Issues in Social and Environmental AccountingVol. 1, No. 2 December 2007Pp 258-275 A New Perspective on Relationship between Corporate Governance and Auditing Ryuuichiro Kurihama Graduate School of Accounting Aichi University, JapanAbstractThis paper clarifies a new perspective on relationship between corporate governance and inde-pendent auditing, and reexamines the contribution of independent auditing to corporate govern-ance through the discussion of the relationship between corporations and society as recentlybrought up concerning Corporate Social Responsibility (CSR). Because we nowadays can nolonger accept uncritically the conventional perspective on relationship between corporate gov-ernance and independent auditing under today’s corporate governance. We need to reconsiderthe view of how corporations and auditing should be toward rebuilding public trust, and to un-derstand the importance of auditing in today’s corporate governance.Keywords: Corporate Governance, Fiduciary duties, Independent auditing, auditing system,Corporate Social Responsibility (CSR)1. Introduction the discussion of the relationship be- tween corporate governance and inde-Independent auditing is an essential ele- pendent auditing from shareholders’ per-ment of corporate governance (the Cad- spective.bury report, 1992; EC Green paper,1996, OECD, 2004, etc.). In order for With corporate globalization and the ITshareholders to be able to check and revolution accelerating, and with corpo-control managers’ behaviors, independ- rate misdeeds and scandals1 more fre-ent auditing is report to shareholders on quent, greater attention has been focusedaudited financial statements. In doing so, on Corporate Social Responsibilityindependent auditors can act in the inter- (CSR) in recent years. Especially, manyests to shareholders. In this context, in- recent corporate misdeeds and scandalsdependent auditing is essential to corpo- have resulted in loss of public trust inrate governance. However, we nowadays corporations and a growing sense of un-can no longer accept uncritically such certainty among people. For example,Ryuuchiro Kurihama is associate professor of accounting at Graduate School of Accounting, Aichi University, email:firstname.lastname@example.org
R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275 259according to a worldwide survey of This requires reconsideration of the rela-Price Waterhouse Coopers (2003), 52 % tionship between corporations and soci-of the CEOs interviewed answered that ety in the discussion of today’s CSR.public trust in corporations has declined The today’s discussion of this relation-as a result of corporate misdeeds and ship regards the relationship betweenscandals. In addition, in Japan, accord- corporations and society not as the rela-ing to a questionnaire survey of Japan tionship between corporations and share-Institute of Social and Economic Affair holders but as the relationship between(Keizai Koho Center) (2007), 51% of corporations and stakeholders, andJapanese livers answered that corpora- places great importance on the relation-tions need to establish corporate ethics ship with stakeholders. The relationshipand prevent corporate misdeeds and between corporations and society canscandals in order to gain public trust. influence the views of corporations andThese indicate that a lot of people share others.awareness of the issues of corporate mis-deeds and scandals. Rebuilding the pub- In addition, CSR also has an impact onlic trust they have lost is their prime task independent auditing, because the con-at the moment. cept of independent auditing has been changing over time as people’s views ofUnder such circumstances, the issue of corporations and society change. Inde-CSR needs to be discussed in terms of pendent auditing is a social institutionwhat benefits corporations bring to soci- that is loosely linked with societyety in the 21st century and for whom they through interaction. We need to redefineexist2. CSR can be defined as efforts the monitoring and check system of cor-aimed at realizing sustained corporate porations to rebuild public trust in thevalue-creation and a better society today’s discussion of the relationshipthrough the erection of mechanisms for between corporations and society.synergetic development of corporationsand society (Japan Association of Cor- This paper clarifies a new perspective onporate Executives, 2003, p.7)3. CSR has relationship between corporate govern-an effect on the conventional views of ance and independent auditing, and reex-how corporations and society should be. amines the contribution of independent auditing to corporate governance1 In these years, more fraud by organizations than fraudby individuals increases. In other words, the cases of in terms not only of their economic aspects but also offraud and illegal acts which are rooted in corporate their social and environmental aspects while making fullculture and ethics increase. We should be fully aware of use of market mechanisms. At the same time, there is athe seriousness of the issues which are managers’ inade- trend on the market side that, instead of emphasizingquate understanding and reaction against their cases, or economic efficiency, market includes the social andmanagers’ active involvement in their cases. See Kuri- environmental aspects when evaluating corporations. Inhama (2005). response to these changes, the way of evaluating corpo-2 When considering CSR, it is necessary to strike a rate value is also changing. This paper focuses on thebalance between economic, social, and environmental negative aspects of CSR (CSR basically has two aspects:aspects (the triple bottom line) of CSR. Which aspect positive aspect and negative aspect) although the tripleshould be given priority is less important (Japan Asso- bottom line is very important in the discussion ofciation of Corporate Executives, 2003). Each corpora- CSR .Because these aspects lead to dual functions oftion is now under pressure to balance the above three corporate governance which this paper discusses. In theaspects. Furthermore, the new corporate investment of future, it is necessary to examine the relationship be-Socially Responsible Investment (SRI) has an impact on tween sustainability accounting and auditing. Seethe market as well as corporations. SRI represents in- Elkington (1998) and GRI reporting guidelines (2002;vestors’ efforts to systematically evaluate corporations 2006) for details about the triple bottom line , and Kuri- hama (2007) for details about the dual aspects of CSR.
