Comparative international auditing and corporate governance

A. Auditing is expected to improve the precision, quality and reliability of information made available to the market, and to enhance investor confidence in such information.

B. With the current trend toward globalization of markets, and rapid growth in international transactions, securing investor confidence is crucial for MNCs.

C. The Organization for Economic Cooperation and Development’s (OECD) revised code of corporate governance emphasizes among other things, that auditors should be accountable to shareholders, and that boards of directors should effectively oversee the financial reporting function.

D. Some of the specific measures introduced by the Sarbanes-Oxley Act to improve corporate governance relate directly to auditing, for example, establishment of a new oversight board for the accountancy profession, tightly defining ‘independence’ of audit committee members, requiring external auditors to report directly to audit committee, and prohibition of certain non-audit services by external auditors.
II. There are major variations in many aspects of external auditing across countries, including the purpose of external auditing, the audit environment, regulation of auditing, and audit reports.

A. The purpose of external auditing can be different between Anglo-American countries and continental European countries. For example, German auditors take a much broader view of the concept of “client” than do their counterparts in the U.K., perhaps due to the particular corporate governance structure in Germany.

B. The cultural value orientation of a particular country can have an impact on the audit environment in that country. For example, the perception of auditor independence and audit judgment can be affected by culture. The audit environment of a country is also heavily influenced by its accounting infrastructure, which includes preparers and users of information, information intermediaries, and mechanisms for regulating accounting information.

C. Approaches taken to regulate auditing in different countries range from those that leave the task largely in the hands of the profession, such as in Anglo-American countries, to those that rely heavily on government, such as in China.

D. There are significant differences in the audit reports in different countries, and sometimes different companies within the same country. For example, such differences could arise as a result of an audit conducted by using a different set of standards from that used in preparing the financial statements (e.g., Toshiba), or by using both local and international standards (e.g., Bayer AG), or by using multiple sets of standards aiming at different audiences (e.g., Unilever).

III. International harmonization of auditing standards is important mainly to assure the international capital markets that the audit process has been consistent across companies.

A. The responsibility for developing international auditing standards rests with the International Federation of Accountants (IFAC).

B. As a condition of membership, IFAC member bodies support the auditing standards and other statements developed by the IFAC through its International Auditing and Assurance Standards Board (IAASB).

C. In December 2004, the IAASB issued a revised ISA 700 aiming at enhancing the transparency and comparability of auditors’ reports across international borders.

D. Auditors are expected to comply with IFAC’s Code of Ethics for Professional Accountants.

E. In accordance with IAS 1, the International Auditing Practices Committee (IAPC) specifies that financial statements should not be described as complying with IFRSs unless they comply with all the requirements of each applicable standard and each applicable interpretation of the IFRIC.

F. The International Organization of Securities Commission (IOSCO) supports IFAC’s standards on auditing.

A. Big 4 accounting firms strongly advocate that auditors’ liability should be limited.

B. In some countries, audit firms are allowed to change their ownership structure in order to limit their liability.

C. In the U.K., for example, audit firms can operate as limited liability companies.

D. Another approach taken to limit auditors’ liability is the use of the concept of proportionate liability, such as is found in Australia and Canada.

E. Statutory cap is yet another strategy for limiting auditors’ liability. This approach is used in Germany.

E. Sometimes auditors include disclaimers of liability in their audit opinions to protect themselves from unintended liability. This is a common practice among the U.K. auditors.
V. One of the main principles governing auditors’ professional responsibilities is independence.

A. Having stockholders involved in the auditor appointment process is expected to strengthen the independence of auditors from management. However, this may not be very effective as it is the management of the company who actually selects the auditor, after negotiating fees and other arrangements.

B. Prohibition of the provision of certain non-audit services to client companies is another method aimed at securing auditor independence. The Sarbanes-Oxley Act in the United States contains specific provisions in this regard.

