Question

Explain the importance of an audit to corporate governance

Answer 1

Corporate governance loosely refers to the whole system of rights, processes and controls established internally and externally over the management of a business entity with the objective of protecting the interests of its stakeholders. At the most elementary level, it can be described as the processes by which investors and stakeholders attempt to minimize the transaction costs and agency costs associated with doing business within a company. To do so the principal prerequisite is to have a clear, transparent, concise and true picture of the company’s financial affairs.

Moreover, the whole process of auditing requires much imagination and careful thought from beginning to end. It is highly demanding and is often described as a very onerous responsibility. No doubt the vast majority of the profession does behave with integrity but auditors can and do some times fail to exercise their duty to as high a standard as is expected of them. Auditors are required by auditing standards to review other financial and non-financial information in the annual report and to report on any inconsistencies between these and the statutory financia1 statements and to report privately to the directors observations on interna1 control resulting from the audit. Therefore, auditors’ role in the achievement of corporate governance in India should be such which facilitates efficient operations through: i) audit of agency costs inherent in a division between the provision of capital and the stewardship of the undertaking such capital is invested in; ii) seeking to ensure a proper standard of performance and accountability for the benefit of all stakeholders. It would also be obligatory for the auditors to understand the importance of transparency and public accountability of the company as a means of ensuring that the stakeholders could hold him also account for the external impact of non-disclosures in the statements or non-transparent statements. This principle of disclosure is of fundamental nature, which arises out of freedom to choose and disclose. Transparency can reinforce sound corporate governance.

The role of the auditors would be to audit the historic financial information in annual report, review for consistency of the surroundings to the annual accounts, reach a view whether statements have been 'properly prepared' and are forward looking statements (not necessarily forecasts) and policies. The auditors have a duty of ‘care’ to existing shareholders of the company and also to any other person and purpose to whom and for which they have or are deemed to have explicitly or implicitly agreed to owe such duty.  

This has been achieved by the process of auditing, however willful or inadvertent negligence in auditing process has led to disastrous consequences. The world had its share of breakdown of corporate governance in form of Enron, Parmalat, Qwest, Global Crossing etc. all from auditing lacunae which shook the very fundamentals of corporate governance. Hence auditing has an important place in the hierarchy of ideal corporate governance structure.

Auditing is defined as obtaining and evaluating evidences regarding assertions about economic actions and events to ascertain the extent to which they correspond with the established criteria, and to communicating the result to the interested users. Thus, it encompasses investigation process, attestation process, and the reporting process, pertaining to economic actions and events. The basic statutory duty of the auditors is to report to the shareholders on whether the company’s annual accounts are properly prepared and give a true and fair view; and on whether the directors’ report is consistent with the accounts.  

Earlier, the auditors were concerned mainly with the interests of the shareholders in conveying them whether the accounts prepared and presented by the company reveal a ‘true and fair’ view of the financial position of the company as on the date of Balance Sheet and of the financial result (profit or loss) for the period ending on that date. The concept of ‘ true and fair’ has not been defined in the Companies Act or any other statute and it entirely depends on the prudence and wisdom of the auditors as revealed from the verification of records and the relevant evidences gathered by them during the course of audit. In the challenging, competitive and complex environment that the corporate world is witnessing, many chaotic events are happening in the working of the corporate which affect the fundamentals of the audit functions and the expectations of the different sections of the community from the auditors and the audit reports get added importance. The role of management and its responsibility have come up for accelerating internal control system to face the challenges and coping up with the international competitive environment. The internal control systems evolved and practised by the corporate bodies to protect their interests and minimize the chances of underutilization of the resources as well as to guard against frauds and errors, have assumed immense importance in view of the new dimensions of corporate working in this era of liberalization and globalization of Indian economy. Audit professionals have to play an important role in vouchsafing the system of not only the financial management but of various related functional activities. Following publication of the Cadbury and Greenbury reports, the Listing Rules now require the auditors to review the directors’ statement on ‘going concern’ ,certain aspect s of the directors’ statements of compliance with the Cadbury code , and certain element s of the report of the remuneration committee. The Listing Rules also require directors to agree with the auditors the content of preliminary announcements of financial results. Therefore, the role of the auditors in ensuring the preparation of transparent accounts in accordance with the accepted accounting standards and practices has become more crucial. The Companies Act has imposed a special duty on Auditors to comment on this aspect in the Auditor's report.  

International Audit Standards uphold that an auditor's mandate may require him to take cognizance and report matters that come to his knowledge in performing his audit duties which relate to: (i)Compliance with legislative or regulatory requirements; (ii)Adequacy of accounting and control systems; (iii)Viability of economic activities, programmes and projects. Two alternative situations emerge when the functions of auditors and the requirements of good governance are placed face to face. The former is confined to 'economic actions and events, while the later is the outcome of a wide range of managerial functions. The question then arises whether the auditors should cross their operational limits in order to bring about the desired level of improvement in the quality of governance, or, alternatively, while restricting themselves to their term of reference, they should operate more effectively so as to help improve the quality of governance. It is established that auditors are not required to traverse their area of operation. Whatever they are expected to contribute towards good governance shall, therefore, be from within their range or sphere of activity. In other words, it is the quality of their performance that will make all the difference, which, therefore, needs to be ameliorated to match the requisites of good governance.