260 R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275through the discussion of the relation- Although corporate governance variesship between corporations and society as depending on the country, region, andrecently brought up concerning CSR. corporation, it basically has two func-This is necessary in order to understand tions4: the positive function and thethe concept of society, corporations and negative function.auditing today, and to think the view ofhow corporations and independent audit- The positive function is something thating should be toward rebuilding public enhances corporate competitiveness.trust. Corporate governance can enhance cor- porate competitiveness through properThis paper is structured as follow. Sec- decision-making on management poli-tion 2 examines changing corporate gov- cies based on the implementation ofernance view through the discussion of more efficient and better management.today’s CSR Section 3 reexamines the This is the positive function of corporaterelationship between corporate govern- governance.ance and independent auditing. Section 4concludes. On the other hand, the negative function is something that prevents corporate misdeeds and scandals. Corporate gov-2. Changing corporate governance ernance can prevent corporate misdeedsview and scandals through the appropriate supervision and evaluation of managers2.1 Dual functions of Corporate Gov- in the execution of their businesses. Thisernance is the negative function of corporate governance.Today’s corporate governance is a sys-tem designed to ensure sustained corpo- Corporate governance is said to be vol-rate growth and development, proper untary and autonomous initiatives ofdecision-making on management poli- corporations although it is legally de-cies based on the implementation of fined. In corporate governance, both themore efficient and better management, positive and negative functions areand the appropriate supervision, evalua- equally important. However, the positivetion and motivation of managers in the function of corporate governance cannotexecution of their businesses (Japan As- be fulfilled without being able to fulfillsociation of Corporate Executives, 2003, the negative function. No matter howp.50).There are two requirements that each corporation fulfills the positivemust be met if a corporation is to fulfill function, it will lose public trust unless itits social responsibility while also im- fulfills the negative function, thus de-proving its competitive position (ibid, creasing the significance of corporatep.50). First, it must establish certain governance itself. In order for a corpora-principles which define the general di- tion to build and maintain the relation-rection that it will take. Second, it must ship of trust with society, emphasisdevelop a system to ensure the imple- should be placed on “what needs to bementation of these principles at all done to work things out” or “minimumtimes; in other words, it must establish a 4 In CSR, this leads to both the positive aspect and thesystem of corporate governance. negative aspect.
R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275 261things to do” rather than on “what to do widely thought that corporations exist toto be successful.5” maximize shareholder value.Therefore, fulfilling the negative func- As is well known, Milton Friedmantion of corporate governance is a mini- viewed the corporations in a free marketmum requirement for corporations to as follows:maintain the relationship of trust with “There is one and only one socialsociety in the discussion of today’s CSR. responsibility of business – to useThere have been numerous cases6 in its resources and engage in activi-which corporations have lost public trust ties designed to increase its profitsbecause they cannot fulfill the negative so long as it stays within the rulesfunction. It may be possible to distin- of the game, which is to say, en-guish the positive function as a volun- gages in open and free competitiontary one from the negative function without deception or fraud” (1962,which is mandatory. In other words, the p.133)negative function of corporate govern-ance is a necessary condition while the In Friedman’s view (1962; 1970), CSRpositive function is a sufficient condi- is to increase profits for shareholders,tion. Corporate governance is a neces- and corporate value is mainly measuredsary and sufficient condition for corpora- by economic efficiency. Specifically,tions to be trusted by society. CSR means to increase profits by pro- ducing and selling quality products and/We need to understand that each corpo- or services, while also paying as largeration must fulfill the negative function amounts of taxes as possible, which inof corporate governance first in order to turn enrich the government and otherrestore public trust although it may be stakeholders. If the managers8 attemptedinsufficient for today’s corporate gov- to fulfill their responsibility for otherernance. stakeholders rather than the sharehold- ers, it would disrupt the free market sys-2.2 Relationship between and corpo- tem. This view affects a basic view torations and shareholders7: Corpora- the present in many corporations. There-tions and Society fore, each corporation places greater emphasis on the relationship with share-In recent discussions on corporate gov- holders and bears social responsibilitiesernance, the mainstream view is that of toward them. In this context, corporatemaximizing shareholder value. It is governance also means to maximize shareholder value.5 From the standpoint of social evolution or institutionalevolution, we can learn from history not because thereare those who survived or succeeded but because there Why do corporations place great empha-are those who could not survive or failed. This is under- sis on the relationship with sharehold-standable from the historical repetition of corporate ers? To answer this question, there is amisdeeds and scandals. The history of corporate mis-deeds repeats itself. neoclassical theory on the profit-6 For examples, the recent cases of Enron and World- maximizing principle of corporations.Com in the U.S.A, Royal Ahold in Holland, Parmalat inItaly, Kanebo, Livedoor, Nikko Cordial Securities in That is, a corporation is a kind of privateJapan and others. 8 This paper uses the term “managers” to designate both7 The discussion here is based on Friedman (1962, directors and officers (management, corporate execu-1970). tives etc.).