C. Regulatory oversight often is used to secure auditor independence. Examples include the Professional Oversight Board for Accountancy (POBA) in the U.K., the Public Company Accounting Oversight Board (PCAOB) in the U.S., and the Public Interest Oversight Board (PIOB) of the IFAC.

D. Mandatory rotation of audit firms has often been advocated as a means of strengthening auditor independence.

E. The large accounting firms have resorted to splitting the organizations into separate entities, each dealing with a specific operation area as a way of addressing the auditor independence issue.

F. In some countries, such as the U.K., the admission criteria for professional auditors have made more stringent on the assumption that it would help secure auditor independence.

G. Some countries have taken a principles-based approach, for example, Canada, whereas some others have taken a conceptual approach, for example, Germany, in addressing the issue of auditor independence. Under a principles-based approach the requirements go beyond any specific situation and mandates a proactive approach based on clearly articulated principles, whereas a conceptual approach focuses on the underlying aim rather than detailed prohibitions.

A. In many countries, listed companies are required to establish an audit committee.

B. An audit committee is generally responsible for monitoring the financial reporting process, overseeing the internal control system and overseeing the internal audit and independent public accounting function.

C. The Sarbanes-Oxley Act contains specific provisions dealing with issues related to audit committees, expanding their role and responsibilities.

D. In 2003, the SEC introduced new rules to prohibit the listing of companies that fail to comply with the Sarbanes-Oxley Act’s requirements.
VII. Internal auditing is a segment of accounting that utilizes the basic techniques and methods of auditing, and functions as an appraisal activity established within an entity.

A. The internal auditing function includes review of the accounting and internal control systems, examination of financial and operating information, review of operating controls, including non-financial controls, of an entity, and review of compliance with laws, other regulations, and management policies.

B. The function of internal auditing is directly related to corporate governance, and the Institute of Internal Auditors (IIA) has issued many statements strengthening the function of internal auditing.

C. The Sarbanes-Oxley Act specifically recognizes the importance of internal auditing in restoring credibility to the system of business reporting, and the SEC requires listed companies to have an internal audit function.

D. Internal auditing is an integral part of managing a MNC. The U.S. Foreign Corrupt Practices Act 1977, the Treadway Commission Report 1987, the Report of the Committee of Sponsoring Organizations (COSO) of the Treadway Commission 1992, and the International Anti-Bribery and Fair Competition Act 1998 all recognize the importance of internal auditing.

Answers to Questions

1. Auditing issues should be of concern to any firm that seeks funds from the capital market, because auditing improves the quality and reliability of the financial information made available to the market, and helps secure investor confidence. This is of particular importance to MNCs as they usually raise funds from capital markets in different countries. Hence, they have to be able to satisfy the needs of a variety of international investors. Failure to do so would jeopardize their efforts to succeed in an increasingly competitive global business environment.

Further, since MNCs are involved in the audit of non-domestic subsidiary companies, international auditing issues are of interest to them.
2. The revised version of the OECD Principles of Corporate Governance issued in 2004 is designed to strengthen corporate governance practices in companies around the world. The main difference between the 1999 version and the 2004 version is that the 2004 version gives shareholders stronger rights. For example, it emphasizes that the auditor should be accountable to shareholders, not to management. It also places more responsibility on the board of directors requiring that the board of directors should effectively oversee the financial reporting function, and ensure that appropriate systems of control are in place.
3. The Sarbanes Oxley Act provides a tight definition of “independent” audit committee members. It requires external auditors to report directly to the audit committee.

The New York Stock Exchange (NYSE) requires listed companies to have an audit committee composed entirely of independent directors. It also requires that listed companies should adopt and disclose governance guidelines, codes of business conduct, and charters for the audit committees.

