finance and accounting - assignment premier
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INDEPENDENT BUSINESS ANALYSIS PROJECT
Supervisor : DR. DUNCAN WALKER
This thesis is presented in partial fulfilment of the Assessment requirements for the award of
Thesis Grade Awarded ..........….....
(To be added by Project Supervisor)
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THE ROLES AND EFFECTIVENESS OF AUDIT
COMMITTEES: A CASE STUDY OF LEHMAN BROTHERS
AND SATYAM COMPUTERS
FINANCE AND ACCOUNTING
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ABSTRACT
This thesis examined the roles and the effectiveness of ACs as provided by corporate governance codes,
in relation to corporate failures, whether the failure is as a result of the ineffectiveness of the ACs.
Given that the AC is perceived to be a means of strengthening the external financial reporting process,
and also facilitating the detection and prevention of corporate misconduct and scandals. It is believed
that many financial and governance failure the world has experienced in the recent past could
have been detected much earlier, if the ACs had been discharging their duties efficiently and
effectively. To achieve the purpose, the study provides answers to four main research questions. First,
are ACs to be blamed for audit/corporate scandals? Second, will AC prevent future audit/corporate
scandals? Third, can mandating AC improve corporate governance? And fourth, are the corporate
scandals a reflection of ineffectiveness of AC’s?
The study used secondary sourced data to investigate the roles of AC in the cases of Lehman Brothers
and Satyam corporate failures. A qualitative case study method was employed to investigate the roles
and the effectiveness of AC activities in their social, political and economic context, by identifying
and evaluating specific areas of interaction between ACs and other parties like executive
management and auditor which affect audit process.
One of the main findings of the study is that many corporate failures are associated with the
ineffectiveness of ACs, and that ACs could have prevented the occurrence of several corporate failures
if they were efficient. However, the ACs cannot be 100% blamed for the failures, This is because their
effectiveness is a subject to so many factors (independence, industry expertise, information flow,
inbuilt willingness to serve, and organizational factors), which are always lacking, and lack of any one
factor always renders the AC ineffective. Second, the study found that mandating the establishment of
ACs in corporations alone cannot improve corporate governance. This is because the cases examined
were all under mandatory regulatory requirements for the establishment of ACs but that did
prevented the occurrence of the failure. Third, lack of harsh punishment on the negligence of the ACs
members was found to be a contributing factor toward the ineffectiveness of the ACs. Fourth, the study
also revealed the need for behavioral consideration in the formation of ACs. The effectiveness of AC is
far beyond establishment and composition but rather the actual process taking place in the ACs
meetings and relation with the management in the company. Finally, it was found that ACs can only
tackle the occurrence of corporate failure when the right people are nominated into the committee,
and independent of any managerial influence.
Some of the findings are consistent, while others are contrary to previous empirical studies on
effectiveness of ACs. The study adds to the current debate on the need for improvement in the roles
played by the AC as public gatekeepers.
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ACKNOWLEDGEMENT
I am greatly indebted to my supervisor who offered a priceless supervision and support throughout
the process thank you Dr. Duncan Walker for being prompt in your response at all time that I
sought direction and guidance, I was fortunate to have you, it has been a memorable experience for
me. My gratitude also goes to our course leader who is also my personal tutor Mr. Fatau Bakare, Dr.
Williams Coffie and Dr. Abubakar Bashir for their advice and encouragement toward my academic
pursued. I also thank Prof. Mike Hynes, Sharrin Mcdowalls, Dr. Yong Wang, Dr. Lucy Zhen and the
entire staff members of the University of Wolverhampton Business School for their immeasurable
assistance in one way or the other.
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DECLARATION
This work has not previously been presented in any form to the University or to any other
institutional body, whether for assessment or other purposes. Save for any express
acknowledgements, references and / or bibliographies cited in the work, I confirm that the
intellectual content of the work is the result of my own efforts and of no other person.
It is acknowledged that the author of any project work shall own the copyright. However,
by submitting such copyright work for assessment, the author grants to the University a
perpetual royalty-free licence to do all or any of those things referred to in Section 16(i) of
the Copyright Designs & Patents Act 1988 (viz: to copy work; to issue copies to the public;
to perform or show or play the work in public; to broadcast the work or make an
adaptation of the work).
Signed …………………………………………….
Date ……………………………………………..
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CONTENTS TITLE PAGE...................................................................................................................................................................................i
ABSTRACT ..................................................................................................................................................................................... ii
ACKNOWLEDGEMENT ........................................................................................................................................................... iii
DEDICATION ................................................................................................................................................................................iv
DECLARATION ............................................................................................................................................................................. v
TABLE OF CONTENTS………………………………………………………………………………………………………………...vi
CHAPETR ONE ............................................................................................................................................................................. 1
INTRODUCTION ..................................................................................................................................................................... 1
1.0 BACKGROUNG INFORMATION ................................................................................................................................. 1
1.2 RESEARCH AIMS ............................................................................................................................................................. 2
1.3 RESEARCH QUESTIONS ............................................................................................................................................... 3
1.4 PROJECT STRUCTURE .................................................................................................................................................. 3
CHAPTER TWO ............................................................................................................................................................................ 5
LITERATURE REVIEW ......................................................................................................................................................... 5
2.0 INTRODUCTION .............................................................................................................................................................. 5
2.1 CORPORATE GOVERNACE FRAMEWORK ........................................................................................................... 5
2.1.1 DEFINITION OF CORPORATE GOVERNANCE ........................................................................................... 6
2.1.2 BOARD SUB-COMMITTEES ............................................................................................................................... 7
2.1.3 THE NOMINATION COMMITTEE .................................................................................................................... 7
2.1.4 THE REMUNERATION COMMITTEE ............................................................................................................. 8
2.1.5 UK CORPORATE GOVERNANCE APPROACH ............................................................................................. 9
2.2 LITERATURE ON AUDIT COMMITTEES ............................................................................................................ 10
2.2.1 WHY SET UP AUDIT COMMITTEE? ............................................................................................................. 10
2.2.2 ROLES OF AUDIT COMMITTEE..................................................................................................................... 12
2.2.3 EFFECTIVENESS OF AUDIT COMMITTEES ............................................................................................. 15
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2.2.4 RANGES OF AUDIT COMMITTEE ................................................................................................................. 17
2.2.5 THE NEED FOR AUDIT COMMITTEE ......................................................................................................... 18
2.2.6 WHY ARE AUDIT COMMITTEES NOT MANDATORY? ........................................................................ 20
CHAPTER THREE ..................................................................................................................................................................... 22
RESEARCH METHODOLOGY .......................................................................................................................................... 22
3.0 INTRODUCTION ........................................................................................................................................................... 22
3.1 RESEARCH APPROACH ............................................................................................................................................. 22
3.2 METHODS ....................................................................................................................................................................... 25
CHAPTER FOUR ........................................................................................................................................................................ 27
RESULTS AND EVALUATION ......................................................................................................................................... 27
4.0 INTRODUCTION ........................................................................................................................................................... 27
4.1 SATYAM COMPUTERS ............................................................................................................................................... 27
4.1.1 ANALYSIS OF AUDIT COMMITTEE OF SATYAM ................................................................................... 28
4.1.2 INDEPENDENCE OF AUDIT COMMITTEE OF SATYAM ...................................................................... 28
4.1.3 REVIEW OF FINANCIAL REPORTING PROCESS AND INTERNAL CONTROL ........................... 29
4.1.4 INFORMATION FLOW AND AUDIT COMMITTEE AUTHORITY ...................................................... 31
4.1.5 RESPONSIBILITIES FOR FRAUD DETECTION AND PREVENTION ............................................... 33
4.2 LEHMAN BROTHERS ................................................................................................................................................. 34
4.2.1 THE AUDIT COMMITTEE................................................................................................................................. 35
4.2.2 REVIEW OF FINANCIAL REPORTING PROCESS, INTERNAL CONTROL AND DISCLOSURE
REQUIREMENT ............................................................................................................................................................... 36
4.2.3 THE USE OF REPO 105 ..................................................................................................................................... 37
4.2.4 RESPONSIBILITY FOR PREDICTION PRVENTION OF FRAUDULENT ACT ................................ 38
4.2.5 AVAILABILITY OF INFORMATION AND AUDIT COMMITTEE ROLES ......................................... 40
4.3 LIMITATIONS OF THE RESEARCH ....................................................................................................................... 41
CHAPTER FIVE .......................................................................................................................................................................... 42
5.0 CONCLUSIONS AND SUMMARY OF FINDINGS ............................................................................................... 42
5.1 SUMMARY OF MAJOR FINDINGS .......................................................................................................................... 43
5.2 SCOPE FOR FURTHER RESEARCH ....................................................................................................................... 43
References: ................................................................................................................................................................................. 45
Appendices.................................................................................................................................................................................46
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CHAPETR ONE
INTRODUCTION
1.0 BACKGROUNG INFORMATION
The contemporary Audit Committees (herein AC) concept began in the late 1930’s when
the US Security and Exchange Commission (SEC) recommended that publicly held
companies form a Committee of non-officer board members that would assure the
independence, Nomination and arrangement of engagement process of external auditor
(xxxx, 2009). Afterward, the ACs played a vital role in the governing structure of public
companies (x 2005). In the last two decades ACs become a commonly used mechanism for
good corporate governance practice globally (xxxx 2004). Essentially, AC is a non-
mandatory structure used by a few corporations and has traditionally been viewed to
oversee the work of outside auditors and liaise with management on internal control and
preparation of financial report, but with limited roles on the issue (xxxx, 2005).
Following the collapse of many high profile corporations that shook the business world,
and caused shareholders, investors and public to lose confidence in many of the
stakeholders involved in governance, and the process of financial reporting. In an attempt
to restore their confidence, there have been a number of pressures, proposals and actions
taken in different countries for reforms in the corporate governance framework with
emphasis on the responsibilities and powers of ACs (xxxx, 2007). Many legislations and
corporate governance reforms have increased the responsibilities, tasks and expectations
from the ACs (xxxx 2013). The trend in ACs advancement makes it to become a common
feature of corporate governance internationally. Thus, their effectiveness becomes an issue
of concern to both researchers and regulators as it serves as a determining factor for
corporate governance success.