262 R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275property owned by its shareholders, holders are any identifiable group orwhose agents are the managers of the individuals on whom the organization iscorporation. Therefore, their only re- dependent for its continued survival. Insponsibility is to maximize profits for the broad sense, they are any identifiablethe shareholders. group or individuals who can affect the achievement of an organization’s objec-Even today, maximizing shareholder tives or who are affected by the achieve-value leads to the improvement of cor- ment of an organization’s objectives.porate value, and ultimately to the en-richment of society as a whole. The rela- Today’s CSR places great importance ontionship between the corporation and the relationship with stakeholders, re-society can be reduced to the relation- garding the relationship between corpo-ship between corporation (especially, rations and society as the relationshipmanagers) and shareholders. This view between corporations and stakeholders,is mainly discussed regarding corporate with many of the discussions based ongovernance in the U.S. However, we the broad sense of stakeholders. Notnowadays can no longer accept uncriti- only shareholders but also stakeholderscally such the view of corporate govern- in the broad sense who provide the envi-ance. ronment for corporate activities are, in a way, capital suppliers for the corporation2.3 Relationship between and corpo- (Schlossberger, 1994). Stakeholders inrations and stakeholders: Corpora- the broad sense bear some risk by beingtions and Society involved in corporate activities, even though the stakes vary from stakeholderCorporations are social institutions or to stakeholder (Clarkson, 1998). Stake-public institutions of society in that they holders in the broad sense entrust theare recognized and approved by society. management of a corporation to theThis view differs from the position that managers. In fact, most recent reports oncorporations exist to maximize share- CSR and corporate governance regardholder value. If corporations were re- the relationship between corporationsgarded as public institutions of society, and society as the relationship betweenit would be necessary to reconsider the corporations and stakeholders in theconventional relationship between cor- broad sense. Thus, it can be concludedporations and society. Accordingly, it that corporations as public institutions ofwould be necessary for each corporation society bear social responsibilities to-to switch its focus from the relationship ward the stakeholders in the broad sensewith its shareholders to the relationship (hereafter called stakeholders).with its stakeholders where the share-holders are regarded as part of the stake- Therefore, corporations have to establishholders (Freeman, 1983; Freeman and corporate governance with more empha-Reed, 1983; Donaldson and Preston, sis on the relationship with its stake-1995; Evan and Freeman, 1998; etc.). holders. Corporate governance is whole management, and is associated with theThe scope of the stakeholder is either integrity of management. This is relatednarrow or broad (Freeman and Reed, to corporate philosophy, corporate cul-1983, p.91). In the narrow sense, stake- ture, and corporate ethics, and obviously
R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275 263to the integrity of managers and/or man- make decisions on the corporation’s be-agers’ fiduciary duties. Today, each cor- half and be responsible for managing theporation needs to redefine exactly the corporation.view of corporation should be and themonitoring and check system of corpo- For whom do managers manage the cor-ration in order to rebuild public trust. poration and to whom are they responsi-For example, each corporation needs to ble?establish stakeholder engagement orstakeholder management, corporate phi- It is commonly thought that managerslosophy and culture, management sys- are shareholders’ agents based on agencytem, internal control system, risk man- contracts and are only responsible to theagement system, compliance system, the shareholders. Corporations are regardedsystem of discloser and accountability, as simply legal fiction that serves as aauditing system and others as integrant nexus for a set of contracting relationsand element parts in the establishment of among individuals (Jensen & Meckling,the system of corporate governance de- 1976, p.310)11 . It is also viewed as asigned to ensure the implementation of kind of private property. This is based onCSR. In doing so, the commitment of the corporate view discussed in contrac-managers and the monitoring and check tual theory and/or agency theory, whereof managers’ decision-making and be- managers make a contract with share-haviors is very important. holders who own the corporation. Under such view, the relationship betweenA big issue is the system of corporate shareholders as principles and managersgovernance becomes a mere façade. It