6. The Public Company Accounting Oversight Board (PCAOB) was established in 2002 as an important part of the efforts aimed at restoring investor confidence in the aftermath of the financial scandals involving major companies and accounting firms in the U.S. The PCAOB has been given extensive powers to tighten the regulation of many aspects of accounting and financial reporting. In the area of auditing the PCAOB has the power to:

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  Establish or adopt auditing standards, quality control standards, and ethical rules in relation to the conduct of audits of public companies,
  
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  Inspect audit firms, require co-operation with quality control reviews and disciplinary proceedings,
  
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  Impose disciplinary sanctions against accounting firms and individual members, and
  
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  Regulate both the U.S. and non-U.S. accounting firms that audit the financial statements of companies listed on the NYSE, by requiring them to become members.
  

7. The Eighth Directive was given effect in the U.K. through the Companies Act 1989, which included specific provisions concerning audit regulation. These include:

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  Restriction of eligibility for appointment as a statutory auditor to those individuals who hold a recognized professional qualification and are subject to requirements of a recognized supervisory body, and
  
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  Specific provisions designed to ensure auditor independence, for example, prohibiting an officer or employee of a company from acting as auditor for that company.
  

8. Variations in the audit reports of companies in different countries are mainly due to the particular auditing standards used in preparing those reports. For example, some companies use local auditing standards, whereas others use International Standards of Auditing (ISAs), or U.S. auditing standards. Some audit reports are prepared on the basis of more than one set of audit standards. Different companies in the same country can use different auditing standards. For example, the audit reports of some Japanese companies, such as Toshiba, are prepared on the basis of the U.S. auditing standards, whereas those of other companies, such as Sumitomo Metal Industries Ltd., are prepared on the basis of Japanese audit standards.

The audit reports of some German companies, such as Bayer AG, are prepared on the basis of both German auditing standards and International Standards of Auditing. Interestingly, in the case of other German companies, such as Hoechst AG, while the audit report states that the audit was conducted in accordance with German auditing standards, the audit opinion includes a statement to the effect that the consolidated financial statements are presented fairly in conformity with U.S.GAAP.

In the case of Unilever, the audit is conducted in accordance with the auditing standards in three countries, the Netherlands, the U.K., and the U.S., and three audit opinions are expressed using three different sets of wording.

It is common for Chinese companies to use Hong Kong auditing standards in preparing their audit report. Mexican companies, such as Tubos de Acero de Mexico, normally have two audit reports, a Report of Independent Accountants addressed to shareholders (often prepared by a Big 4 firm), and a Statutory Auditor’s Report addressed to the general meeting of shareholders. The period covered can be longer than one year. For example, the Tubos de Acero de Mexico audit report dated February 19, 2001, covers a period of three years.

9. International harmonization of auditing standards is expected to:

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  Enhance the credibility of the information provided through corporate financial reports.
  
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  Assure the international capital markets that one set of criteria has been applied consistently across the parent and subsidiary companies.
  
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  Facilitate a more efficient and effective allocation of resources in international capital markets.
  
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  Enable audit firms to increase the efficiency and effectiveness of the audit process globally.
  

10. International Auditing Practice Statement (IAPS) 1014, Reporting by Auditors on Compliance with International Financial Reporting Standards, issued in June 2003 by the International Auditing and Assurance Standards Board (IAASB) of IFAC, specifies that financial statements should not be described as complying with IFRSs unless they comply with all the requirements of each applicable standard and each applicable interpretation of the International Financial Reporting Interpretations Committee (IFRIC). An unqualified opinion may be expressed only when the auditor is able to conclude that the financial statements give a true and fair view (or are presented fairly, in all material respects) in accordance with the identified financial reporting framework.

In the U.S., limited liability partnerships are often used to protect the personal wealth of “innocent” partners from legal action.

Changing the ownership structure of auditing firms is also used in Germany. Historically, the use of a statutory cap (an explicit limit on the auditor’s maximum exposure to legal liability damages) has been common in Germany, mainly on the grounds that it would relieve the auditor of a major worry of the possibility of unlimited liability, and limit the premiums of liability insurance.
12. One factor that complicates the issue of auditor independence is the auditor appointment process. In order to ensure independence from management, the auditor is expected to be appointed by the shareholders of the company. However, in reality, it is the management of the company that actually selects the auditor after negotiating fees and other arrangements, and the auditor’s contractual arrangement is with the company management, not with the individual shareholders.