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The incessant corporate failures in recent years, such as the (Enron, Bre-X, Satyam and
Lehman Brothers) have turned the public searchlight on the ACs and raised a number of
questions on the need for more transparency in running the affairs of publicly owned
companies. The growing public pressure has placed a greater deal for emphasis on ACs role
in pursuit of effective corporate governance, because the result from the investigation of
collapsed companies indicated with clarity that almost every financial and governance
failure, the world has experienced in the recent past could have been detected much earlier
(xxxx, 2007), if the ACs had been discharging their duties efficiently and effectively.
1.2 RESEARCH AIMS
Hence, the purpose of this study is to figure out the actual role and responsibilities of ACs
and to understand the major determinants of effective discharge of ACs duties and to know
whether the effectiveness of ACs will reduce the rate of corporate collapse and enhance the
effectiveness of corporate governance. Significantly, researches/literatures on ACs in the
UK are not much, thus both the UK and the US research findings would be used in this study
to ascertain the effectiveness of ACs. This is because both the UK and the US corporate
governance systems followed the Anglo-Saxon corporate governance model (xxxxx., 2009).
The UK and the US corporate governance reforms Codes stipulated similar attributes
required of ACs to ensure effectiveness in the discharge of their duties diligently, among
which ACs must comprises of an independent directors and with at least one having recent
and relevant financial expertise. These requirements were enacted by SEC in US and FRC in
UK in line with the belief that independent directors with relevant financial expertise are
better monitors of management than the inside directors (xxxx 2014).
However, the major concern is that ACs is commonly viewed as a strong monitoring
mechanism that can make a remarkable contribution within good corporate governance
framework. With the increase in their establishment, independence and expertise, the
number of corporate failures have also increased. This questions their effectiveness and
indicates a sign that there are other factors that may play crucial role in the effectiveness of
their oversight role. The existing research carried out on ACs are mostly on establishment,
characteristics and composition of the ACs, this study will try to investigate into the
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process of ACs operations and their resultant effects on the governance process such as the
internal control system, financial reporting process and the external audit process, using a
case study of some selected high profile corporations that collapsed. However, their
financial reports revealed apparently that they are role models in terms of management
and corporate governance practice, and yet after a few months of release of such reports,
they collapsed. Although, the ACs roles in overseeing the financial reporting process has
been revisited by many corporate governance reforms in a number of countries.
This study will try to explore the unexplored research area in ACs studies, which is the role
and the effectiveness of the ACs and to contribute to the case study research approach by
illustrating the in-depth that can be derived from a case study approach, investigates the
ACs process from within the organization and to see how organizational context affect the
operational process of the ACs. The result of this study will be of immense contribution to
the study of AC nationally and internationally, it will increase more awareness to
companies within the UK on the need for effectiveness of AC, also the regulatory bodies
within and outside UK would find it very useful in terms of making further provisions and
pronouncement to strengthen the AC.
1.3 RESEARCH QUESTIONS
The research will specifically address the following research questions in view of the
changing role/ responsibilities of the ACs:
1. Are Audit committees to blame for audit/corporate scandals?
2. Will Audit Committees prevent future audit/corporate scandals?
3. Can Mandating Audit committee improve corporate governance?
4. Are the corporate scandals a reflection of ineffectiveness of Audit committees?
1.4 PROJECT STRUCTURE
This thesis is structured in the following layout:
Chapter one will contain the general overview of the research topic. In chapter two, a
review of existing literature related to ACs will be looked into from Corporate governance,
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with particular emphasis on (Nomination, Remuneration) and secondly why are ACs set up.
Thirdly, the roles of ACs and fourthly, range of ACs, fifthly the debate about effectiveness of
ACs, sixthly the debate about need for ACs, and lastly the debate about why not mandating
ACs. Chapter three will delve into the Methodology employed in the research with
references to ontology, epistemology, qualitative and quantitative and a Justification for
choosing a particular method. Chapter four will be results and evaluation with detailed
evaluation of two case studies of Lehman Brothers and Satyam and answers the research
questions, by recognizing the limitations of research and evaluate the scope for future
research. Chapter five will be Conclusions and summary of the major findings.
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CHAPTER TWO
LITERATURE REVIEW
2.0 INTRODUCTION
The literature review will be structured as follows: firstly it looks into corporate
governance, with particular emphasis on Nomination and Remuneration Committees and
secondly why ACs are set up. Thirdly the roles of ACs will be examined, fourthly the range
of ACs, fifthly the debate about effectiveness of ACs, sixthly the debate about need for ACs,
and lastly the debate about why ACs are not mandated. In each category the work will try
to investigate the roles of audit as provided by the regulatory bodies and to assess the
current levels of performance of the AC in the UK. The work will also try to uncover the
types of expertise, if any, required of AC members for effectiveness in their operations and
to identify the “knowledge gap” that might have contributed to the recent corporate
failures the world has experienced.
2.1 CORPORATE GOVERNACE FRAMEWORK
Corporate governance evolves with differing variations due to cultural, political, economic
and technological differences among nations. Establishment of corporate governance is
based on structures of ownership affected by these variations. However, in practice two
major approaches to corporate governance are identified depending on the legal system
operating in various countries of the world.
xxxx et al (2014) identified that countries that practices common law legal systems like the
UK, the US, Canada and Australia, developed a corporate governance structure that
concentrates on shareholder’s interest (returns). Mainly, the approach ensures that the
company’s management act in a way that achieves the shareholders objective. It is often
referred to as the outsider model of control as it recognizes the agency problems.
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On the other hand, countries that practice civil law legal systems such as Germany, France
and the Netherlands developed their corporate governance with a focus on the
stakeholders. This practice of corporate governance tries to balance the interest of key
players like the employees, managers, creditors, and customers (xxxx 2014, and xxxx
2014). It is often referred to as the insider model of control as it recognizes that maximum
control of the firm relies with those closer to its actual operation.
Regardless of the approach, the concept of corporate governance entails the system by
which companies are directed and controlled (xxxx, 2012). The continued growth of
companies and the prevalence of the creation of registered companies marked the starting
point for the discussion of corporate governance as ownership is separated from control of
these companies. Xxx (2010) argued that the need for corporate governance practices
became more pronounced in 1980’s as a result of the stock market crash experienced
worldwide and corporate collapse due to poor governance.
2.1.1 DEFINITION OF CORPORATE GOVERNANCE
Corporate governance is the system by which companies are directed and controlled. It is
purposely evolved to facilitate effective, entrepreneurial and prudent management that can
ensure the long-term growth of the company xxxx, 2012). One of the strongest mechanisms
used to achieve these purposes is the Board of Directors (BOD). The BOD are responsible
for the governance of the companies; their responsibilities include planning the strategic
aim of the company, ensuring leadership that will put the strategy into effect, supervising
the management of the company and reporting to shareholders on the stewardship.
Corporate governance is all about what the BOD of the company does and how the
company’s values are set. The BOD carries out its roles through subcommittees. To be
effective, these Committees must possess the utmost balance of skills, experience,
independence and knowledge of the company to help them discharge their respective roles
and responsibilities as required (xxxx, 2012).
The development and improvement of corporate governance standards in most cases
followed the occurrence of corporate governance failures that have highlighted areas of
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particular concern. The Enron/WorldCom and Pamalat failures pointed out issues with
respect to auditors, audit committee independence and deficiencies in accounting
standards. This has provided important corporate governance lessons leading to actions by
many national governments and international regulatory institutions such as IOSCO (xxxx,
2009). From the above scenario, corporate governance deficiencies may not have been
causal in failure in a strict sense. Rather, they facilitated or did not prevent practices that
resulted in poor performance. These incidences raised many questions about the
importance of corporate governance in the success of the business. These questions were
responded to in the UK through strong corporate governance recommendations in the
reports from different Committees set up by the FRC like the Higgs Committee report
(2003), the Smith Committee report (2003) and the Combined Codes updated in 2003
which incorporate the Higgs and Smith Committees recommendations. The US responded
by producing the Sarbanes Oxley Act (2002) and many other countries of the world also
engaged in initiating programmes of reform in corporate governance.
2.1.2 BOARD SUB-COMMITTEES
Every company should be headed by an effective board, which is collectively responsible
for the overall success of the company. The board appoints sub-committees and assigns
some of its role to those Committees to discharge. The Committees are used to increase
objectivity in the board against the inherent conflicts of interest in the discharge of the
board duties and responsibilities. The sub-committees are Nomination Committee,
Remuneration Committee, Risk Committee, Ethics Committee and Audit Committee.
2.1.3 THE NOMINATION COMMITTEE
Historically, directors were often appointed on the basis of personal affiliations. Because of
the vital role of board composition to effectiveness and performance, the corporate
governance reforms sought the inclusion of a Nomination Committee as one of the board
subcommittees to ensure the right people are objectively nominated into the board. The
Nomination Committee is believed to improve the effectiveness of the board through
managing its composition (xxxxx, 2006). They were criticized by activists due to the fact
that the shareholder’s voice is not meaningful in the selection process. However, recently
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the US SEC issued Rule 14a-11, which forces public companies to allow three percent of
board members to be nominated by shareholders. (xxxx, 2010).
The Nomination Committee is to evaluate the existing balance of skills, knowledge, and
experience on the board, and use it when scrutinizing a candidate for appointment. The
Committee is also involved in succession planning in the company. As with other key board
committees, the members of the Nomination Committee should be identified in the annual
report (xxxx, 2010). As a mechanism that improved the decision-making, the Nomination
Committee helps in resolving the power asymmetry between corporate boards and
management by reducing the influence of management on the selection process of new
board members. The decisions of Nomination Committees, like all other committees of the
boards (Audit Committee or Compensation Committee), are subjected to ratification by the
board as a whole (xxxx et al, 2006).
The UK Combined Codes (2008) clearly indicate there should be a formal, rigorous and
transparent procedure for the appointment of new directors to the board and states that
the appointment should be made on merit and against objective criteria. The codes provide
that the Nomination Committee should lead the process for board appointments and make
recommendations to the board, and the majority of the Committees members should be
independent non-executive directors (Para A.4.1). xxxx et al (2006) found that firms with
Nomination Committees are more likely to have a higher number of independent and
foreign directors, and a higher degree of nationality diversity.
2.1.4 THE REMUNERATION COMMITTEE
Remuneration has always been a ‘hot issue’ which attracts a lot of attentions from different
angle. The level of the Remuneration signifies the attractiveness, retention and motivation
of qualified directors required to run the company successfully. To avoid paying more than
necessary, corporate governance Codes provide for the establishment of Remuneration
Committee to structure the director’s Remuneration so as to link rewards to corporate and
individual performance. The major roles of the Committee are twofold; one is to be the
“owner” of the company’s executive and director’s compensation philosophy and program.
