ADDIS ABABA UNIVERSITY

SCHOOL OF GRADUATE STUDIES

SCHOOL OF LAW

Ensuring Good Corporate Governance through Auditors: Appraisal of the Ethiopian

Legal Regime Governing their Roles and Responsibilities

By: Dureti Abate

May, 2016
 ADDIS ABABA UNIVERSITY
SCHOOL OF GRADUATE STUDIES
SCHOOL OF LAW

Ensuring Good Corporate Governance through Auditors: Appraisal of the Ethiopian

Legal Regime Governing their Roles and Responsibilities

A Thesis Submitted In Partial Fulfilment of the

Requirement for Degree of Master of Laws (LL.M) In Business Law

By: Dureti Abate

Advisor: Zekarias Keneaa (Associate Professor)

May, 2016
 ADDIS ABABA UNIVERSITY
SCHOOL OF GRADUATE STUDIES
SCHOOL OF LAW
(Approval Sheet)

Ensuring Good Corporate Governance through Auditors: Appraisal of the Ethiopian

Legal Regime Governing their Roles and Responsibilities

A Thesis Submitted In Partial Fulfilment of the

Requirement for Degree of Master of Laws (LL.M) In Business Law

By: Dureti Abate

Approved by
Board of Examiners

1. Zekarias Keneaa (Associate Professor) _________________________

Advisor’s Name Signature

2. Fekadu Petros (Assistant Professor) _________________________

Examiner’s/ Reader’s Name Signature

3. Tewodros Meheret (Assistant Professor) _________________________

Examiner’s/ Reader’s Name Signature
 Declaration

I, the undersigned, declare that this thesis is my original work, has not been presented for a degree
in any other university and that all materials used have been duly acknowledged.

Declared by:

Name: Dureti Abate

Signature: ____________________

Date:_________________________

Name of Advisor: Zekarias Keneaa (Associate Professor)

Signature: ____________________

Date:_________________________
 Acknowledgement

First of all I would like to praise the Lord, Jesus.

I am deeply grateful to my advisor Zekarias Keneaa (Associate Professor) for his professional
guidance, invaluable comments and unreserved support. This thesis would not have been completed
without his support and guidance.

I would also like to thank Mr. Demelash Debele and Mr. Yohannes Nigatu from the Accounting
and Auditing Board of Ethiopia for their cooperation in explaining questions related to the Board
and providing materials.

I am also thankful Teklework Ayalew, Roza Bargicho, Zelalem Fekadu and Nahom Shewangizaw
for assisting me in gathering materials for the study and all my friends for their encouragement.

I am thankful to my employer, Dilla University, for sponsoring me during the entire study period.

Last, but not least, I would like to extend my special gratitude to my family for their support.
 TABLE OF CONTENTS

Abstract ............................................................................................................................................ i
Acronyms ........................................................................................................................................ ii

CHAPTER ONE ................................................................................................................................ 1

INTRODUCTION ............................................................................................................................. 1

1.1 Background Of The Study ........................................................................................................ 1

1.2 Statement Of The Problem And Research Questions ................................................................ 4
1.3 Objectives Of The Study .......................................................................................................... 8
1.3.1 General Objective .............................................................................................................. 8
1.3.2 Specific Objectives ............................................................................................................ 8
1.4 Significance Of The Study....................................................................................................... 8
1.5 Scope Of The Study ................................................................................................................ 8
1.6 Methodology Of The Study ..................................................................................................... 9
1.7 Limitations Of The Study ........................................................................................................... 9

CHAPTER TWO ............................................................................................................................. 10

THE NOTIONS OF CORPORATE GOVERNANCE AND AUDITING..................................... 10

2.1 The Notion of Corporate Governance ..................................................................................... 10

2.2 Why Corporate Governance Matters....................................................................................... 12
2.3 Significance of Good Corporate Governance .......................................................................... 13
2.4 Corporate Governance Frameworks........................................................................................ 14
2.5 The Notion of Audit and Auditor............................................................................................ 15
2.5.1 Types of Audits ............................................................................................................... 16
2.5.2 The Notion of Auditor ..................................................................................................... 17
2.5.3 Types of Auditors ............................................................................................................ 18
2.6 The Need for Audit of Financial Statements by an External Auditor ....................................... 19
2.7 The Link between Audit and Corporate Governance............................................................... 20

CHAPTER THREE......................................................................................................................... 21

ENSURING GOOD CORPORATE GOVERNANCE THROUGH AUDITORS ........................ 21

3.1 The Role of Auditors in Ensuring Good Corporate Governance.............................................. 21

3.2 Mechanisms of Ensuring Good Corporate Governance through Auditors ............................... 22
3.2.1 Reduction of Conflict of Interest ...................................................................................... 22
 3.2.2 Limits on Multiple Roles and Services by Auditors.......................................................... 23
3.2.2.1 Approaches to Limiting Non Audit Services ............................................................. 25
3.2.3 Disclosure of Non Audit Services by Auditors.............................................................. 26
3.2.4 Setting Audit Tenure and Restricting Personnel Flow .................................................... 26
3.2.5 Audit Committees ........................................................................................................... 27
3.2.5.1 Role of audit committees .......................................................................................... 28
3.2.5.2 Audit Committee Membership, Size and Expertise .................................................... 30
3.2.5.3 Enhancing Effectiveness of Audit Committees.......................................................... 31
3.2.6 Determining the Body to Hire and Compensate Auditors ................................................. 33
3.2.7 Oversight of Auditors...................................................................................................... 34
3.2.7.1 Oversight of Qualification......................................................................................... 36
3.2.8 Non Financial Statement Audit ........................................................................................ 36
3.2.9 Accountability and Reporting Mechanism ................................................................... 37

CHAPTER FOUR ........................................................................................................................... 39

APPRAISAL OF THE ETHIOPIAN LEGAL REGIME GOVERNING THE ROLES AND

RESPONSIBILITIES OF AUDITORS .......................................................................................... 39

4.1 Overview of the Ethiopian Legal Framework on Corporate Governance and Auditors............ 39
4.2 The Roles and Responsibilities of Auditors under the 1960 Commercial Code ...................... 39
4.3 Assessment of the Commercial Code Provisions Governing the Roles and Responsibilities
of Auditors in Light of the OECD Principles of Corporate Governance .......................................... 41
4.4 Appraisal of Provisions Governing Auditors under the Commercial Code .............................. 43
4.4.1 Appointment of Auditors ................................................................................................. 44
4.4.2 Personnel Flow ................................................................................................................ 44
4.4.3 Non Audit Services .......................................................................................................... 45
4.4.3.1 Auditors as Interim Managers .................................................................................... 47
4.4.4 Setting Audit Tenure and Auditor’s Rotation ................................................................... 47
4.4.5 Excluding Individuals Affiliated to the Audit Client from the Role of Auditing ............... 48
4.5 Audit Committee .................................................................................................................... 50
4.5.1 Audit Committee Composition and Membership .............................................................. 50
4.6 Auditors in the Financial Sector ............................................................................................. 52
4.6.1 Appointment of Auditors ................................................................................................. 52
4.6.2 Persons Incompetent to Be Auditors of Companies in the Financial Sector ...................... 53
4.7 Auditors of Private Limited Companies .................................................................................. 54
4.7 The Role of Auditors in the Protection of Minority Shareholders.............................................. 56
4.9 Oversight of Auditors ............................................................................................................. 58
4.9.1 Overview of the Roles of the Accounting and Auditing Board of Ethiopia (AABE) ..... 58
4.10 Auditors’ Responsibilities .................................................................................................... 60
4.11 Auditing Standards ............................................................................................................... 61
4.12 Concluding Remarks and Recommendations ..................................................................... 62
4.12.1 Conclusion .................................................................................................................... 62
4.12.2 Recommendations ......................................................................................................... 66
Bibliography ................................................................................................................................. 69
 Abstract

Business organizations of the company form are the preferred mode of running business in modern
society and they are considered one of the ingenious creations. The limited liability attribute of
such organizations and the opportunity they provide for the public to pool resources together are
the main traits that make them appealing. Inasmuch as companies offer the privilege of limited
liability to their members and enable individuals to pool their resources, they also pose threat to
creditors and members are usually forced to entrust management of their resources in the hands of
few individuals. The special threats of companies and their significance in the economy compel
putting in place legal framework that promotes good corporate governance.

The problems of separation of ownership and control and threats to creditors are rectified by a
check and balance mechanism of audit. Auditors are regarded as watchdogs of a company and they
provide checks on the affairs of management, safeguarding shareholders and other stakeholders
both from fraud and genuine mistakes. The conduct of audit enhances reliability of financial
statements and can bring problems within the company to the attention of concerned bodies before
crisis occurs.

However, for auditors to discharge their duties as watchdogs of the company there needs to be a
legal regime that effectively governs their roles and responsibilities. In the absence of effective laws
that enhance the role of auditors in ensuring good corporate governance, they can be put in a
difficult place where they can not discharge their responsibilities but rather further the interest of
managers or their own personal interest. History has witnessed the collapse of companies around
the world and in the wake, there have been various legal reforms focusing on how to best enable
auditors discharge their duties and foster the good corporate governance of the companies.

How to best ensure good corporate governance through auditors in various laws and corporate
governance codes are dealt through mechanisms of ensuring their objectivity and effectiveness
since checking the work of management is based on independence from management. The exclusion
of individuals affiliated to members of a company from involving in audit of the company,
prohibition of auditors from rendering certain types of services to their audit client, rules on
appointment procedures and the forming of independent audit committees are measures taken in
different countries in order to ensure good corporate governance through auditors.

This work studies how to ensure good corporate governance of companies through external
auditors and assesses the existing Ethiopian legal regime governing their roles and responsibilities
to this end. It examines whether the legal frameworks foster the external auditors’ role in
promoting good corporate governance of Ethiopian companies. The study was conducted based on
legislative and comparative analysis. The findings of the study show that there are different possible
ways to enhance the role of auditors in ensuring good corporate governance. It also shows that the
current legal regime governing companies acknowledges external auditors have a very significant
role in bringing about the good corporate governance of companies and there also exist some
ongoing reforms. Finally, this work provides some recommendations which the writer considers
appropriate.

i
Acronyms

AABE Accounting and Auditing Board of Ethiopia

CPA Certified Public Accountant

IOSCO International Organization of Securities Commissions

NBE National Bank of Ethiopia
OECD Organization for Economic Cooperation and Development
OFAG Office of the Federal Auditor General
PLCs Private Limited Companies
SOX Sarbanes Oxley Act

UK United Kingdom
US United States

ii
 CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Corporate governance is an eclectic subject and the relevant literature is found in several disciplines,
including accounting, business management, economics, finance, law, psychology, political science
and sociology.1 There is accordingly no single definition of corporate governance that can be applied
to all situations and jurisdictions. The various definitions that exist today largely depend on the
institution, author, country and legal tradition.2

The International Financial Corporation defines corporate governance as the structures and processes
for the direction and control of companies.3

The United Kingdom’s Code of corporate governance defines it as the system by which companies are
directed and controlled.4 Corporate governance is also defined as the system by which a business
corporation is directed and controlled at its senior level in order to achieve its objectives, performance
and financial management, accountability and integrity.5
A somewhat broader definition would be to define corporate governance as a set of mechanisms
through which firms operate when ownership is separated from management.6
Corporate governance involves a set of relationships between a company’s management, its board, its
shareholders and other stakeholders and provides the structure through which the objectives of the
company are set, and the means of attaining those objectives and monitoring performance are
determined.7

Corporate governance refers to all issues related to ownership and control of corporate property, the
rights of shareholders and management, powers and responsibilities of the board of directors,
disclosure and transparency of corporate information, the protection of interests of stakeholders that
are not shareholders and enforcement of rights.8 Corporate governance is not limited to rules

1
Minga Negash, “Corporate Governance and Ownership Structure: The case of Ethiopia”, Ethiopian E-Journal for
Research and Innovation Foresight, vol.5, no.1 (2013), p. 33.
2
The International Finance Corporation Corporate Governance Manual, (2nd ed. 2010), BACSON, Hanoi, P.6
3
Ibid
4
The UK corporate governance code(2014) p.1
5
T.Karagiorgos, G.Drogalas , E. Gotzamanis and I. Tampakoudis , “Internal Auditing as an Effective Tool for Corporate
Governance ” , Journal of Business Management , vol.2, no.1 (2010), p.18
6
Stijn Claessens, Corporate Governance and Development (2003), IBRD , Washington DC, p.5
7
Organization for Economic Cooperation and Development (OECD)Principles of Corporate Governance (2004), p.11
8
Hussein Ahmed, “Overview of Corporate Governance In Ethiopia: The Role, Composition and Remuneration of Boards of
Directors in Share Companies”, Mizan Law Review , vol. 6, no.1 (2012) , p.48
1
prescribing how boards of directors operate but extends to the control mechanisms used to reconcile
company managers’ interests and shareholders’ interests which in other words means it deals with the
ways in which suppliers of finance to corporations assure themselves of getting a return on their
investment.9

When companies fail as a result of poor corporate governance, losses through their failures are felt not
only by shareholders. Since employees lose their jobs, their families lose their livelihood, the
consumers lose choice of products, the suppliers lose customers, and the whole economy of a country
may possibly suffer as a consequence.10 Every corporation saved from failure preserves precious jobs
and sustains the economy.11 Corporate governance is a key element in improving economic efficiency
and growth as well as enhancing investor confidence.12 The presence of an effective corporate
governance system, within an individual company and across an economy as a whole, helps to provide
a degree of confidence that is necessary for the proper functioning of a market economy and attract
more investors whose support can help to finance further growth.13 The Organization for Economic
Cooperation and Development (OECD) principles of corporate governance hereinafter (OECD
principles), also state that corporate governance is one key element in improving economic efficiency
and growth as well as enhancing investor confidence.14 The role of auditors in ensuring that
international standards of accounting and reporting are adhered to by corporations is a fundamental
element of this principle.15 The board of directors, the audit committee, the external auditor, and the
internal audit process constitute major factors of corporate governance.16 Corporate auditing is one of
the mechanisms of proving assurance to the investors and other stakeholders. The principal
characteristics of ensuring effective corporate governance such as transparency, accountability and
integrity are enhanced with conduct of audit into the affairs of a corporation.17 In fact accountability,
integrity and transparency are provided in the different definitions of corporate governance as its basic
component. Framework of effective accountability that does not impede boards to drive their
companies forward is the essence of any system of good corporate governance.18

9
Jean Paul, Corporate governance and Value Creation (2005), The Research Foundation of CFA Institute, USA, p.1
10
Commonwealth Association for Corporate Governance Guidelines (CACG) Principles For Corporate Governance In The
Commonwealth (1999), p.15
11
Ibid
12
Using the OECD Principles of Corporate Governance: A Boardroom Perspective,(2008), P. 103
13
Ibid
14
OECD principles, Supra note7
15
CACG Guidelines, Supra note 10, p.15
16
Karagiorgos et al., Supra note 5, p. 15
17
James O. Alabede, “The Role, Compromise and Problems of the External Auditor in Corporate Governance”, Research
Journal of Finance and Accounting , Vol. 3, no. 9 (2012), p. 115
18
The Cadbury Committee Report on the Financial Aspects of Corporate Governance, (1992), p.10
2
Audit can be defined as the process by which a competent independent person objectively obtains and
evaluates evidence regarding assertions about economic activity or event for the purpose of forming an
opinion about and reporting on the degree to which the assertion conforms to an identical set of
standards.19 It is a reassurance to all who have a financial interest in companies, quite apart from their
value to boards of directors. The most direct method of ensuring that companies are accountable for
their actions is through open disclosure by boards and through audits carried out against strict
accounting standards.20 The issue for corporate governance is how to strengthen the accountability of
boards of directors to shareholders21 and the financial audit remains an important aspect of corporate
governance that makes management accountable to shareholders for its stewardship of a company.22

Audit is one of the cornerstones of corporate governance.23 Given the separation of ownership from
management, the directors are required to report on their stewardship by means of the annual report
and financial statements sent to the shareholders.24 The audit provides an external and objective check
on the way in which the financial statements have been prepared and presented, and it is an essential
part of the checks and balances required.25 Auditors, persons who conduct audit professionally, have
been seen as playing an important role in ensuring corporate integrity.26 The external auditor’s
responsibilities and the audit committee’s role in corporate governance are therefore fundamental in
helping to achieve the desired aims of corporate governance.27
The corporate climate in Ethiopia is changing with the emergence of newer companies with several
thousand shareholders who have no control over the company giving rise to the “ownership of wealth
without appreciable control and control of wealth without appreciable ownership”.28 This, in other
words, means the corporate climate has opened up to the age old agency problem whereby owners
have an interest in maximizing the value of their shares whereas managers tend to be more interested
in the private consumption of company’s resources. The aforementioned need for external checks and
balances by auditors is therefore an important factor that has to be considered in corporate governance
of Ethiopian companies.

19
A. C. Fernando, Corporate Governance: Principles, Policies and Practices, (2006), Pearson Education, India, p. 226.
20
The Cadbury Committee Report, Supra note 18, p.41
21
Ibid, p.47
22
Ojo Marianne, The Role of External Auditors in Corporate Governance: Agency Problems and the Management of Risk,
(2009), p. 5, available at: http://mpra.ub.uni-muenchen.de/15989/
23
The Cadbury Committee Report, supra note 18, p.35
24
Ibid
25
Ibid
26
Roman Tomasic, The failure of corporate governance and the limits of law : British Banks and the Global Financial Crisis
in Corporate Governance and the Global Financial Crisis : International Perspectives, (2011), p. 52
27
Marianne, Supra note 22 p. 7
28
Fekadu Petros, “Emerging Separation of Ownership and Control in Ethiopian Share Companies: Legal and Policy
Implications”, Mizan Law Review , vol.4 no.1(2010), p.27
3
Developments in corporate governance thinking and practice have often been responses to company
collapses, corporate corruption or the domination of companies by an individual.29 The US Sarbanes-
Oxley Act was a response to the collapses of Enron.30 The collapse of Arthur Andersen, one of the
five big international audit firms, following the Enron debacle, has swung the spotlight onto the role
that external auditors play in the corporate governance.31 Independent external auditors now play a
fundamental part in corporate governance processes.32 There is no question regarding whether there
should be an audit, but what matters is how to ensure its objectivity and effectiveness.33

The very purpose of this research is therefore to examine the role and responsibilities of auditors under
Ethiopian laws and see if there are any improvements that need to be made by surveying the role of
auditors in foreign jurisdiction, prominent principles of corporate governance and best practices to
come up with results that will enhance the role of auditors in ensuring good corporate governance of
Ethiopian companies.