is as agents are an agency relationship be-very important that each corporation cause a contractual relationship can beneeds to constantly improve the system regarded as an agency relationship be-of corporate governance from stake- tween principals and agents (ibid).holders’ perspective according to the Therefore, managers are expected tochanges in the times and society with a efficiently manage the corporation as anfull understanding of the core concept of agent of the shareholders in order tocorporate governance designed to ensure maximize profits for them12. Managersthe implementation of CSR (so-called need to act in the interest to sharehold-Japanese ‘Kaizen’). ers. In this context, if the manager were to behave against the shareholders’ will,Consequently, we need to think the core such a behavior would be regarded asconcept of corporate governance based inappropriate, and would therefore con-on the viewpoints of stakeholders in fol- stitute a breach of contract.lowing sections 2.4. In the conventional discussion of corpo-2.4 From agency relationship to fidu- rate governance, the issue of governanceciary relationship: the core of corpo- for managers is to design incentives torate governance10 10 See Kurihama (2007) for details. 11 The discussion on contractual or agency theory isAll corporations are a legal person. based on Jensen and Meckling (1976), Frankel (1983),Therefore, they require someone Hodgson (1988), Easterbrook and Fischel (1991), Iwai (1999, 2002), and Kurihama (2007).(representative organ) who (which) will 12 This view is a common belief (Maitland, 1991).
264 R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275ensure managers as agents behave prop- If managers are not the agents of share-erly toward shareholders. The best ex- holders, for what purpose do they exist,ample of such incentives is stock options and to whom do they owe what obliga-as rewards for the managers. tion?However, corporations are not private Managers are the corporation’sentities based on contracts with indi- “fiduciaries”15. Fiduciaries are thoseviduals. Since managers are not the who have been entrusted by others toagents of shareholders, it is very difficult perform certain duties on their behalf. Ato discuss the governance of managers fiduciary relationship is, by nature, anbased on contractual and/or agency rela- unequal relationship built between twotionship (Iwai, 2002). In reality, there is parties or individuals who cannot buildno agency relationship between share- an agency relationship, or either ofholders and managers, and managers are whom bears a greater risk by making anot shareholder’ agents (Boartright, formal contract. In other words, a fiduci-1994).13 ary relationship is built among individu- als and cannot be reduced to an agencyCorporations are public institutions of relationship. Therefore, the concept of asociety. The social responsibilities as fiduciary relationship is essentially dif-well as sustainability of corporations are ferent from that of an agency relation-the greatest concerns of society. Corpo- ship.rate misdeeds, scandals, and subsequentbankruptcy have an enormous impact on In fact, corporations as public institu-public trust because they may lead to tions of society place great importanceunemployment, economic damage, fi- on the relationship with society or stake-nancial shock, the collapse of existing holders. Stakeholders entrust the man-business channels, and social confusion agement of the corporation to its manag-(Drucker, 1950).14 These facts indicate ers because there is a wide gap in infor-that managers do not act on behalf of the mation, knowledge and capability be-shareholders alone, and that the relation- tween stakeholders and managers. Thisship between corporations and society is the fiduciary relationship betweencannot be reduced to the agency rela- managers and stakeholders which is dif-tionship between managers and share- ferent from the agency relationship. Inholders. Even though the relationship the relationship between corporationsbetween managers and shareholders is and society, greater emphasis is placedthe agency relationship, a certain amount on such a fiduciary relationship. Manag-of work must be entrusted to managers ers need to act in the interests to stake-based on the principle of mutual trust as holders.long as there is a wide gap in informa-tion, knowledge and capability between It is very important for managers to ful-them (Frankle, 1983; Higuchi, 1999; fill their fiduciary duties in order toIwai, 1999; 2002). maintain the fiduciary relationship. Fi-13 duciary duties are the duties that have In addition, according to Aoki (2001), there may be alot of situations in which governance by shareholders is 15not either effective or efficient. The discussion on fiduciaries is based on Frankel14 Clarkson (1998) defines the corporation not as a (1983), Boartright (1994), Higuchi (1999), Iwai (1999,nexus of contracts but as a nexus of risks. 2002), and Kurihama (2007).
