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Role of Internal Auditor in Corporate Governance Framework

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Contents Page 1. 0. Introduction2 2. 0. Background2 2. 1. Objectives3 2. 2. Methodology3 2. 3. Layout3 3. 0. Literature Review4 4. 0. Theory5 4. 1. Internal Audit5 4. 2. Corporate Governance Framework5 5. 0. Case Studies6 5. 1. Royal Dutch Shell6 5. 2. Royal Bank of Scotland6 6. 0. Application of theory7 6. 1. Royal Dutch Shell7 6. 2. Royal Bank Of Scotland7 8. 0. Limitations8 9. 0. References9 1. 0. Introduction A good governance system in an organization begins with having internal audit function.

The value and the need to focus on improving strong corporate governance have increased due to a series of failure (bankruptcy and fraud) and financial scandals like earnings restatement to ensure financial reporting quality (Zeleke Belay, 2007).

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These corporate upheavals have driven external regulators to find ways of promoting greater accountability, disclosure and transparency. The main role of corporate governance is to restore the trust and market confidence as well; shareholders. Carl Rosen, 2010) It has been widely recognised that the role of the internal auditor becomes a continuing contributor in terms of developing good corporate governance practices and structure. It is said that an effective internal audit function enables the board to perform its corporate governance duties through organizational involvement, assessment, training, professional guidance and communication at all levels within the organization (Kenneth D’Silva, Jeffrey Ridley, 2007).

Audit committee, managers, internal auditors and external auditors play a critical role in effective control and appropriate leadership within the organization to act in the interest of the shareholders. (Sridhar Ramamoort, 2003). Most companies recognised and valued internal auditing and hence, the role of internal auditors has escalated and is being relied on to contribute significantly in business improvement, strategic and operation risks (Kenneth D’Silva, Jeffrey Ridley, 2007). 2. 0. Background

The revolution of corporate governance started in the early 1990s in the United Kingdom (UK) with the Cadbury report (1992); with a code of best governance practices such as separation of the chairman and chief executive, the independence of audit committees and the practice of regularly reviewing the board’s effectiveness. Corporate governance is the relationships between managers, directors and shareholders (Cadbury report, 1992; FRC, 2012). It is a voluntary code for listed companies in the UK, with “comply or explain” principle.

Listed companies must comply with the listing rules to report on the way they complied or explain why it does not in their annual reports. The principles also apply to the internal audit function; companies that do not have internal audit function are recommended to review if there is a need for one from time to time. This will provide more transparency and accountability of the board of directors which contributed to the development of the UK corporate governance code (FRC, 2012; Keay, Andrew R, 2012).

As mention above, internal auditors plays a unique role in the governance system in terms of monitoring and identifying risk and testing of internal controls processes to ensure effectiveness or efficiency and adherence to relevant law and regulations. The institute of internal auditing (IIA) which was established in 1941 is a guidance setting body and is currently recognise in 165 countries as a comprising mandatory criteria standards and guidelines applicable to all internal auditors for internal auditing practices (IIA, 2013). It is essential that the board understands the importance of corporate governance and internal audit functions.

The quality of corporate governance will have a profound impact on the efficiency of corporate assets use, ability to attract low-cost capital, ability to meet societal expectations and overall performance. It is said that investors are willing to pay more for a company with good corporate governance due to the fact that risk factor is reduced and believes company will perform better in the long term. With good corporate governance, internal audit work should also be performed with high standards and at appropriate level of scepticism.

Further details on the regulatory standards will be discussed in section 2. 1 (FRC, 2012). 3. 1. Objectives The objectives of this report were attained from analysing different literature, e-news and theoretical background of internal audit and corporate governance. Two case studies used in this report is an example of companies who have already experience corporate scandals. Both companies are in different industry but both failures pointed out were similar; internal control, compliances of regulatory guidelines and ethical issues were mainly lacking in both organizations.

In this report, we will discuss on the failure of corporate governance in both organization and how these failures affect the companies. 3. 2. Methodology This research is carried out based on many researchers’ works in the value of role of internal auditor in corporate governance framework. The factors chosen are those identified issue by the Institute of Internal Auditors (IIA) together with other related articles primarily from previous studies. 3. 3. Layout Section 1 and 2 of this report includes introduction and background of corporate governance and internal auditing and methodology of the research.

Section 3 and 4 includes literature review in view of the role of internal auditors in corporate governance framework and the theoretical background. Section 5 is the case study scandal on Royal Dutch Shell and Royal bank of Scotland. Section 6 discusses on how both companies failed to comply with the regulatory guidelines and standards. Finally, Section 7 and 8 discuss on the limitations and conclusions. 3. 0. Literature Review During the early days, internal auditor role is only related to accounting control and security over assets acting as “policemen” checking and monitoring the company’s procedures and compliances with the rules.