1.2 Statement of the Problem and Research Questions

Auditors have been seen as playing an important role in ensuring corporate integrity. However, their
failure to prevent misconduct related to conflict of interests and restrain abuses in the accounting
practices have undermined their effectiveness.34 While expected to be the watchdogs of the
organisation, they are often bought in by managements through some profitable assignments.35 This
has led to the rise of the concept of corporate governance which is about promoting corporate fairness,
transparency and accountability relating to various participants in an organisation.36 Recent unearthing
of corporate frauds in developed countries, developing and transitional economies revealed the fact
that auditors had failed to do what they were assigned to do.37 They involved themselves in unethical
practices and failed to whistle blow when things went wrong in organizations.38

The 1960 Commercial Code of Ethiopia, hereinafter the Code, has basic rules governing auditors of
companies. Despite change in regime and commercial environment, the Code still remains to be the
major body of law governing business organizations in general and auditors in particular.

29
R. I. Tricker Twenty Practical Steps to Better Corporate Governance, (2010), p.5
30
Ibid
31
Ibid p.16
32
Ibid
33
The Cadbury Committee Report, supra note 18, p.35
34
Tomasic, supra note 26, p. 52
35
Fernando, Supra note 19, p.226
36
Ibid
37
Ibid
38
Ibid
4
The Accounting and Auditing Board of Ethiopia (AABE) is the body with oversight power over
auditors, auditing standards and their code of conduct. This Board, established under the financial
reporting Proclamation No. 847/2009 and subsequent Regulation No.332/2014 is entrusted with the
power to issue directives on a wide range of oversight issues and has taken some of the powers of the
Office of the Federal General Auditor. The National Bank of Ethiopia (NBE) has also issued directive
on the approval of appointment of independent auditor for companies engaged in the financial sector.
A corporate governance directive for banks and insurance companies has been enacted and a similar
directive for microfinance institutions is also found at a draft stage. A directive of such kind with
specific focus on corporate governance is not in place for companies engaged in other sectors of the
economy. The Code thus remains to be the major body of law dictating the corporate governance of
such companies.

The Code provides auditors as a mandatory organ of share companies and private limited companies
(PLCs) with more than twenty members. The provisions governing auditors of PLCs are not as
detailed as those governing share companies. Besides, PLCs with less than twenty members are not
obliged to have auditors. Although the Code was enacted over five decades ago, currently, the
overwhelming majority of companies in the country are PLCs formed according to the Code which are
held by family members or other closely related persons.39

In an attempt to cover every possible situation whereby a share company may be left without directors
in a certain financial year, the Code provides that auditors shall carry on management of the company
until a general meeting is called by them for the appointment of directors.40 Such an arrangement
would technically mean there could be circumstances whereby auditors are left to audit their own
activities. Resolving conflict of interest and ensuring independence in such cases would be difficult to
achieve.

The main tasks of auditors in the Code are related to auditing and verifying balance sheets and reports
of the board of directors41 whereas most countries require auditors of companies engaged in the
financial sectors to verify not only information relating to the financial condition but also compliance
of the companies operations with regulatory requirements.42

Provision of non audit services by auditors of a company to the same is another concern in ensuring
good corporate governance through auditors. The collapse of big companies like Enron and Arthur

39
Ethiopia Commercial Law and Institutional Reform and Trade Diagnostic (2007), USAID, p.19
40
Commercial code of The Empire of Ethiopia, 1960, Art .351, proc. No. 166, Neg. Gaz., year 19 , no 3
41
Ibid, Art. 374
42
Solomon Abay, Financial Market Development, Policy And Regulation: The International Experience And Ethiopia’s
Need For Further Reform (2011), p. 99
5
Anderson in the west has been attributed to such provision of multiple services by auditors.
Limitations on non audit services that auditors may provide to the company they audit is a key concept
under prominent corporate governance codes.43 The Ethiopian Commercial Code provides for list of
persons who may not serve as auditors of a company and prohibits auditors from serving as directors
or managers of the company they audited, its subsidiaries or holding companies within three years
after termination of their services.44 Individuals who receive periodical remuneration from directors of
a company, the subsidiary or holding company, founders, contributors in kind and beneficiaries
holding special interest for rendering non audit services are prohibited from becoming auditors. Other
stipulations as to non audit services they may and may not provide during their terms of service or
after its termination is not clearly provided for.

A study conducted by Wolderuphael Woldegiorgis in 1978 on the role of auditors under Ethiopian
laws particularly focusing on public enterprises, pointed out lack of uniformity in the auditing
standards, absence of laws on licensing and qualification requirements as the major problems
concerning the role of auditors under Ethiopian laws.45

However, the legal and economic conditions of the country have changed and different legislations
regulating the role of auditors have been put in place especially for the financial sector. Corporate
governance principles and guidelines have also developed around the world since then. Concerns
revealed by the work mentioned above which was conducted during the military regime also needs to
be re examined in light of the new laws that to some extent attempted to tackle few of the problems
tied to auditing. In addition, the study did not assess the role of auditors from the view point of
ensuring good corporate governance.

A research conducted to find out the practice of some private auditors in exercising the professional
and legal responsibility of auditing in Ethiopia disclosed that private auditors have been producing
misleading audited financial statements by reporting assets that do not exist, considering or not
disclosing inadequate provision for doubtful debts, not disclosing misapplication of accounting
principles, expressing the audit opinion based on the client's interest and others mostly for the sake of
personal financial interest.46 It also revealed that there had been instances where auditors have been
sanctioned by the regulatory body for violating their professional responsibility.47

43
Sarbanes-Oxley Act of 2002 (SOX), section 201(a) and The UK corporate governance code (2014) c.3.8
44
Commercial code, Supra note 40, Art. 370
45
Wolderuphael Woldegiorgis, The Role of Auditors under Ethiopian Laws, (1978, unpublished, Faculty of Law,
HaileSelassie I University), p.83
46
Muluneh Beyene, Auditors Professional Responsibilities and Legal Liability with Regard to Private Auditors in Ethiopia,
(2007,unpublished, Department of Accounting and Finance A.A.U), p.5
47
Ibid
6
The aforementioned study on the role of auditors under Ethiopian laws revealed that auditing has
remained inadequate both qualitatively and quantitatively despite its importance to shareholders,
bankers, creditors, prospective investors, labour unions and the government mainly as a result of lack
of uniform or accepted accounting principles and auditing standards. 48

External auditor’s role in corporate governance is a fundamental complement in helping to achieve

good corporate governance and safeguards are necessary to ensure that their expertise is maximised.49
To have a check on auditor’s role and to prevent them from unethical practices, governments and
regulatory bodies have come out with many regulations, re establishing corporate accountability and
reinforcing investor confidence.50

The previously mentioned work on auditors’ professional responsibility in Ethiopian is focused on the
practice.

A study examining the role of auditors in relation to good corporate governance of Ethiopian
companies has not been done so far.

The purpose of this research is therefore to appraise the different Ethiopian laws governing auditors’
roles and responsibilities and examine whether good corporate governance can be achieved through
them.

Hence, this study will attempt to assess the roles and responsibilities of auditors under Ethiopian laws
in light of prominent good corporate governance principles, codes, and best practices.

Accordingly, the research questions are;

1. What are the roles and responsibilities of auditors under Ethiopian laws?
2. What mechanisms exist to enhance the role of auditors in ensuring good corporate governance?
3. How are auditors regulated?
4. Does the existing Ethiopian legal regime on the roles and responsibilities of auditors
promote/ensure good corporate governance?
5. What should be done to ensure good corporate governance through auditors?

48
Wolderuphael, supra note 45,p.82
49
Marianne, Supra note 22, p.7
50
Fernando, supra note 19, p. 226
7
1.3 Objectives of the Study

1.3.1 General Objective

The main objective of the study is to examine how to ensure good corporate governance through
auditors and to appraise the existing Ethiopian legal regime governing their roles and responsibilities
in this regard.

1.3.2 Specific Objectives

The study has the following specific objectives:
 To examine how prominent corporate governance codes address the roles and responsibilities
of auditors and try to ensure good corporate governance through them.
 To explore the roles and responsibilities of auditors under Ethiopian laws
 To assess the roles and responsibilities of auditors under Ethiopian law in light of well
developed corporate governance principles.
 To assess whether the roles and responsibilities of auditors under Ethiopian law promote good
corporate governance

1.4 Significance of the Study

The examination of the laws and the analysis to be made under this study is hoped would serve
academic purpose. It is also hoped that the study will inform policy makers and legislators and assist
them in making decisions in relation to auditors in the forthcoming overhauling of Ethiopian
Commercial Code. At the same time, the research will point out areas that require further research as
well, adding to the academic significance. To

1.5 Scope of the Study

The study focuses on the role of external auditors (private auditors) of share companies and private
limited companies. It does not examine the roles of auditors for public enterprises or other
governmental institutions since corporate governance issues in such institutions take a different form,
mainly related to accountability, transparency and proper utilization of budget allocated to them by the
government. The study is thus limited to appraisal of the laws governing external auditors in relation
to privately held companies. Neither is internal audit the focus of the thesis.

8
1.6 Methodology of the Study
The major methodology to be employed in conducting this research will be analysis of legal provisions
of the Commercial Code and other laws in the area of study. To this end review of published and
unpublished materials, journals, and books will be made. A comparative approach with prominent
corporate governance systems will also be employed in the due course of the research. This qualitative
approach is hoped to best address the research questions the study aims to answer.

1.7 Limitations of the Study

The researcher has faced different challenges in conducting the study. These challenges, among others,
include the scarcity of materials in the area of study, shortage of time and the fact that laws below
Regulations in the hierarchy of laws are not made available to the public.

The absence of an organized system to assist in distinguishing among operative and repealed laws has
also posed the writer difficulty in conducting the research. The writer has also attempted to access
background documents of legislation but such documents are mostly unavailable. Yet, the writer
believes the work has examined and appraised the relevant existing Ethiopian legal regime in light of
the issue at hand.

9
 CHAPTER TWO

THE NOTIONS OF CORPORATE GOVERNANCE AND

AUDITING

2.1 The Notion of Corporate Governance

The notion of corporate governance has been around for a long time.51 As stated in the introduction, it
is an eclectic subject the relevant literature of which is found in several disciplines and the various
definitions present largely depend on the institution, author, country and legal tradition.

According to the OECD principles of corporate governance, corporate governance involves a set of
relationships between a company’s management, its board, its shareholders and other stakeholders and
provides the structure through which the objectives of the company are set, and the means of attaining
those objectives and monitoring performance are determined.52

Corporate governance refers to all issues related to ownership and control of corporate property, the
rights of shareholders and management, powers and responsibilities of the board of directors,
disclosure and transparency of corporate information, the protection of interests of stakeholders that
are not shareholders and enforcement of rights.53 It is not limited to rules prescribing how boards of
directors operate but extends to the control mechanisms used to reconcile company managers’ interests
and shareholders’ interests which in other words means it deals with the ways in which suppliers of
finance to corporations assure themselves of getting a return on their investment.54
The Cadbury report defines it as a set of mechanisms through which firms operate when ownership is
separated from management and the system of direction and control of a company.55 It focuses on a
company’s structure and processes to ensure fair, responsible, transparent and accountable corporate
behaviour.56

51
Bob Garratt, Why Corporate Governance Matters and How to Measure and Improve Board Performance (2006),
Nicholas Brealey publishing, UK, P. 33
52
OECD principle, supra note 7, p.11
53
Hussein, Supra note 8, p.48
54
Paul, supra note 9, p.1
55
The Cadbury Committee Report, supra note 18, p.24
56
Ibid
10
Some define corporate governance as the appropriate board structures, processes and values to cope
with the rapidly changing demands of both shareholders and stakeholders in and around their
enterprises.57

What can be concluded from the various definitions available is that there is no uniform scope or
content of corporate governance.58 Some focus on the link between shareholders and the company;
some concentrate on the formal structure of the board, codes of board practice and corporate
effectiveness ; yet others believe the focus should be on the social responsibilities of corporations to a
wider set of stakeholders.59

From the academic point of view corporate governance focuses on some structures and mechanisms
that would ensure the proper internal structure and rules of the board of directors; creation of
independent committees; rules for disclosure of information to shareholders and creditors;
transparency of operations and an impeccable process of decision making; and control of
management.60 Operationally speaking, corporate governance is composed of activities of various
kinds, strategic, supervision, auditing, control, and evaluation.61

Corporate governance has traditionally focused on the problem of the separation of ownership by
shareholders and control by management.62 But with the passage of time, experiences gained from
historical developments of corporate wrongs and with the impact of a growing vision of society, the
framework of corporate governance has increasingly broadened.63 It is now accepted that firms should
respond to the expectations of more categories of stakeholders which include employees, consumers,
government and the society as a whole.64

There are ongoing debates on which among the age old shareholders approach and recent broad
stakeholders approach a particular system should adopt.65 However, from the point of view of ease for
implementation, the shareholder approach, particularly, making the accountability of the company
governors to the shareholders is considered easier for implementation.66 In general, the term

57
Garratt, Supra note 51, p.2
58
Fernando, Supra note 19,p.52
59
Ibid
60
Ibid p 9
61
A. Naciri (ed.), Corporate Governance around the World, (2008), Routledge , New York, P.9
62
Fernando, Supra note 19, p.18
63
Ibid
64
Ibid
65
F”Ç ’@_éS, yx!T×’!à yk#ÆNà HG,(2004›.M) g} 124
66
Ibid
11
corporate governance is a useful umbrella term to cover the exercise of power over and within the
company, for the good of all concerned.67

From the different definitions of corporate governance it can be concluded that what lies at the heart of
the notion of corporate governance is the protection of the interest of shareholders and other
stakeholders as the case may be and accountability of management and the board of directors.

2.2 Why Corporate Governance Matters

Corporate governance has become a more important policy issue in many countries.68 Organizations in
modern economies were granted extraordinary privileges allowing them to participate effectively in
social and economic human advances.69 Business organizations of the company model prove to be one
of the most ingenious human organizational creations and they are today shaping every facet of
people’s lives in a non measurable way.70 On the other hand, recent history indicates that private
organizations are also invading political grounds and they are directly impacting politics as well as
development and it is only a matter of fairness, to require some minimum level of good governance
from them as it is also a matter of economic growth, democracy and social justice.71

Another reason is the proliferation of scandals and crises.72 Recent financial audacious frauds among
western corporations were surprising by both their impact and ingeniousness, drawing attention on the
dramatic consequences of weak corporate governance and giving governance issues urgent priority.73
Such frauds have underscored the critical importance of structural reforms in the governance of
companies.74 Although most corporate controversies occurred in the western corporations, they exist in
other economies of the world as well. 75 Successive business failures and frauds in the United States,
several high profile scandals in Russia and Asian crisis have brought corporate governance issues to
the forefront in developing countries and transitional economies as well.76 The scandals also show that
corporate governance issues transcend national boundaries.77 They are in fact considered as

67
Fernando, Supra note 19, p.52
68
Claessen, Supra note 6, p.6
69
Naciri, Supra note 61, P. 344
70
Ibid,p. 2
71
Ibid
72
Claessen, Supra note 6,P.6
73
Naciri , supra note 61,P. 346
74
Ibid
75
Ibid
76
Fernando, supra note19, p 12
77
Naciri , supra note 61,P. 346
12
manifestations of a number of reasons why the subject has become more important for economic
development.78

Increase in importance of private, market-based investment process underpinned by good corporate

governance for most economies has also raised corporate governance issues in sectors that were
previously state held.79 Firms have gone to the public markets to seek capital and mobilization of
capital is increasingly one step removed from the principal owner and the increasing size of firms in
turn increases the need for good corporate governance.80

International financial integration, increase in trade and investment flows leading to many cross-border
issues in corporate governance, technological progress, liberalization and opening up of financial
markets, trade liberalization, and other structural reforms make good governance more important, but
also more difficult.81

2.3 Significance of Good Corporate Governance

Good corporate governance is important on a number of different levels. At the company level, well-
governed companies tend to have better and cheaper access to capital and outperform their poorly
governed peers over the long-term.82 This is mainly because the level of risk assigned to the company
by investors is directly proportional to the cost of capital and by reducing risks such as investors’
rights violation; companies with strong corporate governance structure and practice reduce cost of
equity and debt capital.83
Investors, especially creditors, have recently tended to include a company’s corporate governance
practices such as a transparent ownership structure and appropriate financial reporting as key criteria in
their investment decision making process.84 Therefore, corporate governance practices can determine
the ease with which companies are able to access capital which in turn results in higher growth and
greater employment. 85
Corporate governance improves the management and oversight of executive performance and
accountability combined with effective risk management can bring potential problems to the forefront

78
Claessen, Supra note 6,P.6
79
Ibid
80
Ibid, p. 7
81
ibid
82
The International Finance Corporation, supra note 2, p.17
83
Ibid, P.20
84
Ibid
85
Claessen, Supra note 6, p.14
13
before crisis occurs.86 The economic and social costs of financial crisis can be prevented in such
manner.
Adherence to good corporate governance standards also helps to improve the decision-making
process.87 High quality corporate governance streamlines all the company’s business processes, and
this leads to better performance and lower capital expenditures which in turn may contribute to the
growth of the company.88

The better the corporate governance structure and practices, the more likely that assets are being used
in the interest of shareholders and not misused by managers.89
Corporate governance in companies plays a crucial role in emerging economies, which often do not
have as good a system of enforcing investors’ rights as countries with developed market economies.90
Good corporate governance practices contribute to and improve a company’s reputation.91 This would
mean the company, through its good will, will enjoy greater trust, valuation and ultimately profits.

