Ch 1 Assurance THE REGULATORY ENVIRONMENT (A3)

Question 1

THE REGULATORY ENVIRONMENT (A3)

Answer 1

Audit is a highly regulated industry. This is deliberate as audit is deemed to play a central role in corporate governance.

Question 2

International Standards on Auditing (A3a,b)

Answer 2

are the rules that tell auditors how to do their job. They are developed by the International Auditing and Assurance Standards Board (IAASB). The ISA have
been copied into national standards in most countries.

Question 3

Corporate governance (A3c)

Answer 3

refers to the way that corporations are governed. It is an

all-encompassing concept that includes company relationships with shareholders, society and the environment.

Question 4

Audit committees (A3d)

Answer 4

Some companies have audit committees to help enhance audit independence. When a client has an audit committee, then the auditor will channel much of the audit communication through the audit committee.

Question 5

things that auditors might discuss with the audit committee are in accordance with ISA 260 likely to include issues such as:

Answer 5

= The auditor’s responsibilities in relation to the financial statement audit
= The scope and timing of the audit
= Significant findings arising on the audit
= Any independence issues
= Possible modifications necessary to the audit report
= Any management representation points requested
= Any suspected or actual cases of fraud.

Question 6

International codes of corporate governance (A3e,f)

What is corporate governance?

Answer 6

In many organisations, those CONTROLLING it are not the same people who
OWN it.

Question 7

In the largest organisations, owners may have such small individual stakes that:

Answer 7

o They do not care too much what the organisation does.
o They are not prepared to challenge the directors.
o They do not have the power to challenge the directors.

Question 8

The biggest owners are often INSTITUTIONAL SHAREHOLDERS – for example, pension funds.

Answer 8

o They are investing money on behalf of others – it is not theirs.
o They tend to be “inactive” by nature, preferring not to “rock the boat”

Question 9

Globalisation

Answer 9

has resulted in the biggest companies / organisations

becoming even larger than in the past – which is making the above issues even more important.

Question 10

Recent CORPORATE DISASTERS and the apparent increase in CORPORATE FRAUD
and UNETHICAL BUSINESS BEHAVIOUR have led to

Answer 10

a lack in trust in directors.

Question 11

The agency problem

Answer 11

if you want something done properly, the way you want it done …
Do It Yourself!
Agents are people employed to do something for you. The risk is that they do it for themselves…

Question 12

Agency Costs

Answer 12

= The agent will expect to be paid for their work
= The agent may expect additional benefits
o A nice office
o A company car
o To travel first class while doing your business
= You will have to spend some time and effort monitoring the agent to ensure they are doing what you want … and the less you trust the agent, the more checking you will want to do!

Question 13

Corporate governance is

Answer 13

a series of laws or guidance aimed at making directors manage companies in the best interests of shareholders, and other stakeholders.

Question 14

Corporate governance (In other words)

Answer 14

it is an attempt to deal with the agency problem.

Question 15

Who sets the rules?

Answer 15

= Global – the OECD have developed a Code (OECD = Organisation for Economic Co-operation and Development)
= National – many countries have developed their own systems, sometimes as laws (e.g. Sarbanes-Oxley in the USA) and sometimes as a Code (eg The UK
Corporate Governance Code)
= Companies – many companies have tried to develop their own policies on Corporate Governance, some of which go further than the rules or Code their country expects them to follow
= Other - in some countries, something that appears to be “voluntary” can effectively become law (eg in UK all listed companies are required to either follow the UK Corporate Governance Code, or explain what they have not followed it – Stock Exchange Rules).

Question 16

Underlying concepts behind corporate governance

Answer 16

These are the fundamentals behind how companies (and more importantly those involved with companies, primarily directors) should behave.

Question 17

Fairness

Answer 17

All people affected by decisions (stakeholders) should be treated with equal
consideration.

Question 18

Openness / transparency

Answer 18

All information should be made available to stakeholders, and in a clear manner.
This may suggest companies should not just follow disclosure rules, but also add VOLUNTARY DISCLOSURES if it adds to transparency.

Question 19

Independence

Answer 19

All those in a position of monitoring should be independent of those / what they are monitoring:
= Non-Executive Directors should be independent of the Executives, and of company operations.
= External auditors should be independent of the company, especially its accounting department and processes.
= Internal auditors should be independent of the company, as they are likely to be involved in monitoring systems throughout the company’s operations.

Question 20

Probity / honesty

Answer 20

This is not just telling the truth – it also means finding out the truth, not ignoring it (not “turning a blind eye”).

Question 21

Responsibility

Answer 21

Directors should understand and accept their responsibility to shareholders and other stakeholders, and act in their best interests … and be willing to accept the consequences if they fail in this responsibility.

Question 22

Accountability

Answer 22

This links with responsibility. Directors must be willing to be held accountable for their actions – and shareholders cannot exercise their own responsibility (as owners) unless they have this information available.

Question 23

Reputation

Answer 23

Directors must protect their own reputation, and that of the company they run, as damage to either is likely to lead to more widespread damage to the company.
This raises an interesting debate about whether a director’s private life is in fact private – since a bad personal reputation is likely to affect their business reputation and hence that of the company.

