[cg-frq] batool - corporate governance and the financial reporting

Name: ZUNERA BATOOL Reg no.: MM 103022 Subject: Issues in Financial Reporting Topic: Financial Reporting and Corporate Governance A study of board of directors and audit committee role C

Name: ZUNERA BATOOL Reg no.: MM 103022 Subject: Issues in Financial Reporting

Topic: Financial Reporting and Corporate Governance (A study of board of directors and audit committee role)

Course Coordinator: Sir Amanullah

CORPORATE GOVERNANCE AND THE FINANCIAL REPORTING

A study of board of directors and audit committee role

Introduction

Corporate governance does not only govern the corporate within pre defined and over sighted rules and regulations but it also serves many different purposes for the controlled business of the corporate Here the control means that every function of the business is carried out under controlled environment to avoid any illegal activity

This paper is about how the financial reporting can be affected by good and bad corporate governance practices There are several areas in which good governance practices can save a business from any illegal activity and also can generate the financial reports of high quality In other words, the quality of financial reports can be well maintained only if the good corporate governance practices are observed The high quality financial reporting depends on:

1: board of directors

2: role of audit committee

3: the external auditor and his responsibility

4: the internal auditors and their responsibilities as well as role in the quality of the financial reporting The major factors in ensuring the financial reports quality and truthfulness are the independent and responsible board and the independent, knowledgeable board This paper will be limited to the

evaluation of these two factors

The first section of this paper will deal with the literature review of the practices and the scholarly and practical work of financial and corporate governance experts The second section will deal with the issues or the problems in with respect to the topic and the last section will deal with the social and Islamic aspects of the affects of the deception of the flawed financial reporting and how the good quality reports serve the society positively

PART 1: LITERATURE REVIEW

Levitt (1999) in his speech to directors said,”The link between a company’s directors and its financial reporting system has never been more crucial” Financial reports can be flawed and they can contain bogus or true data and information but the health of the financial reports and the accounting activities can be checked and controlled only if few fractions of the corporate governance system take the

responsibility seriously

The responsibility of corporate governance is defined with respect to the financial reporting by Public Oversight board (POB 1993) as “those oversight activities undertaken by the board of directors and audit committee to ensure the integrity of the financial reporting process” Hence, it is the responsibility of the board of directors to ensure the truth fullness of the financial reports

After the big financial frauds started to strike the market, the think tanks realized that they need to draw some rules and regulation and they have to make businesses follow those rules in order to avoid any more financial scams The first major step in this regard was the Blue Ribbon commission of 1999 and after the Enron scam, the Sarbanes-Oxley Act of2002 These reports were about the audit committee and its enhanced responsibilities and functions

In a paper published in journal of accounting literature 2004, it was said that it is still not defined as

what is the quality of financial reporting? Is it only dependent on the better corporate governance or it

is more than that? This paper also presented the old literature on this issue which was only based on the issues of earning management, frauds and reporting methods This leads us to the new level to define the quality of financial reporting with respect to the corporate governance responsibilities

Board of directors

Board of directors is the only entity in the corporate which can decide if the reports can be of good health or not But boards have to have certain characteristics to ensure the quality of the financial reports as its responsibility In a paper of Arthur Levitt, chairman of security and exchange commission USA, he identified the types of directors that can be a potential hindrance to the truthfulness of financial reports He identified that there are three types of directors in the corporate board The type 1 directors are those who are called executive directors that are company’s employees and are on board, the type 2 directors are the “grey” directors, who are not the employees of the company but yet, have close ties with the company And the type 3 directors those are independent and are no way related to the

company

His study revealed that there is a negative relation between the quality of financial reporting and the type 1 and type 2 directors in the board and their presence in the audit committee also negatively effects the reports health In his paper, he emphasized on the need of the independent directors both

on board and in the audit committee

In his paper, accounting quality, auditing and corporate governance, Eugene A Imhoff said that boards were actually formed to oversee the management of the companies when people invested in the

businesses and they wanted the boards to overlook the businesses for them Also they ensured that the independence of the boards to be ensured With the passage of time, the responsibilities of the boards increased and there were formed sub committees to ease the work for the corporate The audit

committee was once the need and now a requirement for the company to assist board But the financial reports’ health is still the biggest concern because audit committee also needs to be independent in true sense to perform its function properly

Audit Committee, its role and purpose

Audit committees were injected into the corporate by the regulatory authorities so that the financial reports can be made more independently Vefas in 2001, conducted a study on the composition of audit committee revealed that those members of board who form a part of audit committee have less

significant board tenure and they serve fewer other committee They are not experienced enough to be made part of the most responsible committee of the corporate which is directly responsible to examine the process of generation of the financial reporting and are directly accountable to the board, the supreme entity in the board Also these members are actually those “grey” directors who have “equity” share in the company