Good corporate governance results in better operational performance through better allocation of
resources and better management resulting in wealth.92

Generally, well-governed companies are better contributors to the national economy and society.93
They tend to be healthier companies that add more value to shareholders, workers, communities, and
countries in contrast with poorly governed companies that may cause job and pension losses, and even
undermine confidence in securities markets where one exists.94

2.4 Corporate Governance Frameworks

Corporate governance frameworks typically comprise elements of legislation, regulation, self-
regulatory arrangements, voluntary commitments and business practices that are the result of country
specific circumstances, history and tradition.95 The efficiency or otherwise of the governance system
will directly depend on the framework conditions and the desirable mix between elements of the
framework will vary from country to country.96 As new experiences accrue and business circumstances

86
The International Finance Corporation, supra note 2, P. 18
87
Ibid
88
Ibid
89
Ibid, P. 19
90
Ibid, P. 21
91
Ibid,P.22
92
Claessen, Supra note 6, p.14
93
The International Finance Corporation, supra note 2,P. 17
94
Ibid
95
Ibid, P.32
96
Ibid
14
change, the content and structure of this framework needs to be adjusted.97 Companies will need to
carefully monitor such adjustments on a regular basis and update their governance systems
accordingly.98

Governments play a crucial role in making the legal, institutional and regulatory framework within
which governance systems are kept in place.99

In many legal systems and prominent corporate governance principles, regulations are usually found as
legal requirements where no deviation is allowed , comply or explain rules where any deviation needs
to be accompanied by the reason for deviation and suggestions which are recommendation that
companies are at liberty not to adhere to if they wish without owing any explanation.

2.5 The Notion of Audit and Auditor

Audit is the process by which a competent independent person, an auditor, objectively obtains and
evaluates evidence regarding assertions about economic activity or event for the purpose of forming an
opinion about and reporting on the degree to which the assertion conforms to an identical set of
standards.100 Black’s Law Dictionary defines audit as a formal examination of an individual's or
organization's accounting records, financial situation, or compliance with some other set of standards.

Although the objectives and concepts that guide contemporary audits were almost unknown in the
early years of the 20th century, audits of one type or another have been performed throughout the
recorded history of commerce and government finance. 101

The original meaning of the word auditor was “one who hears” and was appropriate to the era during
which governmental accounting records were approved only after a public reading in which the
accounts were read aloud.102

During the industrial revolution, as manufacturing concerns grew in size, their owners began to use the
services of hired managers.103 With this separation of the ownership and management groups, the

97
Ibid
98
Ibid
99
Fernando, Supra note 19, p. 16
100
Ibid, p. 226
101
O.Ray Whittington and Kurt Pany, Principles of Auditing and Other Assurance Services (13th ed.2001) , McGraw-Hill
companies Inc., p.8
102
Ibid
103
Ibid
15
absentee owners turned increasingly to auditors to protect themselves against the danger of
unintentional errors as well as fraud committed by managers and employees.104

Before 1900, consistent with this primary objective to detect errors and fraud, audits often included a
study of all, or almost all, recorded transactions.105 However, in the first half of the 20th century, in
response to the increasing number of shareholder and corresponding increased size of corporate
entities, the direction of audit work tended to move away from fraud detection toward a new goal of
determining whether financial statements gave a full and fair picture of financial position, operating
results, and changes in financial position. 106

In addition to the new shareholders, auditors became more responsible to governmental agencies, stock
exchanges representing these new investors, as well as to other parties who might rely upon the
financial information.107

The word audited when applied to financial statements, means that the balance sheet and the
statements of income and cash flows are accompanied by an audit report prepared by independent
public accountants, expressing their professional opinion as to the fairness of the company’s financial
statements. 108

2.5.1 Types of Audits

i. Audits of financial statements: This type of audit ordinarily covers the balance sheet and the
related statements of income.109 The goal is to determine whether these statements have been
prepared in conformity with a certain standard in use.110 Management, investors, bankers,
creditors, financial analysts and government agencies are usually users of such audits.111
ii. Compliance audit: This is an audit to determine the company being audited is complying with
criteria or standards such as laws or regulations set by a higher competent authority or the
organization’s policy and procedures.112
iii. Operational audit: This is the study of a specific unit of an organization for the purpose of
measuring its performance (evaluation of efficiency and effectiveness). 113

104
Ibid
105
Ibid, p. 9
106
Ibid
107
Ibid
108
Ibid
109
Ibid
110
Ibid
111
ibid
112
ibid
113
ibid
16
 iv. Forensic audit: forensic audit can be defined as an activity of collecting, verifying, processing,
analysing and reporting data in order to obtain facts and evidence that could be used in forensic
financial disputes arising from criminal activities.114 It is the application of methodologies and
technologies by an independent entity to obtain a detailed understanding of underlying
economic risks facing an organization.115
Unlike financial audit, forensic audit is not a periodic event but an ongoing process.116 This
would mean that while financial audit is an auditor’s expression of his/her opinion on the
financial statements of a company for a certain period of time, there is no specific timeline for
forensic audit and the process may last until an alleged fraud is discovered.117
A forensic auditor provides a specialized report intended for legal proceedings and there is no
generally accepted standards prescribed for it.118 Therefore, unlike the external auditor, a
forensic auditor is not limited by auditing standards and can perform professional activities
outside the auditing standards in use with the objective of investigating and detecting fraud.119

v. Tax audit: Tax audit is an examination to determine if taxpayers have correctly assessed and
reported their tax liability.120 It is the process in which a tax collection authority reviews the
reports of an individual or a company to see if all incomes, deductions, and/or credits reported
accurately reflect reality.121 Tax audit may be done on a random basis or when something
appears remiss on a tax return.122 It is a type of forensic audit conducted by government
auditors123 which may involve physical enquiries such as the inspection and examination of
goods in stock and premises.124

2.5.2 The Notion of Auditor

Auditor is a person who conducts audit professionally and is required to certify that the accounts
produced by the client company have been prepared in accordance with a certain accounting standards

114
Predrag Vukadinoviae , Goranka Knezeviae, and Vule Mizdrakoviae, The Characteristics of Forensic Audit and
Differences in Relation to External Audit, (2015) p. 203 available at : http://finiz.singidunum.ac.rs/portal/wp-
content/uploads/sites/3/2015/12/202-205.pdf
115
Stevenson Smith and Larry Crumbley, “Defining a Forensic Audit”, Journal of Digital Forensics, Security and Law , Vol.
4, no. 1, p. 65
116
Ibid, P.77
117
Vukadinoviae et al, supra note 114, p.204
118
Ibid
119
Ibid ,
120
Strengthening Tax Audit Capabilities: General Principles and Approaches (2006), p. 9 available at
https://www.oecd.org/tax/administration/37589900.pdf
121
Farlex Financial Dictionary,(2009),available at http://financial-dictionary.thefreedictionary.com/Tax+audit
122
Ibid
123
http://www.businessdictionary.com/definition/tax-audit.html
124
Strengthening Tax Audit, Supra note 120, p. 9
17
and represent a true and fair view of the company.125 An auditor is a representative of the shareholders,
forming a link between government agencies, shareholders, investors and creditors.126

2.5.3 Types of Auditors

1. Internal auditors
Internal auditors are auditors employed by the organisation for which they perform audits.127 Their
responsibilities vary and may include financial statement audits, compliance audits and operational
audits.128 They may assist the external auditors in completing the financial statement audit or perform
audits for use by management within the entity.129 Internal auditors must have no operating
involvement in activities they audit.130

2. Independent auditors/ External auditors

Independent auditors are usually referred to as certified public accountants (CPA).131 The opinion of
an independent auditor about financial statements makes the statements more credible to such users as
investors, bankers, labour unions, government agencies and the general public.132 Three key points
about the independent audit are:133

 Management remains responsible for preparing and presenting the company’s financial
statements
 The External Auditor is responsible for forming and expressing an opinion on the financial
statements prepared by management
 The audit of the financial statements does not relieve management of any of its responsibilities

3. Government auditors
Government auditors work in various government agencies performing financial, compliance and
operational audits.134 Even if government auditors perform different activities such as financial,

125
Fernando, Supra note 19, P.227
126
Ibid
127
Ibid
128
Ibid
129
Ibid
130
Ibid
131
Ibid
132
Ibid
133
The International Finance Corporation, supra note 2,P.544
134
Fernando, Supra note 19, p. 227
18
compliance and operational audit like internal auditors, they are the employees of governments and
their purpose is to verify a company or any other institution they audit is abiding by relevant laws.135

In Ethiopia, OFAG can audit or cause to be audited accounts of private or public organizations with a
view to protect government and public interest.136 The NBE can also cause to be audited a bank, an
insurance company or a micro financing company by an auditor that is different from the one
appointed by such companies whenever it is not satisfied by the audit report of their independent
auditors.137 These kinds of auditors in Ethiopia can be categorized under government auditors.

2.6 The Need for Audit of Financial Statements by an External Auditor

The need for audit can be best explained by the Latin maxim that goes ‘nemo judex in causa sua’
asserting that no one can be a judge in his own case. Management can hardly be expected to be entirely
impartial and unbiased in reporting on its own administration of business.138 This becomes even more
important where there is separation of ownership and control in companies. Regardless of the case of
the misstatements management may commit, whether deliberate falsifications or accidental errors, the
risk for those who rely on the information is the same and needs to be minimized if it can not be
absolutely eliminated. Therefore, auditing is needed to provide an objective check.

Audit by independent auditors who have no material personal or financial interest in the business is
mainly needed for its independence and the credibility it adds to the financial statements which relied
upon by shareholders, lenders, government regulators, customers and other interested third parties.139

Audit promotes efficient allocation of economic resources since inadequate accounting and reporting
could conceal waste and inefficiency.140 Having regard to the credibility gap unaudited financial
statements prepared by management leaves when transmitted to outsiders, audited financial statements
are the accepted means by which business corporations report their operating results and financial
positions.141 The OECD principles provides that an annual audit should be conducted by an
independent, competent and qualified auditor in order to provide an external and objective assurance to

135
ibid
136
Office of the Federal Auditor General Establishment(Amendment) Proclamation, 2010, Art. 5(5), Proc.No.669,
Neg.Gaz, Year 16, no.20
137
The Insurance Business Proclamation No.746/2012 and The Banking Business Proclamation No.592/2008 empower the
Nation Bank of Ethiopia to appoint its own auditors whenever it is not satisfied with the report of the external auditors of
such companies. The National Bank is given the same authority over micro-financing institutions under article 13(2) of the
Micro financing Business Proclamation No.626/2009
138
Whittington & Pany, Supra note 101,P. 7
139
Ibid, p. 6
140
Ibid
141
Ibid, P .7
19
shareholders that the financial statements fairly represent the financial position and performance of the
company in all material respects.142

2.7 The Link between Audit and Corporate Governance

As stated in the introduction chapter, corporate governance deals with the ways in which suppliers of
finance to corporations assure themselves of getting a return on their investment and corporate auditing
is one of the mechanisms of proving assurance to the investors and other stakeholders. And one of the
aims of corporate governance is tackling problems arising out of the separation of ownership from
management which forces management and directors to report on their stewardship by means of the
annual report and financial statements sent to the shareholders. One key element of corporate
governance is ensuring shareholders’ rights to obtain relevant and material information on the
corporation on a timely and regular basis and auditors play a key role in attesting to the reliability of
information presented to shareholders.143 The audit provides an external and objective check on the
way in which the financial statements have been prepared and presented, and it is an essential part of
the checks and balances required.144 In discussing the role of auditors it is important to raise a
misconception regarding the investing public’s conception of the role of auditors as guarantors of
perfectness of financial statements which is usually referred to as the expectation gap. But auditors are
not guarantors of the accuracy or the reliability of financial statements.145 The principal characteristics
of ensuring effective corporate governance such as transparency, accountability and integrity are
enhanced with conduct of audit into the affairs of a corporation.146

142
OECD Principles, Supra note 7, principle V,C
143
OECD Principles, Supra note 7, Principle II A
144
Ibid
145
Treadway Report on Fraudulent Financial Reporting (1987), P.6
146
Alabede, Supra note 17, P. 115
20
 CHAPTER THREE

ENSURING GOOD CORPORATE GOVERNANCE THROUGH

AUDITORS

3.1 The Role of Auditors in Ensuring Good Corporate Governance

Corporate governance has two fundamental aspects which are the supervision and monitoring of
management performance and the accountability aspect dealing with ensuring accountability of
management to shareholders and other stakeholders.147
The financial audit remains an important aspect of corporate governance that makes management
accountable to shareholders for its stewardship of a company. The control of the board by auditors is
not only the most common, but also the most prominent control mechanism.148
In raising audit as an essential tool for good corporate governance, it is important to make distinction
between internal and external audit. The internal auditor can play a significant role in working with
management, external auditors and the audit committees in ensuring the effectiveness of internal
controls and in bringing any weakness to the attention of the appropriate parties.149 The external
auditor’s role is enhanced by the internal audit.150 Internal audit programmes, all internal audit reports
and findings should be made available to the external auditor at the earliest possible opportunity who
should make use of them and decide whether and to what extent reliance can be placed on the
conclusions and the work of the internal auditor.151 Internal audit therefore contributes tremendously to
the external auditor’s role in corporate governance.

However, the internal auditor usually occupies a unique position as an employee, who at the same time
is expected to review the conduct of management.152 This does not itself impair their objectivity.153
But it is still a difficult role that can create significant tension, particularly where the internal auditor
has to bring to light issues relating to lack of compliance or irregularities.154 In addition to this,

147
Marianne, Supra note 22, P.1
148
Ibid, p.6
149
The Report of the Review Group on Auditing , p. 202 , available at:
www.odce.ie/portals/0/Documents/company/companylawandyou/corporateGovernance/ReviewGrouponAuditing-
Report.pdf
150
Ibid, P. 204
151
Ibid
152
Ibid, p.203
153
King Report on Corporate Governance for South Africa (2002), P.13
154
The Report of the Review Group on Auditing, Supra note 149,P.203
21
depending on certain circumstances related to the effectiveness of the management, a company’s board
may also choose not to establish internal audit functions. 155

The external audit on the other hand in addition to being a statutory requirement for public companies
almost everywhere, it provides an independent and objective check on the way in which the financial
statements have been prepared and presented by the directors.156 The external auditor would facilitate a
situation where managers are encouraged or compelled to be held more accountable.157 For these
reasons ensuring good corporate governance through auditors in this paper is discussed in relation to
the external auditor.

3.2 Mechanisms of Ensuring Good Corporate Governance through Auditors

Contemporary discussions of corporate governance tend to refer to principles raised in three

documents: UK’s Cadbury Report of 1992, the OECD Principles of Corporate Governance (OECD
2004) and the Sarbanes-Oxley Act of 2002 informally referred to as SOX, which is an act by the
Federal Government in the United States.158 King Report on Corporate Governance for South Africa,
2002 (King II) is also known for being broadminded and advanced.159 Therefore, discussions and
analysis in ensuring good corporate governance through auditors in this paper will be made in
reference to these documents.

To ensure good corporate governance through auditors, they should first be able to discharge their
obligations without obstacles in an environment that enhances their effectiveness. Situations that
threaten auditors’ independence have an impact on each of the obligations and duties of auditors.160
The independence of auditors is thus the key factor in ensuring good corporate governance.

3.2.1 Reduction of Conflict of Interest

It has already been established that the main role of auditors is providing objective check and balance
on management of publicly held companies. Conducting checks and balances inevitably calls for
independence of the auditor from the company. Independence is the most essential factor in the
existence of the auditing profession.161 Where independence is the pillar of audit, then it can be

155
King Report, supra note153, P.12 and UK corporate governance code, supra note4, c.3.5
156
Ibid, p.16
157
Marianne, Supra note 22,p.5
158
Cally Jordan, “Cadbury Twenty Years On”, Villanova Law Review, Vol. 58 no.1 (2013), P.18
159
Garratt, Supra note 51,P. 41
160
Ownership Rules Of Audit Firms and Their Consequences for Audit Market Concentration, (2007), p.197 available at:
www.europa.eu
161
Whittington & Pany, Supra note 101, p. 35
22
concluded that ensuring good corporate governance through auditors can not be achieved without
ensuring their independence and objectivity.
King II states that external auditors should observe the highest level of business and professional ethics
and, in particular, their independence should not be impaired in any way.162
Independence can be defined as an environment where auditing bodies are not affiliated with or
controlled by a company, and therefore are more likely to issue an objective opinion.163 Relationships
that may pressure, seduce, or tempt external auditors not to act as diligent judgmental monitors of their
corporate clients must be eliminated or reduced.164 Safeguards which exist to ensure that threats to
auditor’s independence are mitigated may take different forms. The International Organization of
Securities Commissions (IOSCO) Principles of Auditor Independence and the Role of Corporate
Governance states that standards of auditor independence should establish a framework of principles,
supported by a combination of prohibitions, restrictions, other policies and procedures and disclosures,
that addresses at least: self-interest, self-review, advocacy, familiarity and intimidation.165

Prominent measure taken by most corporate governance instruments with this view of ensuring
independence are discussed below.

