts of interest.4.2 Collapse of HIH InsuranceIn Australia, the collapse of HIH Insurance Ltd was observed as the beginning of the reflection into external auditors role. HIH is one of Australias biggest insurers, comprising several separate government-licensed insurance companies, including HIH Casualty General Insurance Ltd, FAI General Insurance Ltd, CIC Insurance Ltd and arena Marine General Insurances Ltd. On 15 March 2001, HIH went into provisional liquidation with losses of A$ 800 million (Peursem, Zhou, Flood Buttimore, 2007).HIH is one of the largest corporate collapses in Australian history. Similar issues arise as in the Enron case. HIH is claimed to mislead in vestors by providing incorrect financial reports to the market and HIHs auditor, Arthur Andersen, may have played a part in its collapse. Andersen conducted the external audits for HIH from 1971 until its collapse in 2001. Their contribution to the failure of HIH is considered in the following sectionsAudit PracticesAs part of audit process, auditors will conduct a risk assessment to determine the structure and cast of the audit. Andersen assessed the risk of HIH and deemed it a maximum risk client, however, the engagement team of Andersen had not prepared the risk management plan and therefore the senior management team at Anderson did not review and approve the plan (Peursem, Zhou, Flood Buttimore, 2007).At the end, the auditor simply drew the misemploy conclusions. Andersen signed off HIHs annual report for the 30th June 2000 and stated that it was a going concern with net assets of $939 million. Nine months later, HIH collapsed with debts of $5.3 billion (Peursem, Zhou, Flood Buttimore, 2007). Andersen used HIH management reports and forecasts and did not obtain able evidence to get the conclusions they did. The liquidator could not find the documentation on the reasons for considering HIH as a going concern. This implies that Anderson failed to produce sufficient working papers to prove that the audit actually is conducted.Auditor IndependenceAndersen had a close relationship with HIH. By the time of liquidation, three former Anderson partners who had conducted HIH financial audit work held positions on the HIH board of directors. This obvious lack of independence between the board of directors and the auditors indicated that the best interests of HIH may have not always be a priority. Andersons failure in producing adequate working papers or in obtaining adequate evidence to support their findings have serious concerns on the quality of the audit they did.A significant independence issue is also reflected in the form of Andersons payment to HIH Chai rman, Geoffrey Cohen for consultancy fees. These fees totaled $190,887 in nine years and included the use of Andersons office and secretary. These fees were not disclosed to the remaining board members in the annual general meetings (Peursem, Zhou, Flood Buttimore, 2007). The close and complicated financial relationship between the auditors and HIH chair raise further questions in this case.Finally, the threat to auditor independence is that Andersen provided both audit and non-audit services to HIH. It raises a question on how can an auditor provide an independent opinion on the financial statements when he may play a role in guiding the preparation of the statements?The Royal Commission in Australia, which investigates the collapse of HIH, has found that the largest corporate collapse in Australia was not due to fraud but the result of attempting to cover the cracks on the overpriced acquisition. Andersons role in it appeared to be substantial.Modern Approach to External Auditor s Role in Corporate GovernanceExternal auditors now have to take a much stricter climb up to their clients (Bourne, 1995). There is an increasing view to support that external auditors should take on a more proactive role (Baxt, 1970).The Companies Act has set the stipulation on appointment, eligibility, qualification, disqualification and removal of external auditors (Davies Prentice, 2003). The intention is to ensure that auditors are able to carry out audit in an impersonal, objective and professional way. It is also to ensure that auditors are independent of the company. The reason for such emphasis is to ensure the external auditors are not in a position of conflict of interests.When there is conflict of interest, disclosure essential be made to shareholders and stakeholders. Alternatively, there should be prohibition to the provision of non-audit services to the company where they act as auditors. To ensure auditors are truly independent and not in a conflict of interest, a uditors should be rotated every year. Thereafter there should be a gap of five years forwards the same auditors are appointed by the company.ConclusionExternal auditors have an essential role in corporate governance through their involvement and their trial of financial statements. The external auditors role in corporate governance is a fundamental complement to achieve the desired objective of corporate governance. Therefore, the duties and obligations of external auditors must be expanded for the rights and interests of shareholders and stakeholders. There must be a modern approach to the auditors role in the corporate governance framework.