Question 24

Judgement

Answer 24

Directors must ensure they have all the necessary information and understanding in order to be able to make sensible business decisions that improve the prosperity of the company.

Question 25

Integrity

Answer 25

This is quite a general term and has a crossover with some of the other terms above. Integrity means honesty, fair-dealing, presenting information without any attempt to bias opinion … and in a more general sense, “doing the right thing”.

Question 26

The UK Corporate Governance Code (UK listed companies)

Answer 26

The main aspects of the UK Corporate Governance Code are set out below.

Question 27

An effective board of directors:

Answer 27

= Should lead company strategy.
= Should include Non-Executive Directors (NEDs) who:
o Contribute to strategy.
o Assess performance of Executive Directors.
o Oversee integrity of financial information, control systems, and risk
management.
o Decide remuneration of Executive Directors.
o Appoint, remove, and consider succession planning of Executive
Directors.
= Should meet regularly, with a formal agenda.
= Should detail its membership (including Chairman, CEO, Senior Independent Director, Committee members) and work in Annual Report.
= Should ensure Chairman and NEDs meet without the Executives, to consider their performance.
= Should ensure NEDs meet without Chairman annually, to consider
performance of Chairman.

Question 28

Chairman and chief executive officer (CEO)

Answer 28

= Should not be the same person.
= Chairman leads Board, and sets agenda for Board Meetings.
= Chairman is key contact for shareholders.
= Chairman is independent on appointment.
= Chairman is not the former CEO of the company.
= CEO runs the company.

Question 29

Board balance

Answer 29

= No one person, or group, should be able to dominate the Board.
= At least ½ the Board, excluding the Chairman, should be independent NEDs.
= Should be an appropriate balance of skills and experience.
= Annual Report must detail which NEDs are considered independent.
= Should appoint a Senior Independent Director – so shareholders have an alternative to talking to the Chairman.

Question 30

Appointments to the board

Answer 30

= Nomination Committee, majority of whom are Independent NEDs.
= Chaired by Chairman (unless Chairman is being discussed).
= Have criteria for selection of new Board members.
= Report its work in Annual Report.
= Organise induction and training for all directors.

Question 31

Annual performance review

Answer 31

= Board, its committees, and individual directors should have performance appraised at least annually.

Question 32

Re-election of board members

Answer 32

= All directors should be submitted for re-election at regular intervals, subject to continued satisfactory performance.

Question 33

Remuneration of directors

Answer 33

= Enough to attract, retain and motivate.
= Significant proportion should be performance-related.
= Should consider industry pay levels.
= NED remuneration should not be performance-related, but should reflect time involvement of the role.
= If a director is removed before the end of contract, provisions should be in place to ensure they are not over-compensated for failure.
= Notice periods no longer than 1 year.

Question 34

Remuneration committee

Answer 34

= At least 3 Independent NEDs as members
= Should set remuneration of all executive directors and the chairman, and
senior management.
= Remuneration of NEDs is flexible – could be by Board as a whole, by
shareholders, or a separate Board Committee.
= Shareholders must approve any long term share options.

Question 35

Financial reporting

Answer 35

= Board should present a balanced assessment of company’s position and future prospects.

Question 36

Internal control

Answer 36

= Board should ensure a sound system of Controls

= Annual review of effectiveness of Controls, and report this in Annual Report.

Question 37

Audit committee and audit

Answer 37

= Audit Committee of at least 3 Independent NEDs.
= At least 1 member to have recent relevant financial experience.
= Main role is liaison with the internal and external auditors on all matters.

Question 38

Relations with shareholders

Answer 38

= Regular dialogue with shareholders.

= Chairman to ensure shareholder views communicated to Board.

Question 39

Constructive use of AGM

Answer 39

= Communicate with investors.
= Encourage debate.
= Allow the use of proxy votes.

Question 40

Institutional shareholders

Answer 40

= Should themselves ensure dialogue with directors.

= Should make considered use of their considerable voting power.

Question 41

The structure and role of an audit committee is as follows (A3g):

Answer 41

= Audit Committee of at least 3 Independent NEDs.
= At least 1 member to have recent relevant financial experience.
= Main role is liaison with the internal and external auditors on all matters
Audit committees have the advantage of increased auditor independence and the disadvantage of increased bureaucracy.

Question 42

Risk management and internal control (A3h,j)

Answer 42

In simple terms, it is the responsibility of directors to assess business risks and design systems to manage those risks. The auditor is only responsible for evaluating the systems as part of normal audit procedures.

Question 43

Audit process

Answer 43

APPOINTMENT (ETHICS) =>
PLANNING (AUDIT STRATEGY) =>
PLANNING (DETAILED AUDIT PLAN) =>
INTERNAL CONTROLS =>
ASSESSMENT AND TESTING =>
REDUCED / DETAILED =>
SUBSTANTIVE TESTING =>
REVIEW (FINALISATION) =>
REPORTING (AUDIT REPORT)