3.2.2 Limits on Multiple Roles and Services by Auditors

The OECD principles states that provision of non-audit services by the external auditor to a company
can significantly impair their independence.166 The obvious theory behind limitation on the multiple
services by auditors is that, without certain kinds of limitations, an auditor whether an individual or a
body corporate, will be tempted to accede to pressure by client company managers to go along with
dubious accounting judgments and obscure presentations.167 This is mainly because the auditor may
fear losing profitable non-auditing business if it does not cooperate.168 This possible adverse effect of
some non-audit services performed for audit clients has been debated continually over the past.169
It is argued that providing non-audit services is important for audit companies to enable their staff to
obtain a broader knowledge and understanding of companies.170
A lack of familiarity with the company could also depending on the nature of the service result in a
non audit service provided by a provider other than the auditor being of lower quality, as the other
162
King Report, supra note 153,P.16
163
Sanjay Anand, The Sarbanes-Oxley Act: An Introduction, (2008), Van Haren Publishing, P.12
164
Robert Charles, corporate governance Change in the wake of the Sarbanes Oxley Act: A morality tale for Policy makers
too (Harvard law school discussion paper No.525, September 2005), p. 5
165
The International Finance Corporation, Supra note 2, P. 548
166
OECD Principles, Supra note 7,P. 55
167
Charles, Supra note 164, P.6
168
Ibid
169
Treadway Report, Supra note 145, P.44
170
Implementation of the EU Audit Directive and Audit regulation, (2014), P.32 available at: https://www.frc.org.uk/Our-
Work/Publications/Audit-and-Assurance-Team/Consultation-Auditing-and-ethical-standards-implem-File.pdf
23
provider might not recognise issues that would be evident to the auditor with its knowledge of the
company.171

The restrictions on providing non-audit services to an audited entity may also reduce audit firms’
incentive to invest in audit innovation.172

Having to obtain a non-audit service from another provider other than the auditor could increase costs
for the company being audited if that other provider had to obtain knowledge of the company that the
auditor already possessed.173 But it is also possible that greater competition to provide such services
could reduce prices.174
On the other hand, some non audit services add commercial pressures to the audit examination and as a
result impair independence.175 At the very least, the auditor’s performance of management advisory
services places him/her in the role of management and raises the perception of impaired
independence.176

The pros and cons of provision of non audit services by auditors to their audit client has thus to be
regulated in a fashion that strikes balance and maintains the objectivity and independence of the
auditor to the extent possible.

SOX and king II acknowledge that independence of auditors could be jeopardized as a result of
provision of other non audit services to their audit client.

Under SOX section 201 external auditors are prohibited from providing certain kinds of non-audit
services to their auditing clients. These services include:

 Bookkeeping services, appraisal or valuation services, actuarial services, internal audit

outsourcing services, management functions or human resources, investment banking services,
legal services, and other services that might be determined by regulation to be impermissible.

An exception to this rule is made should non-audit services that are not prohibited be pre-approved by
the board of directors audit committee.177 The Audit Committee should, however, disclose these
services to investors in periodic reports.178

171
Ibid
172
Ibid, p.34
173
Ibid, p.32
174
Ibid,p.55
175
Treadway Report, Supra note 145,P.44
176
Ibid
177
The International Finance Corporation, Supra note 2, P. 551
178
Ibid
24
King II also proposes that audit committee be entrusted to decide on a case by case basis to select its
179
external auditor for non audit services. The committee is expected to have the necessary business
acumen to address external auditor independence on a case by case basis; thereby preserving the
company’s ability to select its external auditor for non-audit services if that is in the best interests of
the company and its investors.180

3.2.2.1 Approaches to Limiting Non Audit Services

In restricting non audit services by auditors, there are two approaches that could be followed.181
1. A 'black list' of prohibited non-audit services with other services allowed subject to evaluation of
threats and safeguards by the auditor and/or audit committee, and
2. A 'white list' of allowed services with all others prohibited

In following the white list approach there is a risk that with hindsight it becomes evident that certain
services have been omitted, and therefore effectively prohibited, which could have been included.182
Also, new services could arise that might be considered appropriate for the auditor to undertake, but
are not on the list. If a white list is established, the responsible regulatory body would need to
periodically review it, but it would inevitably take a period of time to update.183 On the other hand the
benefits to the perception of the auditor’s independence may be considerable because there would be
much greater clarity as to what is permissible and therefore eliminate the perception of the underlying
threat to the auditor’s independence.184
Prohibiting certain services that are deemed material to the financial statements and/or present an
insurmountable threat to auditor independence, whilst allowing other services if safeguards are put in
place, may not completely avoid possible impairment of auditor independence.185 For this reason
auditors apply a common safeguard which is putting a separate team in place to perform the non audit
service.186 This is of course assuming that the auditor is a firm of a certain kind. This by itself may be
challenged as not being effective against a threat which could operate through unseen and perhaps
subtle influences within the audit firm partnership that may, for example, simply come from the
auditor knowing that the non-audit relationship is important to the firm.187

179
King Report, Supra note153, P. 16
180
Ibid
181
Implementation of the EU Audit Directive, Supra note 170, p.7
182
Ibid, p. 32
183
Ibid
184
Ibid
185
Ibid, p. 33
186
Ibid
187
Ibid
25
It is therefore very difficult to think of an absolute independence of auditors. Although it is impossible
to overcome such challenges unless audit is completely quarantined from non audit services, which
would be absurd,188 placing limitations on non audit services an auditor may provide to audit clients is
a key corporate governance principle.

3.2.3 Disclosure of Non Audit Services by Auditors

Another safeguard measure to ensure independence of auditors is requiring public companies to
disclose the size of fees received from audit and audit-related services versus permitted non-audit
services.189 The Cadbury committee in its report strongly supported full disclosure of fees paid to audit
firms for non-audit work.190
In theory, such disclosure allows investors to better gauge how much the external auditor may still be
pulled by a conflicting interest.191 If the ratio of non-audit services to audit services is too high, the
company gets a lower governance rating, and shareholders are advised to take this into account when
making investments.192 In a severe case, a shareholder resolution requesting that the company’s board
reduce the non-audit services may be made.193
If the external auditor provides non-audit services, this fact must be reported in the Annual Report,
explaining how the auditor retains objectivity and the audit committee and other concerned bodies
such as the remuneration committee should attend the annual general meeting and be ready to answer
questions.194
Similarly, under the UK Corporate Governance Code, if the external auditor provides non-audit
services, the annual report should include an explanation of how auditor objectivity and independence
are safeguarded.195 Disclosure of the amount paid for non-audit services with a detailed description in
the notes to the annual financial statements of the nature thereof, together with the amounts paid for
each of the services described is also proposed under king’s report.196

3.2.4 Setting Audit Tenure and Restricting Personnel Flow

The personal relationship between auditors and the client company managers may, with time, become
so strong as to weaken the resolve of the former to act as diligent judgmental monitors and term limits

188
The Cadbury report stress that potential gains in objectivity from absolute quarantining of non audit services would
not outweigh the disadvantages such quarantine brings to the company.
189
Charles, Supra note149,p.6
190
The Cadbury Committee Report, supra note 18, p.35
191
Charles, supra note 164, p. 6
192
Ibid
193
Ibid
194
David Martin, Corporate governance: Practical guidance on Accountability Requirement, (2006), Thorogood publishers,
London, P.59
195
UK corporate governance code Supra note 4, c.3.7 & c.3.8
196
King Report, Supra note153, P.16
26
are considered to be remedies to such problems.197 The SOX under section 203 requires that audit
engagement partners and audit reviewing partners (the most important auditing firm employees who
deal with the executives of an auditing client) must be rotated off the engagement after five years of
audit service.

And regarding personnel flow, section 206 provides that it shall be unlawful for an audit firm to
perform for a company any audit services, if a chief executive officer, controller, chief financial
officer, chief accounting officer, or any person serving in an equivalent position for the company was
employed by that firm and participated in any capacity in the audit of that company during the 1-year
period preceding the date of the initiation of the audit.

In addition, there is mandatory one year wait for audit firm employee who worked on audit, before
becoming higher-level financial employee at client.198 This is designed to tackle the fear that audit firm
employees anticipating such a presumably nice career shift will be tempted to favour the executives
whose financial oversight they are supposed to be monitoring and judging.199

3.2.5 Audit Committees

Audit committees are an Anglo-Saxon corporate governance mechanism.200 They have gradually
gained broad acceptance in many European governance codes; in countries with both a one-tier
corporate governance systems, where it is a sub-committee of the main board, and in countries with a
two-tier corporate governance system, where it is a sub-committee of the supervisory board assisting it
in its oversight role.201 Audit committee development has been driven by concerns about the
credibility of financial reporting, particularly in relation to the issue of auditor independence.202
The theoretical framework for audit committees generally applied in an Anglo-Saxon setting is in the
agency theory and they are primarily an institution to align the interests of owners and management.203
The establishment of audit committees within the unitary board system is regarded as a reaction to
information asymmetries between the owners of a company and its management.204 From an agent’s
perspective, the implementation of systems or procedures that can provide reliable performance

197
Charles, supra note 164, p. 7
198
Ibid, P. 8, note 10.
199
Ibid, p.8
200
Paul Collier and Mahbub Zaman , Convergence in European Codes: The Audit Committee Concept, (2004), p. 4
201
Ibid, p.23
202
Laura F. Spira, The Audit Committee: Performing Corporate Governance ,(2002), p.16
203
Annette G. Kohler, “Audit Committees in Germany: Theoretical Reasoning and empirical Evidence”, Schmalenbach
Business Review, Vol.57, (2005), P. 234
204
ibid
27
information may serve as a signalling device.205 Audit committee formation initiated by the
management signals that management behaviour aligns with the principal’s expectations.206
The Cadbury report reveals the appointment of properly constituted audit committees as an important
step in raising standards of corporate governance.207
The establishment of effective, Vigilant and informed audit committees to oversee a company’s
financial reporting process are a key practice that can help companies meet their responsibilities and
reduce the incidence of fraudulent financial reporting.208

3.2.5.1 Role of audit committees

There are fewer consensuses on the audit committee’s role in financial reporting, external auditor
selection and internal control and risk assessment.209 Similarly, there are inconsistencies among several
Codes with regard to specification of audit committee structure concerning membership, financial
qualification, and frequency of meetings.210 Nevertheless, oversight of internal and external audit is
almost universally seen as the central purpose of audit committees.211
Under the SOX, audit committee is given responsibility for the appointment and oversight of the
auditors, for recommending their fees and it also must:212
 Approve all audit and non-audit financial functions;
 Ensure auditors rotate according to the tenure set by law and cooling periods are observed;
 Ensure the auditors report to them on matters involving critical accounting policies, alternative
treatments of financial matters, and communication with management (especially any
constraints placed upon them during their audit); and
 Examine any conflicts of interests involving the auditors.

Kings II proposes the following roles of audit committees:213

 Review the functioning of the internal control system and internal audit department;
 Review the risk areas of the company’s operations to be covered in the scope of the external
and internal audits;

205
Ibid, P.235
206
Ibid
207
The Cadbury Committee Report, supra note 18, p.67
208
Treadway Report, Supra note 145,p.6
209
Collier and Zaman, Supra note 200, p.23
210
Ibid, p. 23
211
Ibid, p. 19
212
Martin, Supra note 194, P. 62
213
King Report, supra note 153, P.19
28
  Review the reliability and accuracy of the financial information provided to management and
other users of financial information, and whether the company should continue to use the
services of the current internal and external auditors;
 Review any accounting or auditing concerns identified as a result of the internal or external
audits;
 Review the company’s compliance with legal and regulatory provisions, its articles of
association, code of conduct, by-laws and the rules established by the board;
 Encourage communication between members of the board, senior executive management, the
internal audit department and the external auditors;
 Develop a direct, strong and candid relationship with the external auditors;
 Review the scope and results of the external audit, its cost effectiveness and the independence
and objectivity of the external auditors (and in so doing should review the nature and extent of
any non-audit services provided to the company by the external auditors);
 Consider the rotation policy of the external auditors and whether there is a need to change the
audit partner or senior staff engaged in the audit;
 Draw up a recommendation to the board for the appointment and removal of the external
auditors; and
 Investigate any matters within its terms of reference and safeguard all information supplied to
it.

According to the UK Corporate Governance Code the audit committee should have primary
responsibility for making a recommendation on the appointment, reappointment and removal of the
external auditors.214
In a number of companies the audit committee is specified as the contact point for employees who
wish to report concerns about unethical or illegal behaviour that might also compromise the integrity
of financial statements.215
Audit committees do not only serve as internal monitoring devices which support good corporate
governance, they are also considered to be mechanisms of ensuring that an appropriate relationship
exists between the auditor and the management whose financial statements are being audited.216 They
enable non executive/independent directors to contribute an independent judgement and play a positive

214
The UK Corporate Governance Code, Supra note 4, c.3.7
215
OECD principles, supra note 7, annotations to Principle VI D 6
216
Marianne, Supra note 22, p.6
29
role in an area for which they are particularly fitted, and it offers the auditors a direct link with the non
executive directors.217

3.2.5.2 Audit Committee Membership, Size and Expertise

For the audit committee to be effective it is generally recognised that it should comprise of a sufficient
number of outside/ independent directors.218 The concept of independent audit committee membership
is recognised in a majority country codes and principles that acknowledge audit committees.219 In the
case of unitary structures committee members are non-executive /outside directors while in the case of
two tier boards, all are to be appointed from supervisory board members.220 Auditor independence
would be safeguarded if audit committee were made up of a majority of independent and nonexecutive
directors, and this might signify that their independent status would contribute to auditor’s
independence through bridging communication network.221 Nonexecutive directors can be defined as
those who do not perform any management functions within the company or any of its subsidiaries
whereas independent directors are defined as directors independent of executive management and of
dominant shareholders and free from any business or other relationships which could interfere with
their independent judgement apart from their remuneration and shareholding in the company.222
Auditing committee will be able to exercise power over management which will give independence to
the auditor and that will result in authentic financial reporting meeting the expectation of all the
stakeholders and mainly shareholders.223 Independent directors of audit committees are anticipated to
boost the quality of monitoring because they are not associated with the company either as bureaucrats
or human resources; thus they would act as the shareholders’ watchdog.224
Under the UK Corporate Governance Code the board should establish an audit committee of at least
three, or in the case of smaller companies, two members, who should all be independent non-executive
directors.225 According to the Cadbury Report, non executive directors are independent means that
apart from their directors’ fees, they are independent of management and free from any business or
other relationship which could materially interfere with the exercise of their independent judgement.226
Similarly under SOX section 301 all members of the audit committee are required to be independent.

217
The Cadbury Committee Report, supra note 18, p. 28
218
Collier and Zaman, Supra note 200, p. 14
219
Ibid, p. 16
220
Ibid
221
Hetal Pandya, “Corporate Governance: Role of Auditor and Auditing Committee,” IPASJ International Journal of
Management , Vol.1 , no.2 (2013), p.2
222
Collier and Zaman, Supra note 200, p 16
223
Pandya, supra note 221, P.3
224
Ibid
225
C.3.1 of UK corporate governance code requires that the board should satisfy itself that at least one member of the
audit committee has recent and relevant financial experience.
226
The Cadbury Committee Report, supra note 18, p. 21
30
According to this section, for a director to qualify as independent, he/she should not accept any
consulting, advisory, or other compensatory fee from the company.

The composition of audit committees from non executive directors and requiring their independence is
a prominent principle.227
Their independence is important given that audit committees should serve as representative of
shareholder interests and is required to facilitate a process whereby management and external auditors
can be questioned and held to account if need be. 228

3.2.5.3 Enhancing Effectiveness of Audit Committees

Audit committees are dependent on the information provided by management and could, at times, be
briefed selectively by management and it may in certain circumstances decide to suppress or delay the
disclosure of important information to the audit committee.229 As a consequence, the mere existence of
audit committees will not in itself ensure that the interests of the shareholders and especially the
general public interest are protected in the interaction between the management of a company and the
external auditors.230 The challenge therefore is to improve the effectiveness of audit committees in
enhancing auditor independence.231

The effectiveness of audit committees depends on their having a strong chairman who has the
confidence of the board and of the auditors, and on the quality of the non-executive directors. 232 The
chairperson should be an independent non-executive director with the requisite business, financial,
communication and leadership skills and should not be the chairperson of the board.233 King II
recommends that the board chairperson should not be a member of the audit committee. Membership
of the audit committee should be disclosed in the annual report and the chairperson of the committee

227
The Cadbury Committee recommends that audit committees should have a minimum of three members, membership
confined to non-executive directors. The SOX section 407 specifies that at least one member should be a financial expert.
King II does not specify the size of the audit committee but recommends that the board should appoint an audit
committee that has a majority of independent non-executive directors the majority among which should be financially
literate. It also recommends that the board chairperson should be prohibited from membership to the committee. Audit
committees should be composed exclusively of non executive or supervisory directors that are wholly independent. The
Blue Ribbon Committee recommends audit committees to be wholly independent and independence is defined as having
"no relationship to the corporation that may interfere with the exercise of their independence from management and the
corporation". Similarly the European Commission (2004) recommendation stresses that that the audit committee should
be composed exclusively of non-executive or supervisory directors, of whom the majority are independent.
228
Marianne, supra note 22,P. 4
229
The Report of the Review Group on Auditing , Supra note 149, p. 197
230
Ibid
231
Ibid
232
The Cadbury Committee Report, supra note 18, P.29
233
Treadway Report, Supra note 145,p 41
31
should be available to answer questions at the annual general meeting. Composition of audit
committees from independent directors is also advocated for by OECD principles.234

No one other than the audit committee’s chairman and members should be entitled to be present at a
meeting of the audit committee.235 Besides, If meetings or correspondence of the committee with
internal and external auditors are regularly scheduled regardless of the identification of irregularities or
problems, independent dialogue between the audit committee and the internal auditor no longer imply
treason against management which in other words means, the internal auditor is relieved of tension that
arises from its being ‘’employed” by management.236
Another important factor that would enhance the effectiveness of audit committees is having a charter
of their own. The audit committee should encourage procedures that promote accountability among
management, internal auditor and external auditor, ensuring that management properly develops and
adheres to a sound system of internal control, that the internal auditor objectively assesses
management’s accounting practices and internal controls, and that the external auditors, through their
own review, assess management and the internal auditor’s practices.237 The audit committee should
seek to affirm the existence of these nexuses of accountability by learning the roles and responsibilities
of each of these participants.238 These roles and responsibilities should be commonly understood and
agreed to by each of the other participants in the process, preferably in writing.239