The audit committees are not found to be doing what their mandated charters say; this raises the issue

of transparency here (revealed in the study of the carcello in 2002)

After the Sarbanes-Oxley act (2002), companies are now restricted to perform more ethically with respect to their businesses than they were doing before Sarbanes-Oxley act was signed after the huge fraud of Enron that made the financial world think of controlling the greed otherwise world could die a financial death

Independence

Independence of the audit committee is the most important area With independence of the audit committees, the role of the management in the financial frauds can be restricted to the great extent The studies on audit committees generated different results The two most important results were that even if the audit committee is independent, it is only to review the accounting choices the management makes The second result is that if the audit committee is independent but does not have any expert and knowledgeable person on board, there will be no effect on the truthfulness of the financial reports Only

if the members of the audit committee are knowledgeable, they can support the auditor if they find an issue in the report notified by the auditor

Klein, in 2002 observed that the size of the board is directly proportional to the independence of the audit committee also audit committee’s independence will also be dependent on the independent directors as members of the committee She also showed that as a firm rises and gets more and more growth opportunities, the audit committee’s independence is affected This is probably due to the firm’s desire to grow at all costs All the studies on the audit committee’s performance suggest that the

independence of audit committees is generally affected by the independence of board This is so

because only a stronger board can back a stronger AC against the management in case of any fraudulent activity

If firm’s size is small, audit committee will be less independent or will be controlled entirely by the management Those firms that were involved in any financial fraud were lacking both the independent and even the grey directors on their board That’s why the role of management on the board as well as

in committees is criticized in every committee and in every report

Knowledge and expertise

The other important area in the analysis of the corporate governance’s role in determining the quality of the financial reporting is the knowledge and expertise of the members, on board as well as in the audit committees Sarbanes-Oxley act (2002) has made it a requirement that all AC members should have adequate financial literacy and that at least one of the members of Ac must have the knowledge and expertise in finance Here the important thing to be noted is that the members should be independent not even grey and have sense of responsibility

DeZoort, in his study found that the AC members were fully aware of their responsibilities when he compared their responses with the statements made in the mandate He also found that the AC

members were not given that independence that they needed and company actually disclosed for the public in its reports Also, he found that the AC members themselves were aware of the need of the necessary knowledge they need in order to be in the AC

All the studies including DeZoort’s study pointed on a very important aspect that those audit committee that have experienced and expert members were more likely to control the internal environment of the company as well as they have better understanding of the external auditor’s side and they can support auditors in such disputes instead of sticking to the management

Basely and salterio found in their study on corporate boards and committees that the AC’s

independence and honesty in work depends only on the boards that are chaired by the independent person and not the CEO since boards select AC members But they failed to find any significant role of knowledge in the good quality of the financial reports Their study was the first to identify that the role

of the stock holders, those who own bulk of stocks, can also play a significant role in putting a check in process of report generation and they can be a good tool to maintain the good health of the financial reports These studies did not find any accounting knowledge’s role in improving or challenging the management regarding the financial reports

The first study on how the financial expertise and financial literacy are different and their respective roles in the good quality of financial reporting was done by McDaniel et al this comparative study showed that those who have knowledge of finance responded differently to those who were experts The financial experts were concerned with the relevance and reliability of the reports to mark them as good or misleading, they were less concerned with the general public responses But the financial literates were more concerned about the response from the general public and those items that were

nonrecurring in nature Hence, the knowledge is different from the expertise and both can participate in improving the quality of the accounting reports

The effectiveness of the committee’s role is dependent on the chair of the committee Kalbers and foharty studied the roles of the audit committee as defined by various commissions and regulatory authorities Their study revealed that the effectiveness of the committee is only possible if there is a strong organizational charter, institutional support i.e the management and auditor’s support, and the diligence They also showed through their work that only knowledge can only be used for the financial reporting oversight function, which cannot be proved useful for the other defined functions, 1) oversight

of external auditors; and 2) financial reporting

Gendron and Bedard in (2004) revealed that the audit committee’s meetings cannot show their

effectiveness but they are merely the social construction-ism to satisfy the general public and the respective authorities Therefore it is needed to look at the AC’s activities rather than simply recording them The only historical work done to determine if audit committees really have any power or not was

by Kalbers and Forgarty in 1993 They determined that the power of AC is difficult to measure the power

of AC and that the effectiveness of AC is due to their power This power is the timely and true

information to be extracted from the management

The historical work done on board of directors’ and audit committee’s has shown that only if they are independent and only if they have the knowledge and expertise to handle their duties sincerely, they can really bring the change The above the limits use of earning managements and frauds that history has witnessed were not only due to the greed of the management but also due to the negligence of the corporate governance bodies because they were either not expert or they were not independent All historical work is based on the BLUE RIBBON COMMISSION, 1999 and SARBANSE-OXLEY ACT OF 2002, because these reports changed the corporate governance practices to great extent

