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Total Number of Subscribers: 426 |
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Date: 15 April 2008 |
Compiled by Mr. M. Sathya Kumar |
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, Need to bolster internal controls When auditors plan an audit, one of the first things they assess
is the adequacy and effectiveness of the internal controls in the company
since it is one of the most important determinants of the audit risk. Weak
internal controls increase audit risk and consequently the cost of audit. Simply speaking, internal controls are processes that protect
assets and other resources (eg. human resources) from misappropriation,
inefficient use or exposure to unwarranted risks. Internal control provides reasonable assurance to the company’s management and the board of directors that the company’s objectives are achieved in terms of the effectiveness and
efficiency of operations, the reliability of financial reporting and
compliance with applicable laws and regulations. Internal control of financial reporting covers maintaining
records; provides assurance that transactions are recorded as necessary to
prepare financial statements in accordance with generally accepted accounting
principles (GAAP) and that receipts and expenditures are only made under
proper authorisations. It also provides reasonable assurance for the prevention or
timely detection of unauthorised acquisition, use, or disposition of assets
that could materially affect financial statements. Internal audit is a part of the internal control system. It is a
function that provides reasonable assurance that internal controls are
adequate and are operating efficiently and effectively. Therefore, internal audit is said to be control of controls. The
Audit Committee of the Board of Directors provides a communication channel to
the internal auditor and protects the independence of the internal audit
function. A weak internal audit function that does not have the ability to
detect and report improper behaviour provides temptation to employees to
engage in improper acts. It is the responsibility of the Board of Directors and the
management to establish an internal control system and to ensure that this
system operates effectively. Clause 49 of the Listing Agreement requires the CEO and CFO to
certify, among other things, that they accept the responsibility for
establishing and maintaining internal controls, and that they have evaluated
the effectiveness of the internal control systems of the company and they
have disclosed to the auditor and the Audit Committee, deficiencies in the
design or operation of internal controls, if any, of which they are aware and
the steps they have taken or propose to take to rectify these deficiencies. The effectiveness of the internal controls is significantly
influenced by the integrity and ethical values of the people who design,
install, administer and monitor them. Internal control systems will fail
unless a proper control environment is created within the corporation. Individuals
may engage in dishonest, illegal or unethical acts, if there are strong
enough incentives or temptations to do so. A study shows that the most common incentives for improper
behaviour are pressure to meet unrealistic performance targets, particularly
for short term results; high-performance dependent rewards; and higher and
lower cutoffs on bonus plans. Also, when a company is in the growth trajectory and managers
stretch to achieve targets, internal controls come under stress and may break
down unless the company installs a strong monitoring system. In those
situations managers often perceive the internal control system as an
unnecessary burden and subvert internal controls even if they have no
ulterior motive. This exposes the
resources of the company to unwarranted risks. For example, to achieve the
sales target, managers may relax the credit rating norms and thus expose the
company to undue credit risks. On It is said that the ‘tone should be
set at the top’. The behaviour of the top management sets
the control environment within the organisation. Communication through
behaviour is more effective than communication through written documents like
‘code of conduct’ or ‘company policy’. For example, if the top management disregards applicable laws
and regulations, the culture percolates down across the
organisation. If the Board of Directors does not take the responsibility for
internal control, shareholders cannot be protected from management fraud and ‘waste of free cash flows’. For example, the accounting fraud at WorldCom is a failure of
the board of directors and the Audit Committee. The management committed
fraud against shareholders at a time when WorldCom was struggling because of
the vast overcapacity of bandwidth, combined with a consumer price war and
the rise of mobile telephones. There were huge temptations for the management
to resort to the earnings management because the top management could not
formulate right strategies to face the new challenges. Arthur Anderson, in its internal documents, classified WorldCom
in the ‘high risk’ category, but did not modify the audit procedure because that would have increased the cost of audit.
The audit failure is the result of temptation of partners to retain a client
which contributes significantly to the earnings of the audit firm and to cut
cost of providing services. The audit failure in the case of WorldCom shows that improvement
of audit techniques does not necessarily improve the quality of audit because
audit involves people; and human beings are inherently greedy. Therefore, the
Audit Committee and the board, which is in fiduciary relationship with
shareholders, have to be extra cautious, particularly when the company or the
industry is passing through a bad phase. Coutesy : Mr. Asish K Bhattacharyya |
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