King II proposes that the audit committee should have written terms of reference dealing adequately
with its membership, authority and duties. The terms of reference of the audit committee should be
confirmed by the board and reviewed every year and companies should disclose in their annual reports
whether or not the audit committee has adopted formal terms of reference and, if so, whether or not the
committee has satisfied its responsibilities for the year in compliance with its terms of reference.240
OECD principles take similar stand in on the matter.241

234
Annotations to OECD principle VI E 1 provides that boards should consider establishing specific committees, assigning
a sufficient number of non-executive board members capable of exercising independent judgement to tasks where there
is a potential for conflict of interest. Examples of such key responsibilities are ensuring the integrity of financial and non-
financial reporting, the review of related party transactions, nomination of board members and key executives, and board
remuneration.
235
Collier and Zaman, Supra note 200, p.17
236
Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit
Committees ,(1999), p.39
237
Ibid
238
Ibid
239
Ibid
240
King Report, supra note 153, P.18
241
Annotations to Principe VI E 2 provides that when committees of the board are established, their mandate,
composition and working procedures should be well defined and disclosed by the board and Such information is
32
It should be noted that no matter how effective audit committees can be, they cannot be solely relied
upon to secure auditor independence from management, to protect the public interest or to improve
compliance if the auditor is not prepared to tackle these issues.242

3.2.6 Determining the Body to Hire and Compensate Auditors

In ensuring good corporate governance, it is important to eliminate a relationship in which managers
choose and pay the auditor that is asked to audit the financial process overseen by those managers as
that may tempt auditors not to act as diligent judgmental monitors, as opposed to reciprocating
friends.243

Taking this in to account, there are different approaches to the selection of auditors. In a number of
countries external auditors are appointed at least formally by the general meeting of shareholders or in
two tier systems by the supervisory board and in others by the board itself.244
Under the SOX section 307(2), audit committees are directly responsible for the appointment and
oversight of auditors. The power to hire, fire, and compensate the external auditors thus resides in the
company’s audit committee, as opposed to the management or the board of directors as a whole.245 The
placing of such power in the hands of the audit committee is done in the effort to ensure the
appointment of auditors by the company’s body which is independent of management. Such a
conclusion can be made from the fact that certain accommodation are made to foreign companies that
issue shares in the US to which this requirement is normally applicable. The accommodation is that
foreign corporate governance schemes which do not have audit committees identical to the US are
taken in to account as long as those with oversight responsibility for a company’s external auditors are
independent of management.246

It is important to note that placing such power in the board as a whole could be dangerous since a
board is not required to consist entirely of independent directors.247 The board as a whole may thus be
too easily influenced by the mangers’ preferences and interests.248

The UK corporate governance system recognizes the role of audit committees in the appointment of
auditors but sets out a different approach than the SOX. The audit committee has the primary
responsibility for making a recommendation to the board of directors regarding the appointment,

particularly important in the increasing number of jurisdictions where boards are establishing independent audit
committees with powers to oversee the relationship with the external auditor and to act in many cases independently.
242
The Report of the Review Group on Auditing , Supra note 149, P.197
243
Charles, supra note 164,p.10
244
Corporate governance: A survey of OECD countries (2004), P.99
245
Charles, supra note 164,p.7
246
A survey of OECD countries, Supra note 229, P.99
247
Charles, supra note 164,p.7
248
Ibid
33
reappointment and removal of external auditors for it to put to the shareholders for their approval in
general meeting.249 It is possible for the board not to accept the audit committee’s recommendation but
in such cases it should include in the annual report, and in any papers recommending the appointment
or re appointment, a statement from the audit committee explaining the recommendation and the
reason why the board has taken a different position.250

Moreover, IOSCO principles on auditor oversight sets out that there should be a governance body, an
audit committee that is in both appearance and fact independent of management of the entity being
audited and acts in the interests of investors which should oversee the process of selection and
appointment of the external auditor and the conduct of the audit.251

3.2.7 Oversight of Auditors

Auditors should be subject to oversight by a body that acts and is seen to act in the public interest.252
There is a growing consensus internationally as to the benefits of an auditor oversight system that is
not based exclusively or predominantly on self-regulation.253 An effective oversight of independent
audits is critical to the reliability and integrity of the financial reporting process.254 Oversight of
auditors is therefore critical in ensuring that they play their role in good corporate governance
effectively. An oversight to this effect can occur in several ways, including within audit firms, by
professional organizations, public or private sector oversight bodies, and through government
oversight.255 Oversight may also be provided by supervisory boards and audit committees representing
investors in matters relating to individual companies.256

The IOSCO provides 6 principles for auditor’s oversight that can be summarized as

 Oversight of qualification
 Oversight of independence
 Subjection of auditors to the discipline of an auditor oversight body that is independent of the
audit profession

249
The UK corporate governance code, Supra note 4, c.3.6 & c.3.2
250
Ibid
251
A survey of OECD countries, Supra note 229, P.99
252
Technical Committee of the International Organization of Securities Regulators(IOSCO) Principles for Auditor Oversight,
(2002), P.3
253
Ibid,P.2
254
Ibid
255
Ibid,p.3
256
Ibid
34
An auditor oversight body should establish a process for performing regular reviews of audit
procedures and practices of companies that audit the financial statements of companies.257 This
oversight process may be performed in coordination with similar quality control mechanisms that are
in place within the audit profession, provided the oversight body maintains control over key issues
such as the scope of reviews, access to and retention of audit work papers and other information
needed in reviews, and follow-up of the outcome of reviews.258 Reviews should be conducted on a
recurring basis, and should be designed to determine the extent to which audit firms have and adhere to
adequate quality control policies and procedures that address all significant aspects of auditing.
259
Matters to be considered include:260
 Independence, integrity and ethics of auditors;
 Selection, training, and supervision of personnel;
 Acceptance, continuation and termination of audit clients;
 Consultation on difficult, contentious or sensitive matters and resolution of differences of
opinion during audits;
 Communications with management, supervisory boards and audit committees of audit clients;
 Communications with bodies charged with oversight over the financial reporting process, for
example, on matters such as regulatory inquiries, changes in auditors, or other matters as may
be required;
 Provisions for continuing professional education: an auditor oversight body also should
address other matters such as professional competency, rotation of audit personnel,
employment of audit personnel by audit clients, consulting and other non-audit services, and
other matters as deemed appropriate; and
 An auditor oversight body should have the authority to stipulate remedial measures for
problems detected, and to initiate and/or carry out disciplinary proceedings to impose sanctions
on auditors and audit firms, as appropriate.261
Having in place a regulatory framework that ensures a company's external auditor maintains and
continuously carries out a high quality assurance is a vital element in maintaining investor confidence
and provides the deterrence that is critical to reducing the incidence of fraudulent financial reporting 262

257
A consultative document on auditors’ roles and Responsibilities by the corporate law reform committee for the
companies commission of Malaysia, (2007) p. 45, available at:
http://www.maicsa.org.my/download/technical/technical_clr_auditors.pdf
258
Ibid
259
Ibid
260
ibid
261
Ibid, p. 46
262
Treadway Report, Supra note 145,p 6
35
 3.2.7.1 Oversight of Qualification
Since the effectiveness of an audit in detecting fraudulent financial reporting is related directly to the
quality of that audit, the importance of audit quality to the financial reporting process cannot be
overstated.263 For this reason, the accounting profession must be subjected to extensive regulation to
ensure that independent public accountants provide reliable auditing services.264

According to the IOSCO, establishing qualification requirements and requiring maintenance of

professional competency should improve the quality of auditing. Moreover, the risk that authorization
can be revoked for failure to have or maintain the necessary qualification should be an incentive for
compliance and adherence to auditing standards.
In the US, auditors must pass a rigorous qualifying examination developed by the AICPA (American
Institute of Certified Pubic Accountants) to be eligible to practice. Applicants for the CPA license
should be generally required to

1. Have experience in the practice of accounting,

2. Show evidence of moral character, and
3. Undertake continuing professional education.

Increasing the accounting curricula's emphasis on analytical and problem-solving skills, ethical values,
and historical and cultural awareness is believed to be a useful groundwork for future participants in
the financial reporting process.265

3.2.8 Non Financial Statement Audit

Different kinds of corporate illegality, such as noncompliance with various laws and regulations, may
have a material effect on financial statements.266 Even though the misleading financial statements are a
by-product or a result, rather than the objective of the illegal acts, they result in delivering false
information to the investing public.267 Therefore, a strong control environment is essential and laws
should require the auditor to assess the company's control environment, including its management, in
planning the audit.268 Apart from the requirement of auditors to assess the company’s control
environment, properly designed system of internal control to reduce the incidence of fraudulent

263
Ibid, p. 68
264
Ibid
265
Ibid, p. 79
266
Ibid, p. 32
267
Ibid
268
Ibid, p. 51
36
financial reporting will inherently increase the prevention and detection of noncompliance with laws
and regulations.269

3.2.9 Accountability and Reporting Mechanism

In determining to whom auditors should be accountable, it appears very important to consider the
manner of their appointment. The OECD principles of corporate governance states that the
appointment of auditors by a shareholders’ meeting directly upon the recommendation of an audit
committee or an equivalent body clarifies that the external auditor should be accountable to the
shareholders.270 It also underlines that the external auditor owes a duty of due professional care to the
company rather than any individual or group of corporate managers that they may interact with for the
purpose of their work. External auditors should be accountable to the shareholders and owe a duty to
the company to exercise due professional care in the conduct of the audit.271 The External Auditor
should divulge (potential) errors, misconduct, and violations of legislation or the company’s internal
rules during audits, and report them immediately to the Board of Directors’ Audit Committee or
Supervisory Board.272 The External Auditor should make the company aware, as soon as practical and
at an appropriate level of responsibility, of material weaknesses in the design or operation of the
accounting and internal control systems, which have come to an auditor’s attention and the audit
committee or the supervisory board should take appropriate steps to remedy these problems.273

Regarding how the auditor’s report should be prepared, it is generally recognized that it could be either
qualified or unqualified.

Under the UK companies act an auditors’ report must include the following:274

 Include an introduction identifying the annual accounts that are the subject of the audit and the
financial reporting framework that has been applied in their preparation;
 State clearly whether, in the auditor’s opinion, the annual accounts give a true and fair view of
an individual balance sheet, or profit and loss account of the state of affairs of the company as
at the end of the financial year;
 Include a reference to any matters to which the auditor wishes to draw attention by way of
emphasis without qualifying the report;

269
Ibid, p.32
270
OECD principles, supra note 7, P. 57
271
Ibid, Principle V D
272
The International Finance Corporation, Supra note 2, P. 554
273
Ibid
274
UK Companies Act of 2006, article 495&496
37
  State whether in his opinion the information given in the directors’ report for the financial year
for which the accounts are prepared is consistent with those accounts;
 If the auditor fails to obtain all the information and explanations which, to the best of his
knowledge and belief, are necessary for the purposes of his audit, he shall state that fact in his
report.275
For auditors to carry out their responsibilities properly their rights to have access at all times to the
company’s books, accounts and vouchers in whatever form they are held, and require information from
any officer or employee of the company, or from any such persons or auditors of subsidiary
undertaking should be recognized.276

In addition to these, an auditor must be entitled to receive all notices of, and other communications
relating to, any general meeting which a member of the company is entitled to receive and thus attend
such meeting as well as be heard on matters which concern him as an auditor. 277

275
Ibid, article 498 (3)
276
Ibid, article 499
277
Ibid, article 502
38
 CHAPTER FOUR

APPRAISAL OF THE ETHIOPIAN LEGAL REGIME

GOVERNING THE ROLES AND RESPONSIBILITIES OF
AUDITORS

4.1 Overview of the Ethiopian Legal Framework on Corporate Governance and

Auditors
The major corporate governance legal framework for Ethiopian companies is the 1960 Commercial
Code which devotes section to governing the roles of auditors in a share company. With regard to
auditors, the Financial Reporting Proclamation 847/2014 and Regulation no 332/2014 enacted under it
constitute the major body of laws governing auditors in Ethiopia. The corporate governance of
companies engaged in the financial sector and their audit process is governed by various pieces of
legislation, mainly directives, issued by the National Bank of Ethiopia. This chapter aims to assess the
various laws governing auditors of companies in Ethiopia and evaluate whether the existing legal
framework enables the ensuring of good corporate governance through auditors.

4.2 The Roles and Responsibilities of Auditors under the 1960 Commercial Code
The roles of auditors of share companies under the Commercial Code include the following
1. Verifying and reviewing with directors report prepared by experts of the Ministry of
Commerce and Industry (Currently Ministry of Trade and Ministry of Industry)on valuation of
contributions made in kind within six months from the date of formation of a share
company;278
2. They should convene a general meeting for election of directors when there are no surviving
directors and may carry on general management of the company until the next shareholders
general meeting;279
3. They should prepare and submit to the general meeting special report on dealings made
between a company and a director or another organization in which one of the directors is an
owner, partner, agent, director or manager.280 The auditors should be notified of such
transactions;

278
Commercial Code, Supra note 40,Art.315(3)
279
Ibid, Art. 351 (4) &(5)
280
Ibid, Art.356 (3)
39
 4. Audit the books and securities of the company, verify the correctness and accuracy of the
inventories, balance sheets and profit and loss accounts, to certify that the report of the board of
directors reflects the correct state of the company's affairs;281
5. Submit to the annual general meeting a written report on the manner in which they have carried
out their duties along with their comments on the report of the board of directors;282
6. Recommend approval of the accounts and make such comments thereon as they think fit or
refuse to recommend approval by giving reasons for referring the matter back to the directors;
283

7. They may comment on the proposed distribution of profits;284

8. Inform the directors of any irregularities or breaches of legal or statutory requirements and
notify the general meeting whenever the breach is grave;285
9. Inform the public prosecutor of any matters which would appear to disclose the commission of
an offence286
10. Call a general meeting where the directors fail to do so or when shareholders representing at
least 20% of the capital so request. 287
11. Call a general meeting according to article 391(2) of the Commercial Code;
12. Auditors shall be present at shareholders' meetings and at the annual general meeting;288
13. Give a reasoned advice to the general meeting on the mode of presentation of the accounts or
the methods of valuation; 289 and
14. The auditors may at any time make on the spot such audits and checks as they think necessary (
including holding company’s) and may call for any information, agreements, books, accounts,
minute books and such other documents as may be required for the proper execution of 'their
duties. 290

281
Ibid, Art.374
282
Ibid, Art.375(1)
283
Ibid, Art.375(2)
284
Ibid, Art.375(3)
285
Ibid, Art.376
286
Ibid, Art.376
287
Ibid, Art.377
288
Ibid, Art.378(2)
289
Ibid, Art.448 (1)
290
Ibid, Art.378(1)& 379
40
4.3 Assessment of the Commercial Code Provisions Governing the Roles and
Responsibilities of Auditors in Light of the OECD Principles of Corporate
Governance

4.3.1 OECD Principle II - The Rights of Shareholders and Key Ownership Functions
One of the corporate governance principles under the OECD principles is facilitating the exercise of
shareholder’s rights.291 Under this principle the shareholders should obtain relevant and material
information on the company on timely basis.292
The Commercial Code under article 375(4) prohibits the general meeting to consider the balance
sheets in the absence of the auditors’ report. Presence of the auditors at share holders’ meetings and
annual general meetings is also a mandatory requirement as per article 378(2) of the Code. The
company’s auditor’s report and explanations on any questions that may be raised are therefore
recognized as shareholders’ decision making process.
The OECD principles do not only call for the availability of material and relevant information to
shareholders but also the availability of the information on a timely manner.293 In this regard, the
Commercial Code recognizes the right of any shareholder to inspect and take copies at the head office
of the balance sheet, the profit and loss account and the directors' and auditors' reports to be submitted
at the annual general meeting during the fifteen days which precede an annual ordinary general
meeting and extraordinary meeting.294 The Code provides that reports of the auditor should be readily
available for interested shareholders at least 15 days before the shareholders’ meeting and this
promotes the right of shareholders to acquire relevant material and relevant information on a timely
manner.

OECD Principle II.C.3 provides that effective shareholder participation in key corporate governance
decisions, such as the nomination and election of board members, should be facilitated.
The role of auditors in ensuring good corporate governance in this regard becomes evident when the
company is left without any surviving director. Although such instances appear to be rare, the
legislature has regulated the situation by entrusting the auditors with the responsibility of convening a
general meeting for the election of directors.

4.3.2 OECD Principle V- Disclosure and Transparency

This principle of corporate governance addresses disclosure and transparency and provides illustrative
list of activities that demand timely and accurate disclosures. One of the listed items is related party

291
OECD principle, Supra note 7, Principle II
292
Ibid, principle II.A.3
293
Ibid, principle II.C.1 & II.A.3
294
Commercial code, Supra note 40,Arts.417 &422
41
transactions under OECD PrincipleV.A.5 which dictates that the company should run with due regard
to the interests of all its investors and to this end the company has to fully disclose material related
party transactions. Annotation to the principle define related parties as entities that control or are
under common control with the company, significant shareholders including members of their family
and key management personnel. According to this definition, transactions with directors or an entity
where one of the directors of the company is owner, partner, agent, director or manager of such entity
could qualify as related party transactions.

The Commercial Code does not absolutely prohibit transactions between a director and the company
except under article 357(1) but subjects the transaction to the approval of the board of directors
according to article 356(1). The auditors should be given notice of the approved transaction and they
shall present a special report on the matter to the general meeting which may take the action it sees
fit.295

OECD Principle V.B requires that information should be prepared and disclosed in accordance with
high quality standards of accounting and financial and non-financial disclosure. Auditors’ role in this
regard and under the Commercial Code can be seen in relation to their advisory role on mode of
presentation of the accounts and the method of valuation as provided under article 448. Through their
reasoned expert opinion on the mode of valuation and presentation of accounts auditors contribute to
the good corporate governance of the company.

