CORPORATE

GOVERNANCE
and AUDITS
FACILITATOR: ALFONSO S. BESTOYONG, CPA, MBA
 What is Corporate Governance?
❖ … is the SYSTEM by which business corporations are
directed & controlled.
❖ … it is the PROCESS by which owners & creditors of
an organization exert control & require
accountability of the resources entrusted to the
organization.
❖ … is the STRUCTURE that specifies the distribution
of rights & responsibilities among different
participants in the corporation.
❖ … it is the STRUCTURE where;
company objectives are set,
decisions on corporate affairs are made, and
the rules & procedures are defined to attain those
objectives and to monitor performance.
 What is the Importance of
Corporate Governance?
⚫ Business management is the
coordination & distribution of economic
resources throughout an organization.
⚫ While smaller businesses typically rely on
business owners to complete these
functions, large companies often have several
layers of management to oversee operations.
⚫ Corporate governance is…
⚫ a managerial tool for extremely large
or publicly held companies.
 What is the Significance of
Corporate Governance?

⚫ Corporate governance protects the

financial interests of individuals in a
company, whether they are owners,
managers, employees or outside
stakeholders.
⚫ Governance includes guidelines or
policies that provide a framework
individuals must follow when working in
the company. Publicly held companies
 What are the Features of
Corporate Governance?
⚫ Companies use corporate governance to set a
minimum standard of acceptable behaviour for
employees in the business.

⚫These features can include ;

honesty,
integrity,
accountability transparency,
fairness, and
proper relationships with other companies
in the business environment.
 What are the Effects of
Corporate Governance?
⚫ Using corporate governance can create a
competitive advantage for companies in
the business environment.
⚫ Governance that provides specific
responsibilities for each owner, manager
and employee in the company ensures little
or no confusion for competing activities or
tasks related to business functions.
Learning Objectives…
❖ Understand what is the nature, responsibilities &
accountabilities of corporate governance.
❖ Learn who are the parties involved in corporate
governance & their respective responsibilities.
❖ Know what are the corporate governance challenges
and failures.
❖ Understand why the auditing profession was partly
blamed for (the recent) corporate failures.
❖ Learn the significance of creating an audit committee.
❖ Enumerate & explain the audit committee oversight
responsibilities.
❖ Know the basic principles of good governance & best
practice recommendations that business can adopt.
 Key Parties Involved in Effective
Corporate Governance
⚫ The KEY PLAYERS in corporate
governance are the:
stockholders (owners),
board of directors,
audit committees,
management,
regulatory bodies, and
both internal & external auditors.
 Corporate Governance Failures
in the past decades…
⚫ The board of directors is often at the top of the list when it
comes to responsibility for corporate governance failures.
Some of the problems with the board of directors
included:
❖ Inadequate oversight of management.
❖ Approval of management compensation plans,
particularly stock options that provided perverse
incentives, including incentives to manage earnings.
❖ Non-independent, often dominated by management.
❖ Did not spend sufficient time or have sufficient
expertise to perform duties.
❖ Continually re-priced stock options when market
price declined.
The Auditing Profession was Also Responsible for
Corporate Governance Failures!
⚫ Some of the ways the auditing profession was
responsible were:
Too concerned about creating “revenue enhancement”
opportunities for the firm, and less concerned about
their core services or talents
Were willing to “push” accounting standards to the limit
to help clients achieve earnings goals
Began to use more audit “shortcuts” such as inquiry and
analytical procedures instead of direct testing of
account balance.
Relied on management representations instead of testing
management representations.
Were too often ‘advocates’ of management rather than
protectors of users
What is Expected of the Audit Profession?
⚫ Users should expect auditors to have
A. the expertise,
B. independence, and
C. professional skepticism to render an unbiased
and justified opinion on the financial
statements.
⚫ Auditors are expected to gather sufficient
applicable evidence to render an
independent opinion on the FS.
 Ownership Issue on the Company’s FS!