R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275 265been entrusted to someone to perform source, and therefore the behavior ofonly for the entrusters. Of the fiduciary managers must be monitored in order toduties, the most fundamental ones are maintain the fiduciary relationship.“the duty of loyalty,” “the duty of care,”and “accountability.” The duty of loyalty Furthermore, in order to maintain therequires fiduciaries to loyally perform fiduciary relationship, some form oftheir duties only for the entrusters’ inter- public intervention by judicial organiza-ests rather than their own. The duty of tions or others is essential. This is be-care requires fiduciaries to perform their cause the fiduciary relationship includesduties with proper care even if perform- the problem that managers hold a dele-ing such duties is not beneficial to them. gated power that is susceptible to abuseAccountability requires fiduciaries to (Frankle, 1983). Actually, the “duty ofexplain business details to the entrusters. loyalty”, “the due of care”, andOf course providing information is not “accountability”, which are the mostenough in it. These three impose some fundamental ones of fiduciary duties, aresort of integrity and ethics on them. To- also legally defined. Public interventionday’s cases of corporate misdeeds and is regarded as necessary and is imple-scandals16 are excellent examples of mented in actual governance.managers who disregarded their fiduci-ary duties17. 3. Corporate Governance and Audit-Corporations bear social responsibilities ing; a new perspectivetoward stakeholders while managers arethe fiduciaries of corporations. There- 3.1 Conventional view of role for inde-fore, the managers have fiduciary duties pendent auditing in corporate govern-toward the stakeholders. Fulfilling fidu- anceciary duties is essential if managers areto gain the trust of society. These fiduci- Contractual or agency theory providesary duties are the core of corporate gov- an effective approach to independenternance designed to ensure the imple- auditing studies. A lot of studies basedmentation of CSR. Corporate govern- on this corporate view are being con-ance is one of their initiatives to restore ducted (Jensen & Meckling, 1976; Wal-trust and confidence. In order to achieve lace, 1980; DeAngelo, 1981; Antle,this, corporations must at least fulfill the 1982; Watts & Zimmerman, 1983, 1986;negative function of corporate govern- Sunder, 1997, etc.). Many conventionalance. In order for corporations to fulfill view of independent auditing is designedCSR and for them to be trusted by soci- based on this theory18.ety, the managers must not only fulfillfiduciary duties, but also be checked As explained in section 2.4, an agencyabout whether they are performing such relationship assumes both shareholdersduties appropriately. Because humanintegrity and ethics are a scarce re- There is also the conventional view of independent auditing based on free markets (efficient market hy-16 See notes 8 regarding today’s case. pothesis) (AAA, 1973; Wallace, 1980, Watts and Zim-17 As stated above in introduction, a lot of Japanese merman, 1986 etc). Since the discussion here focuseslivers (62%) answered that managers need to build on the relationship between corporate governance andsound ethics and to comply with laws, regulations, auditing, this view is omitted. The conventional view ofsocial norms and others. independent auditing based on contractual and/or
266 R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275as principals and managers as agents to tionship between managers and share-be rational economic men who do their holders by enhancing the credibility ofbest to maximize their self-interest. financial statements. Independent audit-However, an asymmetry of information ing serves to reduce agency costs whichexists between shareholders and manag- inevitably arise from the agency rela-ers. Therefore, a moral hazard arises, tionship between managers and share-namely that the managers are more holders. In doing so, shareholders canlikely to behave opportunistically, know- check and control managers’ behaviors,ing that the shareholders have only im- and therefore independent auditing canperfect information about the managers’ contribute to shareholders.behaviors. Agency costs may also ariseinevitably to avoid loss from the moral Independent auditing partially performshazard. Because there is such a potential the function of governing managers forconflict between shareholders and man- shareholders by monitoring and control-agers, greater attention should be fo- ling their behaviors in corporate activi-cused on the issue of governance, or ties to enhance the credibility of finan-how managers’ behaviors should be cial statements (Lee, 1993). It plays anmonitored and controlled19. important role in facilitating the building of the agency relationship (Sunder,In order for shareholders to check and 1997). In this context, independent au-control managers’ behaviors, informa- diting is essential to corporations as ation disclosure or financial statements nexus for a set of contracting relationsneed to be provided to the shareholders. among individuals (Jensen, 1983). ThisArmed with such information, share- is the conventional perspective on theholders can effectively monitor and con- relationship between corporate govern-trol the managers’ behaviors. However, ance and independent auditing. Ofsuch financial statements may be inaccu- course, this perspective is closely relatedrate, or falsified intentionally by the to the objective and inherent limitationmanagers. It is virtually impossible for of independent auditing and the scope ofthe shareholders to directly check the auditors’ responsibility. However, bycredibility of financial statements. When changing corporate view, we nowadaysthe managers provide financial state- can no longer accept uncritically suchments, they are most likely to agree to the conventional view of independentprovide evidence that the information auditing.has been carefully prepared to avoid ac-cidental errors and has been free of in- 3.2 Contribution of independent au-tentional manipulation (Jensen and diting to corporate governanceMeckling, 1976; Wallace, 1980)20.Therefore, independent auditing is nec- As sated above, inappropriate corporateessary to support the good agency rela- management itself may cause a corpora- tion to lose public trust. Therefore, eachagency theory and the one based on free markets are thesame in that both seek to enhance the credibility of corporation needs to redefine its corpo-financial information. In addition, both views assume rate ethics and monitoring and checkthat the primary users of independent auditor’s report are 20shareholders. In this theory, shareholders as rational economic men19 As stated above in 2.4, the governance of managers can maximize their profits and control managers if theyalso includes incentive contracts such as bonuses and can trust and utilize financial statements. Therefore, thestock options. managers ask for independent auditing.