4.3.3 OECD Principle VI- the Responsibilities of the Board

Another key corporate governance principle, Principle VI.A, dictates that board members should act
on fully informed basis.

According to the annotations to the principle this should be taken to mean that the board should be
satisfied that key corporate information and compliance systems are fundamentally sound and
underpin the key monitoring role of the board.

The role of auditors in ensuring good corporate governance in this regard can be seen in light of article
374 and 376 of the Commercial Code. Whenever auditors inform directors of irregularities or breaches
of legal or statutory requirements according to these provisions, they are enabling the board to act on
fully informed basis and take appropriate measures.

295
Ibid, Art.356(1)&(3)
42
4.4 Appraisal of Provisions Governing Auditors under the Commercial Code
If auditors are to ensure good corporate governance in a company, it is already established that it is a
must to first ensure their independence from their audit client. In the previous chapter, four prominent
mechanisms designed to ensure good corporate governance through auditors were raised and they
basically involve ensuring their independence. These mechanisms will be discussed in relation to the
Ethiopian scenario in the following subsections.

The concept of audit and auditors in the Commercial Code is raised in relation to share companies and
private limited companies to a certain extent. The provisions on auditing are derived from the UK
Company act of 1948 which was later amended by the Company Act of 1967.296

The Commercial Code no where provides for a definition of an auditor and does not expressly use the
term external auditor. The aforementioned UK Company Acts from which the provisions on auditing
in the Commercial Code are borrowed from do not also use the term external auditor. According to
these acts, auditors of a company shall make a report to the members of the company and each annual
general meeting shall appoint or reappoint an auditor. 297

The Commercial Code in article 375 provides that auditors shall report and provide their
recommendations and comments to the annual general meeting of shareholders .In article 371 of the
Code it is provided that it is the shareholders that can appoint or remove them. This means that the
auditors in the Code are watchdogs of shareholders’ interests and do not depend on the acceptance of
their works by the management unlike internal auditors who do.298 Internal auditors, although their
works are similar with that of the external auditor, work as an aid to management and depend on the
299
acceptance of their work by the later. Internal auditing is often seen as an overall monitoring
activity with responsibility to management for assessing the effectiveness of control procedures.300 As
a result of such responsibility to the management of a company, internal auditors are called “the eyes
and ears of management” and there is no legal requirement to appoint an internal auditor in the
Commercial Code.301Therefore, the term auditor in the Commercial Code stands for and addresses
external auditor.

296
Peter Winship, Background Documents of the Ethiopian Commercial Code of 1960, 1974, p. 64.
297
UK Company Act of 1967, section 14(1) and UK Company Act of 1948, section 159 (I)
298
Wolderuphael, Supra note 45, p. 12
299
Ibid
300
Hamdu Kedir,Arega Seyom and Addisu Gemeda, “Internal auditing standards and its practice the case of East Arsi
Zone, Ethiopia”, Basic Research Journal of Business Management and Accounts, Vo. 3, No.6 (2014), p. 81
301
Wolderuphael, Supra note 45, p. 12
43
 4.4.1 Appointment of Auditors
The manner of appointment of auditors has a direct implication on their independence and
consequently their role in ensuring corporate governance. It has been already established that auditors
of a company should not be subject to the hire and fire power of management whose activity they are
going to audit as this would impair their objectivity and inflict fear of loss of one’s job.

Auditors of share companies are initially appointed by the meeting of subscribers and by the annual
302
general meeting after the company has come into existence. This means that the power to appoint
auditors is left to the shareholders. This is in line with the accountability of auditors to the shareholders
and the company. However, details as to the appointment process are not provided for in the Code.
Basic questions relating to who would propose the auditor for appointment by the annual general
meeting and the manner thereof are not addressed.

These questions may not be of importance where the company is formed as between founders but they
become of great significance where the company is formed by public subscription of shares to
numerous shareholders.303 Appointment of auditors by the annual general meeting obviously
presupposes that a survey is conducted to select an auditor from the market beforehand. Otherwise it is
practically impossible for the annual general meeting, the meeting of shareholders with the board and
management, to come up with an auditor right at the meeting. Appointment in such a manner is
moreover a formality matter in many countries as shareholders are there to approve nominations by a
certain body which could be the board or a subcommittee of the board.304

In the absence of a clear provision determining the body proposing the appointment by the general
meeting and a restriction on management from participating in the auditor selection process, it is
possible that managers may get involved in hiring auditors which puts the latter’s independence at
stake.

4.4.2 Personnel Flow

In the Commercial Code auditors are prohibited from appointment as managers or directors of their
audit client, its subsidiary, or its holding company within three years from the date of termination of
their function as auditors.305

302
Ibid, Art. 369(1)
303
Winship, Supra note 296. The problem of auditing of share companies has been one of the most fundamental
problems of the law and made with reference to the British law at the time. The most refined and the most effective of all
the solutions appeared to be that which submits the auditing of accounts of public or semi public organisations with a
very high standing. This implies that audit in the commercial code seems to have been mainly associated with public or
semi public companies.
304
Report of the Review Group, supra note149, p. 227
305
Ibid, Art.370(2)
44
A prohibition of the kind found in the Commercial Code is also available in other legal systems with
the view to prevent auditor independence impairment that may result from enticing job offers from
their client company upon termination of their audit service. As mentioned in the preceding chapter,
SOX imposes one year wait for audit firm employee who worked on audit, before becoming higher-
level financial employee at client.
In this regard, the Code is upholding auditor’s independence at a significant level and thereby creating
conducive environment for good corporate governance. However, the legislature’s limitation of the
prohibited posts auditors could not assume in their audit client to director and manager appears to be
narrow both in terms of nomenclature and scope if the intended outcome is to be achieved. The
prohibition from becoming directors in the specified period may achieve its goal of ensuring
objectivity of auditors since directors of a company will form the board of directors making it easier to
establish who a director is. However, managerial posts may be offered to the ex auditor in disguise.
In addition, as long as prohibitions are limited to directorship and management, the effort in achieving
auditor’s objectivity through this means will be futile as there are varieties of posts that a company
may offer to its former auditors as a lure to compromise their judgement.
To curb such situations, the law should take this in to account and also distinctly determine the persons
to whom the bar is applicable in cases where the auditor is a firm.
The other limitation of the provision is its failure to govern the reverse scenario. There is no cooling
off period required for managers and directors of a company if they wish to cease their position and
decide to become an auditor.

4.4.3 Non Audit Services

Auditors should not be under any pressure or fear of loss of income from their client in carrying out
their duties if they are to maintain their independence and discharge their professional duty in the best
possible way. Rendering other services than auditing is one cause of potential pressure resulting in
biased judgement. A biased judgement may not necessarily come from pressure of losing income from
the other services: the mere fact of rendering certain types of non audit services will impair
independence. The SOX under section 201 prohibits auditors from rendering book keeping services to
their audit client because otherwise they will be auditing what they themselves have done.
Independence could be impaired due to external pressure by the audit client and at times it doesn’t
even exist to be impaired when the auditor is placed to judge his/her own work.
The regulation of non audit services that auditors may and may not provide to the company alongside
auditing is one way of ensuring that they promote good corporate governance of their client
companies.
The Commercial Code provides a somewhat non audit services restriction under article 370(1) (c).

45
Art. 370. - Persons not competent.

(1) The following persons may not be elected as auditors:

(a) Founders, contributors in kind, beneficiaries holding special benefits, directors of the company or
of one of its subsidiaries or of its holding company;
(b) Spouses or relatives by consanguinity or affinity to the fourth degree inclusive, of the persons
mentioned in sub-art. (1) (a);
(c) Persons who receive from the persons mentioned in sub-art. (1) (a) a salary or periodical
remuneration in connection with duties other than those of an auditor.

Accordingly, persons who receive a salary or periodical remuneration for non audit services from
founders, contributors in kind, beneficiaries holding special benefits, directors of the company or of
one of its subsidiaries or of its holding company are declared incompetent to become auditors of the
company.
However, the provision does not clearly prohibit non audit services that could be given to the
company. Receiving periodical remunerations or salary presupposes that there is an ongoing
relationship between the persons making and receiving such payments and the auditor is perpetually
dependent on the individuals for his/her income. This restriction is of course very important in
preserving the auditor’s objectivity.

It may be argued that if rendering non audit services to the individuals mentioned in article 370 makes
the person providing the service incompetent to become an auditor of the company, provision of such
services to the company itself should be prohibited for stronger reason. Broadly interpreted in such a
manner, article 370 would mean that individuals receiving periodical remuneration or salary from a
company may not be auditors of the company. This in other words is excluding employees of a
company from becoming auditors thereof.
In fact, legislation governing share companies engaged in the financial sector clearly provide that
employees of such companies may not become auditors.
Nevertheless, article 370 will still fall short of governing non audit services since non audit services
that could be delivered on contractual basis with lump sum payment arrangements are not prohibited.
Such contractual relationships if involving huge amount of payment are equally, if not more, capable
of impairing auditors’ objectivity in conducting audit.
An absolute ban on auditors from rendering non audit service to their audit client is detrimental not
only to the auditor but also to the audit client, bearing a negative consequence on its corporate
governance. Restrictions that intend to safeguard auditors’ objective judgement from compromises
46
resulting from rendering other services to the same client are better achieved either by putting fee caps
that may be received from the non audit services and/or identifying those services that may jeopardize
his/ her independence and prohibiting delivering them to their audit client.

4.4.3.1 Auditors as Interim Managers

Under article 351(5) of the Code, auditors are allowed to provisionally carry on the management of the
company with a view to tackle situations where there are no surviving directors of the company.
Article 351
4) Where there are no surviving directors, the auditors sha1l convene a general meeting without delay
for directors to be elected. (Emphasis added).
5) During the period prior to the calling of the general meeting under sub article (4), the auditors may
carry on the management of the company.

The auditor’s involvement in the management of the company will be for a short period of time if they
choose to carry on since sub article 4 requires them to convene a general meeting without delay for the
election of directors.
However, even if they may be in such a position for a limited period of time, their independence can
be at stake and they might end up auditing their own works.306
Setting a time frame for convening the meeting for this purpose can also foster good governance of the
company since the phrase “without delay” is subject to interpretation.

4.4.4 Setting Audit Tenure and Auditor’s Rotation

As discussed in the previous chapter, the setting of a maximum period of time in which auditors could
serve a company is a common mechanism designed to prevent them from building intimate
relationship with management. This, in turn, enhances their role in the good corporate governance of
companies they audit. In Ethiopia, both extended audit tenures and short audit tenures may be a source
for the emergence of threats to auditor independence and audit quality with the risk even higher when
auditors have extended audit tenures.307
An auditor of a share company is initially appointed by the meeting of subscribers and holds office
until the next annual general meeting.308 An auditor appointed at an annual general meeting may hold

306
Recommendations and position paper of the business community on the revision of the commercial code of Ethiopia,
p. 29, available at: http://www.ethiopianchamber.com/data/sites/1/psd-hub-publications/position-of-the-business-
community-on-the-revision-of-the-commercial-code-of-ethiopia.pdf
307
Amsalu Gelaneh, The Impact of Extended Audit Tenure on Auditors Independence And Audit Quality In Addis Ababa ,
(2011, unpublished, Department of Accounting and Finance A.A.U), p.79
308
Commercial Code, Supra note 40, Art. 369(1)&(2)
47
office for three years.309 The Code does not prohibit an auditor appointed by the meeting of
subscribers from being reappointed at the annual general meeting. There fore, the maximum period an
auditor could continuously serve a share company could be four years.

The tenure of audit firms is usually governed taking into account the service years of the key audit
partner. Under the French system for example, companies must consider audit contracts for renewal or
change at least every six years and while the same auditing company may be retained for a new
310
mandate, the principal audit partner must be rotated. The SOX in regulating audit tenure of audit
firms under Section 203 states that it shall be unlawful for a registered public accounting firm to
provide audit services to an issuer if the lead (or coordinating) audit partner (having primary
responsibility for the audit), or the audit partner responsible for reviewing the audit, has performed
audit services for that issuer in each of the 5 previous fiscal years of that issuer.

The Commercial Code does not make distinction between audit firms and individual auditors in their
audit tenures. Regulating the tenure of individual auditors and audit firms distinctly with a relatively
longer service years for audit firms along with requirement of key audit partner rotation could be
beneficial to the company being audited as well as the audit firm.

However, the Code tries to avoid situations whereby auditors and their audit clients build close
relationship that may compromise the former’s independence. This in turn ensures auditors effective
contribution to the good corporate governance of their audit client.

4.4.5 Excluding Individuals Affiliated to the Audit Client from the Role of Auditing
Article 370(1) of the Commercial Code provides a list of individuals that may not be elected as
auditors of a company. These individuals include;
 Founders;
According to article 307 of Commercial Code, founders include persons who sign the
memorandum of association and subscribe the whole of the capital. Where a company is
formed by the issuance of shares to the public, persons who sign the prospectus bring in
contributions in kind or persons who are to be allocated a special share in the profits are also
considered founders. A person who has initiated plans or facilitated the formation of the
company is also given the status of a founder according to the provision.
 Beneficiaries holding special benefits;

309
Ibid, Article 369(2)
310
Related Party Transactions and Minority Shareholder Rights, OECD (2012), P.11, available at
http://dx.doi.org/10.1787/9789264168008-en
48
 The Code does not define who beneficiaries holding special interest are but special interest
could be based on classes of shares and the term may encompass shareholder with preference
shares as per article 336 of the Code.
 Directors of the company , its subsidiaries or its holdings company;
The term director is also not defined in the Commercial Code. The Banking Business
Proclamation No. 592/2008 under article 2(6) defines the term as any member of the board of
directors of a bank, by whatever title he may be referred to. Similarly, article 2(10) of the
Insurance Business Proclamation No.746/2012 defines director as any member of the board of
directors of an insurer, by whatever title he may be referred to. Generally, Director may be
defined as a person having control over the direction, conduct, management or superintendence
of the affairs of the company.311
 Contributors in kind
 Spouses or relatives by consanguinity or affinity to the fourth degree of the aforementioned
individuals
 Persons who other than as an auditor receive salary or periodical remuneration from the founders,
contributors in kind, beneficiaries of special interest, directors of the company or one of its
subsidiaries or its holdings company

By Such restrictions, the law attempted to ensure that auditors render an objective judgement which is
not affected by personal interest and familial or occupational affiliations.
Exclusion of persons with such kinds affiliation to a company (or spouses, relatives by affinity or
consanguinity to the affiliated persons) from becoming an auditor thereof is a common approach to
ensuring auditor independence and good corporate governance in other legal systems as well.312
The scope of this exclusion appears to be broad especially since restriction on the basis of relationship
by affinity and consanguinity extends to the fourth degree. However, given the conflict of interest such
exclusions aim to avoid, the provision fails to effectively regulate certain meaningful relationships that
may impact the audit.
If conflict of interest is to be avoided, persons affiliated to employees who contribute to the
bookkeeping or preparation of books of accounts of the company or other documents on which the
auditor needs to form opinion should be incompetent to become auditors. As the financial audit
involves investigating the works of such employees, an auditor affiliated to them will be in a difficult
position to pass an objective judgement on works done by them.

311
Fernando, Supra note 19, p. 189
312
Ownership Rules Of Audit Firms, supra note 160
49
Another important issue in relation to auditors’ independence is the consequence of works done by
them while they were in circumstances that are believed to impair their independence. In this regard,
the Commercial Code under article 370(3) provides that reports of auditors adopted by the annual
general meting shall not be invalid except in case of fraud merely by reason of the fact that they fall
under the category of persons incompetent to be auditors under the Code.

The reason for prohibiting the individuals from audit of the company is obviously the need to avoid
probable conflict of interests. Apart from that, these individuals are assumed to be professionally
competent. It is therefore sound not to invalidate works done by them where no fraud exists in the
execution of audit by the mere fact that they are in certain ways placed in positions entailing probable
conflicts of interests.
Where the work of the auditor has been adopted, the legislature chooses to hold the report valid except
in case of fraud regardless of it declaring the auditors incompetent to do the work initially.
As logical as this may be, it nonetheless opens room for what the legislature intended to avoid in the
first place. As modern day audits do not involve checking each and every detail of the audit clients’
financial statements, books of account or other documents, the crafting of article 370(3) gives leeway
for the auditor to commit fraud. Detecting and proving fraud can also be very difficult.
For these reasons, a strictly proactive approach needs to be adopted with no room for auditors in the
mentioned scope of incompetency to undertake audit of the company. To this end, auditors should
declare that they do not fall within the incompetency ambit with a consequence for any false
declaration.

4.5 Audit Committee

The concept of audit committee with roles and responsibilities that can positively enhance the role of
auditors in the corporate governance of a company as discussed in the previous chapter is no where to
be found in the Commercial Code although there is no prohibition of board sub committees.
The newly enacted Bank Corporate Governance Directive No.SBB/62/2015 and Insurance Corporate
Governance Directive No.SIB/42/2015 have introduced Audit committees to the banking sector.

