Corporate Law Test

Corporate governance is a central and dynamic aspect of business. Corporate governance

involves the function of direction rather than control.

Corporate governance is a set of rules, practices and processes used to direct and control a
company. It involves balancing the interests of a company’s stakeholders such as management,
shareholders, suppliers, customers, financiers, government and the community. Moreover, it is
essential for the success and sustainability of the business over a period of time. When the set of
rules and processes which form the governance mechanism of a firm are ineffective or fail, it can
have disastrous consequences for a business. Several large organizations such Enron, Parmalat
and Satyam, to mention but a few. It doesn’t happen overnight and there are several warning
signs which a firm must take note of in order to avoid such failures. Some of the governance
issues faced by the firms which eventually lead to corporate governance failures are –

Ineffective governance mechanisms, for example, lack of board committees or committees

consisting of few or a single member.

Non-independent board and audit committee members, for example where a CEO fulfilled
multiple roles in various committees

 Management, who deliberately undermines the role of the various governance

structures by circumventing the internal controls and making misrepresentations
to auditors and the Board.
 Inadequately qualified members, for example, audit committee members not
having appropriate accounting and financial qualifications or experience to
analyze key business transactions, family members holding board positions
without appropriate knowledge or qualifications.
 Ignorance by regulators, analysts etc. of the financial results and red flags.

Corporate governance failures have resulted in massive problems faced by the companies over
the years. A couple of examples of corporate governance failures which forced businesses and
government authorities to rethink their stance on corporate governance are:

 Parmalat
  Enron
 Satyam
 The Enron scandal, which broke out in October 2001, eventually led to the bankruptcy of
the Enron Corporation, an American energy company based in Houston, Texas. It was the
largest bankruptcy reorganization in American history at that time.
 The primary reason for the failure of Enron was attributed to an audit failure. The problem
faced by Enron was despite having structures and mechanisms in place for good corporate
governance. Nobody flaunted and flouted these rules and regulations! The board of
directors turned a blind eye to open violation of the code. Particularly, when it allowed the
CFO to serve in special purpose entities(SPEs). The auditors failed to prevent suspect and
questionable accounting. The auditors did not even examine the SPE transactions.
 Enron shareholders filed a $40 billion lawsuit after the company’s stock price fell. It
achieved a high of US$90.75 per share in mid-2000, plummeted to less than $1 by the end
of November 2001. On December 2, 2001, Enron filed for bankruptcy under Chapter 11 of
the United States Bankruptcy Code.

Corporate governance is critical issue faced by all companies. The Enron case highlight the fact
that poor corporate governance can lead to a downfall of the largest companies. Regulatory
bodies have increased their scrutiny on the firms are under increased scrutiny by regulatory
bodies which increases the importance of good governance. Digital solutions can help firms
implement a robust governance mechanism to help significantly reduce risk of governance
failure

Parmalat scandal

There is a number of serious corporate governance failures which led to the Parmalat’s crisis.
Firstly, one of the non-executive directors in Parmalat was not independent as he had been
working in Parmalat as a senior manager since 1963. Secondly, the chairman and chief executive
position were not separated as was recommended by corporate governance codes of practice in
Parmalat Finanziaria. Hence both positions were held by Tanzi. Thirdly, the Preda corporate
governance code in Italy specified that where a group of shareholders controls a company, it is
even more important for some directors to be independent from the controlling shareholders.
This was certainly not upheld by Parmalat. Also, there was no adequate explanation given by the
company for this lack of compliance. As in the case of Enron, the failure of Parmalat to establish
careful checking and monitoring structures within the company’s governance framework laid it
bare to the abuse of power and fraudulent activity. Unless these devices for detecting fraud and
misconduct are in place, it is relatively easy for Enron-like situation to arise.

The Parmalat case may seem to differ in terms of the simplicity of its fraud. The audited
statements from Bonlat were used to show cash balances that were reported by the parent
company. Thus, it used in offsetting high levels of debt on its balance sheet. Each quarter with a
set of forged documents would show purported cash holdings at Bonlat that matched the head
office's requirements.