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Two is to provide a forum where Remuneration issues are fully and vigorously reviewed,
analyzed and acted upon (xxxx et al 2008). However, these roles vary from company to
company, and it is subject to various factors such as ownership structure, concern of
shareholders and directors capabilities.
The Combined Corporate codes (2008), states that ‘the board should establish a
Remuneration Committee which should ensure a formal and transparent procedure for
developing policy on executive Remuneration and fixing the Remuneration packages of
individual directors, and ensure no director is involved in deciding his or her own
Remuneration (Para B.2). The Committee should comprise of at least three or in the case of
small companies, two independent non-executive directors (B.2.1). As the issue of
executive Remuneration becomes increasingly complex, and drawing more public
attentions, the Committee’s job grows and become challenging. But when the Committee
get organized and stay well informed they will achieve an optimal performance (xxxxx
2008), and for transparency, the Remuneration Committee members should be identified
in the annual report; the company chairman can be a member of the Committee but should
not chair the Committee (xxxx 2010).
2.1.5 UK CORPORATE GOVERNANCE APPROACH
The UK approach is a combination of high standards of corporate governance. In
September 2009 Governance Metrics International report ranked it second in a table
showing average governance performance among companies in different countries. The
corporate governance Codes establishes good governance practices, although companies
can choose to adopt a different approach if they find it more appropriate to their prevailing
circumstances “Comply or Explain” approach. The development of the UK corporate
governance has its roots in a series of corporate failures and scandals in the late 1980s
through 1990s. The codes have undergone a series of update by FRC through a series of
Committees to meet the prevailing circumstances facing companies in the UK. In 1991 a
Committee Chaired by Adrian Cadbury was set which issued a series of recommendation-
known as the Cadbury report in 1992. It addressed the issue of relationship between
chairman and chief executive among others. In 1995, there was a recommendation from a
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separate Committee on Remuneration of directors and in 1998 the two reports were
harmonized to form what is now known as the UK corporate governance code. In 1999
guidance was issued to enrich the corporate governance Code, which assists directors to
develop risk management and internal control. Year 2003 sought the update and
incorporation of recommendations from reports on the role of non-executive directors and
the role of the audit committee. The FRC was given autonomous responsibility of
regulating the corporate governance and reporting, including publishing and maintaining
the Codes.
2.2 LITERATURE ON AUDIT COMMITTEES
An Audit Committee can be defined as a sub-committee established by the governing body
that will make arrangement for internal audit and facilitate the smooth completion of
independent audit. AC is saddled with the responsibility of enhancing the performance of
the board to fulfil its lawful responsibilities and ensure the credibility and objectivity of the
financial statements (xxxx 2004). The duties of ACs include recommendations and
appointments of the external auditors, review the company’s financial statement to ensure
it portrays the true and fair view of the company’s financial position, taking actions and
concerns raised by the external auditor, serve as intermediary between the external
auditor and the management, advice on any findings of external auditor and Internal audit
investigations (xxxxx 2010).
2.2.1 WHY SET UP AUDIT COMMITTEE?
This section explores the factors in the financial, legal and social environment that
significantly influenced the establishment of corporate AC. In Particular, the roles and
actions played by courts, security, exchange commissions and some professional
accounting bodies.
The concept of AC is not a new phenomenon, but appeared first in the late 1930’s when the
SEC and New York Stock exchange called for the establishment of ACs in public companies.
This was prompted by the case of xxxxx in 1940. Securities and Exchange Commission
(SEC) released accounting series No.19, the investigation result proposed that, to assure
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auditors independence, a Committee be selected from non-officer board members to
nominate auditors and arrange details engagement. The decision by the New York Stock
Exchange requiring all listed companies to have ACs as of June 30th 1978, made ACs an
integral part of corporate governance and a major determinant of corporate governance
effectiveness (xxxx, 1986). The increase in the formation of ACs is traceable to major court
actions like the case of Mattels’ (1971), where SEC emphasized the importance of ACs in the
need for action concerning misleading interim reporting. The Mattel’s consent was
accepted to establish an AC to ensure settlement; the court ordered that the company
established a financial control and AC who are responsible for review of financial control,
accounting procedures, and dissemination of financial statement to the public.
Since 1940, when accounting series release No.19 was issued, the SEC had continually
supported the establishment of corporate ACs. Several other court cases also required
certain corporations to establish ACs and had prescribed clearly their duties in the consent
of decree which arose from the case SEC v. Lum’s et al, the court in settling the SEC’s
allegation of manipulation and proxy fraud, ordered that a standing AC be established and
it should consist of two or more members of the board of directors who were not officers
or employees of the company. Significantly, in most cases absent of ACs was identified as a
major contributing factor to most of the allegations raised. In exception 1976, the SEC again
emphasized the need for AC as a means of deterring questionable and illegal corporate
payment and other practices. Accordingly, the commission resolves in their proceedings
the establishment of a committee comprising of independent members of the board of
directors, who are responsible for full investigation and utilization of outside auditors to
conduct the necessary detailed inquiries (xxxxx, 1986). The commission believes that
objectivity and independence will be well enhanced if the auditor deals with an AC of
independent directors or the board of directors in determining service and fees.
Most of the call and recommendation for the establishment of ACs in US and UK came as a
result of increased corporate mismanagement and scandals, which become a daily
occurrence phenomena and corporate directors, were faced with different charges, ranging
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from price fixing, bribing and maladministration. Time, resources limitations and the level
of board responsibility, intensify the kind of challenges the board are faced with. Such as:
a. Companies have increased in size, diversity and complexity
b. Directors’ knowledge limitation makes it impossible to discuss every facet of their
company’s activities.
c. The number of law suit against directors is in the increase not only because of their
actions, but also because of management actions.
d. The directors’ requirement for reasonable care in discharging their responsibilities
to shareholders received emphasis toward litigation.
In an effort to meet the challenges in their changing responsibilities as part of their roles,
the corporate board place more importance in the establishment of ACs to aid them
(Birkett, 1986).
Many organizations and association has contributed immensely toward the setting up of
ACs in US, UK and other countries of the world, either by supporting or recommendations
for the establishment based on the prevailing circumstances. In recent years the call for the
establishment and strengthening the ACs has increased as a result of increase in the
number of corporate failures around the globe, which exposed the weakness of the
corporate governance system even in the most advanced economies who embraced the
concept for so long. In responses to the call different countries accept the idea of
establishing an audit committee to form part of their board of directors as a mitigating
mechanism against corporate misconduct.
2.2.2 ROLES OF AUDIT COMMITTEE
To ascertain the roles of ACs in a broader form, a regulatory review has to be made. The
need for ACs came amid of unexpected corporate failures that stem from corporate
misconduct (xxxxx, 2005). As corporate failures become more pronounced, more attention
is drawn on the role of ACs in preventing such failures. The increased in the number of
corporate failures has increased the perceived role of ACs from being seen as a means of
strengthening the external financial reporting process to being seen as a means of detecting
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and preventing corporate misconduct and scandals. Originally, ACs is a non-mandatory
structure used by few corporations on recommendations by court as a means of settling
allegations of corporate misconduct. In recent years, a number of professional and
regulatory commissions in the US, the UK and many other countries of the world have
recommended the adoption of the concept and increased their advocacy on the expanded
roles of the ACs. Notably are the Sarbanes-Oxley Act of 2002 in the US, the report of
Australian treasury (2002), the recommendation of Smith Committee (2003) and the Higgs
review (2003) in the UK (Turley et al, 2003). Most recently, in 2008 the FRC of the UK
issued guidance on ACs which elaborates on the expanded roles of ACs, to include:
• To monitor the integrity of the financial statements of the company and any formal
announcements relating to the company’s financial performance, reviewing
significant financial reporting judgments contained in them;
• To review the company’s internal financial controls and, unless expressly addressed
by a separate board risk committee composed of independent directors or by the
board itself, the company’s internal control and risk management systems;
• To monitor and review the effectiveness of the company’s internal audit function;
• To make recommendations to the board, for it to put to the shareholders for their
approval in general meeting, in relation to the appointment of the external auditor
and to approve the remuneration and terms of engagement of the external auditor;
• To review and monitor the external auditor’s independence and objectivity and the
effectiveness of the audit process, taking into consideration relevant UK
professional and regulatory requirements;
• To develop and implement policy on the engagement of the external auditor to
supply non-audit services, taking into account relevant ethical guidance regarding
the provision of non-audit services by the external audit firm; and to report to the
board, identifying any matters in respect of which it considers that action or
improvement is needed, and making recommendations as to the steps to be taken.
The roles of ACs are based on different legislative traditions in various countries. In some
countries the roles of ACs has historically been taken care of by other bodies such as
20
supervisory boards or the board of directors. The duties of ACs include recommendation
and appointment of the External Auditors, review the company’s financial statement to
ensure it portrays the true and fair view of the company’s financial position, taking actions
and concern raised by the External Auditor, serve as intermediary between the External
Auditor and the management, advice on any findings of External Auditor and Internal audit
investigation (xxxx, 2002 xxxxx, 2010). The everyday upsurge in corporate collapse
Consequently increased the expectations of corporate AC responsibility, the
responsibilities of AC became so intensified after the two regulatory reforms of Blue
Ribbon committee’s report 1999 and the corporate and criminal Fraud Accountability Act
of 2002, which is better known as Sarbanes Oxley (SOX, 2002) (xxxx, 2005). The corporate
governance reforms in both UK and US has redefined and re-emphasized the roles,
responsibilities and expectations from the participants in financial reporting of publicly
own companies (xxxx, 2005). More emphasis is given on the roles of ACs, the ACs are faced
with the challenge of effectively overseeing the company’s financial reporting process in
entirely different corporate governance environment.