4.5.1 Audit Committee Composition and Membership

An audit committee under Directive No.SBB/62/2015 and Directive No.SIB/42/2015 is a mandatory
sub committee of the board of director of banks and insurance companies.
The committee should have a minimum of 3 directors one of whom should have accounting or auditing
expertise or experience in the field of finance and the sub-committee is entrusted with various roles

50
and responsibilities.313 The committee reports to the full board and is therefore answerable to the
Board of Directors.314
The responsibilities of the sub-committee are similar to proposed roles of audit committees under King
report as discussed in the previous chapter.
The concept of audit committee is based on the existence of non executive/ independent directors. It is
such independence of members of the committee that is considered to give them the intended role of
watchdogs of shareholders’ interests. Composition of audit committees from independent directors is a
recognized principle in the OECD principles, King Report, SOX, Cadbury report and the UK
Corporate Governance Code.
In the absence of a requirement of independence of members of the committee, its establishment alone
might not have significant effect on the corporate governance of banks or insurance companies. They
could of course enhance the efficiency of the board from the division of labour point of view as a sub-
committee having at least one member with expertise in the field of audit, accounting or finance and
the mandatory monthly meetings.
The full fledged benefits of audit committees however presuppose the existence of independent or non
executive directors to a certain level. Even if non-executive directors play a significant role in
providing independent and objective guidance and direction of management and company, the
Commercial Code and other relevant laws do not require companies to have independent non-
executive directors and do not distinguish the roles of the board from that of the management besides
its failure to define independence of board of directors.315 It can thus be concluded that the audit
committee under both directives do not reflect the essence of audit committees as in well developed
corporate governance guidelines and principles. The directives also do not prohibit the board
chairperson from membership to the audit committee but the prohibition is important if the committee
is to discharge its responsibilities without hindrance.
The audit committees are entrusted with the power to approve the provision of non audit services by
the external auditor and ensure that there are proper checks and balances in place so that the provision
of such services does not interfere with the exercise of independent judgment of the auditors.316
In the absence of the notion of non executive directors or certain criteria for the independence of the
audit committee from management, the exercise of such power by the committee can not ensure the
desired goal of ensuring auditor’s independence. There is also need to put in place some legal

313
Bank Corporate Governance Directives, 2015, Directive. No. SBB/62, Annex III on the role of Audit Committees
314
Ibid
315
Hussein Ahmed, “Reforming Corporate Governance In Ethiopia: Appraisal Of Competing Approaches” , Oromia Law
Journal , vol .3, no. 1, p.184
316
Bank Corporate Governance Directives, Supra note 297, Annex III, no iii, 9& 10 on the role of Audit Committees
51
framework on provision of non audit services giving clarifications on the types of services that audit
committees may consider for approval.

4.6 Auditors in the Financial Sector

The legal regime governing auditors of the financial sector is different from the other sectors in some
aspects.
Even if the main legal framework for the sector remains to be the Commercial Code provisions on
share companies it is also governed by other Proclamations and directives by the National Bank of
Ethiopia. The role of auditors in companies engaged in the financial sector will thus be discussed in
light of these laws under the following sub-sections.

4.6.1 Appointment of Auditors

Appointment of auditors for banks follows a similar approach for other share companies governed by
the provisions of the Commercial Code but involves the recommendation of audit committee.
According to articles 6 (6.1.2) and article 10 (10.4.3) of bank corporate governance directives No.
SBB/62/2015, the board of directors proposes the appointment to the general meeting of shareholders
who finally decides upon the appointment.
The directive under article 6(6.1.2) clearly provides that the power of the general meeting of
shareholders to decide upon the appointment of auditors can not be delegated to any other organ in the
bank structure.
In addition to the decision of the shareholders, the appointment of an auditor must be approved by the
National Bank. 317 This is clearly a stricter criteria and oversight of auditors of banks which makes the
National Bank the ultimate body with the power to appoint auditors indirectly.
In this process of appointing auditors, the directive provides that audit committees have the duty to
recommend the appointment of the auditors.
The appointment of auditors of insurance companies is governed identically and needs to be approved
by the National Bank.318 Auditors appointed by microfinance institutions on the other hand need not go
through the process of approval by the National Bank but need to be appointed with yardsticks
satisfactory to the Bank.319
The clear stipulations of the power of shareholders to appoint auditors as non delegable for the banking
sector and the requirement of approval by the National Bank may contribute towards the enhancement
in quality of the audit process in the banking and insurance sector. This would mostly be true because

317
Banking Business Proclamation, 2008, Art. 24(1) , proc .No. 592, Neg. Gaz, year 14,no.57
318
Insurance Business Proclamation, 2012, Art. 28(1), proc. No746, Neg. Gaz, year18, no. 57 and Insurance Corporate
Governance Directives, 2015, Directive. No. SBB/42, Annex III on the role of Audit Committees
319
Micro-financing business Proclamation, 2009, Art. 12(1), proc. No. 626, Neg. Gaz. , year 15, no. 13
52
shareholders might simply endorse proposal by the board at the annual general meetings as it is mostly
the case in other countries where appointment of auditors by shareholders meeting is simply a matter
of formality than carefully deliberated decision.
Given the impact of financial companies on the economy, subjection of the appointment of auditors to
approval by the regulatory body may add to the good corporate governance of the companies.

4.6.2 Persons Incompetent to Be Auditors of Companies in the Financial Sector

Criteria for competency of auditors of companies engaged in the financial sector are found in different
legislation governing the sector.
Under article 24(2) of Banking Business Proclamation No.592/2008, the following persons are
incompetent to be auditors of banks:
a) A shareholder, director or employee of that bank;
b) A spouse or relative by consanguinity or affinity to the first degree to a person falling within
the categories provided under paragraph (a) of this sub-article; or
c) A firm of auditors of which any partner or a staff member falls within the categories provided
under paragraph (a) or (b) of this sub-article.
Similar prohibitions are found under article 28 of the Insurance Business Proclamation No.746/2012
and article 12(4) Micro-financing Business Proclamation No.626/2009.
These prohibitions are additions to the ones under the Commercial Code broadening the scope of
incompetency of auditors.320
In the legislature’s ambition to eliminate conflicts of interest; spouse or relative by consanguinity or
affinity to the first degree of employees and shareholders without any distinction are restricted from
becoming auditors of the company.
However, the need to avoid conflict of interest in the case of audit should not unreasonably
overshadow the other needs of the company in promoting its own good corporate governance through
auditors.
The prohibitions under the Proclamations unnecessarily restrict companies’ access and choice of
auditors from the market.
Under the existing legal framework a company in the financial sector is effectively prohibited from
appointing a renowned audit firm for a price which it considers fair for the mere fact that one of the
staffs of the audit firm has a sister in law who is employed as a secretary in the company. The situation
would make sense if the audit firm’s staff member is participating in the audit as a key audit partner or
assistant or if the sister in law is involved in tasks that would be subjected to audit.

320
Article 60(3) of the Banking Business Proclamation No. 592/2008 and article 59(3)of the Insurance Business
Proclamation No.746/2012 state that nothing proclaimed therein shall be construed so as to relieve these financial
institutions from compliance with the provisions of the Commercial Code
53
Affiliation to such individuals employed in the company does not in all cases make the auditor prone
to impairment of independence.
Restrictions should not therefore be blindly imposed. Rather, situations and relationships that would
make the auditor vulnerable and biased should be identified so as to effectively do away with conflict
of interest.
The National Bank may issue directives on audit tenure of auditors of banks, insurance companies and
micro-financing institutions. Article 25(3) of the Banking Business Proclamation No.592/2008, article
29(1) of the Insurance Business Proclamation No.746/2012 and article12 (3)(c) of Micro-financing
Business Proclamation No. 626/2009 provide for the power of the NBE to issue directives on audit
tenures of the auditors of the respective companies.

4.7 Auditors of Private Limited Companies

Private limited companies constitute the overwhelming majority of companies in Ethiopia and their
contribution to the economy is also significant. Good corporate governance in terms of private limited
companies should therefore be considered by the legal framework on good corporate governance.

PLCs established according to the Commercial Code are obliged to have auditors where there are more
than 20 members.321 In such cases, not less than three auditors shall be appointed in the memorandum
of association.322
A cross reference to the provisions of the Code governing auditors of share companies is made only
with regard to duties and liabilities of auditors.323 Apart from singling out these provisions, a mutatis
mutandis application of the provisions of the Code governing auditors of share companies is not called
for and notable different rules are found in the Code.
One of such provisions is the requirement of a minimum of three auditors under article 538(1). While
the maximum number of members of a PLC could not be more than 50 and where there is no
limitation of member size for share companies, the reason for requiring a minimum of one auditor for
share companies but three for private limited companies is illogical. The reason behind such
imposition is not clear and it obviously subjects the company to an extra expenditure for remuneration
of auditors.
Once auditors are appointed in the memorandum of association they may be re-appointed at such
periods and under such conditions as may be provided in the articles of association as provided for
under article 538(2).

321
Commercial code, Supra note 40, Art.525(2)
322
Ibid, Art.538(1)
323
Commercial code, Supra note 40, Art.538
54
This would mean that the details of re-appointment are governed by the articles of association and no
tenure limitations, competency requirements or appointment procedures in the case of share companies
are applicable to PLCs.
Auditors of a private limited company may, therefore, stay in office for a period of time which is
prolonged enough to jeopardize their independence through close relationship with management of the
audit client.
The Code also does not provide for cases of incompetency to be an auditor of a PLC neither does it
regulate auditor’s future relationship as potential employee of the company.
In such conditions, it is almost impossible to ensure the good corporate governance of PLCs through
auditors. The audit of these companies needs to be properly regulated and emphasis given to them
should not be any less than that given to share companies. This is mainly because the limited liability
status granted to a company is meant to be accompanied by a mechanism of assuring the credibility of
the financial affairs of a company which can only be provided through audit and more importantly,
such companies can be public interest entities regardless of their size.324
The notions of a ‘Reporting Entity’ and ‘Public Interest Entity’ in the Financial Reporting
Proclamation and their implication on the requirement for PLCs to appoint auditors need to be
discussed at this point.

The Proclamation under article 2(18) provides for a definition of a reporting entity as any entity, other
than public bodies and micro enterprises, required by law to submit financial reports whereas micro
enterprises are defined as enterprises the AABE will determine as such in its directives based on its
own criteria. Furthermore, reporting entities have the obligation to have their financial statements
audited as per article 9 of the Proclamation.

It could therefore be a requirement for all private limited companies to have auditors if AABE does not
disregard them as micro enterprises.

According to article 2(17) of the Proclamation, the Board could also from time to time qualify a
reporting entity that is of significant public relevance (because of the nature of its business, its size or
its number of employees) as a public interest entity. The provision clearly qualifies a company whose
securities are admitted to trading on a regulated capital market, banks, insurance companies and any
other financial institutions and public enterprises as public interest entities.

Based on these provisions, PLCs could be among those companies the Board could qualify as public
interest entities in the directives it will issue from time to time.

324
Hussein, Supra note 315, p. 193
55
AABE has not issued any directives until this point in time when the writer conducted the study.
Forthcoming directives by the Board should take into account that PLCs constitute majority of
business entities in the country and need to be strictly regulated.

4.7 The Role of Auditors in the Protection of Minority Shareholders

The protection of minority shareholders is one of the pertinent issues in ensuring good corporate
governance and the role of auditors in protecting minority shareholders in the Ethiopian context will be
discussed under this sub-section.
The concept of minority shareholder is frequently understood to mean a shareholder that does not
exercise a substantial degree of control or influence over a company’s affairs.325
Black’s law dictionary defines minority shareholders as shareholders who own less than half of the
total share outstanding and thus cannot control the corporation’s management or singlehandedly elect
directors.

The Commercial Code neither clearly defines minority shareholders nor explicitly refers to their
right.326

The OECD principles of corporate governance calls for the protection of minority shareholders and
provides that they should be protected from abusive actions by, or in the interest of, controlling
shareholders acting either directly or indirectly, and should have effective means of redress.327
It can be generally said that a legal regime which incorporates the following provides protection to
minority shareholders.328
 the right to proxy voting;
 the right of shareholders to bring derivative suits;
 cumulative voting or proportional representation of minorities on board of directors;
 pre-emptive rights of shareholders whenever new shares are issued which can be waived only
by shareholders’ vote ;
 a minimum percentage of share capital that entitles a shareholder to call ordinary general
meeting set to be less than or equal to 10 percent; and
 No compulsion of shareholders to deposit their shares prior to shareholders’ meeting.

325
Protection of Minority Shareholders in Listed Issuers, Technical Committee Of The International Organization Of
Securities Commissions (2009) p.6 , available at : https://www.iosco.org/library/pubdocs/pdf/IOSCOPD295.pdf
326
Article 352 of the Commercial Code attempts to address minority rights but the use of the term ‘shareholders with
different legal status’ lacks clarity and makes it difficult for implementation.
327
OECD Principles, Supra note 7, principle III A 2
328
Fekadu, Supra note 28, p.18
56
These being general mechanisms of protecting minority shareholders that a company law regime might
consider in extending protection to minority shareholders, it is needless to mention that the role of
auditors in protecting minority shareholders is closely related to disclosure of the company’s affairs.
This is mainly because the role of auditors as mentioned in previous chapters is verifying whether the
financial statements of the company, reports of management and the board of directors are correct and
reflects the correct state of the company.
Disclosure of a company’s affairs is one of the keys to protecting minority shareholders.329 One of the
major concerns in a company’s affairs in relation to minority shareholders that require disclosure is
related party transactions which can be abused by executives and controlling shareholders.330
Special reports prepared by auditors about the terms and conditions of such transactions are important
in equipping shareholders with sufficient information to make a judgement.331 In various jurisdictions,
external auditors provide an assurance to the board and shareholders that material information
concerning related party transactions is fairly disclosed and alert them of any significant concerns with
respect to internal control.332
The Commercial Code under article 356(1) & (2) lays down that auditors shall be given a notice on
any dealings made directly or indirectly between a company and a director and they shall submit a
special report on the dealings to the general meeting so that it may take any action it thinks fit.
The special report auditors prepare upon being notified of the dealings (disclosure) is an important tool
in shareholders’ decision making process in relation to such dealings approved by the board. In
addition to the special audit report, the requirement of approval of the dealings can also protect
minority shareholders where there exists a representation of these shareholders in the board of
directors.
However, the day to day businesses of the company are managed by the general manager who may not
be a member of the board as provided under article 348 and the Code requires auditor’s special report
only on dealings directors make with the company. The absence of a legal requirement to notify
auditors of dealings the general manager and other persons performing key management function may
make with the company either directly or indirectly could be detrimental to shareholders in general and
minority shareholders in particular.

The role of auditors in protecting minority shareholders’ interests in the Commercial Code is also
found under article 377(2) which obliges auditors to call a general meeting upon the request of

329
OECD principle, supra note 7, p.42
330
Related party Transactions, Supra note 330, p.11
331
Ibid, p. 34
332
Ibid, p.28
57
shareholders holding less than 20% of the capital. Article 368(2) also allows such shareholders to
select an auditor.
In addition to the aforementioned special rules in the interest of minority shareholders, it should be
noted that the roles and responsibilities of auditors in a company will in general benefit the entire
shareholders, minority and controlling alike.

4.9 Oversight of Auditors

The oversight of auditors and their licensing has been the role of OFAG and Civil Service College.
Their power with regard to issuance, renewal, suspension and cancellation of certificate of competence
of auditors as provided under article 5(16) & (17) of the Office of the Federal Auditor General
establishment (amendment) Proclamation No.669/2010and article 5(3) of the Civil Service College
reestablishment Regulation No. 121/2006 is repealed and entrusted to newly established bodies by the
Financial Reporting Standards Proclamation No.847/2014. The Accounting and Auditing Board of
Ethiopia (AABE) is now entrusted with licensing of auditors and the institute of certified public
accountants (not established yet) has also been given a role in the licensing and registration process.333
Continuing professional education as may be specified in Directives of the Board enacted as per
article18 (4) of AABE Establishment Regulation can enhance the role of auditors in ensuring good
corporate governance through their professional development. Furthermore, reporting entities are
obligated to submit their financial report to the AABE as per article 8 of the Financial Reporting
Proclamation broadening its oversight power.
The Board is established as an autonomous government organ having its own legal personality
accountable to the Ministry of Finance and Economic Development.334 This basing of the auditor
oversight system on a government organ is consistent with the wide international consensuses of a
system that is not based exclusively or predominantly on self regulation.

4.9.1 Overview of the Roles of the Accounting and Auditing Board of Ethiopia (AABE)
The principles for auditor oversight by IOSCO provide that a mechanism to require that auditors have
proper qualifications and competency before being licensed to perform audits, and maintain
professional competence should be put in place. A mechanism should also exist to withdraw
authorization to perform audits of publicly traded companies if proper qualifications and competency
are not maintained.

333
Financial Reporting Proclamation, 2014, Art. 18(4)(a) & Art 2(4), proc. No. 847, Neg. Gaz, year20, no.81
334
Establishment and Determination of the procedure of the Accounting and Auditing Board of Ethiopia Council of
Minsters Regulation, 2014, Art.3, Reg. No 332, Neg. Gaz, year21, no. 22
58
Consistent with this, AABE is empowered to issue directives related to the professionals including for
the acceptance or rejection of application, suspension, cancellation or renewal of certificate and
registration.335 It is also empowered its own examination and quality requirement directives.336 A
quality assurance scheme is also considered.337 The number of qualified professional accountants in
the country is too small and falls short of meeting national demand in both the private and public
sectors, including the academia.338 AABE recognizes that it needs to promote awareness of the
accountancy profession at universities and influence curricula for accountancy education to align it
with entry requirements to professional accountancy education.339 The Board’s plans to work on
enhancing qualification through influencing curricula can in turn enhance its effectiveness in oversight
of qualifications.

The other principle by IOSCO is putting in place mechanism to require that auditors are independent
of the enterprises that they audit, both in fact and in appearance. Effective standards, regular
assessments, and regulatory oversight generally increase the likelihood that independence is
maintained.

Auditors in Ethiopia shall not engage in any activity that is likely to impair their professional
independence as auditors whether independence in appearance or independence of mind.340 One of the
objectives of AABE as provided under article 5(5) of the Establishment and Determination of the
Procedure of AABE Regulation No. 332/2014 is protection of the professional independence of accountants
and auditors. However, the existing framework does not provide for effective standards to ensure
independence.

