Corporate Ownership & Control / Volume 5, Issue 1, Fall 2007

ROLE FOR AUDITING IN CORPORATE SOCIAL RESPONSIBILITY AND CORPORATE GOVERNANCE: UNDER NEW CORPORATE VIEW

Ryuuichiro Kurihama*

Abstract

Auditing plays a key role in Corporate Social Responsibility (CSR) and corporate governance. Auditing is essential to corporations and society because it is a medium to build a good relationship between corporations and stakeholders. However, a role for auditing in CSR and corporate governance has not been adequately discussed under new corporate view. This paper clarifies the relationship between CSR, corporate governance and auditing, and reexamines a role for auditing in CSR and corporate governance through the discussion of the relationship between corporations and society as recently brought up concerning CSR. This is necessary in order to think the view of how corporations and auditing should be toward rebuilding public trust.

Keywords: Corporate Social Responsibility (CSR), Corporate Governance, Auditing, Fiduciary duties

* Ph.D., Associate Professor of Accounting and Auditing, Graduate School of Accounting , Aichi University, Japan, Tsutsui 2- 10-31, Higashi-ku, Nagoya-shi, Aichi, 461-8641, Japan, E-mail: [email protected] / [email protected].

1. Introduction governance, and considers the core concept of corporate governance designed to ensure the In recent years, Corporate Social Responsibility implementation of CSR. Section 4 examines how (CSR) (see endnote 1) has attracted growing attention, auditing contributes to the system of corporate and has become one of the key topics. CSR has an governance as well as how auditing must be changed effect on the conventional views of how corporations, under new corporate view. Section 5 concludes. market and society should be. CSR also has an impact on auditing, because the concept of auditing has been 2. Impact of CSR on Corporations: changing over time as people’s views of corporations corporations and society and society change. Auditing is a social institution that is loosely linked with society through interaction. 2.1 Today’s CSR Although it is said that auditing is an essential element of the system of corporate governance, a role CSR has been discussed since a long time ago. In the for auditing in CSR and corporate governance traditional context, each corporation has a social designed to ensure the implementation of CSR has not responsibility toward its shareholders, placing great been adequately discussed under new corporate view. importance on its relationship with them. Under such This paper clarifies the relationship between circumstances, CSR means boosting profits by CSR, corporate governance and auditing, and producing and providing quality products and reexamines a role for auditing in CSR and corporate services, and paying as large amounts of taxes as governance through the discussion of the relationship possible. Therefore, it has been considered that the between corporations and society as recently brought function of corporations is to maximize profits for up concerning CSR. And it examines how auditing their own shareholders. However, corporations contributes to rebuilding the mutual trust of nowadays can no longer accept uncritically such a corporations and society as well as how auditing must view of CSR. be changed in line with CSR. This is necessary in With corporate globalization and the IT order to understand the concept of society, revolution accelerating, and with corporate misdeeds corporations and auditing today, and to think the view and scandals (see endnote 2) more frequent, greater of how corporations and auditing should be toward attention has been focused on CSR in recent years. rebuilding public trust. Social demands for corporations change with the This paper is structured as follow. Section 2 times, and social reactions to corporate behaviors are argues changing corporate view through the also becoming more extensive and/or faster. discussion of CSR, and reviews a relationship not Particularly, many recent corporate misdeeds and only between corporations and shareholders but also scandals have resulted in loss of public trust in between corporations and stakeholders. Section 3 corporations and a growing sense of uncertainty clarifies a relationship between CSR and corporate among people. For example, according to a survey of 109