Blue Ribbon Commission, 1999

This report especially made it a necessary requirement for the corporate to have only independent directors in the audit committee This report also gave recommendations on the free and fair work of audit committee and also mentioned the duties of audit committee in the good quality of financial reporting

Sarbanes-Oxley act, 2002

Sarbanes-Oxley act was signed after the big bang of Enron This act was passed to protect investors by improving accuracy and reliability of corporate disclosures This act specified new duties for board and its sub committees (especially the audit committee) It was made mandatory for corporate to have an auditor’s report in the financial report to make the investors assure (to some extent) that they will not

be cheated It has also mandated that three directors in the audit committee must be independent and all members must have financial knowledge with at least one director to be expert in financial matters

Part 2: ISSUES

With respect to the corporate governance role in generating high quality reports, there are many issues from the performance of the board of directors to the shareholders’ active role in compelling the

company to act faithfully

There are two main bodies involved on the top level of the corporate governance

1: board of directors

2: audit committee

Issues related to board

A strong board can make a strong audit committee and with a strong audit committee, directors can stop or at least the limit the management’s activities to expropriate other’s rights by presenting the false figures and facts on their reports

The first issue involved in the good corporate governance practices is to give the free hand to the board

of directors Since, board represents all the shareholders, so board is responsible for every activity of the management to ensure that no one gets hurt due to the illegal practices of management This needs an experienced and independent board But unfortunately, the independence of the board is put on

“check” by the executive directors (those who work for the company and are also board members) These executive directors mostly vote out those matters that can prove to be beneficial for the

shareholders but that limit the management’s chances to get the extra benefits

The executive directors and the “grey” directors limit the boards’ ability to approve a trustworthy financial report that depicts the real situation of the financial reality of the company Most often, we see the big corporate with country wide or worldwide business have impressive boards with experts and men of knowledge of their fields that too are independent These boards are called “trophy boards” These trophy boards attract more and more investors but do not do much in ensuring the good health of financial reporting

Satyam computers limited (now known as Mahindra satyam computers limited) was a company with a

trophy board with all the big names of society from retired judge to the regional manager of World Bank But this company ended up with the biggest financial scandal in India And the day, the financial scandal of this company (once considered to be a company with best corporate governance practices) was opened by the CEO of this company (who was the main culprit) the first body to look stunned was none other than the trophy board of directors

Hence, another issue arises that no matter how much knowledgeable or independent board is, if it is neglecting its responsibilities to look at the “financial activities” of the company, it is overlooking all its

responsibilities Similarly, we have the example of Enron , where the directors themselves were involved

in remunerating themselves huge sum of money, for probably, overlooking their responsibilities to act

as representatives of the general public So even a board can be greedy if it is not composed of honest, truthful and God fearing people

Issues related to audit committee

A strong and independent board can elect good, independent and knowledgeable AC members

Sarbanes-Oxley act (2002) has made it mandatory to have three independent directors with all of the members of the committee to have essential financial knowledge and at least one director to have expertise in financial reporting or accounting processes

Audit committee’s performance is directly associated with the board If board is headed by CEO, then audit committee is also chaired by one of the powerful figure of management This will automatically kill the purpose of fulfilling the requirements of respective authorities because there is no need obey the law but not with the spirit Hence, the issue is that the audit committee to act responsibly depends totally on the strong and independent board

If the audit committee is comprised of the executive or grey directors, then there is no need to make such committee because it will already kill the purpose of creating such committees and the quality of financial reports will remain a question mark

If the audit committee is chaired by CFO or any other management office, there will be no chance to catch the culprit also in case external auditor raises any objection related to any accounting data or any other report making process, he will not have that support from the audit committee that otherwise he can get IF the audit committee is not under control of the management Therefore, to head the audit committee there should be some independent director not even a grey director

Audit committees mostly lack the expert members they are often made with those member who are either not very experienced or who do not have any significant experience of work even with the board The issue with this kind of audit committee is that this committee will never have that power or

effectiveness which otherwise it can have if it has expert and knowledgeable members

But then, there is another issue with the committee which is independent and is not controlled by any management fraction, even then it cannot perform well because if the audit committee, the most important body after the board of directors, does not have that necessary knowledge and expertise to handle and communicate with the finance department of the company, they cannot present the board a truthful financial report But to some extent, it can give at least some threat to the management if they try to do any fraud that gets visible to the committee