Another complicating factor relates to the practice of auditors providing various non-audit services to their client companies. Although the U.S. Sarbanes-Oxley Act and other regulations have specific provisions prohibiting auditors from providing certain non-audit services, still there are unresolved issues in this area. For example, large audit firms argue that certain consulting work, such as in the areas of information systems and electronic business, in fact helps improve audit quality.

13. The oversight role of an audit committee involves ensuring that quality accounting policies, internal controls, and independent and objective outside auditors are in place to deter fraud, anticipate financial risks, and promote accurate, high quality and timely disclosure of financial and other material information to the board, to the public markets, and to shareholders [Source: Blue Ribbon Committee (1999, p.20).] In many Anglo-Saxon countries, it is commonly accepted that the external auditor works for and is accountable to the audit committee and board of directors. This is different in many Continental European countries, such as Germany and France, where the auditor works for the supervisory board.
14. A major difference between internal and external auditing is that they have different functions. The primary function of internal auditing is to examine, evaluate, and monitor the adequacy and effectiveness of the accounting and internal control system, whereas the primary function of external auditing is to express an opinion on the financial statements. Another difference is that the internal auditor is a person within the organization, whereas the external auditor is an independent person outside the organization. Finally, the role of the internal auditor is determined by management, and its scope and objective vary depending on the size and structure of the firm and the requirements of its management; none of these is true for the external auditor. Management does not determine the role of the external auditor. In some countries, such as Germany, the role of the external auditor is defined in the statute. In most countries, it is defined in professional standards. International Standards of Auditing issued by the IFAC also clearly define the role of auditing.

Solutions to Exercises and Problems
1. The audit report of Unilever N.V. and Unilever PLC reflect several features that are unique to MNCs.

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  The report has been prepared in accordance with the relevant requirements of three countries, the U.K., Netherlands, and the U.S.
  
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  It covers three related companies located in three countries.
  
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  It has been signed by three audit offices of a Big-4 accounting firm, located in three countries.
  
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  The audit opinion is expressed separately in terms of the requirements of three countries.
  

2. Circumstances under which the auditor should express a qualified opinion, disclaimer of opinion, and adverse opinion as per International Standard of Auditing (ISA) 700 are as follows:

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  In accordance with IFRSs: To issue an unqualified opinion, compliance with all the requirements of each applicable standard and each applicable interpretation of IFRIC is required. The auditor should be able to conclude that the financial statements give a true and fair view (or are presented fairly, in all material respects) in accordance with the identified financial reporting framework.
  
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  In accordance with IFRSs and a national financial reporting framework: To issue an unqualified opinion, the financial statements must comply with the requirements of each of the frameworks individually.
  
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  In accordance with a national financial reporting framework with disclosure of the extent of compliance with IFRSs: Entities that prepare their financial statements in accordance with a national financial reporting framework may disclose additionally, in the notes to those financial statements, the extent to which they comply with IFRSs. Such a note is treated no differently from any other note to the financial statements. The auditor considers if the assertions made in the note is appropriate. If the auditor is of the opinion that the reference to compliance with IFRSs is not misleading, the he or she may express an unqualified opinion on compliance with the national financial reporting framework. Otherwise, a qualified opinion should be issued.
  