IOSCO suggests that auditors should be subjected to the discipline of an auditor oversight body that
should also have the authority to stipulate remedial measures for problems detected, and to initiate
and/or carry out disciplinary proceedings to impose sanctions on auditors and audit firms, as
appropriate. AABE under article 6(1) of the above mentioned regulation should establish a code of
conduct. It also conducts quality assurance reviews of public auditors, audit firms and persons
associated with them to determine where they have complied with applicable auditing standard. 341 As
per article 6(6) of the Regulation, AABE facilitates arbitration or conciliation to amicably resolve
disputes between professionals and their clients. It also takes disciplinary actions where appropriate as

335
Ibid, Art. 6(2)
336
Ibid, Art. 6(3)
337
Ibid, Art. 26
338
Accounting and Auditing Board of Ethiopia (AABE) Five Year Strategic Plan (Fiscal years 2016-2021), p.24
339
Ibid
340
Financial Reporting Proclamation, Supra note 333, Art. 33(1)(b)
341
Ibid, Art.4(2)(i)
59
provided in article 6(12). AABE could also initiate proceedings where its directives and the Financial
Reporting Proclamation appear to have been violated.342

Auditors are under the oversight of the AABE and the framework in place recognizes the fundamentals
of auditors’ oversight although details are not yet in place.

4.10 Auditors’ Responsibilities

In the Commercial Code, auditors have the responsibility to inform public prosecutors of any matter
which would appear to disclose the commission of an offence.343

With regard to companies engaged in the financial sector, auditors of an insurance company have a
duty to report their audit findings and conclusions to the NBE.344 They should also immediately notify
the NBE of grave irregularities and offences.345 Auditors of banks also have similar responsibilities.346
The Banking Business Proclamation No.592/2008 further provides under Sub article 3 of article 26,
which deals with duties of auditors, that a person appointed as an auditor of a bank may not operate an
account with, or be granted any type of loan, advance or facility from that bank except in the normal
course of business and at an arm’s length basis.

Auditors of micro financing institutions also have similar responsibilities of reporting irregularities and
offences. 347 They should also submit to the NBE their audit findings and conclusions.348

According to article 31 of the Financial Reporting Proclamation No.847/2014, auditors, both public
and certified, should notify the officers and all members of the board of the reporting entity they audit
of any material irregularity and unless they are satisfied that no such irregularity has taken place or the
board of the entity have taken adequate steps to remedy the irregularity, they should report to the
AABE within 30 days from the time of issuance of the notice to the board of the company.

According to article 33 (1) (b) of the Financial Reporting Proclamation, an auditor should not engage
in any activity that is likely to impair his professional independence as an auditor whether
independence in appearance or independence of mind.349 However, From the reading of article 33 (2)

342
Ibid, Art. 38
343
Commercial code, Supra note 40, Art. 376(1)
344
Insurance Business Proclamation, Supra note 318, Art.30
345
Ibid, Art.31(5)
346
Banking Business Proclamation, Supra note 317, Art. 27(4)
347
Micro-financing business Proclamation , Supra note 319, Art.13(5)
348
Ibid, Art. 13 (1)
349
Article 33(6) of the Financial Reporting Proclamation No. 847/2014 defines independence of mind as the state of mind
that permits the provision of opinion without being affected by influences that compromise professional judgement,
allowing an individual to act with integrity, and exercise objectivity and professional scepticism. Independence in
appearance on the other hand means the avoidance of any fact or circumstance creating on an informed and reasonable
60
of the Proclamation, it can be understood that an auditor or his partner or any person employed by him
or any person working under his supervision and control or under the supervision and control of his
partner is not effectively prohibited from keeping the books, records or accounts of an audit client.
Participation in the book keeping will undoubtedly give rise to auditing one’s own work.350 Such
participations should be absolutely prohibited non audit services and excluded even under those
categories impliedly permissible upon disclosure.

With a view to maintain the independence of auditors, the Proclamation under article 34 also obliges
auditors(both individuals and audit firms) to withdraw from auditing any reporting entity when they
consider that it may have a conflict of interest or lack professional independence.

4.11 Auditing Standards

Auditing standards have a role in ensuring that factors such as objectivity, integrity and independence,
factors which are essential in the external auditor’s performance of his/her responsibilities are
respected.351
This being the case, the implementation of auditing standards is dependent on accounting standards in
use.352 The quality of accounting standards along with other institutional factors such as the existence
and enforcement of laws governing investor protection also affects the quality of financial
information.353
Despite the impact of accounting standards on the quality of financial information and the impact of
auditing standards on the external auditor’s performance of his/her responsibilities, the Commercial
Code has no requirement for compliance with accounting and auditing standards. 354
The Financial Reporting Proclamation No. 814/2014 aims to rectify the absence of requirement for
compliance with accounting and auditing standards in the Commercial Code and other laws by
repealing provisions of the Code pertaining to financial reporting and introducing a new set of
financial reporting standards and auditing standards.

Article 5 of the Proclamation provides that applicable financial reporting standards to be used when
preparing financial statements shall be standards issued by the International Accounting Standards

observer the impression that the integrity, objectivity or professional scepticism of a firm or member of an audit team has
been compromised.
350
Martin, Supra note 194, p.61
351
Marianne, Supra note 22, P. 7
352
Ethiopia – Accounting and Auditing Report on the Observance of Standards and Codes, (2007),P.12 available at:
www.worldbank.org/ifa/rosc_aa_ethiopia.pdf
353
Marianne, Supra note 22, P. 7
354
Ethiopia- Accounting and Auditing Report, Supra note 352 p.1
61
Board, the International Public Sector Accounting Standards Board or their successors. The provision
also empowers the AABE to adapt or amend any of the standards.

These reporting standards are:

 International financial reporting standards;

 International financial reporting standards for small and medium enterprises ;and
 International public sector accounting standards applicable to charities and societies.

In addition to determining financial reporting standards that should be used in preparing financial
statements, the Proclamation under article12(1) stipulates that the auditing standards to be used by
auditors in Ethiopia shall be the International Standards for Auditing issued by the International
Federation of Accountants or its successor as adopted, adapted or amended by AABE.

The absence of requirement for compliance with accounting and auditing standards both in the
Commercial Code and other laws and the problems associated therewith can therefore be rectified by
these rules in the Financial Reporting Proclamation.

4.12 Concluding Remarks and Recommendations

4.12.1 Conclusion
Corporate governance is defined differently by authors in different disciplines. The concept is eclectic
and a pressing issue given the impact of corporations in various aspects of human affairs. The
different privileges companies enjoy exclusively call for a greater transparency and accountability.
Audit has been a mechanism of monitoring management performance and check and balance system
since the industrial revolution to aid in ensuring the accountability of corporations. The concept and
scope of audit has developed over the years and has gained the status of corner stone in the governance
of companies.

The impact of auditors’ role in corporate governance has been brought to the forefront after the
collapse of big companies like Enron. Although such debacles revealed auditors have failed to
discharge their professional responsibilities, their role in corporate governance remains undoubted.
The response to the collapse of companies has thus been reforming corporate governance systems and
legislation on the role of auditors in companies and putting in place a strong oversight body on
auditors and the auditing profession.
In discussing the role of auditors in corporate governance, both internal and external auditors have
significant roles and the latter will benefit from the work of the former and should decide on how to
62
make use of it and the extent of reliance on such works. Although internal audit contributes
significantly to corporate governance, the external auditors are in a better position to provide the
necessary check on a company’s management and board of directors. The role of auditors in ensuring
good corporate governance thus mainly refers to audit through external auditors.

The very concept of audit is founded on checking whether works subject to the audit conform to a
certain set of standards that serve as an objective standard. Audit has historically emerged on the
conception that managers can not be judges of their own work. This shows that the effectiveness of
auditors is inherently related to their independence and objectivity. Literatures on audit provide that
the auditing profession can not exist in the absence of independence from the body subject to audit.

Taking this into account, corporate governance systems and legislative reforms in different countries
conducted with the view to ensure good corporate governance through auditors revolve around
ensuring the independence of auditors. The oversight of auditors and the auditing profession are
equally based on objectivity and independence.

To ensure good corporate governance through auditors, their independence is considered by different
corporate governance mechanisms from the start of their duties, i.e. from the hiring process to the
accomplishment of their duties and even after the termination of their services.
The most prominent legislation and documents dictating the subject of corporate governance like the
OECD principles, the SOX, King Report on Corporate Governance for South Africa, the Cadbury
report, and the UK Corporate Governance Code all stress on the independence of auditors to ensure
good corporate governance through them. Requiring transparency from auditors is also recognized as
an important measure to ensure good governance of companies. The writer has relied on these
documents in conducting this work.

Ensuring that auditors are not subjected to the hire and fire power of management is the first step that
is taken to enhance their role. When managers are empowered to hire and fire auditors, their
independence is greatly endangered. The placement of external auditors in the presence of internal
audit function within a company is basically the search for auditors free from control by managers.
The selection of auditors by the company’s members (shareholders) is intended as a solution to this
problem and is a common trend across the world. However, a requirement that auditors be appointed
by shareholders has not been sufficient to ensure their independence. Recent developments try to
ensure that managers do not get involved in the appointment process. The SOX requires appointment
of auditors of public companies by audit committees of independent directors while UK Corporate
63
Governance Code requires auditors be recommended by independent committee ( audit committee ) to
the board of directors for presenting it to appointment by shareholders. The board of directors is
required to provide justifications for any rejection of the recommendation by the board of directors.

Excluding auditors affiliated to certain shareholders, directors, managers, and employees of a company
from the audit of such companies is the other prominent method of ensuring auditors’ independence
thereby their role in ensuring good corporate governance. The degree of relationship that is taken as a
cause for the ‘incompetency’ of auditors varies among different countries but all of them have
ensuring objectivity of the auditor at the heart.
A regulation of non audit services auditors may provide to their audit client is the other measure with
similar objective. An absolute ban on provision of such services is believed to be detrimental to the
company and not advocated for to ensure good corporate governance. Services that could jeopardise
the auditor’s independence because of their nature are identified and prohibited by law. The SOX has
list of services that auditors may not give to their audit client. Other non audit services are subjected to
the approval by independent subcommittee of the board in case of unitary board structure and by
supervisory boards in where two tire board systems exist. An obligation to disclose fees paid for non
audit services is also devised to ensure the independence of auditors and also enable creditors and
investors in general to gauge the reliability of auditor’s reports.
This also assists oversight bodies to take appropriate measures.
Audit tenures are regulated by the law to prevent auditors from creating close friendship with
management of the company and end up covering for any fraud or irregularity they should reveal in
their reports or to the management itself. Different timeframes exist among countries in this regard.

The control of personnel flow is the other technique in upholding the objectivity of auditors. Company
laws ensure that cooling periods are in place for auditors to become high level employees of their audit
client. Likewise, managers, financial officers or directors are required to follow cooling period before
they become the auditor of the company they served in that capacity.
Mechanisms that are designed to ensure corporate governance through auditors once they are elected
to carry out audit also involve imposing an obligation to conduct audit in accordance with high quality
auditing standards, work closely with internal audit and audit committees, and oblige them to report
irregularities to the board of directors or management and sever cases to regulatory bodies.
The subjection of the audit profession to government regulation rather than self regulatory regime is
the other important step countries have taken to ensure good corporate governance through auditors.

64
This work appraised the Ethiopian legal regime governing auditors to see if it enables ensuring good
corporate governance through them. The writer has analysed the Commercial Code provisions on
auditors, Proclamations enacted to govern the financial sectors and subsequent directives, the Financial
Reporting Proclamation and the regulation enacted under it in the appraisal.

The Ethiopian legal regime was appraised in light of developed corporate governance principles and
laws. The laws have mechanisms to safeguard auditors’ independence and objectivity which are in
essence similar to prominent corporate governance systems of other countries.

However, the details of the laws do not address the issues they ought to resolve adequately. With
regard to the election auditors, the Commercial Code provisions only provide that they shall be elected
by shareholders in case of share companies and members in case of PLCs. Other stipulations that
ensure managers do not involve in the election are not provided. The appointment of auditors of
companies in the banking and insurance sectors are on the other hand subjected to the approval by the
regulatory body of the sector, the NBE, which may add to the good corporate governance of such
companies. A directive by the NBE has also introduced audit committees into the governance of such
companies. Although the roles of the committee is similar with other systems where the concept is
well developed, audit committees in companies engaged in the financial sector in Ethiopia lacks the
very essence of audit committees which is independent members.
Although PLCs can not be as large as share companies in terms of members’ size generally, they can
be of public interest as a result of the amount of money involved in running their business and the
limited liability privilege they enjoy. However, the Commercial Code does not have detailed rules
governing their auditors as in the case of share companies. Neither does it provide a mutatis mutandis
application of the provisions on share companies.
Incompetency of becoming an auditor of a company on the ground of affiliation is also found in the
Commercial Code and Proclamations on the financial sector. The writer believes the relationships the
legislator took into account to draw the incompetency scope on the basis of familial relationships need
to be changed taking in to account the present day society and mainly practicality. Relationships of
affinity or consanguinity to the fourth degree under the Code can be difficult for implementation. On
top of that the Code does not impose proactive measures to ensure such auditors do not involve in the
audit of the company.
Non audit services that could impair auditors’ independence are not identified and prohibited. The
Commercial Code does not have adequate rules on this regard and s does not tackle potential
impairment of independence and objectivity.

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The banking and insurance sectors Proclamations add to the Commercial Code prohibitions and
exclude auditors affiliated to employees of the institutions either by affinity or consanguinity up to the
second degree from becoming auditors of such companies.

The setting of audit tenure and control of personnel flow are also found in the Commercial Code. A
maximum of 4 years is provided for auditors of share companies but the tenure of auditors of PLCs is
not set by the law. Personnel flow limitations in the form of a cooling period is available only with
regard to auditors who want to become directors or managers of their audit client. The reverse of the
situation and enrolling in other financial positions are nevertheless unregulated.

The Financial Reporting Proclamation has brought new developments in audit and corporate
governance and requires independence of mind and appearance from auditors. Some of the provisions
however do not uphold the independence of auditors as the writer noted. It has done away with the
problems associated with the absence of auditing standards and also laid the foundation an auditor a
governmental oversight body, AABE. The board has powers that an auditor oversight body should
have as recommended by IOSCO. However, as it is a newly established entity, it has not yet enacted
directives on the issues it is empowered to regulate. Even though the Financial Reporting Proclamation
has introduced changes in accounting and auditing standards, financial reporting processes and
oversight of the auditing profession, it is auditors appointed in accordance with Commercial Code that
will audit Ethiopian companies.355 The proclamation repealed the Commercial Code’s provisions
pertaining to financial reporting only and other provisions remain operative.

The writer has analysed the existing legal regime governing the roles of auditors in Ethiopia in light of
well developed corporate governance Codes and principles and considers the following
recommendations appropriate in ensuring good corporate governance of Ethiopian companies.

4.12.2 Recommendations
It has been said that the foundations for ensuring good corporate governance through auditors
generally exist. The Commercial Code is under revision and the newly established Accounting and
Auditing Board of Ethiopia which is empowered to issue directives on wide range of issues concerning
auditors is expected to come up with new directives. So it should be seen to it that the reforms ensure
independence of auditors and enhance their role in the good governance of Ethiopian companies.

355
Financial Reporting Proclamation, Supra note 333, Art. 10(1)
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 The rules on the appointment of auditors of share companies should provide in detail how auditors
should be presented to the shareholders’ meeting for appointment. The processes preceding the
presentation of auditors for appointment by shareholders should explicitly prohibit the
involvement of managers.
 Companies that the AABE is expected to qualify as pubic interest entities should be made to have
audit committees. Although the concept of non executive/independent directors does not exist in
the law, members of the audit committee should be subjected to certain criteria of independence.
Requiring a certain degree of independence from members of existing audit committees of
companies in the financial sector and audit committees in other companies for the future will
enable the companies to fully benefit from such committees. The board chairperson should also be
prohibited from becoming a member of an audit committee.
 With regard to non audit services, the legislature should prohibit auditors from providing to their
audit clients non audit services that may compromise their objectivity. (the SOX may be taken as
guideline).
 The Financial Reporting Proclamation No.847/2014 which is permissive of the rendering of book
keeping services under article 33 should be amended to leave no room for provision of such
services by auditors.
 The independence of auditors can be enhanced and good corporate governance can be ensured
through them if the personnel flow rules imposing three years wait on auditors before becoming
managers and directors of the audit client under the Commercial Code are rephrased to include not
only becoming managers and directors but also financial officers.
 A cooling off period should be provided for ex directors, ex managers and ex financial officers of
a company if they wish to become auditors thereof.
 Another point that should be considered is the incompetency scope for becoming an auditor for
financial sectors. Such limitations have in mind ensuring the auditors’ independence and
objectivity and they should be geared towards this purpose. A company’s choice of auditor should
not be unnecessarily limited and restrictions should also be possible to implement. The limitations
in these laws which are based on relationships of consanguinity and affinity to employees should
be narrowed down to employees significantly contributing to the book keeping, and preparation of
documents the auditor is bound to certify. Auditors should also be made to make a declaration that
they are not excluded by such incompetency rules with sanction for any false declaration.
 As long as audit is considered a necessity for share companies, the legislator should ensure that
the audit conducted best contributes for the company and other stakeholders. Therefore,

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 incompetency scope for becoming an auditor for financial sector, once the aforementioned
amendment is made, should be applicable to share companies and PLCs in the other sectors.
 With regard to PLCs, the Commercial Code provision requiring them to appoint a minimum of 3
auditors should be revised and the minimum number of auditors should be reduced to 1.
 The minimum rules on audit tenure and incompetency of PLCs should be set by the law in a
fashion similar to share companies and not be left among matters to be determined under the
memorandum of association.
 The criteria for the exemption of PLCs from appointing external auditors should be shifted from
members’ size to financial status and employee size as in the case of the UK Company Act.
 Personnel flow restrictions similar to share companies need to be put in place where PLCs have
external auditors.

68
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