Section B – TWO questions ONLY to be attempted
TR Co is a well-established public limited company listed on the national stock exchange of a western European country. It is currently undergoing its statutory annual audit from the reputable firm of accountants Shaw & Bennett LLP, who have been its auditors and business advisors for more than 10 years. Over this period the managing partner of Shaw & Bennett has become a very good friend of the chief executive officer (CEO) of TR Co, and their families regularly holiday together.
The chairman of TR Co is expecting the audit to be signed off, but the audit partner managing the audit has suspicions around the adequacy of a series of provisions and whether contingent liabilities noted in the accounts would not more accurately be accounted for as provisions. She also disagrees with the capitalisation of research expenditure and other intangible assets on the statement of financial position, rather than treating them as expenses in the statement of profit or loss. She has questioned the financial controller, who is a professionally qualified accountant, about these matters but is getting minimal cooperation from him. It appears that the chief financial officer (CFO) has pressurised the financial controller to apply these accounting policies, as he has himself been pressurised by the CEO to ensure that profits over the next two years are presented favourably towards the time which the CEO’s share options can be exercised.
The audit partner herself is being pressurised by the managing partner of Shaw & Bennett to sign off the accounts as a ‘true and fair view’ and not to challenge the accounting policies of the company, as the renewal of the audit contract with TR Co is imminent.
Required:
Describe the primary roles of a chief executive officer (CEO), and criticise the actions of the TR Co CEO described in the scenario, recommending more appropriate behaviour.
The role of the CEO
The CEO of TR Co is responsible for both the development and execution of the company’s long-term strategy with the prime objective of creating shareholder value. This leadership role entails being ultimately responsible for all day-to-day management decisions and for implementing the company’s long and short-term plans. The CEO should act as a direct liaison between the board and senior management team, and also communicate to the board on behalf of management. The CEO should inculcate a culture which establishes those shared attitudes, goals and behaviours which characterise the values promoted by the company. The most critical aspect of corporate culture is shared values, so the CEO should ensure that these are applied consistently from top to bottom and across all departments in TR Co.
Inappropriate actions
In the current situation at TR Co the behaviour and motives of the CEO are highly questionable. By pressuring the CFO to apply accounting treatments which might artificially inflate the actual profit figure, and indirectly causing the financial controller to be uncooperative with the auditors on this matter, the CEO is not exhibiting the core values expected of the most senior executive director on the board.
It appears that the primary motivation behind the CEO’s actions is self-interest. By applying the suggested accounting treatments, it is likely to generate a higher share price at the time the CEO is planning to exercise his share options. This is clearly an attempt by the CEO to manipulate the reported profit figure to engineer an unrealistic capital gain, and therefore is an unacceptable abuse of his power.
Although not stated, it could also be inferred that the CEO is using his friendship with the senior partner at Shaw & Bennett to exert pressure on the auditors to accept the accounting treatments without question. The auditors are acting for the shareholders of TR Co, so the behaviour of the CEO is a breach of his fiduciary duty as a director of the company.
Correct behaviour
The CEO should require the company’s accounts department to draw up financial statements which accurately reflect corporate performance through the correct application of accounting standards. This is because any overstatement of profit would not be in TR Co shareholders’ interests and any subsequent downward adjustment is likely to detrimentally impact on the share price. Any capital gain received when share options are issued should be an accurate reflection of the additional value which has been gained since the options were granted, and so this remuneration tool acts as a motivator to drive long-term business performance through the alignment of shareholder and option holder interests.
The CEO should encourage all staff to be open and engaging in their relationship with the auditors, and not to obstruct them in their work. This type of cooperative behaviour would be in line with the culture which TR Co would want to exhibit, promoting and conducting its affairs with the highest standards of integrity, probity and corporate governance. All external parties would want TR Co to be a transparent company which is being managed in the best interest of its shareholders.
The CEO should never allow any personal friendships to affect his responsibilities as a director of the TR Co. Therefore, in this instance he should refrain from discussing any aspect of the audit with the senior partner at Shaw & Bennett, instead allowing the audit committee to effectively discharge one of their primary duties.
Explain the threats to independence to the Shaw & Bennett audit team, the financial controller and the CFO of TR Co which arise from this situation.
The current situation at TR Co presents several threats to the independence of various stakeholders involved in the audit.
The Shaw & Bennett audit team
The auditors are engaged to act on behalf of the shareholders of TR Co to independently validate and verify the accuracy of the company’s reported financial performance. However, the pressure from the managing partner, who is friendly with the CEO to not question the policies and sign off the accounts, appears in part to be based on impending renewal of the audit contract. Although not explicitly stated, it could be implied that any future contract awarded to Shaw & Bennett is contingent on the outcome of the current audit. Therefore, if the audit partner decides to pursue her doubts further and delay completion of the audit, this could jeopardise an existing revenue stream for the audit firm. This dilemma clearly presents a threat to her independence and professional judgement.