4. The previous version of paragraph 8.151 of the Code of Ethics for Professional Accountants reads as follows:

“Using the same lead engagement partner on an audit over a prolonged period of time may create a familiarity threat. This threat is particularly relevant in the context of the audit of listed entities and safeguards should be applied in such circumstances to reduce such threat to an acceptable level. Accordingly for the audit of listed entities:

(a) The lead engagement partner should be rotated after a pre-defined period, normally no more than seven years; and

(b) A partner rotating after a pre-defined period should not resume the lead engagement partner role until a further period of time, normally two years, has elapsed.”
The revised version has changed part (b) above to read, “A partner rotating after a pre-defined period should not participate in the audit engagement until a further period of time, normally two years, has elapsed.” This change effectively prohibits the rotating lead engagement partner from participating in any auditing role, not just the lead engagement partner role, until a further period of time has elapsed.
5. Providing proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders, and facilitating effective monitoring are two important objectives of good corporate governance (OECD, 1999). This has implications for the role of auditing. For example, the OECD (2004) emphasizes that auditors should be accountable to shareholders, not management. This requirement goes to the heart of the issue of auditor independence. Auditing facilitates the achievement of the objectives of good corporate governance. For example, external auditing provides assurance to shareholders and other that the information contained in the published financial statements are of high quality, and internal auditing assists in monitoring risks and providing assurance regarding controls within the company.
6. It has been argued that a two-tiered corporate structure, with a management board and a supervisory board, prevalent in many Continental European countries such as Germany, may be better suited for addressing corporate governance issues including the issue of auditor independence than the one board of directors corporate structure prevalent in Anglo-Saxon countries. The rationale behind this argument is that under the two-tiered structure, the audit responsibility is to the supervisory board, rather than to the management board, and therefore, the auditor is in a better position to be independent from the influence of the management board. The supervisory board is unlikely to influence the auditor, as its function is to oversee management’s performance.

Conceptually, this seems to be a plausible argument. However, whether or not this in fact is the case is an empirical question the answer to which depends on how the functions of the two boards are conducted in reality.

7. The ownership structure of some business entities in China, particularly former state enterprises redefined to create new economic enterprises, can be described as unique, because it does not conform to the concept of an entity as the term is commonly understood in the Anglo-Saxon countries. Historically, business enterprises in China also have other social obligations in addition to conducting its business activities. These other obligations include provision of education, housing, and health care for their workers and the citizens in the region. As a result, other entities that are in those other areas of obligation also have an ownership interest in any given business enterprise. This means, the ownership of such an enterprise extends beyond the shareholders and tends to be vague. Under these circumstances, the auditor’s responsibility also becomes less certain.

8. In this exercise, the students are expected to explain the concept of accounting infrastructure, identify its components, and explain the main features of the accounting infrastructure in their own country.

9. The Public Company Accounting Oversight Board (PCAOB) was established in 2000 to, among other things, strengthen the auditing function in the U.S. For example, the PCAOB has the power to establish or adopt auditing quality control standards and ethical rules in relation to the conduct of audits of public companies, and it may also impose a broad range of disciplinary sanctions against accounting firms and individual members.

One important step it has taken towards achieving its objective is the decision to require the auditors of SEC registered companies to obtain membership in the PCAOB. The purpose of this requirement is to ensure high quality in audit reports of companies that are listed on U.S. stock exchanges. Initially, auditors of both U.S. and non-U.S. companies that were listed on U.S. stock exchanges were required to obtain membership in the PCAOB. However, later it was announced that the PCAOB was willing to rely on the quality standards of some foreign audit firms, thereby removing the requirement for some foreign audit firms, which audit companies listed on U.S. stock exchanges, to obtain membership in the PCAOB.

Another important step is the publication of a new audit standard (PCAOB Release No.2004-003), requiring two audit opinions from auditors of listed companies: one report on internal control over financial reporting, and one on the financial statements.