An audit committee with all the knowledge and expertise is the best according to the corporate

governance practices Because it can prove to be a potential threat to the corporate management and they cannot try to expropriate other shareholder’s rights by giving themselves illegal and unjustified reasons A question arises here that if an ideal audit committee can be a good committee or can it perform its tasks well? This question arises the issue that if an ideal AC given enough space to perform

their tasks well? Since it is basically the management which can hide certain information from even the audit committee, the internal auditor can twist the accounting records and can even construct some information In this way the truthfulness and quality of the financial reporting can be questioned

Knowledge and expertise

Knowledge and expertise, as described earlier, is a good tool for an independent and free audit

committee Such a committee can interrupt the report making process by checking the monthly or quarterly financial data so that they can prepare themselves as well as can report the board if they find any deceptive construction done by the financial experts of the management

An ideal AC can strengthen the hands of internal auditor which often is under pressure of management and is appointed to find those ways with which the management can get the escape from bitter

questions of auditor Only if the internal auditor is honest with his job, he can assure, to some extent, the good quality of financial reports If not openly, he can help the audit committee secretly, and this will not be against his job because his job is to do the job honestly

An independent and ideal AC can check the audit committee’s meeting records (called minutes) and can see if the minutes actually show the activities of the committee or there is included any deceptive or misleading disclosure In this way, audit committee can save its image of being less effective and

powerless If only audit committee exerts pressure on the management through board of directors, a lot

of things can become straight within the business

With professional know how and expertise, audit committee can review the reports before presenting them to the board, thoroughly and can figure out any deception in those reports if they have the

previous record with them In this way a fraud can be caught at the very beginning of its creation Only if the audit committee realizes its power and effective control over the financial reporting process, the financial process oversight and the audit function oversight, it can be a good tool to keep the

management into the limits ad world can be saved from any financial frauds big or small

But it is also a sad aspect of the corporate that no matter how strong the board or its sub committees may be, the management does not let it work independently It more than often buys the independence completely or partially The grey directors who are presented as “independent” directors often turn the tables by voting in favor of management due to several reasons Therefore, to have good corporate practices and to be powerful, the board and committee need to be honest and of upright character, at least they should not have greedy personality aspects

PART 3: PROPOSAL

These issues, mentioned above can be solved only with the honest adherence to the corporate

governance rules and regulations

Currently, the regulatory authorities have revised their rules and now present very strict corporate ordinance which can bring real change into the society The only problem is that these rules are obeyed

in letter and not in spirit To obey laws in real means to be ethical and ethics means that the conscience

is not dead Therefore only proposal that has ever been given on obeying the rule actually was the

ethics Corporate ethics became another dimension of business and now, every regulatory authority has

issued the paper of corporate or business ethics Again, ethics cannot be enforced like law they cannot

be followed honestly because there is no scale to measure the honesty of a person or a group of people working in money

PART 4: THE ISLAMIC PERSPECTIVE AND SOCIETY

Last part of this paper deals with the impact of these practices on society at large and what Islam says about such practices Being Muslims and living is a Muslim majority society (though not completely Islamic in many aspects) we are more responsible than others when it comes to honesty and justice and truthfulness Since the western system has failed to maintain the truthfulness and quality of business where, society can benefit, now they realize that there needs to be business ethics and “corporate social responsibility” if they want their business to grow The business solely depends on the society, if people will not take any interest into a business, it will collapse, and therefore the first thing to run a business successfully is to run it truthfully

ALLAH (swt) says in Holy Quran: 23: 7

“But those whose desires exceed those limits are transgressors”

Therefore, to exceed the limits and to ask for more than what is the right share means nothing but to invite anger of ALLAH History has seen that no matter how successfully the buggers planned but in the end, they ended up with nothing but humiliation The case of ENRON is the biggest example

But those, who observe their limits, and do not ask for more than their due share, for them ALLAH says:

Holy Quran: 23: 8-11

“Those who faithfully observe their Trusts and their covenants; And who (strictly) guard their prayers Those will be the heirs Who will inherit Paradise: they will dwell therein (forever) “

The above verses indicate that those who do their jobs with truthfulness and those who do not break trusts, they will be the dwellers of paradise This means that ALLAH swt likes such people

In another place, ALLAH swt says

Holy Quran: 33:72

“Truly, We did offer Al¬Amânah (the trust or moral responsibility or honesty and all the duties which Allâh has ordained) to the heavens and the earth, and the mountains, but they declined to bear it and were afraid of it (i.e afraid of Allâh's Torment) But man bore it Verily, he was unjust (to himself) and ignorant (of its results).”