Introduction
Internal audit function is essential for establishing a solid governance system within an organization. The importance of emphasizing strong corporate governance has grown as a result of various failures (such as bankruptcy and fraud) and financial scandals, which include the manipulation of earnings reports to enhance the quality of financial reporting (Zeleke Belay, 2007).
The increase in corporate disruptions has led external regulators to search for ways to promote accountability, disclosure, and transparency. Corporate governance plays a crucial role in rebuilding trust and market confidence among shareholders (Carl Rosen, 2010). Recognizing the importance of the internal auditor in establishing good corporate governance practices and structure, it is widely acknowledged that an effective internal audit function allows the board to fulfill its corporate governance responsibilities through organizational involvement, assessment, training, professional guidance, and communication at all levels within the organization (Kenneth D’Silva, Jeffrey Ridley, 2007).
Multiple parties within the organization, including the audit committee, managers, internal auditors, and external auditors, all play a vital role in ensuring effective control and appropriate leadership (Ramamoort, 2003). Their primary duty is to act in the shareholders’ best interest. Most companies highly appreciate and acknowledge the value of internal auditors (D’Silva and Ridley, 2007). As a result, their role has gained increasing significance as they are now trusted to make substantial contributions in areas like business improvement, strategic planning, and managing operational risks.
Background
The background information is provided in the paragraph above.
The revolution of corporate governance started in the UK during the early 1990s with the Cadbury report (1992). This report introduced a set of best practices for governance, which included separating the chairman and chief executive roles, ensuring audit committees’ independence, and conducting regular board effectiveness reviews. Corporate governance is concerned with the connections among managers, directors, and shareholders (Cadbury report, 1992; FRC, 2012). In the UK, it is a voluntary code applicable to listed companies that follows the “comply or explain” principle.
Companies that are listed must comply with listing rules and disclose their compliance or provide explanations for non-compliance in their annual reports. These rules also apply to the internal audit function, and it is recommended for companies without one to periodically assess if it’s needed. This helps enhance transparency and accountability of the board of directors, which has played a significant role in shaping the UK corporate governance code (FRC, 2012; Keay, Andrew R, 2012).
The role of internal auditors in the governance system is to monitor and identify risks, test internal controls, and ensure effectiveness, efficiency, and adherence to relevant laws and regulations. The Institute of Internal Auditing (IIA), which was established in 1941, is a guidance setting body that is recognized in 165 countries. The IIA sets mandatory criteria, standards, and guidelines for internal auditors in their auditing practices (IIA, 2013). It is crucial for the board to recognize the importance of corporate governance and internal audit functions.
The optimization of corporate asset allocation, the capacity to secure low-cost capital, the ability to meet societal demands, and overall performance are significantly influenced by the effectiveness of corporate governance. It is widely recognized that companies with strong corporate governance receive higher valuations from investors due to reduced risk and an indication of long-term success. Moreover, a robust system of corporate governance facilitates the implementation of internal audits that adhere to rigorous standards and maintain an appropriate level of skepticism.
The purpose of this section is to outline the objectives.
The objectives of this report were met by examining literature, e-news, and theoretical background on internal audit and corporate governance. Two case studies are provided, showcasing companies that have encountered corporate scandals. Despite operating in different industries, both companies faced similar shortcomings such as insufficient internal control, failure to comply with regulatory guidelines, and ethical concerns. The report will explore the corporate governance failures within these organizations and analyze their impact on the companies.
The methodology of the study is to be emphasized.
This research is based on the findings of multiple researchers who have studied the significance of internal auditors in corporate governance frameworks. The factors examined in this study are those identified by the Institute of Internal Auditors (IIA) and other relevant articles, mainly from prior research.
Literature Review
Originally, the role of an internal auditor was primarily focused on accounting control and asset security. They served as “policemen,” overseeing and evaluating company procedures to ensure compliance with regulations.
The internal auditor plays a crucial role in helping the company generate trustworthy accounting information for decision-making. Their responsibilities have evolved to include involvement in operating systems, the implementation of effective governance and controls, assessing the effectiveness of management control practices, and aiding in the achievement of company objectives and governance. They serve as the management’s watchful eyes and ears, essential for maintaining a system of checks and balances (Deloitte, 2012). Creative accounting, such as in the Shell case, was one of the causes behind corporate scandals.
Financial statements provided to stakeholders may not accurately reflect the true state of affairs. The involvement of dishonest directors in corporate scandals is significant. They may be aware that the accounts have not been accurately prepared and intentionally conceal issues from shareholders, giving the false impression that the company is performing well. Personal greed, ethical disregard, organizational deficiencies, neglect by auditors, and systemic factors are all believed to contribute to this deception (Piet Eenkhoorn, Johan Graaflandal, 1998).
The Turnbull report in the UK suggests that when setting up an internal audit function, certain factors should be considered. For example, the number of employees can indicate potential risks, as a larger workforce may lead to increased complexity in payroll. Additionally, if some companies show signs of the board not implementing risk assessment and addressing risks, it may suggest the necessity for an internal audit department (Amanda Williams, 2012).