Internal auditor assists company in producing reliable accounting information for decision-making purposes. However, their role has now expanded to be involved in operating systems, implement effective governance and controls and assess effectiveness of managements control practices and assisting in achieving company objectives and governance. They are the eyes and ears of the management, which is vital in the system of checks and balances (Deloitte, 2012). One of the reasons leading to corporate scandals was creative accounting (for example, Shell case).

Financial statements presented to stakeholders may not be in fact “true”. Dishonesty of directors plays a vital role in corporate scandals; such as knowing the accounts may not be done properly and deliberately hiding the problems from shareholder that the company is performing well. Some says it is also due to personal greed (for example, employees at RBS Libor scandal), ethical laxity, weakness in functioning area, auditor oversight or systemic factor as a main cause of deceit (Piet Eenkhoorn, Johan Graaflandal, 1998).

The UK’s Turnbull report provides some suggestions that have to be taken into consideration when establishing internal audit function. Some factors like number of employees might indicate risks; with more employees complexity of payroll may increase. Some companies which indicate the boards failing to implement risk assessment and responding to risk might have simply implied the need for an internal audit department (Amanda Williams, 2012).

The likelihood of the organization not achieving its goals is highly possible if there is a major internal control failure for example in the case of Royal bank of Scotland. (Amanda Williams, 2012). 4news (2013) mention that ethical misbehaviour leads to sanctions which RBS needs to sort it out (4news, 2013). So, without a quality activity, transparency and responsibility of the internal audit; can’t assure good corporate governance. Internal auditors often find themselves in an anomalous position in a reporting structure.

Most Internal auditor report to senior management but yet are expected to review management conduct and effectiveness objectively. To prevent conflict of interest, internal auditor should report primarily and directly to the board and its audit committee rather than to senior management. (Amanda Williams, 2012). However, there is always limitation to the effectiveness of internal audit reports; for example, they may not be privy to all sources of information throughout the company if it is not within the management structure or management cannot accept the findings.

Therefore, internal auditor may face certain dilemma and criticism and hence soften the findings in report to avoid confrontation or to safeguard their positions. To protect the independency, political power should be given to the internal auditors. In view of the Libor scandals reported in myfinances. co. uk (2013), mention that IIA have drafted out a new code and is pending for further consultation which internal auditors will be given much more power to report to the chairman rather than chief executives to maintain their independence (myfinances, 2013) . 0. Theory 5. 4. Internal Audit Institute of Internal Auditors (IIA, 2012) defined internal auditing role in governance processes as promoting appropriate ethics and values within the organization, ensure effectiveness and accountability, effectively communicate risk and control information appropriately and coordinating activities among the board, external and internal auditors and management in various areas. Some of the IIA standards include in section 2110.

AI standards; the function of an internal auditor should evaluate, design, implement and review on the effectiveness of the organization ethics, objectives and activities. Internal auditor helps organization in detecting and preventing fraud, testing internal control and monitor compliance with company policy and government regulation (IIA, 2012). Internal Auditor plays like a frontline player in governance activities which includes risk-driven efforts provided for critical inputs to other governance participants, including the audit committee and management (Dana R.

Hermanson, Larry E. Rittenberg. 2003). 5. 5. Corporate Governance Framework Sir Adrian Cadbury defined corporate governance as the system by which companies are directed and controlled (Cadbury report, 1992). Cadbury report was particularly concerned with the low level of confidence in financial reporting and is generally believed to be the foremost cornerstone of modern corporate governance. Its findings and recommendations leading to the present day evolutions of corporate governance worldwide had quite an effect on the corporate world.

The three basic principles included: openness, integrity and accountability (Jan Cattrysse, 2005). The Cadbury Report included some financial aspects; the role and responsibilities of the board, consisting of executive directors and majority of independent non-executive directors; auditing and reporting of financial information to shareholders; appointment of non-executive audit committee and roles includes monitoring and reviewing effectiveness of company internal audit functions (Cadbury, 1992).

Turnbull report (September 1999) has the most significant implications on corporate governance and also on internal auditing recommending guidelines which includes listed companies are expected to have a sound system of internal control to safeguard shareholders’ investment and company’s assets. Management needs to review effectiveness of internal control on an annual basis. Business risk should be evaluated regularly. Board is responsible for internal control and the need for internal audit department needs to be kept under review (FRC, 2005). A brief touch on the United States (U. S. Commodities Futures Trading Commission (CFCT), it is an independent agency of the government that regulates commodity futures and option markets. The Commodities Exchange Act (CEA), 7 U. S. C. § 1 et seq. , is to prevent fraudulent conduct in trading of future contracts and mission is to protect market participants and public from fraud, manipulation, abusive practices and systemic risk related to the sale of commodity and financial futures and options (CFCT, 2013). In view of the corporate scandals one cannot help but wonder how long this ‘comply or explain’ principle will still last.

