Factors Affecting Corporate Governance and Audit Committees in Selected Countries

©2005 The Institute of Internal Auditors Research Foundation

EXECUTIVE SUMMARY

In recent years the issue of corporate governance and committees related to it and their impacts on
corporate performance have continued to gain widespread prominence in the capital market economy.
The expectations of stakeholders with respect to the corporate governance process have never
been higher, and scrutiny by regulators and investors never more stringent. Attention has turned to
not only the effectiveness of corporate governance and the boards of directors, but also to those
committees to which responsibility and accountability have been delegated by the corporate decision-
making center as it fulfills its fiduciary obligations.

Corporate governance is the system by which organizations are governed and controlled. It is
concerned with the ways in which corporations are governed generally and in particular with the
relationship between the management of an organization and its shareholders. In this respect,
several control mechanisms, often in the form of committees, are implemented within the organization
in order to monitor its management activities and functioning. As a part of critical corporate
governance mechanisms, the audit committee has an oversight function dealing with different
managerial activities, corporate reporting, and auditing. This oversight includes ensuring the quality
of accounting policies, internal controls, and independent auditors to enhance control mechanisms,
anticipate financial risks, and promote accurate, transparent, and timely disclosure of corporate
information to various users of the organization’s financial information.

In most developed capital markets the debate about the improvement of corporate governance
structures has underlined the importance of an independent oversight board. The financial crisis of
recent years demonstrates the importance of this oversight board in the framework of the audit
committee. Following these events, regulatory and professional bodies pushed for the universal
adoption of audit committees on the basis of the assertions that these committees could be effective.
This requires that the necessary measures will be taken to assure their independence and objectivity.
The actions undertaken should respond to users’ criticisms of the lack of confidence in transparency
and quality of financial reporting as well as the inability of external auditors to provide the safeguards
expected.

However, the implementation of corporate governance framework and associated committees

varies from one country to another. While the general framework is partly set by law and partly by
the various agents within the organization, the environment and the regulatory bodies in each
country play a central role in this process. Corporate governance and the audit committee, like any
other organizational structure, are significantly affected by the legal, institutional, financial, cultural,
and political circumstances in each country.

The Institute of Internal Auditors Research Foundation

Factors Affecting Corporate Governance and Audit Committees in Selected Countries
©2005 The Institute of Internal Auditors Research Foundation

In contrast to corporate governance literature in the United States of America (USA) — and to
some extent the United Kingdom (UK) — relatively little is known about particular governance
practices in other countries. A country’s legal and economic institutions are essential for providing
good corporate governance, since they create a framework for forming contracts and enforcing
them. Besides that, currently there are some major differences within the European countries in
the field of governance. Therefore the research in international corporate governance could also
fruitfully examine individual mechanisms implemented in major capital markets.

Both in the USA and European Union, strong actions have been undertaken to enhance the public
confidence in the area of governance. This has provided the regulators the central oversight role in
capital markets. In recent years, several changes regarding the environmental factors have been
put in place. These consist of increasing legal protection of investor rights and foreign shareholdings
in capital markets. The latter can be related to facilities offered by market regulators for multiple
listings.

This study attempts to identify and understand the specific characteristics of the structure of
corporate governance and audit committee systems in general, and the audit committee and internal
and external audit functions as implemented in selected countries. In this respect, five countries
(France, Germany, the Netherlands, the United Kingdom, and the United States) among the most
developed nations have been selected. The study attempts to identify the significant differences in
corporate governance and their impacts on corporate structures in these countries. This has been
achieved with a detailed analysis of the current systems implemented in these countries, their
historical backgrounds, the changes made, and the reasons for them.

Chapter 1 provides an overview of corporate governance and audit committees. The chapter
discusses the importance of the theoretical foundations of this field with an emphasis on the economics
of corporate governance. The discussion on the audit committee and its relationship with other
control instruments demonstrates the outstanding place of this structure, particularly within publicly
listed companies. This explains why setting up audit committees within publicly traded companies,
despite there being only mitigated empirical evidence that they are effective in strengthening corporate
governance, has nonetheless become widespread. The discussion in the chapter also indicates
that, as expected, increased independent director experience and greater audit knowledge are
associated with audit committee member support for high audit quality.

Chapter 2 discusses the factors affecting the efficiency and effectiveness of corporate governance
and the audit committee. The study tries to identify the environmental (legal, institutional, financial,
economic, and social) as well as firm-specific factors affecting the current corporate governance
and the audit committee. It highlights the importance of such factors in selected countries.

The Institute of Internal Auditors Research Foundation

Factors Affecting Corporate Governance and Audit Committees in Selected Countries
©2005 The Institute of Internal Auditors Research Foundation

Chapter 3 reviews the major features of corporate governance and audit committees in France,
Germany, the Netherlands, the UK, and the USA. The choice of countries has been made on the
basis of their diversity and differences as well as their representative characteristics and positions
as developed capital markets. The study attempts to identify and understand the specific
characteristics of the structure of corporate governance and audit committees as implemented in
these countries.

This study considers corporate governance issues from an international perspective. The
internationalization and increasingly interlocked nature of global economies require a thorough
understanding of corporate structure at an international level, enabling multinational corporations
to function better. The major objective of the study is to contribute to a better comprehension of
environmental factors and the levels of risk with which multinational firms are faced. It has been
designed to provide up-to-date information about current and proposed corporate governance and
audit committee rules and practices, comparing and contrasting these in selected countries.

The Institute of Internal Auditors Research Foundation