The following factors describe a potential audit client. For each factor, indica

ID: 2484309 • Letter: T

Question

The following factors describe a potential audit client. For each factor, indicate whether it is indicative of poor corporate governance. Explain the reasoning for your assessment. Finally, identify the risks associated with each factor.

a. the company is in the financial services sector and has a large numer of consumer loans, including mortgages, outstanding

b. the CEO's and CFO's compensation is based on three components: 1. base salary, 2. bonus based on growth in assets and profits, 3. significant stock options

c. the audit committee meets semiannually. it is chaired by a retired CFO who knows the company well because she had served as the CFO of a division of the firm. The other two members are local community members- one is the president of the chamber of commerce and other is a retired executive from a successful local manufacturing firm

d. the company has an internal auditor who reports directly to the CFO and makes an annual report to the audit committee

e. the CEO is a dominating personality- not unusual in this environment. He has been on the job for six months and has decreed that he is streamlining the organization to reduce costs and centralize authority

f. the company has a loan committee. It meets quarterly to approve, on an ex-post basis, all loans over $300 million (top 5% for this institution)

g. the previous auditor has resigned because of a dispute regarding the accounting treatment and fair value assessment of some of the loans

Explanation / Answer

Factors

Explain Your Reasoning and the Implications of Poor Governance

a. The company is in the financial services sector and has a large number of consumer loans, including mortgages, outstanding.

This is not necessarily poor governance. However, the auditor needs to determine the amount of risk that is inherent in the current loan portfolio and whether the risk could have been managed through better risk management by the organization.

The lack of good risk management by the organization increases the risk that the financial statements will be misstated because of the difficulty of estimating the allowance for loan losses.

b. The CEO’s and CFO’s compensation is based on three components: (a) base salary, (b) bonus based on growth in assets and profits, and (c) significant stock options.

This is a rather common compensation package and, by itself, is not necessarily poor corporate governance. However, in combination with other things, the use of ‘significant stock options’ may create an incentive for management to potentially manage reported earnings in order to boost the price of the company’s stock. The auditor can determine if it is poor corporate governance by determining the extent that other safeguards are in place to protect the company.

c. The audit committee meets semi-annually. It is chaired by a retired CFO who knows the company well because she had served as the CFO of a division of the firm before retirement. The other two members are local community members – one is the President of the Chamber of Commerce and the other is a retired executive from a successful local manufacturing firm.

This is a strong indicator of poor corporate governance. If the audit committee meets only twice a year, it is unlikely that it is devoting appropriate amounts of time to its oversight function, including reports from both internal and external audit.

There is another problem in that the chair of the audit committee was previously employed by the company and would not meet the definition of an independent director.

Finally, the other two audit committee members may not have adequate financial experience.

This is an example of poor governance because (1) it signals that the organization has not made a commitment to independent oversight by the audit committee, (2) the lack of financial expertise means that the auditor does not have someone independent that they can discuss controversial accounting or audit issues that arise during the course of the audit. If there is a disagreement with management, the audit committee does not have the expertise to make independent judgments on whether the auditor or management has the appropriate view of the accounting or audit issues.

d. The company has an internal auditor who reports directly to the CFO, and makes an annual report to the audit committee.

The good news is that the organization has an internal audit function. However, the reporting relationship is not ideal. Further, the bad news is that a staff of one isn’t necessarily as large or as diverse as it needs to be to cover the major risks of the organization.

e. The CEO is a dominating personality – not unusual in this environment. He has been on the job for 6 months and has decreed that he is streamlining the organization to reduce costs and centralize authority (most of it in him).

A dominant CEO is not especially unusual, but the centralization of power in the CEO is a risk that many aspects of governance, as well as internal control could be overridden.

The centralization of power in the CEO is a risk that many aspects of governance, as well as internal control could be overridden, which of course increases the risk of fraud and the risk faced by the external auditor.

f. The Company has a loan committee. It meets quarterly to approve, on an ex-post basis all loans that are over $300 million (top 5% for this institution).

There are a couple of elements in this statement that yield great risk to the audit and to the organization, and that are indicative of poor governance. First, the loan committee only meets quarterly. Economic conditions change more rapidly than once a quarter, and thus the review is not timely. Second, the only loans reviewed are (a) large loans that (b) have already been made. Thus, the loan committee does not act as a control or a check on management or the organization. The risk is that many more loans than would be expected could be delinquent, and need to be written down.

g. The previous auditor has resigned because of a dispute regarding the accounting treatment and fair value assessment of some of the loans.

This is a very high risk indicator that is indicative of poor governance. The auditor would look extremely bad if the previous auditor resigned over a valuation issue and the new auditor failed to adequately address the same issue.Second, this is a risk factor because the organization shows that it is willing to get rid of auditors with whom they do not agree. This is a problem of auditor independence and coincides with the above identification of the weakness of the audit committee.