There seems to be a growing demand for ‘compliance’ and less interest in the ‘explanation’. Surely, the more emphasis is being placed on compliance, the more need for control and for independent audits in general. Only compliance provides proper assurance for good corporate governance. 5. 0. Case Studies 6. 6. Royal Dutch Shell The Royal Dutch Shell has been around for more than a century being the second largest oil exploration and production company in the world in terms of revenue. Shell headquarters is in Netherlands with its registered office in London, United Kingdom (Shell, 2013).

In 2004 Shell announced that it financial statements overstated its oil reserves resulting a huge reclassification of 4. 47 billion (approximately twenty-three per cent of previously report prove reserves) barrels of oil in April 2004 which originally reported as proven oil and gas reserves in 2002. In February 2005, approximately 1. 37 billion barrels of oil were removed which was originally reported as proved reserves in 2003. Financial statements were restated accordingly. Reserves are an oil company’s most valuable asset, and any reclassification into less certain categories is a major concern for investors (ICMR, 2005).

It was uncovered by an external auditor, Ryder Scott instead of Shell’s group reserve auditor which Shell has mention in 2004 annual report that there was a lack of appropriate resources and confusion or roles and responsibilities with respect to the group reserves coordinator and auditor (Shell annual report, 2004) 6. 7. Royal Bank of Scotland The Royal Bank of Scotland group PLC (RBS) was founded in 1727 is headquartered in Edinburgh, the United Kingdom. It provides banking and financial products to personal, commercial, corporate and institutional customer worldwide (RBS, 2013).

London interbank offered rate (Libor) is an international benchmark for which banks are required to use to monitor financial transactions between other banks and customers. The scandal was uncovered in 2012 by CFTC, when it was found that a number of banks like Barclay, UBS and RBS have been fixing the interest rate during the financial crisis as a means of making higher profits under the nose of their internal auditors. It was found that employees have been manipulating the Libor rate particularly Yen and Swiss Franc Libor submission from 2006 to 2010.

Despite five internal audits was done by RBS group internal auditor the manipulation of submission was failed to detect by them. They even mention that adequate systems and controls were in place; if it is then why wasn’t it reported earlier. The internal auditors were under fire from regulators for failing to spot on the manipulation of Libor interest rate and should report directly to company board and having sufficient resources to do so (Reuters, 2013). 6. 0. Application of theory Dechow, et al. (1995) find that firms with weak corporate governance are more likely to manipulate earnings.

If internal audit function is said to be effective in providing assurance; sufficient resources should be provided in terms of both financially and qualified experienced staff; so that work practices can be independently and objectively performed (IIA, 2013). 7. 8. Royal Dutch Shell According to IIA standards, internal auditor should be someone who is qualified and has experience; however this is not the case for Shell. A retired Shell engineer was acting as Group Reserve Auditor to perform this function.

He was an experience engineer but does not have adequate training or expertise on how to conduct his works and the rules and standards on which his opinions should be based. He reported to the management of Shell’s exploration and production division which were the same people he audited (David Gwilliam, et al. 2009) which clearly shows a conflict of interest (Stephen J. Korotash. 2004). According to IIA (2013) standards 1210, internal auditor must possess the knowledge, skill and other competencies needed to perform their individual responsibilities (IIA, 2013).

Which in this case, Shell failed to conform to applicable regulations including not conforming to the requirements of SEC guidance Rule 4-10 in a number of significant ways (Stephen J. Korotash. 2004). Shell organization is structure with two boards and a committee of directors, this resulted in lower accountability. Roles and responsibilities of the top management was unclear; making misrepresentation easier (David Gwilliam, et al. 2009). Clearly, there is a lack of effective internal controls over the reserves estimation and reporting processes.

As mention in section 2 literature review, creative accounting scandals happened due to the desirableness in creating strong appearance of financial statements. Shell established their reserve figure was deficient both in terms of over-optimism and in failing to comply with SEC rules and interpretative guidance (Stephen J. Korotash, 2004). An internal review of the governance structure of Shell was carried out in 2004 whereby, they merge two parent companies Royal Dutch Petroleum and Shell Transport and trading company into single new parent company.

The management have concluded that in order to win back investor confidence, ensure greater transparency and avoid accounting failures was to overhaul its corporate governance system (Shell, 2004). Shell’s decentralized system required an effective internal reserves audit function (David Gwilliam, et al. 2009). 7. 9. Royal Bank Of Scotland One of the many roles of internal auditor is supposed to alert company about potential risks and ensure risk is report to company’s leadership. However, it does seem to be in the case of RBS scandal leading to manipulation of submission of Libor.