FEE (2012), identified the differences between countries in relation to the roles of ACs to
be mainly on:
a. The extent of exceptions applied to establish ACs
b. Whether the minimum numbers of ACs is specified or not. i.e the number of
independent members of ACs differ from one country to the other.
c. Whether the chair of the board can be chair of the AC or not
d. Whether remuneration policies for members of ACs are developed
e. To what extent the auditor attends meetings of ACs
Because of the differences in corporate governance Codes between countries, some of the
differences in ACs are likely to remain (FEE, 2012). Despite the differences between
countries, the roles of the ACs might still be similar. Recent corporate governance reforms
in the UK by regulatory bodies which broadly redefined the roles and responsibilities of
stakeholders in public corporations. Most notably, the reforms emphasizes more on AC,
21
which is commonly viewed as monitoring mechanism created to ensure confidence in the
integrity of an organizations process and procedure relating to internal control and
corporate financial reporting.
2.2.3 EFFECTIVENESS OF AUDIT COMMITTEES
In number of cases, an accusation finger has been pointed at ACs, in the event of financial
failures of companies. The question is, are these fingers pointed in the right direction. Most
of the responsibilities of the failures rest with the management who are unwilling to
present a clear looks of the procedures and the rationale behind most of their deals. While
they lacked the access to information that will allow them have better understanding of the
situation, the ACs are sometimes at a fault of not being inquisitive on a matter of concern
for more details (xxxxx, 2005). The growing public pressure has placed a greater deal for
emphasis on ACs roles in pursuit of effective corporate governance. xxxxx (2013), states
that ACs are failing to deliver on their responsibility whenever an organization suffers a
catastrophic failure or even significant risk that could have been prevented. Xxxx (2006)
also found that ACs in most cases are rarely utilized as management control tools, they are
rather used as compliance to SOX and the SEC requirement. Accordingly, xxxx et al (2010)
state that most of the ACs rely heavily on the information provided by the CEO and CFO
who are the suppose person the ACs is expected to provide oversight to protect
shareholders. Unless the ACs has effective and independent information source, it
effectiveness is not guaranteed (xxxx, 2013).
However, a significant number of prior research established that the mere formation of AC
in organization result in substantial benefits. For example xxxxx et al (1999) found that the
presence of AC is significant factor in enhancing third party perception of auditor
independence. xxxxx (1996) concluded that firms with ACs are associated with fewer
shareholder lawsuits alleging fraud, fewer quarterly earnings restatements, fewer SEC
enforcement actions, fewer illegal acts and fewer instances of audit turnover when there is
an auditor-client disagreement. Similarly, xxxxx (2006) found that ACs are associated with
higher quality audit. However, these findings are in conflict with the result from xxxx
22
(1996) which concluded that the presence of AC has no significant effect on the likelihood
of financial statement fraud and that interaction of the AC with board does not impact on
the likelihood of financial statement fraud. It was further suggest that the board
composition is more likely to constrain fraud in an organization than AC. This finding
correspond to the findings of xxxx et al (2005) who conclude that it is the board that
effectively constrain abnormal earning not the AC, And xxxxx (2007) who determines that
the mere presence of AC does not reduce the occurrence of errors and non-compliance
qualifications.
However, it has been observed recently that ACs comprising of independent and
knowledgeable directors with right information is in the right position to ask management
the right question to determine whether the company’s management is sufficiently
managing risk as identified by Blue ribbon committee report as one of the ACs best
practice. The most important and reliable source of information to ACs as pointed out by
xxxx (2013) are the employee whistleblowers, lower level executive and the external
auditor, although communication from employees to ACs requires the employees to
acknowledge the misconduct or the risk attached to it, also they need to be motivated to
reveal the information directly to the ACs. Although, In some cases, the ACs do not act on
the information disclose to them by the individual whistleblowers due to their relationship
with the management of the company and negligence of duties as enshrined in corporate
governance Codes (xxxx, 2013). An example of such situation could be found in the case of
Enron. Where Sherron Watkins wrote a letter to Enron chairman Kenneth Lay, disclosing
his personal fear about what is happening in the company by saying “I am incredibly
nervous that we will implode in a wave of accounting scandals”, the Chairman then push
the matter to inside counsel to administer and investigate Watkins’ complaint, in place of
employing the service of independent counsel to investigate on the matter. The inside
counsel then take the matter to the regular outside counsel of the company who received
substantial legal fees from Enron, to carry out the investigation. After a short investigation,
the regular counsel gave Enron a report that generally found no substance in Watkins’
complaint. After the Enron’s bankruptcy, a separate investigation was carried out by an
23
independent board committee, using a different counsel and found a significant substance
to Watkins’ complaint (xxxxet al, 2002 pp 34-35). For effectiveness, the whistle blowing
system should be well administered by the companies with oversight from the ACs, and it
presence should be well known to all and sundry in the organization. The ACs should
consider any complaint by whistleblowers and relate to the auditor any matter concerning
the financial reporting process (xxxx., 2008).
xxxx (2013) suggested that a new behavioural approach to corporate governance focusing
on the psychological aspects of human being inside organization need to be evolve in order
to reduce the emergence of corporate scandals in the near future. This suggestion came
after a careful examination of eight cases of corporate scandals where xxxx et al, (2006),
conclude that the root cause of the failures were: 1) poor strategic decision; 2)over-
expansion and ill-judged acquisition; 3) dominant CEOs; 4) greed, hubris and a desire for
power; 5) failure of internal control and ineffective boards. Furthermore, xxxxx (2013),
observed that ACs members acknowledge with accuracy the degree of change in
management incentives, although it’s not all the Committee members that believed that the
change in incentives result in change in management behaviour. It is concluded that the
effects of both trust and incentives on ACs decision to support management versus the
External Auditor are affected by the perception of the intent to deceive (Rose et al., 2010).
However, identifying the perceive intent to deceive and trust in human being call for the
inculcation of psychological knowledge into the main stream of governance activities. By
combining both the existing approach to corporate governance with a new behavioural
approach which focus on human factor, stakeholders confidence will be restored to expect
good corporate governance.
2.2.4 RANGES OF AUDIT COMMITTEE
Corporate governance Codes differences between countries, makes the practices of ACs
varies world over. Some countries mandate the establishment of the ACs by law, Example
Canada, Australia, Singapore and Thailand. Others are mandated by regulatory bodies,
Example Bangladesh, Malaysia and US. But in the UK audit committees’ establishment are
encourage by Codes of best practice, in many countries of the world ACs are not mandated
24
nor encourage by any Code, it is at the discretion of the firm to appoints or not to appoints,
therefore the operation of ACs differs in certain respect. xxxxx (2004) observed that ACs do
not operate in a vacuum and their operation and effect cannot be adequately examined
without regard to the institutional and organizational context in which they function and
the power relation which are intrinsic to that context. The underlying corporate culture
affects the operation of ACs. Generally, ACs are expected to operate the same irrespective of
the organization. But it is observed that there exists some significant difference between
the ACs activities in private and public sector. External financial reporting functions are
performed by higher proportion of private than public sector ACs, also in the cases of
reviewing public statements with regard to financial issues, a greater proportion of private
than public sector ACs perform the function. The only external financial reporting functions
carried out by a greater proportion of ACs in public sector is reviewing the entity’s entire
annual account (xxxx 1998). This is due to the absence of written ACs charter, despite the
express requirement of the ACs activities in most of the corporate governance Codes.
Turley and Zaman (2007) observed that organizational culture affect the operation of AC’s,
most significant effect of AC on corporate governance in certain instances occur outside the
formal settings and process.
2.2.5 THE NEED FOR AUDIT COMMITTEE
An AC is a sub-committee established by the governing body that will make arrangement
for internal audit and facilitate the smooth completion of independent audit. Audit
Committee is saddled with the responsibility of enhancing the performance of the board to
fulfil its lawful responsibilities and ensure the credibility and objectivity of the financial
statements (xxxxx, 2004). The duties of ACs includes recommendation and appointment of
the External Auditors, review the company’s financial statement to ensure it portrays the
true and fair view of the company’s financial position, taking actions and concerns raised
by the External Auditor, serve as intermediary between the External Auditor and the
management, advice on any findings of External Auditor and Internal audit investigation
(xxxx, 2010). The function of an AC is generally seen as assisting the Board in providing an
independent review of the effectiveness of the financial reporting process, internal control
25
and risk management system of the company, overseeing the audit process and performing
other duties and responsibilities as assigned by the Board, the Board has full responsibility
and authority for the management and supervision of the business. The AC does not take
over these functions but will report and make recommendations to the full Board on
matters pertaining to its work and findings (xxxx, 2002).
The continued changes in business environment, and increase in complexities of modern
day corporations increase the need for the establishment of ACs to enhance the governance
process of those corporations. Similarly, the growth and increase in corporate activities
result in increased risk and responsibilities of corporate directors, the need to reduce the
risk further increase the need for an AC as the means of reducing such risk. Consequently,
AC became an addition to the corporate practice (xxxxet al, 1977 in xxx, 1986). As more
interest group evolve with keen interest on the activities of corporations, the AC is viewed
as watchdog for the distance interest group who has no direct access to what is happening
in those corporations. Those who argue on the need for ACs emphasize that AC ensures
good relationships between directors, investors and auditors. AC also helps in the
discharge of accountability and directors execution of their responsibilities. ACs influences
power relations between accountability and auditing (xxxx, 2004).
ACs are often perceived as an effective mechanism reducing agency cost, ACs are expected
to monitor the reliability of the company’s accounting processes and compliance with
relevant corporate legal and ethical standards which includes maintenance and prevention
of fraud controls (xxx 2004 and xxxx, 2004). However, many research on the ACs effect on
corporate governance revealed that it is not all of these perceived potentials were achieved
by adoption of AC concept, rather in some cases the ACs aides the perpetration of most of
the corporate scandal the world witness either deliberately or out of non-commitment to
their duties as prescribed in the governance Codes, like the cases of Enron in 2001 and
number of scandals involving large US companies such as world.com and global crossing
(xxxx, 2009).
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2.2.6 WHY ARE AUDIT COMMITTEES NOT MANDATORY?
Audit Committee is becoming a top issue in the discourse of corporate governance because
of it perceived role in the corporate monitoring, the concept has gain wide acceptance as a
monitoring tool and a deterrent against the management and enhance the work of external
auditor. In the past two decades, the persistent corporate failure has generated many
concerns among academicians and regulators regarding establishing ACs, either to
mandate the establishment or not due to increasing expectation on the ACs. According to
xxxx (2014), those advocating the non-mandatory AC argued that, requiring a complete
independent on AC and enforcement of mandatory rules would create a significant
financial cost, adding that the risk of financial misstatements and accounting fraud is
negligible in their country; therefore, it is a country specific problem. The Institute of
Chartered Accountants of New Zealand states that, a mandatory approach for small market
would channel limited resources on compliance rather than value creating strategy,
therefore mandatory approach is not appropriate for New Zealand market given there is no
evidence of financial misreporting in New Zealand to compare with the magnitude in some
advance economies like Australia and U.S (xxxx 2014). Furthermore, empirical evidences
on firms that adopted a high quality AC in New Zealand shows no evidence that best
practice AC improved financial reporting quality, it is also found that no evidence that best
practice AC were associated with lower audit fees (Rainsbury and Bradbury, 2009).
