Essay: External Auditing

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External Auditing UK

Modern corporations are run by directors and managers, who are essentially investing the funds of investors. These managers owe a fiduciary duty to the investors, but as far back as Adam Smith it was recognized that managers could not be expected to treat the money of others with the same care that they would treat their own. Thus, it has been recognized for 275 years that some degree of corporate governance must be built into the management structure of modern corporations.

Corporate governance in the United Kingdom, at least with respect to firms traded on the London Stock Exchange, is based on the Combined Code. The code is based on the Code of 1998, with input from other codes and reports, dating as far back as the Cadbury Report of 1992, which marked the origins on modern corporate governance in the UK. This paper will explore the most significant developments in corporate governance in the United Kingdom, with a primary focus on the elements of the Combined Code. Brief mention will also be made of the Sarbanes-Oxley Act, an American legislation that applies to dozens of the largest British companies by virtue of their trading on the New York Stock Exchange. The objective of the paper is to analyze the process of corporate governance development in the UK over the past ten years. Lastly, the report will examine the impacts of the Combined Code on a couple of UK companies, with the intent of determining the precise impact that the code has had on British corporations.

Background

For most of capitalist history, there has been little in the way of formal corporate governance initiatives. A series of corporate scandals, however, culminated in the publishing of the Cadbury Report of 1992, upon which modern corporate governance legislation in the UK was based. In 1998, the Hampel Report was initiated as a review of the Cadbury Report's effectiveness in changing corporate governance in the UK (Hampel Report, 1998). The outcome of the Hampel Report was that the findings of the Cadbury Report and the Greenbury Report on director's compensation were combined.

The next significant event was the Higgs Report of 2003. The Higgs Report, titled the Review of the Role and Effectiveness on Non-Executive Directors was a review of said directors and of the audit committee, with the intent to bolster the Combined Code. This report came as a result of the scandals in the United States, including Enron, Tyco and WorldCom.

The United States responded to these crises with wholesale legislative change in the form of the Sarbanes-Oxley Act. This Act placed stringent corporate governance on all companies publicly traded in the U.S. Sarbanes-Oxley (SOX) did not directly impact the Combined Code, but it did impact British corporations. In effect, British companies trading in both London and New York were faced with double the corporate governance regulation, being subject to both SOX and the combined code. This dramatically increased the cost of governance, given that the Combined Code is principles-based, rather than SOX's rules-based code, and therefore much less costly to implement (Financial Reporting Council, 2006). The excessive cost of implementing the American governance code has lead many British companies to withdraw from U.S. markets (Madigan, 2007). Rules-based governance legislation, in particular SOX, was rejected by the Financial Report Council, which has long favoured a principles-based system.

Roughly concurrent with the Higgs Report was the Smith Report. This report addressed the independence of external auditors in light of the Arthur Andersen/Enron scandal in the U.S. The Smith Report was published as guidance for listed companies with respect to meeting audit requirements under the Combined Code (Smith Report, 2005).

External Auditing

The Combined Code provides guidance of all aspects of corporate governance. The role of auditors at the outset of the code was relatively minor. External auditors were expected to play their basic role under the earliest versions of the Combined Code. The Hampel Code had a provision that non-employee directors on the audit committee must understand the details of the business. The role of external auditors, however, was not explicitly addressed.

However, after the Arthur Andersen/Enron scandal, the role of external auditors was given more attention in the Combined Code. The Smith Report was the most important report in shaping the new expectations of auditors within the Code. The Smith Report came about as a response specifically to the auditing crises in the United States. Smith's report developed and codified the role of audit committees. These provisions included the following. The audit committee was to include at least three members, all of them independent non-executive directors. One of the members had to have relevant and recent financial experience. The roles of the audit committee were also laid out in the Smith Report: to monitor the integrity of the financial statements; to review the company's internal financial control system; to monitor and review the effectiveness of the company's internal audit function; to make recommendations concerning the appointment of external auditors; to review the independence and objectivity of external auditors, and to implement policy regarding non-audit services performed by the auditors (Smith Report, 2003). The code also specified that the audit committee be provided by the company with sufficient resources to perform these tasks.

Oversight of the Combined Code falls under the auspices of the Auditing Practices Board at the Financial Reporting Committee. The APB was founded in 1991, and was placed under the FRC in 2002.

The shifting role of auditors in the past ten years echoes the trend of years preceding this decade. Originally, external auditors were charged with the detection and prevention of fraud. Then came a move towards the verification of financial statements, which was one element of fraud detection. Scandals such as BCCI highlighted the need for renewed emphasis on fraud detection. Then, however, as consulting feeds increased, the role of auditors softened again (Ojo, 2006).

After the adoption of the Combined Code, the role of auditors began to change again. At that time, the Big Five still performed auditing services, but in many cases derived significantly more income from non-auditing services (Ibid). With increased scrutiny from shareholders and regulators with respect to accounting fraud, the major auditing firms were forced to re-emphasize the fraud detection and financial statement analysis portion of their business, at the expense of their consulting business.

To this end, the main industry associations governing external auditing in the UK adopted codes of ethics in the mid-2000s. The Institute of Chartered Accountants of Scotland, for example, adopted a version of the 2005 International Federation of Accountants (IFAC) Code (ICAS, 2009). The aforementioned Auditing Practices Board of the Institute of Chartered Accountants in England and Wales (ICAEW) issued its own code off ethics in 2004. The board readily admits that the changes were essentially thrust upon them by a worldwide move to end self-regulation of the auditing industry. When the APB issues its code of ethics, this was intended to supercede the codes previously issued by other professional associations in accountancy. One of the unique elements in this code of ethics was that it incorporates elements of public perception into the code. Previously, public perception had not been an issue in the external auditing industry. In light of the high-profile scandals on both sides of the Atlantic, however, public confidence had been shaken in the auditing profession.

The APB code highlights a couple of major shifts in the role that external auditors play in the corporate governance framework. One is that auditors were now subject to increased public scrutiny. They were forced to manage not only their actual independence but the public perception of independence. This represents a new level of accountability to shareholders. Corporate governance distills down to protecting the shareholders investments. The fact that shareholders at this point are so skeptical of external auditors' ability to fulfill their duties to the shareholders that 'perception of independence' clauses are deemed necessary shows the degree to which consulting services and auditing failures have shaken public confidence. Both the Smith Report and the APB code were born of the perception that auditors were no longer fulfilling their vital role as protectors of public confidence in the investment system (Groom, 2002).

The other major shift this hints at is a shift away from auditors as being the last line of defense. By the APB's own admission, their code of ethics was produced in response to a "world wide move to end self-regulation" (ICAEW, 2006). This indicates that the external auditor is no longer trusted with the role as the last line of defense. Indeed, Sarbanes-Oxley in the United States essentially strips that role away from external auditors and gives it to the PCAOB. In the United Kingdom, the authorities have not been as strict and the auditing industry still maintains its traditional role, but the public and the government are increasingly skeptical that the industry can fulfill that role.

The most recent change in the role of the external auditor in the corporate governance… [END OF PREVIEW]

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