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Price Waterhouse Coopers (2003), 52 % of the CEOs CSR itself. In order for a corporation to build and interviewed answered that public trust in other maintain the relationship of trust with society, corporations has declined (see endnote 3). Rebuilding emphasis should be placed on “what needs to be done the public trust they have lost is their prime task (see to work things out” or “minimum things to do” rather endnote 4). than on “what to do to be successful (see endnote 8).” The new corporate investment of Socially Therefore, controlling the negative aspect of Responsible Investment (SRI) has an impact on the CSR is a minimum requirement for corporations to market as well as corporations. SRI represents maintain the relationship of trust with society. There investors’ efforts to systematically evaluate have been numerous cases in which corporations have corporations in terms not only of their economic lost public trust because they cannot control the aspects but also of their social, human, and negative aspects. It may be possible to distinguish the environmental aspects while making full use of positive aspect as a voluntary one from the negative market mechanisms. At the same time, there is a trend aspect which is mandatory. In short, the negative on the market side that, instead of emphasizing aspect of CSR is a necessary condition while the economic efficiency, market includes the social, positive aspect is a sufficient condition. Hence, CSR human, and environmental aspects when evaluating is a necessary and sufficient condition for corporations. In response to these changes, the way of corporations to be trusted by society. evaluating corporate value is also changing. Each Each corporation must control the negative aspect corporation is now under pressure to balance the of CSR first in order to restore public trust although it above four aspects. may be insufficient for today’s CSR. Under such circumstances, the issue of CSR needs to be discussed in terms of what benefits 2.3 Corporations and society: relationship corporations bring to society in the 21st century and with shareholders (see endnote 9) for whom they exist (see endnote 5). CSR can be defined as efforts aimed at realizing sustained As is well known, Milton Friedman viewed the corporate value-creation and a better society through corporations in a free market as follows: the erection of mechanisms for synergetic “There is one and only one social responsibility development of corporations and society (Japan of business – to use its resources and engage in Association of Corporate Executives, 2003, p.7) (see activities designed to increase its profits so long endnote 6). This requires reconsideration of the as it stays within the rules of the game, which is relationship between corporations and society in the to say, engages in open and free competition discussion of today’s CSR, since this relationship can without deception or fraud” (1962, p.133) influence the views of corporations and others. In a free market, CSR means to increase profits, and corporate value is mainly measured by economic 2.2 Dual aspects of CSR efficiency. Specifically, CSR means to increase profits by producing and selling quality products Although CSR varies depending on the country, and/or services, while also paying as large amounts of region, and corporation, it basically has two aspects: taxes as possible, which in turn enrich the government positive aspect and negative aspect (Taka etc., 2002, and other stakeholders. Therefore, each corporation pp.17-18) (see endnote 7). CSR serves to maximize places greater emphasis on the relationship with the positive aspect. The positive aspect is something shareholders and bears social responsibilities toward that positively affects society, and includes social them. Under such conditions, CSR means to contributions, volunteer activities, philanthropy (pro maximize shareholder value. bono activities), and others performed by corporations Why do corporations place great emphasis on the which are not just compliance with laws and relationship with shareholders? To answer this regulations. This aspect boosts corporate question, there is a neoclassical theory on the profit- competitiveness. maximizing principle of corporations. That is, a On the other hand, CSR controls the negative corporation is a kind of private property owned by its aspect. The negative aspect is something that shareholders, whose agents are the managers of the negatively affects society, and includes corporate corporation. Therefore, their only responsibility is to fraud, violation of laws and regulations, and deviation maximize profits for the shareholders. In this context, from social norms. This aspect prevents corporate if the managers attempted to fulfill CSR for other misdeeds and scandals. stakeholders rather than their own, it would disrupt CSR is said to be voluntary and autonomous the free market system. initiatives of corporations. In CSR, both the positive Even now, maximizing shareholder value leads to and negative aspects are equally important. However, the improvement of corporate value, and ultimately to the positive aspect of CSR cannot be promoted the enrichment of society as a whole. The relationship without being able to control the negative aspect. No between the corporation and society can be reduced to matter how each corporation promotes the positive the relationship between managers (see endnote 10) aspects, it will lose public trust unless it controls the and shareholders. Thus, each corporation only bears negative aspect, thus decreasing the significance of social responsibilities toward shareholders. This view 110