However, as vast majority of research indicates that AC provides ample benefits to the
governance of corporations. In Australia after the collapse of high flying companies, the
ASX mandate the establishment of AC’s in 2003 to top 500 companies listed in the S&P/ASX
under ASX listing rule 12.70. while non-top 500 were not mandate to have AC’s as they are
not under the listing rule 12.70, rather they are subject to ASX listing rule 4.10.3 which
provide either to have an AC’s or to explain why AC is not justifiable to them. (xxxx, 2011).
The argument is that in as much as AC’s is important to one group of companies, it must be
important to another group too in all ramifications. For example, a company’s performance
may improve in a given year to move to top 500 and in the following year when met with
unfavourable market situation moves back to top 300, which means the structure of their
27
AC must be fluctuating year in year out, in essence it does not make any difference
mandating or not mandating.
Similarly, in 2003, Japanese amended corporate Codes give large companies the option to
adopt or not to adopt the USA style of AC. The companies that choose to adopt the USA style
are required to establish the AC, while those companies who choose not to adopt US style
are place on the conventional Japanese corporate governance, which does not require them
to establish an AC (xxxxx, 2005). This indicates that the corporate governance framework
in most cases determines mandating or not mandating ACs. After the passage of Sarbanes
Oxley many countries that adopted the Sarbanes Oxley Codes mandated the establishment
of AC’s on certain categories of listed companies while others did not, but has instituted
new rules that mandates the use of AC’s in certain circumstances. However, xxxx (2010),
state that the number of countries mandating the establishment of AC recently has increase
(see appendices 1 for the list of countries).
CHAPTER THREE
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RESEARCH METHODOLOGY
3.0 INTRODUCTION
This Chapter explores the procedural framework within which this research is conducted.
The Chapter will discuss the research approach, the methods employed and the rationale
behind the selection of the approach and methods in the conduct of the research.
Research is a diligent and systematic inquiry or investigation into a subject in order to
discover or revise facts. While, methodology described and approach to the investigation
which may be transform into research programme about answering unanswered
questions. Therefore, a good research method could be developed by careful understanding
of philosophical literatures which gives a philosophical solution to a question of “Why
Research”. Developing the philosophical perspective requires a choice between two
different dimensional views of scientific approach to research, that involves either a
subjective or an objective approach to research. And the origin of these two major
approaches is traced from the several core assumptions concerning the ontology (reality),
epistemology (knowledge), and finally the methodology (xxxxx, 2004).
3.1 RESEARCH APPROACH
Debates and arguments are much in recent years within many of the social sciences field in
relation to merits of quantitative and qualitative strategies of research (objective and
subjective) strategies of research. The decision to adopt one among the two by individual
researcher vary considerably, some researchers sees the two strategies as entirely separate
and opposite having varying philosophical positions existing between them. While others
see to mix the two in their research is the best alternative (xxxxx, 1998, 2010 and Johnson
and xxxxx, 2004). However, xxxx (2002) warns that such a suggestion underestimate the
legitimacy that are related with the choice of methods, where quantitative approach is
viewed as more scientific and ‘objective’, qualitative approach is always viewed as
‘subjective’.
The advocate of Quantitative research approach developed assumptions that are
commonly called positivist philosophy. This approach to social science research developed
29
from the natural sciences, where it is believed that social observation should be treated as
an entity as the same way that scientist treats physical phenomena. They further argue that
observer is separate from the entities that are subject of the observation and maintain that
social science inquiry should be objective (xxxx, 2004). On the contrary, the advocate of the
Qualitative research approach (also called constructivist and interpretivists) reject the
assumption of the positivists approach. They argue that researchers cannot distance
themselves from; what is being observed, the study’s subject matter or the methods of
study. They maintain that the researcher is characterized by in built biasness reflected by
their background, status, interest, values and resources (xxxx, 2004). Therefore, they argue
for the superiority of constructivism, idealism, relativism, humanism and sometimes
postmodernism. It is also believed that multiple constructed realities abound, that time-and
context-free generalizations are neither desirable nor possible, that is also impossible to
differentiate In total the causes and effects and that logic flows from specific to general, and
that the knower and the known cannot be separated because the subjective knower is the
only sources of reality (xxxx, 2004).
Both side of the argument view their paradigms as the ideal for research, and that
qualitative and quantitative research approach, including their associate methods cannot
and should not be combined. Positivists approach is face with increasing critics as being
inappropriate approach to the study of social science phenomena. Saying the success
recorded by the objectivism approach in natural sciences research has not been repeated in
the social science research due to its significant weakness. These critics identify that
subjectivism is more related to the study of social science due to the complexity of the
social science research (study that involves human beings). They argue that the
researchers that employed a nominal ontology and its accompanying epistemology realize
more explanatory success (xxxxx, 2004). However, subjectivist approach is not without its
own weakness and critics, it is observed by its critics that it is unable to replace objectivist
approach and so it is condemn as an alternative to objectivist approach. Although,
subjectivist argue that there are many equal version of reality and each version of it is
personal and community-specific, therefore each version of reality cannot be compared as
30
it is viewed as good as the other. Moreover, xxxxx (1997) pointed out that because of the
absent of absolute basis for scientific knowledge, theories are incommensurable, hence a
given theory cannot be held as more valid than the other.
It is noted by researchers that the heated debate between critics and proponent of both
approaches that argument on ontology and epistemology cannot end in any philosophical
solution, because there is no right or wrong philosophical stance. In this regards,
xxxxx(1997) stated that many of the present realists and empiricist are pragmatics, they do
not disturb themselves about the ontology and the epistemology but about the particular
problem they face from their theories and investigation, and argue that there is no basis for
advocating any view as unequivocally correct conception of the relationship between
philosophy and social science, as the philosophy itself is a matter of philosophical dispute.
Therefore, the decision to choose among the two approaches depends on the aims of the
research and the kind of research questions. This study will tries to explore the unexplored
research area in ACs studies, which are the roles and the effectiveness of the ACs by
investigating the ACs process from within the organization. To do that, qualitative
approach is appropriate as it can describe events, persons and phenomena scientifically
without the use of numerical data as against the quantitative approach which requires data
to be analyzed in terms of numbers (xxxxx, 2002). Both are useful and valid, however
qualitative is more concerned with collection and analysis of information in many forms,
mostly non numeric. It tends to focus on exploring as much details as possible, and aim to
achieve ‘depth’ rather than ‘Breath’, as the researcher gains an insider’s view of the field,
because of the researcher’s close involvement and that allows the researcher to find issues
that are often missed by the quantitative approach. On the other hand, quantitative is
mostly concerned with collecting and analyzing data in numeric form with the aides of
statistical techniques which allows sophisticated analysis. Although, because of complexity
of human beings it is difficult to treat them as matters in natural sciences, and so social
sciences research of this nature required the use of qualitative approach because it can
suggest possible relationships, causes, effect and dynamic process of an event (xxxx, 2002).
31
Research is a systematic investigation to find answers to problem. Scientifically,
quantitative research methods are employed in an attempt to establish general laws or
principles. The naturalistic or qualitative approach to research gives more credence to
subjective experience of individuals, which focus on individual case rather than general
law-making (xxxx, 2002). Whilst quantitative research may be mostly used for testing
theory it can also be used for exploring an area and generating hypotheses and theory.
Similarly qualitative research can be used for testing hypotheses and theories even though
it is mostly used for theory generation.
3.2 METHODS
To understand how and why a company is committed to fraudulent financial reporting and
the role of ACs in that regard, therefore a qualitative case study approach to research is
needed for several reasons as advocated by xxxx (2007) to use a bottom-up approach in
qualitative research by inductive process. The study reviewed Secondary data from data
banks, and analyzed the details as they relates to the roles of AC’s in the failure of the
selected companies (Lehman and Satyam). A case study allows for deep understanding of a
situation (xxxxx, 2007). The researcher employed a qualitative case study method to
investigate the roles and effectiveness of ACs in the failed companies, using several data
sources, including available public information, academic journals, public legal findings and
reports of investigation committees. According to xxx (2014), a case study method does not
seek to control any variables; it looks at case in its natural context and can be undertaken
by using any approach (a positivists or interpretivist). After the investigations carried out
by the Examiners in the failure of Lehman Brothers and the investigations of serious fraud
investigation office (SFIO) and Central Bureau of investigation (CBI) in the case of Satyam,
many source documents become available publicly which provided rich real-time pictures
of what happened in the companies, which the researcher would not otherwise have access
in the case of most research project. However, the observable phenomena that can be
found in the documented cases using the evidence from investigation agencies and the
confession in press articles (such as managers’ quotes and the analyses of Journalists). they
are not academic sources but research based evidence showed that “press has fulfil the role
32
of watchdog or monitors for accounting frauds by undertaking original investigation from
other intermediary sources (auditor, analyst and lawsuit), and rebroadcast it to public.
Hence, the use of some reputable press articles and publications (financial times, wall
street journal, CNN-IBN, business outlook) to examine the corporate scandals and the roles
played by the established gatekeepers.
The case study is a multiple one looking at the two largest fraud cases in India and USA,
involving Satyam computer services (labelled as “India’s Enron”) by Indian media and Case
of Lehman Brother plc (term as the largest corporate scandal in the history of USA). The
used of multiple case studies is often considered more compelling, and the overall study is
therefore regarded as being more appealing as it gives a researcher the room to consider
multiple experiments as against single case study (xxxx, 2014). Both the cases involved
fraud and manipulation of financial statements which was perpetrated by the top
management for a long period without being spotted by the established monitoring
mechanism. Different research method has been employed in the study of ACs; in this study
Case study appear to be appropriate to study how ACs operates in their social, political and
economic context. xxxx (2004), states that qualitative research method using case studies
provide significant potential for researching ACs activities in the organizational and
institutional context in which they operate, adding that cases may allow identification of
specific areas of interaction between ACs and other parties like executive management and
auditor which affect audit process.