⚫ Management is responsible for issued financial

statements. Although other parties may be sued
for what is contained in the statements,
management is ultimately responsible.
⚫ Ownership is important because it establishes
responsibility and accountability. Management must
set up and monitor financial reporting systems that
help it meet its reporting obligations.
⚫ It cannot delegate this responsibility
to the auditors.
What is an Audit Committee?
⚫ An audit committee is a subcommittee of
the board of directors that is composed of
independent, outside directors.
⚫ The audit committee has oversight
responsibility (on behalf of the full board of directors
and its stockholders) for the
A. outside reporting of the company (including
annual financial statements);
B. risk monitoring and control processes; and
C. both internal and external audit functions.
 The Outside Director!
⚫ An outside director is not a member of
management, legal counsel, a major vendor, outside
service provider, former employee, or others who
may have a personal relationship with management
that might impair their objectivity or independence.
⚫ The audit committee is responsible for assessing
the independence of the external auditor and engage
only auditors it believes are independent. Auditors
are now hired and fired by audit committee
members, not management. The intent is to
make auditor accountability more
congruent with stockholder and third-party
needs.
The External Auditor!
⚫ The external auditor should discuss any controversial
accounting choices with the audit committee and
⚫ … must communicate all significant
adjustments made to the financial statements during
the course of the audit.
⚫ In addition, the processes used in making judgments
and estimates as well as any disagreements with
management should be communicated.
Other items that need to be communicated
by the External Auditor include:
A. All adjustments that were not made during
the course of the audit,
B. Difficulties in conducting the audit,
C. The auditor’s assessment of the accounting
principles used and overall fairness of the
financial presentation,
D. The client’s consultation with other auditors,
E. Any consultation with management before
accepting the audit engagement,
F. Significant deficiencies in internal
control.
 Assessing the Quality of an Organization’s
Corporate Governance – by the Auditor
⚫ The auditor might utilize the following
procedures in determining the actual level of
governance in an organization:
❖ observe the functioning of the audit committee by
participating in the meetings, noting the quality of the
audit committee questions and responses,
❖ interactions with management regarding
issues related to the audit, e.g.
A. providing requested information on a timely basis,
B. quality of financial personnel in making judgments,
C. accounting choices that tend to ‘push the limits’ towards
aggressiveness or creating additional reported net
income,
D. the quality of internal controls within the organization.
 Assessing the Quality of an Organization’s
Corporate Governance – by the Auditor
❖ review the minutes of the board of directors meetings
to determine that they are consistent with good
governance,
❖ review internal audit reports and especially determine
the actions taken by management concerning the
internal auditor’s findings and recommendations,
❖ review the compensation plan for top management,
❖ review management expense reimbursements to
determine
✔ (a) completeness of documentation,
✔ (b) appropriateness of requested reimbursement, and
✔ (c) extent of such requests.
❖ review management’s statements to the financial press
to determine if they are consistent with the company’s
operations.
Case #1 – A = Company Code of Ethics
⚫ The auditor might use the following approaches to
determine whether a corporate code of ethics is
actually followed:
A. observe corporate behavior in tests performed during
the audit, e.g. approaches the company takes to purchasing
goods, promoting personnel, and so forth,
B. observe criteria for promoting personnel; for example
does performance always take on greater importance than
how things are done,
C. observe corporate plans to communicate the
importance of ethical behavior, e.g. webcasts, emails, and
so forth to communicate the importance of ethics,
D. review activity on the client’s whistleblowing website,
or a summary of whistleblowing activities reported by
the internal auditor,
E. read a sample of self-evaluations by corporate officers,
the board, and the audit committee and compare with
the auditor’s observations of behavior,
F. examine sales transactions made during the end of
quarters to determine if the sales reflect ‘performance
goals’ as opposed to the company’s code of ethics.
 Case #1 – B = Company Code of Ethics
⚫ Are auditors equipped to make subjective
judgments?
⚫ This should be a great discussion question because
many young people are attracted to the
accounting profession because there are rules and
relative certainty as to how things are done. However,
as the profession is evolving, more judgments are
required in both auditing and accounting.
⚫ Audit personnel need to be equipped to make
judgments on whether the company’s governance
structure operates as intended and whether there are
deficiencies in internal control when it does not operate
effectively. The profession believes that auditors can
make such judgments.
Case #1 – C = Company Code of Ethics
⚫ Assessing the competence of the audit committee
can occur in a number of ways. Fortunately, the
most persuasive evidence comes from the
auditor’s direct interaction with the audit
committee on a regular basis.
⚫ The auditor can determine the nature of questions
asked, the depth of understanding shared among
audit committee members, and the depth of items
included in the audit committee agenda.
⚫ Many audit committees have self-assessment of their
activities using criteria developed by CPA firms, or by
the National Association of Corporate Directors. The
auditor should also review the minutes of the audit
committee meetings and determine the amount of
time spent on important issues.
Case #1 – C = Company Code of Ethics
⚫ An external auditor should be very reluctant to
accept an audit engagement where the audit
committee is perceived to be weak. There are a
number of reasons including:
1) The lack of good governance most likely influences
the organization’s culture and is correlated with a
lack of commitment to good internal control.
2) The auditor has less protection from the group that is
designed to assist the auditor in achieving
independence.
3) The company may be less likely to be fully
forthcoming in discussions with the auditor
regarding activities that the auditor might question.
Case #1 – D = Company Code of Ethics
⚫ Internal auditing is an integral part of good