R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275 267system to rebuild public trust. managers’ fiduciary duties. In fact, au- diting, throughout history, has been aIn gaining the trust of society, each cor- clearly recognized means of checkingporation must at least prevent corporate the fidelity of fiduciaries or entrusteesmisdeeds and scandals. To fulfill the (Brown, 1905), and therefore has its ob-negative function of corporate govern- jective that serves essentially for corpo-ance, each corporation needs to rate governance.strengthen corporate governance with afull understanding of the core of corpo- The possible roles of independent audit-rate governance. Thus, the system by ing in corporate governance (especially,which managers can fulfill their fiduci- the negative function) can be summedary duties as well as the system of moni- up as follows.toring (and checking) them are needed. 1. Independent auditing enhances theAlthough it is possible for each stake- credibility of financial statements.holder to monitor and check the fiduci- This role allows stakeholders toary duties of managers, the ability to check the activities of managersmonitor and check managers’ behavior is based on audited financial state-limited because there is an asymmetry of ments. In short, independent audit-information as well as a wide gap in ing leads to supporting the functionsknowledge and capability (a wide gap in of stakeholders’ governance in orderinformation processing ability) between to control the behaviors of manag-managers and stakeholders. Therefore, ers.independent auditor with independence 2. Independent auditing checks andand expertise plays an important role to controls the fiduciary duties of man-complement the checking function of agers, and performs the importantmanagers’ fiduciary duties, which are function of governing managers.the core of corporate governance. Inde- The following are some of the in-pendent auditing as statutory auditing volvements of independent auditingalso play an important role of a sort of in the fiduciary duties of managers:public intervention. In doing so, inde- a) Independent auditing is in-pendent auditing can contribute to stake- volved in detecting and pre-holders. Indeed, stakeholders bear some venting the fraud or illegal actsrisks by being involved in corporate ac- of managers. Detecting theirtivities and are highly interested in cor- fraud or illegal acts and pre-porate fraud and going concerns. Hence, venting them lead to the role ofstakeholders require independent audi- monitoring and controllingtors’ active involvement in corporate their fiduciary duties. Actually,fraud and going concern issue on the independent auditing detectsground of many recent corporate mis- and prevents material misstate-deeds and scandals. Independent audit- ments caused by fraud, errors,ing does not serve to reduce agency and illegal acts21.costs which inevitably arise from the b) Independent auditing is in-agency relationship between managers volved in corporate manage-and shareholders, but is publicly and ment or administration. Manag-legally expected to check and control the ers are responsible for building,
268 R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275 using, and improving internal and objectively by Independent control22. Evaluating internal auditors. In other words, inde- control over financial reports in pendent auditing contributes to independent auditing lead to corporate governance by deter- the role of checking and con- ring managers’ behaviors. trolling the fiduciary duties of 3. Independent auditing contributes to managers. These are actually rebuilding the relationship of trust performed in some practices23. between corporations and society. c) Independent auditing is in- Independent auditing not only rein- volved in business risk which forces a fiduciary relationship be- may suppress the continued tween corporations and existing progress of each corporation. It stakeholders by checking and con- is managers’ responsibility to trolling the fiduciary duties of man- cope with various business agers but also helps expand to a fi- risks and maintain their corpo- duciary relationship between corpo- rate brands24. Since auditors rations and potential stakeholders. nowadays are involved in go- Independent auditing corrects man- ing concerns issue, they are agers’ fraud, errors and illegal acts, involved in business risk in and leads corporations in the right some sense. Independent audi- direction, thus functioning as a con- tors’ active involvement in troller of society. business risk increasingly leads to their role of checking and How independent auditing can contrib- controlling the fiduciary duties ute to corporate governance has been of managers. discussed. Corporate governance will d) Independent auditors indirectly clearly be reinforced by independent control managers. Managers auditing. In this context, independent are more likely to fulfill their auditing plays an important role in cor- fiduciaries duties because they porate governance in the true sense. know that their fiduciary duties will be checked independently In the future, we reexamine the existing21 objective and inherent limitation of inde- In the future, in independent auditing, it is thought tobe necessary to actively detect and prevent fraud, er- pendent auditing and the existing scoperors, and