10. a. In the U.S., audit regulation is within the framework of professional self-regulation. For example, the PCAOB is an independent body, which has the authority to take the necessary steps as the main oversight body. In Germany, audit regulation is through legal means, rather than within the framework of professional self-regulation. For example, there are specific legal provisions concerning admission requirements, auditor’s rights and duties, disciplinary measures, etc. Statutory auditors in Germany are required to register with a public law body (WPK), whereas in the U.S., the statutory auditors are required to obtain membership in the PCAOB.

b. As two countries that follow the Anglo-Saxon traditions, the U.K. and U.S: have many similarities in the mechanisms put in place to regulate auditing. However, there are also some differences. Unlike in the U.S., there is no uniform system of examination in the U.K. for entry into the profession as an auditor. Four professional bodies in U.K. conduct their own entrance examinations.

The Accounting Foundation, which performs the public oversight function in the U.K., is funded by the accounting profession and other interested parties, whereas its U.S. equivalent, the PCAOB, is funded by government.

In the U.K., to become a Registered Auditor (the U.K. equivalent term for statutory auditor), auditors are required to register with one of the four professional bodies recognized for this purpose (namely, the Institutes of Chartered Accounting in England and Wales, Scotland, and Ireland, and the Association of Chartered Corporate Accountants). On the contrary, in the U.S., statutory auditors of all SEC registered companies (including foreign companies) must be members of the PCAOB.
11. As a condition of membership with the IFAC, professional accounting bodies are obliged to support the work of the IFAC and endeavor to implement its pronouncements in their countries. However, the main problem facing the IFAC in its efforts to discharge it responsibility for harmonizing auditing standards internationally is that it does not have any power to enforce its pronouncements. As a result, it has to rely on the goodwill of its member bodies in various countries for compliance.

Another major issue is the extent of diversity in auditing standards used in different countries. This is primarily due to the differences in the accounting infrastructure prevailing in those countries. For example, if there are no effective mechanisms in a particular country to enforce regulations, the level of compliance with standards is likely to be low. As long as these differences exist, they will cause problems in achieving harmonization.

In some countries, the concept of external auditing -- an outsider examining the books and records of a company -- may be problematic culturally. An example would be Japan. Implementation of international auditing standards in such a country would be relatively more difficult.

Nationalism also may play a role in some countries. For example, some professional bodies may not respond positively to the idea that they have to follow a set of standards developed by an international body.

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  State that the preparation of financial statements is the responsibility of the company’s management, and that the auditor’s responsibility is to express an opinion.
  
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  Identify the accounting policies under which the financial statements have been prepared.
  
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  State the procedures followed in formulating an opinion.
  
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  State their opinion clearly.
  

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  The auditors of Cadbury Schweppes state in their report that they have also audited the information in the part of the Report on Directors’ Remuneration that is described as having been audited. This is required by the U.K. Companies Act 1985. Neither of the other two audit reports makes any reference to Directors’ remuneration.
  

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  The audit report of Cadbury Schweppes is much longer compared with the other two reports. Unlike the other two reports, it contains a detailed description of the respective responsibilities of Directors and auditors. It specifically mentions the review of the company’s corporate governance statement to see if it reflects the Company’s compliance with the Code specified by the Listing Rules of the Financial Services Authority.
  

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  The Cadbury Schweppes report states that the auditors are not required to consider whether the Board’s statements on internal control cover all risks and controls. The BASF audit report states that in the audit, the effectiveness of the internal checking system and proof of the details provided in the Consolidated Financial Statements and Management’s Analysis are assessed. The Kubota Corporation report makes no specific reference to internal controls.
  
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  A unique feature of the Cadbury Schweppes report, compared with the other two reports, is that it contains two sets of opinion addressed to two different audiences, U.K Opinion and U.S. Opinion, and the two opinions are worded slightly differently.
  

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  The three audit reports express the auditor’s responsibility in three different ways.
  
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    Kubota: to express an opinion on the financial statements.
    
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    Cadbury Schweppes: to audit the financial statements and the part of the Report on Directors’ Remuneration described as having been audited in accordance with relevant U.K. legal and regulatory requirements and auditing standards.
    
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    BASF: to give an assessment of the Consolidated Financial Statements and Management Analysis.
    

(b) Issues of interest to IFAC.