corporate governance. It contributes to
corporate governance in three distinct
ways:
1) It assists the audit committee in its oversight role by
performing requested audits and reporting to the
audit committee,
2) It assists senior management in assessing the
continuing quality of its oversight over internal
control throughout the organization,
3) It assists operational management by providing
feedback on the quality of its operations and controls.
 Case #4 = Failures of Auditors
1) Allowing companies to use “cookie jar
reserves” to manage earnings.
2) Allowing improper revenue recognition
3) Assisting companies in using creative
accounting for mergers and acquisitions
that did not reflect economic reality.
4) Assisting management in meeting
earnings targets that helped managers
achieve stock option price targets.
Case #4 = “Cookie Jar Reserves”
Cookie jar reserves are essentially funds that companies have
“stashed away” to use when times get tough. The rationale is that
the reserves are then used to “smooth” earnings in the years when
earnings needs a boost. “Smooth” earnings typically are looked
upon more favorably by the stock market. An example of a cookie
jar reserve would be over-estimating an allowance account, such
as allowance for doubtful accounts. The allowance account is
then written down (and into the income statement) in a bad year.
Auditors may have allowed cookie jar reserves because
they are known to smooth earnings, and smooth
earnings are rewarded by the market. On the flip side,
fluctuating earnings are penalized, and present more
risk to the company of bankruptcy or other problems.
The Sarbanes-Oxley Act addressed the issue by creating
an oversight body, the PCAOB, but also addressed the
issue in other ways. For example, Congress felt that
creating more effective Boards would decrease the use of
earnings management.
Case #4 = Improper Revenue Recognition
⚫ Allowing improper revenue recognition is one thing
that auditors may have done in their unwillingness to say “no”
to clients. For example, companies shipped out goods to
customers at the end of the year for deep discounts and
allowed returns at the beginning of the next year. This
practice is known as channel stuffing. Since the goods had a
great chance of being returned, it would be improper to
recognize all as revenue.
⚫ Again, auditors were unwilling to say “no” to clients. Greed is
probably the reason here. If companies claim more revenue,
their stock would grow in the short-term, making management
richer, and making management more willing to give pay
raises to their auditors.
⚫ With the establishment of stronger audit committees and
certification of financial statements in the Sarbanes-Oxley Act,
this kind of accounting trickery will certainly decrease.
Case #4 = “Creative Accounting”
⚫ Creative accounting for M&A included the use of the
“pooling” method of accounting. Pooling allowed acquiring
companies to value existing assets at historical costs and did
not require the recognition of goodwill for the acquisition.
Because true costs (values) were not shown on the financial
statements, management was often encouraged to bid up
prices for acquisitions with the result that many of them were
not economic. The creative accounting also shielded
the income statement from charges that would have
otherwise hit income including: goodwill
amortization, depreciation, and depletion expenses.
⚫ Greed, the same reasons as the revenue recognition issue,
was most likely the motivation for this creative
accounting.
⚫ Discussion between an educated audit committee and auditor
plus certification of financial statements required by
Sarbanes-Oxley will certainly address this issue.
 Case #4 = Assisting Management to
Meet Earnings
⚫ Assisting management to meet earnings. Too
often, auditors confused ‘financial engineering’
with value-adding. In other words, auditors
often sought to add value to their clients by
finding ways to push accounting to achieve
earnings objectives sought by management.
These earnings objectives then played a major
role in escalating stock prices – all desired
because of the heavy emphasis of management
compensation on stock options.
⚫ Incentives were misaligned. Most of
management compensation came in the form of
stock options.
 Case #5 – A = Audit Committee vs. External
Auditor’s Independence
⚫ This is intended to be an open-ended discussion. There
are a number of factors that have been mentioned in the
discussions regarding auditor independence. The
following is representative of some issues
discussed:
1) The audit firm’s policy for rotating auditors in charge of
the engagement,
2) Whether or not the client has hired personnel from the
audit firm for significant financial or management
positions in the company, such as the Chief Financial
Officer was the former partner in charge of the audit
engagement,
3) The nature of non-audit services provided by the audit
firm,
4) The existence of any social or other relationships with
management,
 Case #5 – A = Audit Committee vs. External
Auditor’s Independence
5) Audit committee experience with the audit firm in
other situations, such as the auditor provides services
for other entities with which the audit committee
member has an association,
6) The existence of any charges brought against the
auditing firm by the SEC,
7) The audit firm’s involvement in significant lawsuits
where their judgment has been questioned,
8) The amount of fees charged by the auditing firm. If
the audit fees are too low, the audit committee should
question the thoroughness and independence of the
work. If fees from non-audit work are high, the audit
committee will want to question that relationship and
possible effect on judgments made by the auditor.
 Case #5 – A = Audit Committee vs. External
Auditor’s Independence
9) The manner in which individual audit partners are
compensated by the public accounting firm. For
example, if an audit partner’s compensation is
determined significantly by whether or not a client
is retained, then there might be questions about
what the auditor would do to retain the client.
10) The general reputation of the firm.
11) The firm’s policies and procedures for attracting
and retaining talented audit personnel.
12) The process of assigning personnel to an audit.
13) The firm’s expertise in the industry.
Case #5 – B = Audit Committee Influencing
External Auditor’s Independence
⚫ The main way that the audit committee can
influence the independence of the
internal audit department is…
⚫ by choosing who is in charge
of the department.
⚫ The “tone at the top” in the internal audit
department will go a long way. Further, the
audit committee ought to approve the scope of
the internal audit charter, approve annual
audit plans, as well as annual budgets.
 Case #5 – C = Audit Committee’s Pre-approval of
Non-Audit Services by External Auditor