illegal acts that will cause material misstate- of independent auditors’ responsibility inment for stakeholders than detecting and preventing order to contribute to corporate govern-material misstatement by such fraud, errors, and illegalacts for shareholders. ance from stakeholders’ perspective.22 COSO (1992) is very famous in the concept anddefinition of internal control. The discussion here isbased on the internal control of the COSO. In addition, 3.3 Contribution of auditing system toCOSO ERM (Enterprise Risk Management-integrated corporate governanceFramework) was published at 2004.23 In addition, auditing of internal control over finan-cial reporting performs in conjunction with auditing of Since independent auditing alone has afinancial statements by same independent auditors (so - limitation, it alone cannot adequatelycalled performance of an integrated auditing) in the contribute to corporate governance. InU.S., the Grate Britain, France, South Korea, and Japan(from April 2008). order for independent auditing to con-24 For example, Japanese Auditing Standards actually tribute to corporate governance effec-include “serious deterioration of brand image” as busi- tively, mutually complementary systemsness risk information.
R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275 269to independent auditing may be required. of performing the duties of outside cor-Such systems include Japanese corporate porate auditors in the business report”.auditors (or audit committee)25 and inter- The latter is “auditing of accountingnal auditing which play an important matters”, “system to ensure the appropri-role in complementing independent ate performance of the duties of inde-auditing26. pendent auditors”, “remuneration etc. of independent auditors”, “audit of ac-Today, it is necessary for Japanese cor- counting policies, etc.”, “audit of finan-porate auditors (Kansayaku) or audit cial statements”, and “election of inde-committee to fulfill their duties with a pendent auditors, etc”. On the otherbasic viewpoint to the establishment and hand, the scope of auditing of audit com-operation of the system of good corpo- mittee is both auditing of officers’ andrate governance. And, it is desirable for directors’ performance and auditing ofcorporate auditors or audit committee to accounting matters (JCAA, 2007b). Theprevent corporate misdeeds and scandals former is “audit of officers’ performanceand to ensure and safeguard sustained of duties”, “audit of directors’ perform-growth and development of their corpo- ance of duties”, “auditing of internalration as their fundamental duties. The control system”, “audit of internal con-scope of auditing of corporate auditors is trol over financial reports”, “auditing ofboth auditing of directors’ performance discloser system”, “audit of officers’ and(Gyoumu Kansa) and auditing of ac- directors’ competitive transactions”,counting matters (Kaikei Kansa) (JCAA, “auditing of business report etc.”, and2007a). The former is “audit of direc- “the status of performing the duties oftor’s performance of duties”, “auditing outside audit commissioners in the busi-of decision-making of board of direc- ness report”. The latter is “auditing oftors”, “performance audit of the board of accounting matters”, “system to ensuredirectors’ duty of supervision”, “audit of the appropriate performance of the du-internal control system”, “audit of direc- ties of independent auditors”,tors’ competitive transactions”, “auditing “remuneration etc. of independent audi-of business report etc.”, and “the status tors”, “audit of accounting policies,25 etc.”, “audit of financial statements”, Japanese corporations can select either the traditional and “election of independent auditors,Japanese style of corporate governance mechanism (two-tier board system: board of directors and board of cor- etc”.porate auditors) or the new style of corporate govern-ance mechanism (one-tier board system: the committeesystem) modeled on American style of corporate gov- Furthermore, internal auditing has theernance mechanism (see Kurihama, 2005 for details). functions of both auditing activities andAlthough there are some opinions that the committee consulting activities. Of course, internalsystem works on corporate governance, it is very impor-tant for each Japanese corporation to adopt the structure auditors need to accomplish both audit-of corporate governance fitting for each corporate phi- ing activities and consulting activities inlosophy and culture. This paper basically focuses on the main scope of activity which is riskcorporate auditors adopted by large majority of Japa-nese corporations. According to a survey of JCAA , the management, control, and the process ofnumber of Japanese corporations which adopt the com- governance (IIAJ, 2004). It is desirablemittee system is 110 corporations (include listed andunlisted corporations) as of 11 December 2007. that internal auditing is not only conven-26 Conversely, corporate auditors (or audit committee) tional compliance auditing and risk-or internal auditing alone cannot adequately contribute based auditing but also the auditing de-to fulfilling CSR and corporate governance. signed to verify the effectiveness of the