It is highly probable that the organization will not achieve its goals if there is a significant internal control failure, as seen in the case of the Royal Bank of Scotland (Amanda Williams, 2012). According to 4news (2013), unethical behavior results in sanctions that RBS needs to address. Therefore, without a strong internal audit function that emphasizes quality activity, transparency, and responsibility, good corporate governance cannot be ensured. Internal auditors often find themselves in a unique reporting position.
According to Amanda Williams (2012), internal auditors usually report to senior management but are required to impartially evaluate the behavior and effectiveness of management. To avoid conflicts of interest, it is recommended for internal auditors to primarily report directly to the board and its audit committee instead of senior management. Nevertheless, there are constraints on the effectiveness of internal audit reports. For instance, if specific information falls outside the scope of management or if management rejects the findings, internal auditors may be unable to access all sources of information across the company.
Therefore, internal auditors may encounter certain dilemmas and criticism and may thus downplay their findings in reports to avoid conflict or protect their positions. To ensure independence, it is suggested that internal auditors be granted political power. In light of the Libor scandals reported on myfinances.co.uk (2013), it is mentioned that the Institute of Internal Auditors (IIA) has developed a new code that is currently awaiting further consultation. This code would empower internal auditors to report directly to the chairman instead of the chief executives as a means of maintaining their independence (myfinances, 2013).
Theory
According to the Internal Audit Institute of Internal Auditors (IIA, 2012), internal auditing plays a key role in governance processes by promoting ethical behavior and values within the organization. It is responsible for ensuring effectiveness and accountability, as well as communicating risk and control information in a suitable manner. Additionally, it coordinates activities between the board, external and internal auditors, and management in different areas. Some of the IIA standards are included in section 2110.
AI standards dictate that the internal auditor’s role involves assessing, creating, executing, and assessing the effectiveness of an organization’s ethics, goals, and operations. They assist in identifying and preventing fraud, evaluating internal controls, and ensuring compliance with company policies and government regulations (IIA, 2012). In governance activities, the internal auditor acts as an essential participant by offering risk-focused contributions to various stakeholders, such as the audit committee and management (Dana R. Hermanson, Larry E. Rittenberg. 2003).
According to Sir Adrian Cadbury, corporate governance refers to the system that governs the direction and control of companies (Cadbury report, 1992). The Cadbury report primarily focused on addressing the lack of trust in financial reporting and is widely regarded as a crucial element in contemporary corporate governance. The report’s conclusions and suggestions have significantly impacted corporate practices globally.
Jan Cattrysse (2005) identified openness, integrity, and accountability as the three fundamental principles. The Cadbury Report (1992) focused on financial aspects such as the role and responsibilities of the board, which consists of executive directors and a majority of independent non-executive directors. The report stressed the significance of auditing and reporting financial information to shareholders. Moreover, it suggested appointing a non-executive audit committee to oversee and evaluate the company’s internal audit functions.
The Turnbull report, published in September 1999, highlights the importance of corporate governance and internal auditing. It suggests that listed companies should establish a strong internal control system to protect shareholders’ investments and company assets. The management team should annually assess the effectiveness of internal controls and regularly evaluate business risks. The board is responsible for internal control and should periodically review the necessity of having an internal audit department (FRC, 2005).
The U.S. Commodities Futures Trading Commission (CFCT) is an independent agency of the government responsible for regulating commodity futures and option markets. Its main goal, as stated in the Commodities Exchange Act (CEA), 7 U.S.C. § 1 et seq., is to prevent fraudulent behavior in trading future contracts and safeguard market participants and the public from fraud, manipulation, abusive practices, and systemic risk associated with the sale of commodity and financial futures and options (CFCT, 2013). The durability of the ‘comply or explain’ principle must be questioned given the prevalence of corporate scandals.
Compliance is becoming more important and explanations are receiving less attention, emphasizing the significance of control and independent audits. Ensuring good corporate governance relies on compliance.
Conclusion
The internal auditor has a crucial role in the organization’s corporate governance, as they help overcome financial crises and restore stakeholder confidence for the future. When shareholders and the public lose faith in a company, regaining their trust requires significant effort.
The paper highlights the importance of having independent and trustworthy auditors for effective corporate governance. It also emphasizes the need for adequate resources from board members and audit committee. The study of two prominent corporate cases suggests that strengthening the current corporate governance structure, as recommended in the UK, may not guarantee prevention of future failures in corporate governance.
Limitations
There is an abundance of literature available on corporate governance, which makes it difficult to select the right sources. However, there is a scarcity of literature regarding the responsibilities of internal auditors in corporate governance. This assignment concentrates specifically on the role of internal auditors in UK governance, resulting in a limited number of case studies on this subject. Additionally, one of these case studies is RBS from 2012, which further restricts the amount of literature covered.