⚫ 1. Tax Return for Company:

⚫ Approval argument.
⚫The auditor is already aware of all the information,
so can efficiently prepare the return. Tax accounting
is different than audit accounting, so accounting
treatments can be different in both settings and will
not affect each other.
⚫ Non-Approval:
⚫ On the other hand, some argue that tax preparation
is a consulting activity, i.e. the auditor would need to
be a client advocate and thereby should not prepare
the tax return.
 Case #5 – C = Audit Committee’s Pre-approval of
Non-Audit Services by External Auditor

⚫ 2. Tax Return for Management and

Board Members:
⚫ Approval:
⚫ The auditor is an expert. The services can be viewed as
a benefit for management and the board.
⚫ Not Approve:
⚫ Performance of the tax services too closely aligns the
auditor with management and the board. The auditor
has to be a client advocate in developing the tax
returns. This may mentally conflict with the auditor’s
need to be objective in all other work involving the
client.
 Case #5 – C = Audit Committee’s Pre-approval of
Non-Audit Services by External Auditor

⚫ 3. Tax Return paid for by Managers,

not company:
⚫ Approval:
⚫ This is an independent service not paid for by
the company.
⚫ Not Approve:
⚫ The argument is the same as #2 above.
Although paid for by the individuals, there is
still the possibility of conflict.
 Case #5 – C = Audit Committee’s Pre-approval of
Non-Audit Services by External Auditor
⚫ 4. Overseas Assistance for Internal Audit
Department:
⚫ Do not approve.
⚫ It is the responsibility of management to prepare a
review of internal control, and the auditor does an
independent analysis. Further, the performance of
internal audit work is one of the areas that have been
explicitly prohibited by the SEC.
⚫ 5. Security Audit of Information Systems:
⚫ Approve.
⚫ This is not a conflict of interest as it is an audit or
assurance service.
⚫
 Case #5 – C = Audit Committee’s Pre-approval of
Non-Audit Services by External Auditor
⚫ 6. Train Operating Personnel on Internal
Controls:
⚫ Approve.
⚫ Auditors are experts on this area. There is no direct
conflict with the performance of the audit. Better trained
personnel should imply better internal controls – beneficial
for both management and the auditor.
⚫ Not Approve.
⚫ The PCAOB is explicit that management has the
responsibility to design, implement, and evaluate internal
control. Thus, training personnel is a management task
that cannot be performed by the auditor. It could,
however, be performed by a different public accounting
firm.
 Case #5 – C = Audit Committee’s Pre-approval of
Non-Audit Services by External Auditor

⚫ 7.Perform Internal Audit Work for the

Company:
⚫ Do not approve.
⚫ It is the responsibility of management to prepare a
review of internal control, and the auditor does an
independent analysis. Usually internal audit is
responsible for “management’s” end of assessing
internal controls.
⚫ The audit of effectiveness and efficiency is akin to
consulting and would be interpreted by most
people as compromising the auditor’s
independence.
 Case #5 – C = Audit Committee’s Pre-approval of
Non-Audit Services by External Auditor

⚫ 8. Provide, at no cost, Seminars to Audit

Committee Members.
⚫ Approve.
⚫ The audit committee can make a decision as to
whether a particular member will attend the
seminar. It is one way that an audit committee
member can keep up on the profession.
⚫ The only potential problem would occur if the
audit committee only relied on the audit firm
for updates on accounting and audit issues.
 Case #5 – C = Audit Committee’s
Pre-approval of Non-Audit Services by
External Auditor
⚫ 9. Seminars for both Audit and
Non-Audit Clients.
⚫ Recommend Approval.
⚫ The key is whether the audit
committee feels that it may lose
some of its objectivity in performing
its oversight role.
THIS IS YOUR
“THE END”!!!