33
CHAPTER FOUR
RESULTS AND EVALUATION
4.0 INTRODUCTION
The cases of corporate scandals involving two major companies in USA and India (Lehman
Brothers and Satyam computers) are analyzed in an attempt to assess the roles and the
effectiveness of ACs in the face of the corporate failures.
4.1 SATYAM COMPUTERS
At the time of this study the case company (Satyam) has been acquired by Tech Mahindra
and renamed to “Mahindra Satyam”. SATYAM was a rising star in the Indian outsource IT
industry, the company was incorporated by two brothers Mr. B Rama and Mr. B Ramalinga
Raju on 24th June 1987 as a private limited company with only 20 employees with
headquarters at Hyderabad, to provide software development and consultancy services to
large corporations. The company grew rapidly and converted to public company in 1991.
SATYAM growth as global business makes it to be seen as the “India’s growing success”. In
the year 1997, SATYAM was chosen by the Switzerland based world economic forum and
world link magazine as one of the India’s most remarkable and rapidly growing
entrepreneurial companies (xxxxx, 2010). SATYAM was listed on the New York stock
exchange and extranet, its network covers 67 countries across the world.
The company employed 40,000 IT professionals across its development centres in the
world. The company provides services to over 654 global companies among which 185 are
fortunes 500 corporations. In 2003, SATYAM became provider of IT services to World Bank
and entered into a long term contract with World Bank. SATYAM won a number of awards
for innovation, corporate governance and accountability. The last was in September, 2008
when SATYAM received an award from world council for corporate governance “A global
peacock award” for global excellence in corporate accountability (xxxxx, 2009, xxxx, 2010
and xxxx, 2013).
34
The company turned from being India’s IT Empire, the fourth largest company with high
profile customers to nation’s biggest corporate scandals in the living memory of India
(xxxx, 2010) following the confession of its chairman and founder Mr. Raju of a committed
fraud to the tune of $1.47 billion. The confession of Mr. Raju came at the middle of
resistance by the SATYAM investors on the announced management decision to used $1.6
billion on a bid to acquire two MAYTAS companies (MAYTAS infrastructures ltd and
MAYTAS properties) to deploy the purported cash available for the benefit of investors.
The resistance of the investors forced the chairman to reverse his decision within 12 hours.
Another big shocker to the company came when World Bank announced on 23rd December,
2008 that they have barred SATYAM from business with them for eight years and on 7th
January, 2009 Mr. Raju resigned.
4.1.1 ANALYSIS OF AUDIT COMMITTEE OF SATYAM
AC is expected to monitor the integrity of the company’s financial reporting procedures and
internal controls. The AC is also expected to select, retain, oversee and evaluate the
company’s external auditor, as recommended by stock exchange board of India (SEBI)
listing agreement and the New York stock exchange (NYSE). The AC at SATYAM existed but
seems not be active.
4.1.2 INDEPENDENCE OF AUDIT COMMITTEE OF SATYAM
The board of directors is the highest decision making body in the company established with
responsibility for ensuring that requisite system of control of the company’s business and
its records are established in accordance with the provisions of the company Act 1958 (as
amended) regulations made thereunder and in accordance with best accounting practices
(xxxx, 2007).
In his confession letter Mr. Raju states “None of the board members, Past or present, had any
knowledge of the situation in which the company is placed. Even business leaders and senior
executives in the company, such as Ram Mynampati, Subu D, T.R Anand, Keshab Panda,
Virender Agarwal, A.S. Murthy, Hari S.V Krishnan Vijay Prasad, Manish Mehta, Murali V,
Sriram Papani. Kiran Kavale, Joe Lagioia, Ravindra Panumetsa, Jayaraman and Prabhakar
35
Gupta are unaware of the real situation as against the books of accounts. None of my or
Managing Director’s immediate or extended family members has any idea about these issues”
(xxxx, 2013).
Evidence from the confession letter of the chairman and reports of investigation agencies
like SFIO and CBI on SATYAM scandals reveals SATYAM board was composed of ‘chairman-
friendly directors’. Each of the board member was there on the personal invitation of the
chairman, as against the regulatory requirement for nomination of independent directors.
This correspond with the findings of xxxxx (2013) which examine the roles of directors
appointed from the same social network with the CEOs and found that the social ties has a
negative effect on variables that ensure their oversight quality, however, social ties formed
through ‘Advice networks’ do not hinder the quality of AC oversight. Again, xxx (2014) also
states that the friendships “have a negative impact on corporate financial integrity,
fostering earnings manipulation, low levels of audit effort, concealment of financial
distress, and cover-ups of internal control weakness.” This confirm the findings of xxxx
(2010) that the ties between the top management of SATYAM and the board members did
not allowed them to know what was happening in the company.
4.1.3 REVIEW OF FINANCIAL REPORTING PROCESS AND INTERNAL CONTROL
The AC of every company has the responsibility to review and monitor the integrity of
company’s financial reporting procedure and internal control under both legal and
regulatory requirement. Legally, an independent director owes the shareholders the duty
of good faith and duty of care. However, they are not expected to display extraordinary care
but that much which a man of ordinary prudence would take his case (xxxxx, 2010).
Similarly, the AC is designed to act as an independent voice on the board of directors with
regard to audit and corporate governance issues and is seen as valuable asset, particularly
with respect to maintaining the independence and integrity of internal audit function (xxxx,
2008). “Central Bureau of investigation (CBI) findings on diversion of SATYAM funds abroad,
have identify three suspicious foreign bank accounts in US, which were held in the name of
three different individuals. About rupees 60 crore belonging to SATYAM were channelized into
those accounts bearing non-Indian names, and the transaction was not found in the books of
36
SATYAM. Also the CBI report states that a whistleblower (Hyderabad origin UK National
settled in London) contacted CBI and informed the investigation agency that there are six
bank accounts and fictitious firms that Mr. Raju floated in London had served their purpose
and were liquidated long before the scam came to light. They were started in 1999 and closed
down just before the listing of SATYAM’s ADRs on New York Stock Exchange in May 2001”
(xxxx, 2010). Neither the AC nor the independent auditor came across it, they failed to be
inquisitive in their respective duties, while paragraph 13 of ISA emphasized that no matter
the auditors experience with a particular clients, they should maintain an attitude of
professional cautions. In other word, they should consider that fraud is always possible and
that they need to take into account (xxxx, 2008).
However, the level of fraud perpetrated by Mr. Raju and associate in SATYAM scandals
clearly demonstrated how AC duties and responsibilities were violated despite the eminent
personalities sitting in the AC of the company. This confirms the claim of xxxx (2006) who
said that if AC actually performed their duties well, they could enhance the transparency of
company and re-established the public trust in the stock market. With their qualification
and experience, commitment to critical issues about the company is highly expected and it
is incumbent upon all the AC members to be inquisitive and ask important questions more
than once.
“Serious fraud investigation office (SFIO) findings revealed that SATYAM was deeply involved
in making false disclosure to the stock exchange. The company used the name of Chintalapati
Srinivasa amongst its directors, friends and relatives list till December 31, 2008 at the stock
exchange. In reality Mr. Chintalapati was a director form 1990 till Jan 23, 2003 and held the
position of executive director only till 31 August 2000. It was further found that the company,
in its annual account for the year 2002-03, had reported certain extra ordinary items, which
on deduction would have brought the company under losses. False fully, SATYAM activities
displayed an EPS of Rs 9.77 per share, which on correction stands at (-) 1.93 per share. The
reported EPS was used to move up the share price of SATYAM at the stock market”. (xxxx,
2010)
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The core of the AC members is to understand important financial-reporting issues and
development affecting the company, take a close look at the management key activities and
bring in a personal history of business judgement and ethical standard and skill to the their
task which some time book cannot provide (xxxxx, 2011). However, when members of
management or those charged with governance responsibility comprise of the group who
perpetrate the fraud and irregularities like the case of SATYAM, it is more likely that it will
go undetected by the company’s internal control system and the auditors, because they
have greater scope to override controls and conceal fraud (xxxxx 2004). It is on record that
Howard Sherma, chief executive of GovernanceMetrics International, a corporate
governance rating services, said his firm gave a warning report to its clients in December
2006 that “SATYAM’s AC had no members who qualified as expert in audit-committee
financial practices. He said his view was based on US Securities and Exchange Commission
expectation. SATYAM is listed in both US and India; therefore it is subjected to both US and
Indian securities law. GovernanceMetrics evaluate the shares in MSCI Emerging Market Index
in which SATYAM shares are included” Sherma further added that “No one can claim that
having a recognized accounting expert on AC would have prevented or uncovered the fraud.
But certainly it would have reduced the risk” (xxxx, 2009). Contrary to that, there are
number of research findings which indicate that accounting expertise is associated with
better financial reporting outcomes. For example xxxx (2007), Krishna and Visvanathan
(2008), However, a well planned and executed fraud always involves collusion and is
complex in nature, and may remain undetected for a considerable period of time when
commensurate with relax and uncommitted gatekeepers (xxxx 2004).
4.1.4 INFORMATION FLOW AND AUDIT COMMITTEE AUTHORITY
By authority, an AC should have clear right to seek information, makes decision and carry
out its prescribed duties, the conduct of AC members are designed to ensure that all of
them are kept informed about what is going on and that control is exercised over the
executive management, the AC has a set of overriding duties to exercise for control to be
effective (xxxx, 2005). The presence of AC most often gives a notion that the system of
corporate governance is adequate when in actual sense it is not.
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According to SFIO findings an ex-senior executive of the company Jose Abraham blew the
whistle on the scam of SATYAM. In an e-mail dated December 18, 2008, Jose Abraham sent his
findings to an independent director of the company Mr. KG Palepu, who then forward the mail
to Mr. M Rammohan Rao, who is the chairman of the AC of the company. The chairman also
forwarded same to other members of the committee, the statutory auditor Mr. S
Gopalakrishna and the chairman Mr. Raju (xxxx, 2010).