The Parmalat scandal has raised questions about how the company could fudge its numbers for
so long without any help from outside. The auditors, says Mittelstaedt, should have least spoken
to Bank of America to verify that they held the $4.9 billion Parmalat claimed. The system of
checks and balances that support corporate governance needs to function effectively.
Consequently, both Enron and Parmalat highlight the essential functions of non-executive
directors, audit and disclosure, as well as ethicality of management. Corporate governance
mechanisms cannot prevent unethical activity by top management. However, they can at least act
as a means of detecting such activity by top management before it is too late.

(b) The Enron Board was organized into five committees as follows
(1) The Executive Committee met on an as needed basis to handle urgent business

matters between scheduled Board meetings.

. (2) The Finance Committee was responsible for approving major transactions which,
in 2001, met or exceeded $75 million in value.
(3) The Audit and Compliance Committee reviewed Enron's accounting and
compliance programs, approved Enron's financial statements and reports.

(4) The Compensation Committee established and monitored Enron's compensation

policies and plans for directors, officers and employees.

(5) The Nominating Committee nominated individuals to serve as directors.

The following are the weaknesses identified in the committees of Enron which resulted to its
collapse and bankruptcy.
(1) Fiduciary Failure. The Enron Board of Directors failed to safeguard Enron
shareholders and contributed to the collapse of the seventh largest public company in the United
States, by allowing Enron to engage in high risk accounting, inappropriate conflict of interest
transactions, extensive undisclosed off-the books activities, and excessive executive
compensation. The Board witnessed numerous indications of questionable practices by Enron
management over several years, but chose to ignore them to the detriment of Enron shareholders,
employees and business associates.
(2) High Risk Accounting. The Enron Board of Directors knowingly allowed Enron
to engage in high risk accounting practices.

(3) Inappropriate Conflicts of Interest. Despite clear conflicts of interest, the Enron
Board of Directors approved an unprecedented arrangement allowing Enron's Chief Financial
Officer to establish and operate the LJM private equity funds which transacted business with
Enron and profited at Enron's expense. The Board exercised inadequate oversight of LJM
transaction and compensation controls and failed to protect Enron shareholders from unfair
dealing.
(4) Extensive Undisclosed Off-The-Books Activity. The Enron Board of Directors
knowingly allowed Enron to conduct billions of dollars in off-the-books activity to make its
financial condition appear better that was and failed to ensure adequate public disclosure of
material off-the-books liabilities that contribute to Enron's collapse.
(5) Excessive Compensation. The Enron Board of Directors approved excessive
compensation for company executives, failed to monitor the cumulative cash drain caused by
Enron's 2000 annual bonus and performance unit plans, and failed to monitor or halt abuse by
Board Chairman and Chief Executive Officer Kenneth Lay of a company-financed, multi-million
dollar, personal credit line.
(6) Lack of Independence. The independence of the Enron Board of Directors was
compromised by financial ties between the company and certain Board members. The Board also
failed to ensure the independence of the company's auditor, allowing Andersen to provide
internal audit and consulting services while serving as Enron's outside auditor.
FACULTY OF BUSINESS AND INFORMATION TECHNOLOGYDEPARTMENT OF ECONOMICS AND
FINANCEAUDIT AND ASSURANCE SERVICES IIASSIGNMENT 1PREPARED BY:
Mrs.P. M. LesaInstructions Date:8thAugust, 20221.Answer bothquestions.2.Proper in-text
citations should be done clearly where necessary.3.Use Times New Romans/Arial, font 12 and
1.5 spacing.4.Use the Harvard style of referencing.5.The assignment is due for submission on
10/09/20226.The maximum number of pages is four (04), excluding references and the cover
page.7.This assignment is due for submission3 weeks from date of receipt (20thAugust 2022 to
10thSeptember 2022)Question

You are a manager in Quid & Co, a firm of Chartered Certified Accountants, and you have
taken on the responsibility for providing support and guidance to new members of the firm. Quid
& Co has recently recruited a new audit junior, Sam Tyler, who has come across several issues
in his first few months at the firm which he would like your guidance on. Sam’s comments and
questions are shown below:

Crow Co is tendering for an important contract to supply Hatfield Co. I know that Hatfield Co is
also an audit client of our firm, and I have heard that Crow Co’s management has requested our
firm to provide advice on the tender it is preparing. What matters should our firm
consider in deciding whether to provide advice to Crow Co on the tender? (5 marks)

Required: For each of the issues raised, respond to the audit junior, explaining the ethical and
professional matters arising from the audit junior’s comments.