An internal audit report gave RBS bank Libor setting as a clean bill of health was misleading for the stakeholders (Telegraphy, 2013). RBS failed to comply with the governance code where there is a lack of internal control and violation of U. S. Commodity Futures Trading Commission (CFTC) regulatory leading to the failure of RBS. The CFTC reported (2013) that RBS failure to implement controls for making Libor submission which allows conflict of interest to happen in the organization. Some of the guidelines and act which include Turnbull report (2005) mention hat internal review should cover all material controls, including financial, operational and compliance controls and risk management systems and the act of CFTC (2011) section 6a rules covering market manipulation and fraud and section 9a (CFTC, 2001) commodity exchange act and etc. RBS Group internal auditor has also mention that there was a lack of discussion of strategy and risk and hence, failed to identify the risk and preventing it from happening (Risk Business, 2008; CFCT, 2013). This scandal has cause RBS operating expenses fell by ? 59 million and headcount fell by 9,600. More importantly, losing the shareholders and public confidence in RBS; they will have to rebuild the trust all over again (RBS annual report, 2012). CFTC (2013) report mentions that conducting of internal audit of its submission should be done periodically every six months. RBS must now implement better internal controls and write up clear submission procedures and policies on interest rates including Libor in order to ensure that any submissions are reliable (CFCT, 2013). As mention in section 2. literature reviews, in response to Libor corporate scandal; a new document which is still under consultation till 16th April 13 is designed to avoid a repeat of the Libor and other scandals by the IIA (myfinances. co. uk, 2013). 7. 0. Conclusion Internal auditor plays an important role in corporate governance in an organization to overcome financial crisis, restoring stakeholders’ confidence for the future. When shareholders and the public lose the confidence in the company, it will take much more efforts in regaining it back.

Having independence, qualified with integrity auditor is fundamental to a company good governance practices and with the required resources from the board members and audit committee. The evidence presented in this paper based on study of two major corporate cause celebres provides at best muted support for the viewpoint that seeking to reinforce the existing corporate governance structure along the lines advocated in the UK will necessarily act to prevent any such future failure of corporate governance. 8. 0. Limitations

The limitations with this topic was, ample literatures is available for corporate governance and it is very difficult to select appropriate ones however, not very much on roles of internal auditor in corporate governance. As this assignment focus is on the Role of internal auditor particularly in UK governance, there is limited number of case study for this topic. Moreover one of the case study RBS is a recent case in 2012 hence, not much literature has been covered. 9. 0. References ? Agrawal, A. and S. Chadha. 2005. Corporate governance and accounting scandals.

Journal of Law and Economics (48): Pg. 371-406. [Accessed: 02 March 2013] Amanda Williams. 2012. Internal Audit. [ONLINE] Available at: http://www. accaglobal. com/content/dam/acca/global/PDF-students/2012s/sa_apr12_p1_audit. pdf. [Accessed 13 March 2013] Andrew R. Keay. 2012. Accountability and the Corporate Governance Framework: From Cadbury to the UK Corporate Governance Code (August 31, 2012). [ONLINE] Available at SSRN: http://papers. ssrn. com/sol3/papers. cfm? abstract_id=2143171. [Accessed 02 April 2013] Barclay Simpson, 2013.

RBS had 21 staff involved in Libor scandal. [ONLINE] Available at: http://www. barclaysimpson. com/news/rbs-had-21-staff-involved-in-libor-scandal-news-801537104. [Accessed 13 April 2013] BBC News. 2013. Libor scandal: RBS fined ? 390m. [ONLINE] Available at: http://www. bbc. co. uk/news/business-21348719. [Accessed 12 April 2013] Carl Rosen. 2010. Corporate Governance in the Wake of the Financial Crisis [ONLINE] Available at: http://www. unctad-docs. org/files/CG-in-Wake-of-Fin-Crisis-Ch5. pdf. [Accessed 13 April 2013] CFTC, Melissa Jurgen. 013. ORDER INSTITUTING PROCEEDINGS PURSUANT TO SECTIONS 6(c) AND 6(d) OF THE COMMODITY EXCHANGE ACT, MAKING FINDINGS AND IMPOSING REMEDIAL SANCTIONS. [ONLINE] Available at: http://www. cftc. gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfrbsorder020613. pdf. [Accessed 13 April 2013] Common Dreams. 2004. Shell Report Exposes Lies on Oil Reserves. [ONLINE] Available at: http://www. commondreams. org/headlines04/0419-08. htm. [Accessed: 10 March 2013] Dallas, Lynne. 2002. A Preliminary Inquiry into the Responsibility of

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