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The role of the Auditors in the UK Corporate Governance

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par N'semy Aubin Mabanza
University of Wales, Cardiff Law School - LLM (Master of laws) in Commercial Law 2004
  

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2.3. Internal control in the UK

Internal control is the whole system of financial controls established in order to

provide reasonable assurance of: effective and efficient operations; internal

financial control; and compliance with laws and regulations. Under the UK

corporate governance system, the board of directors is elected by the shareholders

who in practice exercise their control in a number of ways The recent scandals has

159

attracted considerable attention.

There was concern about systems for controlling corporate action, particularly that

of company directors. The role of auditors and the extent of their independence

were criticised; the audit report at the time considered as being the ultimate

indicator of corporate based upon an independent opinion on the company's

affairs became the subject of debate. The Cadbury Report recommended that 'the

directors should report on the effectiveness of the company's system of internal

control' and that this report should be reviewed by the auditors. Moreover, to

enforce the recommendations of the Cadbury Report, sanctions have been

imposed since 1993 for companies listed on the London International Stock

Exchange. With the Cadbury Report, companies boards became more responsive

to shareholders' concerns as it stated:

`Bringing clarity to the respective responsibilities of directors, shareholders, and auditors will also strengthen trust in the corporate system. Companies whose standards of corporate governance are high the more likely to gain the confidence of investors and support for the development of their business'(1.6, p.58).

The Cadbury Report considers that all directors, whether or not they have executive

responsibilities, should be responsible for ensuring that `the necessary controls over

the activities of their companies are in place and working'. In addition, the Cadbury

report' view was that the board of directors is responsible for the governance of

159. Rutternam Working Group,1994.p.1

companies, these responsibilities include the company' strategic aims, providing the

leadership to put them into effect, supervising the management of the business and

reporting to shareholders. However, one of the requirements of the Code of Best

Practice on directors was to include a report in their annual control on the

effectiveness of the company's system of internal control (CBP, 4.5.p.59 ). This latter

requirement was not considered in the draft guidance of the Working Group set up to

develop a set of criteria for assessing effectiveness. In 1995, the Combined Code of

the Committee on corporate governance (the Code) was published. One of its

requirements was to assist listed companies about the internal control question.

Principle D.2 of the Code states that' the board should maintain a sound system

of internal control to safeguard shareholders' investment and the company's assets';

the directors should, at least annually, conduct a review of the effectiveness of the

group's system of internal control and should report to shareholders that they have

done so. The review should cover all controls, including financial, operational and

compliance controls and risk management'(D.2.1).

It was argued that a company's system of internal control has a key role in the

160

management of risks that are significant to the fulfilment of its business objectives.

A sound system of internal control contributes to safeguard the shareholders'

investment and the company's assets; company's objectives, its internal control

organisation and the environment in which it operates are continually evolving

161

and, as a result, the risks it faces are continually changing.

160.A.Chambers,'Tolley's corporate governance'

161.ibid

A sound system of internal control therefore depends on a thorough and regular

162

evaluation of the nature and extent of the risks to which the company is exposed.

Since profits are in part the reward for successful risk-taking in business, the purpose

of internal control is to help manage and control risk appropriately rather than to

163

eliminate it. The Turnbull Report was set up in 1999 to address the issue of internal

control and respond to these Provisions in the Combine Code. It represented the

culmination of several years' debate concerning companies' systems of internal

control. The report was accompanied by the code of practice.

However, Turnbull aimed not to transform companies' systems of internal control but

to make explicit the systems of internal control, which many of the top- performing

companies had developed, in order to standardize internal control and achieve best

164

practice. Solomon suggests that without an effective system of internal control,

companies can undergo substantial financial losses as a result of unanticipated

disasters. In the UK as in the USA the recent collapses of Maxwell, Barings and

Enron have been attributed in part to a failure of the company's system of internal

control. The board of directors is responsible for the company's system of internal

control; it should set appropriate policies on internal control and seek regular

assurance that will enable it to satisfy itself that the system is functioning effectively;

the board must further ensure that the system of internal control is effective in

165

managing risks in the manner which it has approved. Moreover, it is the role

of management to implement board policies on risk and control.

162.A.Chambers,'Tolley'sCorporate governance'.

163.ibid.

164.J. Solomon and A. Solomon , ' Corporate governance and Accountability'.

165.ibid

In fulfilling its responsibilities, management should identify and evaluate the risks

faced by the company for consideration by the board and design, operate and monitor

a suitable system of internal control which implements the policies adopted by the

166

board. In the Enron case, the function of the NEDs was as they did not detect

fraudulent accounting activities through their internal audit function; indeed, the

167

internal audit committee failed completely in policing their auditors. Serious conflicts

of interest have arisen involving members of Enron's internal audit committee, for

example, Lord Wakeham was on the audit committee at the same time as

168

having a consulting contract with a consulting contract with Enron.

These examples show that people in responsible positions who should have detected

unethical activities, were themselves not independent. Enron illustrated that the board

of directors was composed of a number of people who have been shown to be of poor

moral character and willing to conduct fraudulent activity; this was the genuine root

169

of the company's corporate governance failure. Moreover, the internal audit

committee did not perform its function of internal control and of checking the external

170

auditing function. However, it seems that on a practical level the Turnbull Report has

had a far-reaching impact on corporate risk disclosure, as companies have been

encouraged to comply with its recommendations by producing detailed reporting of

171

their risks.

166.J. Solomon and A . Solomon , ' Corporate governance and Accountability'.

167.ibid

168. The Economist , 7 February 2002.

169. J. Solomon and A . Solomon ,'Corporate Governance and Accountability `.

170.ibid

171. ibid

The Cadbury Committee Working Group, limited the directors' s reporting

responsibilities to internal financial control which are those established to provide

reasonable assurance of the maintenance of proper accounting records and the

reliability of financial information. In fact, the internal control process shows the

importance of the non- executive director in the UK corporate governance.

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