Nov 2017 Q1 a.
Ebaatsake Ltd designs and manufactures luxury motor vehicles. The company employs 2,500 staff and consistently makes a net profit of between 10% and 15% of sales. Ebaatsake Ltd is not listed; its shares are held by 15 individuals, most of them from the same family. The maximum shareholding is 15% of the share capital.
The executive directors are drawn mainly from the shareholders. There are no non-executive directors because the company legislation in Ebaatsake Ltd’s jurisdiction does not require any. The executive directors are very successful in running Ebaatsake Ltd, partly from their training in production and management techniques, and partly from their hands-on approach providing motivation to employees.
The board is considering a significant expansion of the company. However, the company’s bankers are concerned with the standard of financial reporting as the Finance Director (FD) has recently left Ebaatsake Ltd. The board is delaying provision of additional financial information until a new FD is appointed.
Although Ebaatsake Ltd does have an internal audit department, the Chief Internal Auditor frequently complains that the board of Ebaatsake Ltd does not understand his reports nor provide sufficient support for his department and the internal control systems within Ebaatsake Ltd. The board of Ebaatsake Ltd concur with this view. Adoko & Co, the external auditors have also expressed concern in this area and the fact that the internal audit department focuses work on control systems, not financial reporting. Adoko & Co are appointed by and report to the board of Ebaatsake Ltd.
The board of Ebaatsake Ltd are considering a proposal from the Chief Internal Auditor to establish an audit committee. The committee would consist of one executive director, the chief internal auditor as well as three new appointees: One appointee would have a non-executive seat on the board of directors.
Required:
Discuss how the formation of an audit committee could address the issues raised in the above scenario. (14 marks)
View Solution
- Improved financial reporting
Now that the financial director has left, the company appears to have no-one internal with appropriate financial reporting knowledge for a company which appears to be a considerable size (employing 2,500 staff).
The establishment of an audit committee should include recruiting personnel with financial reporting experience therefore improving the quality of financial reporting and allowing the board more time to concentrate on running operations, which is particularly important given their ‘hands on’ approach. - Strengthening the internal audit position
Currently the internal audit position is poorly supported and reports directly to the board who do not understand the reports. As a result the control environment will be weak resulting in low motivation to monitor and maintain important internal controls.
The establishment of an audit committee will strengthen the position of the internal audit function, by providing a greater degree of independence from management. It should also promote the need for a strong control environment to the board, which should then lead to implementation of an appropriate internal control system. - Strengthening the position of the external auditor
If internal audit findings are not understood, it is likely the same is true of deficiencies reported by external auditors Adoko & Co.
The audit committee, if established, will strengthen the external auditor’s position by providing a channel of communication and forum for issues of concern. - Strengthening the independence of the external auditor
The external auditors are currently appointed by the Ebaatsake board. This could result in a familiarity threat to the independence of the external auditors if they develop too close a relationship with the board over time.
An audit committee can recommend the appointment of the external auditors based on appropriate criteria only (quality of service, independence and competence for example). This will help prevent such an independence issue arising. - Non-executive director
There are currently no non-executive directors and therefore, no independent advice given when making key decisions. Ideally there would be equal numbers of executive and non-executive directors; however the non-executive director appointed as part of the proposed audit committee may at least contribute an independent view. - Increased credibility
The bank’s concerns over financial reporting highlights the company’s failure to follow best practice when it comes to corporate governance and it is already affecting relations with stakeholders.
Establishing the audit committee should increase public confidence in the credibility and objectivity of Ebaatsake’s financial statements. It will also demonstrate to the bank that although Ebaatsake is not required to comply with specific corporate governance regulation, the company is prepared to take steps to move towards corporate governance best practice.