270 R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275process of risk management, control sys- be possible to contribute to corporatetem, and governance as its mission. governance effectively. To this end, it is necessary to structure one auditing sys-Each auditing, which is independent au- tem by reconsidering the roles of eachditing, corporate auditors (or audit com- auditing involved so that they can con-mittee) and internal auditing, plays an tribute to corporate governance moreimportant role in corporate governance, effectively as one auditing system (orand is mutually complementary relation- auditing network) (Figure1). By doingship. For example, the Cadbury report so, corporate governance will drastically(1992) and the Hampel report (1998) in be reinforced.U. K., EC Green Paper (1996), auditingstudies (JAA, 2003 etc.) in Japan and so In the future, human resource develop-on recommended that independent audit- ment from viewpoint of independenceing strengthen collaboration with audit and expertise in auditing (especially,committee (corporate auditors in Japan) corporate auditors, the members of auditto enhance the governance function of committee, and internal auditors) is oneindependent auditing for shareholders. of important issues in order for auditingHowever, until now, each auditing have system to function effectively. More-not effectively cooperated and ade- over, it will be necessary to examine thequately interacted with each other as one optimum form of independent auditing,auditing system, particularly for stake- and eventually the optimum form of oneholders. auditing system including corporate auditors (or audit committee) and inter-Consequently, when independent audit- nal auditing. On the other hand, corpora-ing, corporate auditors (or audit commit- tions need to increasingly support audit-tee), and internal auditing effectively ing system because it plays very impor-cooperate and adequately interact with tant role in corporate governance if theyeach other as one auditing system not for want to restore public trust.shareholders but for stakeholders, it will Figure1: Contribution of auditing system to corporate governance
R.. Kurihama / Issues in Social and Environmental Accounting 2 (2007) 258-275 2714. Conclusion diting, auditing of corporate auditors (or audit committee), and internal auditingA conventional perspective on the rela- need to effectively cooperate and ade-tionship between corporate governance quately interact with each other as oneand independent auditing is discussed auditing system in order to contribute towidely from shareholders’ perspective. corporate governance more effectively.Under such view, independent auditing In order for one auditing system to con-plays an important role in checking tribute to corporate governance in thewhether managers maximize the interest true sense, it is necessary to for us toof shareholders by enhancing the credi- reconsider one auditing system as corpo-bility of financial statements presented rate auditing based on the question,to shareholders by managers. Therefore, “What does an auditing system bring toindependent auditing contributes to society?”, and to find a new view of un-shareholders, and supports the agency derstanding auditing system through therelationship between managers and discussion of today’s CSR. Based on theshareholders. However, we can no foregoing discussion, the analytical do-longer accept uncritically a conventional main of auditing system is presented inperspective on the relationship between Figure 227. Independent auditing as wellcorporate governance and independent as corporations as public institutions ofauditing. society needs to contribute to public trust. In the future, corporations need toFrom the foregoing discussion, we can increasingly support each auditing be-understand that it is necessary to think cause auditing system plays an impor-the relationship between corporate gov- tant role in corporate governance. More-ernance and independent auditing from over, managers need to position eachstakeholders’ perspective. Today’s inde- auditing as contribution to corporatependent auditing needs to play an impor- governance, and as not a “cost” but antant role in checking managers’ fiduci- “investment” in sustained corporate de-ary duties for stakeholders. In doing so, velopment.independent auditing can contribute tostakeholders. In other words, independ- In a true sense, auditing as social controlent auditing needs to contribute to not is a medium to ensure the good relation-supporting the good relationship be- ship between corporations and stake-tween managers and shareholders but holders. Auditing is a social infrastruc-supporting the good relationship be- ture to build up public trust as a socialtween corporation and stakeholders. In capital, and is indispensable presence forthis context, independent auditing is an stakeholders and corporation. Stake-essential element of today’s corporate holders and corporation need to have agovernance. This is a new perspective better understanding of the importanceon the relationship between today’s cor- of auditing in corporate governance.porate governance and independent au- When stakeholders, corporation, andditing. auditing effectively cooperate and ade- quately interact with each other and gen-In addition, since independent auditing erate a synergistic effect, they are able toalone has a limitation, independent au- build up a better society.
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