This is similar to Enron case where Sherron Watkins reported a concern but the AC did
nothing over it (xxxx et al, 2002 pp 34-35). This signifies the height of lack of commitment
to ensuring the whistle blower system operate effectively in the company by both the
management and the AC (xxxxx 2013), Mr. Abraham only got the courage to blew the
whistle when he became an ex-officer of the company. The whistle blower system as
suggested by xxxxx (2013) is one of the primary sources of authentic information for the
AC, but in most cases management of companies do not support the establishment of that
system. In this regards, it is clear that the AC of SATYAM had no clue to what happened, as
mentioned by Ved Jain, President of the Institute of Chartered Accountants of India “the AC
seems to be sleeping.”(xxxxx, 2009),
Again, the AC authority on the independent auditor was stampeded by the management of
SATYAM; investigation show that “the auditor price Waterhouse partners Gopalakrishna and
Srinivas Talluri audited the account of SATYAM for eight years till the accounting fraud came
to light”. If the AC had exercised it authority on the selection, recommendation and
appointment of the independent auditor and the rotation of the office, it could be said the
story of SATYAM could have been different. This is similar to the findings of xxxx et al
(2010), that despite the attention received by the concept of AC from academic literatures
and by regulators in different countries, some companies experiences suggest that AC are
typically ineffective and are lacking the sufficient power to be strong governance
mechanism. Similarly, xxxxx (2013), states that ACs are failing to deliver on their
responsibility whenever an organization suffers a catastrophic failure or even significant
risk that could have been prevented. In this case, because of the auditor’s long standing
relation with the management, they became ineffective to figure out and report to AC the
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gray areas in the financial statement for a long period of time, and it is so glaring that AC
and the auditors could have stop the occurrence of the fraud long before it became worse.
The whistle blower system that should be strengthening by the AC was inexistence. And the
very few employees with good conscience occasionally report their worries on the
irregularities going on but the AC committee refused to act on their report.
4.1.5 RESPONSIBILITIES FOR FRAUD DETECTION AND PREVENTION
Categorically, the functions of SATYAM’s AC included “oversight of the company’s financial
reporting process and disclosure of financial information to ensure that the financial
statement are correct, sufficient and credible” and “Reviewing with the management,
performance of statutory and internal auditors and adequacy of the internal control
systems” (Company’s Annual report 2008 in xxxxx, 2009). However, evidence has shown
that if the AC had discharged it function as required by SEBI, it could have been a different
story to be told about SATYAM. A number of events have posed the need for AC’s deep
involvement to unearth the actual picture and to be able to detect and prevent the
eventualities.
For example, in terms of disclosure the AC committee did not ensure the correctness,
sufficiency and credibility of SATYAM financial statement. Firstly, there exist a lawsuit in
Texas US, initiated since 2007, which require huge amount in compensation and
punishment for damages; it had not been reported to SEBI or the SEC (xxxx, 2009). This is
an event of serious non-disclosure of material facts. Secondly, SATYAM lost one of its
branch cases in London also not reported (xxxx, 2009). This clearly violates both the
provision of SEBI and New York SEC on disclosure obligations. The third incidence relates
to the World Bank ban on SATYAM for providing “improper benefits to bank staff,” which is
related to bribery, however, the bank did not report it to the company AC for an action to
be taken for good governance. This confirms the findings of xxxx et al. (2008) which shows
that firms with less active AC are indeed less likely to identify ineffective internal controls.
Similarly, decision to spend the entire cash reserve of the company on a related party
transaction at a gross overvaluation required the AC to make a thorough investigation on
40
the matter, but it was clear that the AC did not carry out any tangible investigation before
accepting the decision by the board. “Investigation has found that Maytas properties valued
at $1.3 billion which was said to have 6,800 acres of ‘Land ‘ under development, only 100
acres could be verified. Also, the promoters of Maytas infrastructures claimed to owned only
35% at the time of bid, but CNBC a business channel revealed that the promoters were
holding as much as 85%, all of which the SATYAM AC has no knowledge of it while it is part of
their functions to get to the root of such transactions”. Coincidentally, this correspond with
the findings of xxxxx (2013) which conclude that when directors are appointed from the
same social ties with CEOs, the social ties have a negative effect on variables that ensure
their oversight quality. In the end it renders the AC inefficient and not being able to ask any
serious question and easily get convinced with silly answers.
4.2 LEHMAN BROTHERS
Lehman Brothers had started as a small general store at Montgomery, Alabama in 1844.
Henry Lehman, an immigrant from Rimpar, Germany, founded it. It was established as a
small shop selling groceries, dry goods and utensils to the local cotton farmers. In the year
1850, his two brothers, Emmanuel and Mayer, joined him in the business, and they jointly
named the business LEHMAN BROTHERS. However, Lehman Brothers metamorphose from
general merchandising business to a commodities broker that bought and sold cotton for
planters living around Montgomery, Alabama. In 1858, they opened a New York office,
concentrating their operation in the New York office gave them the chance to spearhead
the formation of the New York cotton exchange in 1870. The first commodities futures
trading venture. Mayer Lehman was appointed to it first board of directors.
During depression in 1930’s, Lehman was the first firm to come up with a new method of
financing known as the private placement when companies were unable to raise capital. An
innovative idea then, the private placement nowadays becomes a standard financing
technique. The economic expansion of 1950’s which was driven by electronic and
computer technology, Lehman Brothers was deeply involved in the investment
opportunities in the sector, and engaged in underwriting digital equipment corporation’s
first public offering. In the 1960’s and 1970’s the firm expanded its tentacles, when U.S
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companies expanded internationally, to increase its presence globally by opening offices in
Europe and Asia. In 1980’s Lehman Brothers acted as an advisor on several large U.S and
cross -border transactions, Lehman Brothers also take part in the new market as a result of
computer boom by backing companies like Intel, the company that introduced the world’s
first microprocessor to raised fund.
In 1984, Lehman Brothers was acquired by American Express and merged with its retail
brokerage Shearson to form Shearson Lehman Brothers. Soon after that American Express
pulled out in 1993, Lehman Brothers once again became known solely as Lehman Brothers.
While the firm prospered over the years, it has content with ample challenges over the
years, especially the shortage of capital when American Express pulled out in1994. In 2000,
Lehman celebrated its 150th anniversary, however despite its ability to survive through the
challenges; the collapse of the US housing market ultimately brought it to its knees in 2008,
as its involvement in the subprime mortgage turned disastrous. Lehman was the fourth
largest US investment bank at the time of its collapse, with 25,000 employees worldwide. It
was the largest victim of the US subprime financial crisis that collapsed the global financial
markets in 2008. On 15 September 2008, Lehman filed for Chapter 11 bankruptcy, with
$639 billion in assets and $619 billion in debt, which makes it the biggest in history (HBS,
2014)
4.2.1 THE AUDIT COMMITTEE
The AC of Lehman Brothers existed for some time, due to the long-standing institutional
practice in the company, Consistent with the Sarbanes Oxley provision, the AC reports on
their roles in the annual account of Lehman Brothers.
4.2.2 REVIEW OF FINANCIAL REPORTING PROCESS, INTERNAL CONTROL AND
DISCLOSURE REQUIREMENT
“We continue to be committed to industry best practices with respect to corporate
governance. Our Board of Directors consists of ten members. With the exception of our CEO,
all of our directors are independent. The audit, nominating, and corporate governance,
finance and risk, and compensation and benefit committee are exclusively composed of
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independent directors. The AC includes a financial expert as defined in the SEC’s rules. The
board holds regularly scheduled executive session in which non-management directors meet
independently of management. The board and all its committees each conduct a self-
evaluation at annually. Last year, overall director attendance at board and committee
meetings was 96%. We have an orientation program for new directors. Our corporate
governance guidelines also contemplate continuing director education arranged by the
company. Our Code of ethics is published in our website. We have designed our internal
control environment to put appropriate risk mitigants in place. We have a global head of risk
management and a global risk management division, which is independent. The company’s
management assessed the effectiveness of our internal controls. Based on our assessment, we
believe that the company’s internal controls are effective over financial reporting.
Independent auditors have also considered these controls effective. We also sponsor several
share-based employees’ incentives.” (Lehman Brothers Annual Report 2007 in Da Silveira
2013).
Above is an excerpt from the Annual Report of Lehman Brothers a few months before it
collapse, which portrays how robust the company is in adherence to Sarbanes Oxley
provisions and good corporate governance practice. But sufficient evidence contradicts the
assertion of the company’s management for being adherence to best governance practice
as observed by xxxx (2010), that Lehman was bankrupt right before September 2008. This
make legal expert to believed that Lehman executives deliberately manipulated
information in the statements, and the auditors and AC purposely closed their eyes to these
balance sheet manipulations as early as 2000’s (xxxx, 2011). Especially in the use of Repo,
significantly Lehman used Repo 105, and failed to disclose it to the government, rating
agencies, investors, and the board of directors. It is believed that the auditor and the AC
were aware of the situation, and sufficient evidence from the bank examiner’s report
findings indicates a breach of fiduciary duties. However, the report states clearly that the
board of directors was unaware of Lehman’s Repo 105 program and transactions (page
945).
43
This could be because the management has over powered the board or lack industry
knowledge from the part of the board and AC members as found by Cohen et al (2008) that
AC members with industry expertise are likely to have superior ability for understanding,
interpreting and assessing the quality of financial reports than members with no industry
expertise. However, when the top management takes control of the board agenda, the AC
might not be able to get right information to discharge it oversight duties (xxxxx et al,
2009). And this reveals the inability of the AC to act on behalf of the board as a sub-
committee of the board responsible to the board for reviewing the system of control over
the company’s business.
4.2.3 THE USE OF REPO 105
Repo is a financial instrument used by financial institutions routinely to transfer securities
under short-term arrangement to finance immediate liquidity needs. On who to control the
transfer asset FAS 140 provided that it should be treated as a financing arrangement or
sale (xxx, 2011 and xxxxx, 2013). Although, Repo 105 was in line with American accounting
standards, it purpose in Lehman was to deceive and they used techniques to reduced it
reported leverage substantially (xxxx, 2011). And it is observed that financial statement
fraud techniques vary by industry. In technology companies, the identified techniques are
in revenue recognition, while financial services sector’s fraud techniques relate to
misappropriation of asset (xxx, 2000). This is again confirmed by xxxxx et al (2010a) that
AC members with strong industry expertise would have sufficient knowledge to assess the
business activities and risk to be able to evaluate the appropriateness of the use of
accounting methods and whether estimate are realistic, leading to higher quality financial
reporting.
Lehman reported having over twenty operating committees to review risk decisions as
they claim “Risk management is one of the core competencies of the firm” (xxxxx, 2010).
