How to Appoint an External Auditor according to OECD?
Maintaining good corporate governance is not an easy job. It requires having discipline and commitment, an effective risk management strategy, transparency in information sharing and a robust evaluation system. External auditors are one of the main factors that help maintain good corporate governance in any organization.
What is Corporate Governance and why it is important to maintain?
Governance is the system and the set of rules and policies that help direct and control organizations. It embraces the relationship between all the decision-making stakeholders in an organization; shareholders, the board of directors, and the corporate management, that have ramifications on the organization's strategy and performance.
Good corporate governance is essential for investors; it reveals a lot about its current situation, direction and business integrity. It helps strengthen the financial viability of a business and create more investment opportunities.
Internal Audits Vs External Audits
Companies perform a yearly internal audit of their financial statements through an internal auditing committee. Shareholders often require an additional external audit annually to make sure there are no misstate financial information and rule out any possibility of intentional errors in material information.
External auditors are independent auditors appointed by the company's shareholders; they usually belong to Certified Public Accountant Firm (CPA) to help remove any bias in the company's financial review. While internal auditors typically report to the audit committee which liaises the communication with the board of directors and the management, external auditors submit their reports to the shareholders directly. External audits, help stakeholders make better and more informed decisions.
The most significant difference between an internal and external audit is the external auditor's absolute independence. Audits performed by third parties usually result in straightforward and honest results without impacting daily work relationships within the company, unlike internal auditors. Independent auditors hold themselves accountable to have no interest in their clients' financials and are not directly related.
Role of External Auditors in Corporate Governance
Companies usually perform external audits for two reasons:
1. Law requirement: large corporations are usually mandated by the law to have external auditing by independent auditors.
2. Shareholder requirement: reporting back to the shareholders with their findings regarding the company's accounting reports and financial performance.
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However, external auditing can provide much more than just reassurance regarding the financial performance of the company; it can also help in:
- Improving internal systems and procedures: auditors get immersed in the business and understand the overall systems and environment, enabling them to identify deficiencies in the accounting systems and make recommendations to help improve the business and be less prone to fraud or error.
- Reassuring shareholders: shareholders are usually remote and have low involvement in the company's' operation. So, one of the key functions of external auditors is protecting shareholders' interests. The external auditor is not under the company's influence and ensures that the business is profitable and run in the shareholders' best interest.
- Support strong crisis and risk management strategy: external auditing can also help develop efficient crisis-management plans if a financial crisis hit the business. It provides the board of directors and the management with an effective strategy that they can use to sustain confidence among investors.
- Providing credibility: external auditor verifying financial statements provides credibility to the company in the ecosystem. Investors are more inclined to invest or buy businesses with positive external auditing; it provides security that the company is free from material error or malpractice.
So, what are the characteristics of external auditors?
Independence: External auditors' decisions and findings shouldn't be influenced by anyone, with no personal interests in the business they are auditing. The external auditor should maintain imparity and avoid being biased.
Integrity: External auditors must comply with different rules and regulations and provide fair and honest reporting.
Confidentiality: External auditors usually unearth sensitive information about the business; they shouldn't misuse the audit information for personal gain.
Objectivity: External auditors reports and communication with shareholders should be objective, true and accurate. Any personal opinions or views shouldn't affect communication.
Due Professional Care: auditors should work in accordance with the standards set for the profession. Auditors that have exercised due professional care develops a complete defence against any future charges.
OECD mandates for external auditors
1. The External Auditor must be appointed by shareholders following a call for tender, under the conditions and subject to the terms of reference of the Audit Committee's recommendation.
2. The External Auditor appointment shall be for four years with the option of one extension of two years non-renewable.
3. The External Auditor's primary role is to determine whether the management has established systems and practices that provide reasonable assurance that the organization's financial, human, and physical resources are safeguarded and protected; and operations are conducted economically and efficiently.
4. The External Auditor shall carry out such examinations and inquiries as necessary to enable it to report to the shareholders on the organization's annual financial statements.
5. Also, the External Auditor shall be tasked with performance audits. These performance audits include assessment of effectiveness, economy and efficiency of the organization's activities.
Some of the OECD regulations for corporate governance were updated following the Enron scandal in 2001 and its financial havoc that caused Arthur Andersen LLP's dissolution. Despite the poor accounting practices of Enron, Arthur Andersen auditors helped the CEO hide mountains of debt and toxic assets from investors and creditors
Following the crisis, there was a pressing need to re-examining the governance regulations; the OECD issued a revision to its Corporate Governance principles in 2004 related to the role of institutional investors:
- The Principles recommend that institutional investors acting as fiduciaries should disclose their corporate governance and voting policies, including their procedures for deciding on using their voting rights.
- Suppose institutional investors claim to have an active corporate governance policy. In that case, they should set aside the necessary human and financial resources, so they can carry out this policy in a way that their beneficiaries and portfolio companies would expect.
- The Principles also state that institutional investors that act in a fiduciary capacity should disclose how they manage conflicts of interest that may influence how they exercise their ownership rights. For example, how they vote their shares at the annual meeting.
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References:
https://www.oecd.org/finance/financial-markets/42229620.pdf
http://www.oecd.org/daf/ca/oecdworkoncorporategovernance.htm