The financial controller
The financial controller, being a qualified accountant, is obliged to comply with a professional code of ethics. This will govern the financial controller’s professional behaviour in a number of areas including acting at all times with integrity, which is currently being challenged by being uncooperative with the auditors. The financial controller should also apply professional competence and due care always, so knowingly capitalising normal expenditure and failing to make sufficient provisions would be a further ethical breach. It appears that the financial controller is being intimidated by the CFO to act in this inappropriate way, which compromises objectivity and independence and is totally unacceptable.
The CFO
The CFO, who is also probably a qualified accountant, is being pressurised by the CEO to ensure that high profits are declared over the next two years. Although he does not appear to have anything personally to gain except to keep the CEO, his line manager, happy, the CFO is still using his position of authority to deliver the desired results. This behaviour is of particular concern because the CFO is a director of TR Co and has a fiduciary duty to act in good faith on behalf of shareholders, yet his actions are a clear breach of the trust placed in him.
Recommend suitable safeguards at TR and Shaw & Bennett to prevent such conflicts as identified in the scenario, and to address the threats to independence identified.
Suitable safeguards which could be introduced to deter unacceptable behaviour and prevent any conflicts of interest include:
Job descriptions
By clearly defining the roles of the CEO and the chairman of TR Co it will avoid any risks arising from conflict of interest. By concentrating on representing the interests of the shareholders, the chairman is promoting the highest standards of corporate governance in the company. The chairman may also be responsible for signing off the financial statements, and so would query any irregularities brought to his attention by the auditors. This safeguard is likely to deter the CEO from acting in a way that is in his personal interests, rather than those of the shareholders.
Board continuous professional development
All directors should continuously develop their knowledge and skills base, concentrating specifically on the duties and obligations necessary to be effective members of the board. This would include a greater awareness of their fiduciary relationship to act in good faith and in the best interests of the company. Duty of care is a specific fiduciary duty, requiring every director to use reasonable skill and care in carrying out their tasks, and would deter both the CEO and CFO from acting inappropriately at the TR Co.
Corporate code of conduct
If TR Co developed and issued a corporate code of conduct, it would act as formal control over individuals’ behaviour. By prohibiting certain behaviours and actions, and then stipulating sanctions which could be applied for any serious breach, the code should deter anyone in the company from behaving or acting inappropriately. Therefore, if the CEO was aware that his attempts to manipulate the financial statements could result in disciplinary proceedings being brought against him, he would be less inclined to act as he did.
Safeguards which could address the threats to independence of those parties involved in the TR Co audit include:
The CFO
Corporate governance provisions include the essential role of an audit committee, which acts as an intermediary to ensure that external auditors are independent of both the company and its management. The audit committee reinforces the auditors’ independence by providing a channel of communication where they can raise any concerns or issues found during an audit, which should improve the quality of financial reporting. At TR Co, this would have enabled the audit partner to express her reservations about the capitalisation of expenses and adequacy of provisions, without needing to refer the matter to attention of the CFO. The audit team would then be assured of the full cooperation required from TR Co to satisfactorily resolve these matters before signing off the audit.
The financial controlle
The promulgation of a corporate code of conduct should outline the core values of the business, together with those ethical principles based on them. It can also explain how staff are supposed to approach ethical problems, and the standards to which professionals will be held to account. This would clarify the responsibility of the financial controller and allow for the correct discharge of duties without fear of intimidation.
However, should any employee feel that they are being pressurised to act in an inappropriate way, such as sanctioning wrong accounting treatments, then a whistleblowing channel should be available. This allows for any employee to anonymously raise their concerns with an independent group of non-executive directors to investigate further.
The Shaw & Bennett audit team
As a professional firm of accountants, Shaw & Bennett must adhere to the code of ethics which governs the accountancy profession. The code should contain a conceptual framework which allows individual accountants to evaluate and address any threats to compliance which they identify in the course of their work, and promulgates safeguards to either eliminate the identified threat or reduce it to a more acceptable level. Such safeguards should include policies and procedures in the following areas:
（i）identify and handle any personal relationships between audit team members, including partners, and clients;
（ii）manage the reliance on revenue derived from individual clients, such as TR Co;
（iii）quality control policies and procedures to ensure audits are conducted properly;
（iv）prohibiting any individual from influencing the outcome of an engagement;
（v）consulting with the firm’s technical team on contentious accounting issues.