Ultimately, the risk management structure appeared to be ineffective and dysfunctional as
they were disregarded in most cases of risk assessment (xxxxx, 2009, xxxxx, 2010, and
xxxxx, 2013). From all account, it appeared that “the top management wilfully certified the
accuracy of financial statement knowing they were inappropriate, and an accounting scandal
44
was in making and the Sarbanes Oxley Act was violated”. This is because of the
ineffectiveness of the instituted watchdog due to power relation existing between the AC
and the management as observed by Turnbull (2004), that AC have not been working and
cannot be relied upon to protect investors unless they become a separate board elected by
investors on democratic rather than a plutocratic basis. AC is increasingly failing to deliver
on their responsibilities due to lack of risk awareness system in most of the organizations
(xxxx, 2013).
4.2.4 RESPONSIBILITY FOR PREDICTION PRVENTION OF FRAUDULENT ACT
AC is delegated with the responsibility of overseeing the financial reporting process of
companies as a subcommittee under the board of directors. In the case of Lehman the
discharge of these duties is lacking as claimed by xxxxx (2011) that warning signs were
apparently visible to detect the possibility for the bankruptcy of the firm, arguing that the
auditors and the AC ignored the statement of cash flows in their analysis as examination of
the statement revealed that “Although Lehman Brothers had $7.286 billion in cash and cash
equivalents on November 30, 2007, an analysis of its cash flows signal a major dysfunctions in
working capital management. Specifically, this is shocking for financial instruments: over a
three year period, they generated net negative cash flows of $161.657 billion.” The inability to
predict the catastrophe the firm faced by analysis clearly indicates that the AC either did
not understand the statement or were blind folded by superficial performance, which did
not allowed them to be inquisitive on a matter of concerns for more details (xxxxx, 2005).
Although, it is not the primary roles of the AC to detect a fraud, but it is expected the
auditors and AC working together should discover frauds or errors, which are material to
the financial statement (xxxx2004), the AC’s first priority should be to make sure financial
projection are sound (xxxxx et al, 2009). But that appeared to be lacking in the case of
Lehman brothers. Conclusively, xxxxx (2013) state that the net negative cash flows signal a
deficiency which could have been prevented, nevertheless, the AC and the auditors failed to
recognize the lack of correlation between the statement of cash flows with balance sheet
and income statements. More so, the 2005-2007 statement of cash flows of Lehman gave a
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clear prediction of the coming bankruptcy, which was completely detectable by careful
examination. xxxxx (2011) enumerated the signs for the distress in the cash flows
statement to include:
i. “Chronic inability to generate cash from operating activities
ii. Massive and systematic investment in working capital items and even more
intensive investment in financial tools and instrument.
iii. Systematic use of external financing to offset operating deficit, in which mainly
included long-term debt.
iv. Steady deterioration of cash flows over three years leading to crisis.
These were enough warnings for disaster appearing in the near future; the top
management were aware as members of Lehman tax department, maintain that they were
also aware of the trouble ahead (xxxxx, 2009). The system of bonuses in the investment-
banking sector has been identified as contributing factor toward substantial risk taking,
and some firms had limited understanding and control over their potential balance sheet
and liquidity needs that most of the allege fraud activities were undertaken by top
management members who want to look like an exceptional traders and achieve a higher
bonuses. The AC needs to better understand the behaviour and risks that a company’s
incentive plans encourage and whether such risks are appropriate (xxxx, 2009). In this
regard, xxxxx et al (2010) mention that in 2006, Lehman made a deliberate decision in
pursuing a higher-growth business strategy, by switching from low a low-risk brokerage
model to capital-intensive banking model, where they buy and stored asset, which
primarily should have been moved to the third party. All these were pre-warnings posed to
the monitoring mechanism (AC) to predict their probable consequences.
4.2.5 AVAILABILITY OF INFORMATION AND AUDIT COMMITTEE ROLES
According to xxxxx (2013), the effectiveness of AC can only be guaranteed when there is an
effective and independent source of information, the ability of the AC to obtain information
independent of the CEO and the CFO is crucial for effective oversight. The AC of Lehman
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Brothers were not well informed on what was going on with Lehman, as the Examiner’s
report found that “sufficient evidence show that Mr. Matthew Lee forwarded a whistle-blower
letter to the independent auditors apposite to Lehman Repo 105 activities and reporting on
$50 billion in the second quarter 2008, but the auditors failed to informed the AC of Lee’s
allegations, while they were aware that the financial information may be materially
misleading because of the failure to disclose the effect of the Lehman Repo 105” (Examiners
report volume 3 p.1033). Although, the AC make an effort during a meeting with the
internal and external auditors by requesting the external auditor to assist with the
investigation into the allegations made by Lee, the external auditor refused to informed the
AC about the Repo 105 claims by Lee, even though the AC asked to be told about each
allegations (xxxx, 2013).
The Actions of the external auditors and lawyers are clear negligence of duties, as both are
in the best position to assist in the evasion of ‘good faith’ obligations of an investment bank
and has a burden of protecting the public from ‘shams transactions (xxx, 2010). Evidence
also showed that “In the first quarter of 2008, while other investment bank were reporting
massive losses from written-downs heavy commercial and residential real estate holdings,
Lehman reported a profit by manipulating it equally troubled real estate portfolios comprised
of $25 billion in prime.” (xxxx, 2013). According to xxxx (2011) Lehman engaged in creative
and deceitful accounting practice, which temporarily removed securities and troubled
liabilities from Lehman balance sheet, recording the transactions as sales while reporting
quarterly financial result to public. The AC was unable to questions that due to cover up by
the management of the company and they lack information from other sources. In most
cases, as identified by xxxx et al (2009) that the management may take over the agenda
setting process like the case of (Enron, WorldCom and Hollinger) where the senior
management took control of the agenda and were able to control the flow of information to
the board and the AC. Beasley concluded that “information timeliness can be an important
issue and may reduce the ceremonial role played by AC.” This confirm the explanation of
xxxxx et al (2005), who said that information asymmetry always exist in the board and the
independent directors are always on the unprivileged side of this asymmetry.
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4.3 LIMITATIONS OF THE RESEARCH
Limitations of the study is that, it is solely based on secondary data without the inclusion of
primary data, which could have been used to gather the experience of the ACs members
through interaction, interviews and questionnaire. However, the nature of regulations
guiding the release of vital information from companies in the UK makes it difficult for the
researcher to use the primary data, despite it important as a source of information for
social science research of this nature. The use of only two case studies might not give the
required insight to understand the roles and the effectiveness of AC within the
organizational and institutional context. Therefore, the findings are either inconclusive or
limited. Time constraint is identified as limitation on the side of the researcher as case
study research is time consuming and require in depth investigation into the matter of
study before concluding. The study would have been appropriate and insightful if it was
conducted using both primary and secondary data, from existing companies. In that, it can
give the present view of ACs activities as against the information from the collapse
companies.
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CHAPTER FIVE
5.0 CONCLUSIONS AND SUMMARY OF FINDINGS
As outlined in chapter one, this thesis examined the roles and effectiveness of AC in the face
of incessant corporate failures; Chapter four discussed the roles and effectiveness of AC
from the perspective of two major failed companies. Over the past 7 decades, the AC
concept is receiving a considerable attention and growing from a committee saddled with
the responsibility of Nominating and arranging the engagement process of independent
auditors to a Committee now responsible for overseeing the integrity of the financial
statements of company, the review of the company’s internal financial control and
monitoring and reviewing the effectiveness of the company’s internal audit function. As
business environment is continuously changing and business risks are increasing, so did
the roles, responsibilities and challenges facing AC grew, especially in the wake of
corporate failures such as Enron, WorldCom, Pamalat, and Madoff.
The attention of regulators and academicians turned on the AC roles in the aftermath of the
2008 subprime crisis, seeking the way out to improve activities of the governance
mechanism and ensure investor’s confidence resurface on corporations. In most of the
corporate failures, the AC is being accused of not discharging their duties as required and
they are associated with the corporate failures. However, the roles of the AC is a
challenging one and it depend on so many factors to be discharged effectively as identified
by researchers (Independent, industry expertise, information flow, and inbuilt willingness
to serve by AC members), and the absence of any of such factors most often renders the AC
ineffective.
This study concludes that in most cases Companies report conformity with regulations by
having an AC that appears effective but is not actually effective in substance. However, the
presence of AC has enhanced the quality of financial reporting and affected the potential
threat of fraud to a certain degree. But lacks of industry specific expertise cripple the effort
of the AC.
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5.1 SUMMARY OF MAJOR FINDINGS
After evaluating the result, the study reveals the following key findings;
In both case scenarios, the perpetrated fraud could have been prevented if the ACs were
proactive in the discharge of their duties, because the signals existed long before the
occurrence of the failures. However, lack of information, which should have been supplied
by the auditors and whittles blower prevented the AC from predicting the looming failures
facing the companies. It is also found that the readily available information at the disposal
of the AC is the one provided by the management whom the AC is to monitor, however, it
was suggested by xxxxx (2013) that the effectiveness of AC can only be guaranteed when
there exist and effective and independent source of information.
The study also found that effectiveness of AC is not determined by either mandatory or
voluntary AC, as in both cases AC establishment is a mandatory requirement. All that is
needed is the understanding of the sector specifics risks associated with the company,
which is lacking by the AC members. Lack of harsh punishment on the negligence of AC
members also contributes to the laxness of the AC in the discharge of their duties. The
concept of AC entirely failed to recognized behavioural aspect of human being in the
formation of AC, while certain personality trait could not be ignored.
5.2 SCOPE FOR FURTHER RESEARCH
The findings of this study open further scope for research, as many areas need to be
studied and investigated for detail understanding of the actual process involved in AC
activities and the determinants of their effectiveness. Further research should include (i)
consideration on the AC behaviour to find what exactly is happening in the ACs meetings.
(ii) The research should investigate whether after appointment into the ACs, the
independent director continues to remain independent or not. (iii) Further studies should
theorize a concept that will ensure a continue training for ACs members on their roles and
the resultant effect of not doing their duties. (iv)Focus on the enhancement of information
flow between auditors and ACs. Therefore, a longitudinal case study method will suit this
study, as it can give an in depth information required to understand exactly how ACs
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behave, to be able to come up with a way out on how to improve the activities of the ACs.
The research could also be undertaking using a case study combined with survey method,
several benefits of case studies can be realized through open-ended questions and semi-
structured interviews and other methods of survey data collection.