Corporate Ownership & Control / Volume 5, Issue 1, Fall 2007 is mainly discussed regarding corporate governance in also stakeholders in the broad sense who provide the the U.S as described later. environment for corporate activities are, in a way, capital suppliers for the corporation (Schlossberger, 2. 4 Corporations and society: 1994). This means that stakeholders in the broad relationship with stakeholders sense bear some risk by being involved in corporate activities. From this standpoint, the managers have Corporations are social institutions or public fiduciary duties toward the stakeholders. Thus, it can institutions of society in that they are recognized and be concluded that corporations as public institutions approved by society. This view differs from the of society bear social responsibilities toward the position that corporations are a kind of private stakeholders in the broad sense (hereafter called property based on the contractual relationship among stakeholders). individuals. If corporations were regarded as public CSR is whole management, and is associated institutions of society, it would be necessary to with the integrity of management. This is related to reconsider the conventional corporate view as well as corporate philosophy, corporate culture, and corporate the traditional relationship between corporations and ethics, and obviously to the integrity of managers society. Therefore, it would be necessary for each and/or managers’ fiduciary duties. CSR requires that corporation to switch its focus from the relationship managers sufficiently explain corporate efforts toward with its shareholders for whom it maximizes profits to rebuilding the trust of relationship between the stakeholder model (Freeman, 1983; Freeman and corporations and society to stakeholders. Today, each Reed, 1983; Donaldson and Preston, 1995; Evan and corporation needs to redefine exactly the view of Freeman, 1998 etc.) where the shareholders are corporation should be and the monitoring and check regarded as part of the stakeholders. The stakeholder system of corporation in order to rebuild public trust. model provides an important framework for Consequently, under the stakeholder model, examining the relationship between corporations and corporations as public institutions of society are to society. The scope of the stakeholder model is either bear social responsibilities toward their stakeholders narrow or broad (Freeman and Reed, 1983, p.91). In and eventually each person. the narrow sense, stakeholders are any identifiable group or individuals on whom the organization is 3. CSR and Corporate Governance dependent for its continued survival. In the broad sense, they are any identifiable group or individuals 3.1 Relationship between CSR and who can affect the achievement of an organization’s corporate governance objectives or who are affected by the achievement of an organization’s objectives. Corporate governance is a system designed to ensure Today’s CSR places great importance on the sustained corporate growth and development, proper relationship with stakeholders, regarding the decision-making on management policies based on relationship between corporations and society as the the implementation of more efficient and better relationship between corporations and stakeholders, management, and the appropriate supervision, with many of the discussions based on the broad sense evaluation and motivation of corporate executives in of stakeholders. In fact, most recent reports on CSR the execution of their businesses (Japan Association view the relationship between corporations and of Corporate Executives, 2003, p.50). There are two society as the relationship between corporations and requirements that must be met if a corporation is to stakeholders in the broad sense. Social context also is fulfill its social responsibility while also improving its very important because each stakeholder’s behavior competitive position (ibid, p.50). First, it must can vary depending on the social context or social establish certain principles which define the general circumstances. However, the concept of stakeholders direction that it will take. Second, it must develop a in the broad sense gives rise to numerous issues (see system to ensure the implementation of these endnote 11), including the difference in stake among principles at all times; in other words, it must stakeholders, their priorities, and the problem of establish a system of corporate governance. Corporate managerial discretion. governance has functions both enhancing corporate To help solve these problems, some consider that competitiveness and preventing corporate misdeeds any stakeholders who bear some form of the risk (for and scandals. Each corporation has to strengthen example, business risk etc.) by being involved in corporate governance on condition that they focus on corporate activities can be regarded as the CSR. stakeholders being involved in the corporation, even Corporations must control the negative aspect of though the stakes vary from stakeholder to CSR first in order to restore public trust although it stakeholder (see endnote 12). Corporations are public may be insufficient for today’s CSR through the institutions approved by society. In the broad sense, discussion of CSR. Literally, corporations need to stakeholders entrust the management of a corporation strengthen corporate governance in order to control to the managers, because there is a wide gap in the negative aspect of CSR. Corporate governance knowledge and capability between managers and today is regarded as a system designed to promote stakeholders. In addition, not only shareholders but CSR and to ensure sustained corporate growth and 111

Corporate Ownership & Control / Volume 5, Issue 1, Fall 2007 development. Thus, each corporation has to establish Therefore, every contract must conform to the the system of corporate governance from the principles of both self-interest and self-responsibility. viewpoint of CSR, and needs to reexamine the system In a certain contract, the contracting parties enter of corporate governance with more emphasis on the into an agreement after specifying and understanding relationship with its stakeholders. the details of the contract. In this case, the contracting A big issue is that a structure of corporate parties, who equally pursue their own interests, are in governance becomes a mere façade. In short, it is an equal relationship. Therefore, each party focuses important that each corporation establishes the system on its own interest and has no obligation to consider of corporate governance designed to ensure the the other party’s interest. Conversely, neither party implementation of CSR which function effectively has the right to ask the other party for such regardless of the style of corporate governance consideration. structure. For example, each corporation needs to This contractual relationship can be reduced to establish stakeholder engagement or stakeholder an agency relationship. The agency relationship is management, corporate philosophy and culture, equal to a contractual relationship built by principals management system, internal control system, risk and agents on their own free will. It is assumed that management system, compliance system, the system both principals and agents are rational economic men, of discloser and accountability, and auditing system and that there exist an asymmetry of information (an etc (see endnote 13) as integrant and element parts in imperfection of information) as well as conflicts of the establishment of the system of corporate interest between them. Under such circumstances, a governance designed to ensure the implementation of moral hazard of agents is likely to arise, and in order CSR. Therefore, the commitment of managers and the to avoid the resulting loss, agency costs (see endnote monitoring and check of managers’ decision-making 16) also inevitably arise. Therefore, it is extremely and behaviors is very important. important to consider how the behaviours of agents The key is that corporations need to constantly can be monitored and controlled. Specifically, greater improve the system of corporate governance attention is focused on how incentive contracts should according to the changes in the times and society with be designed so that agents behave appropriately. In a full understanding of the core concept of corporate short, a key issue for both principals and agents is to governance designed to ensure the implementation of make optimum contracts. Both parties pursue their CSR (so-called Japanese ‘Kaizen’). own interests through contracts, and naturally bear Consequently, we think the core concept of self-responsibility. corporate governance based on the viewpoints of Furthermore, contractual relationships mostly stakeholders in following sections 3.2 and 3.3. preclude public intervention by, for example, judicial organizations, because contracts are regarded as a 3.2 Contractual or agency relationship private autonomy which is formed through the and corporate governance: corporate view agreement of the parties involved, where the freedom of contract is highly respected. However, when the All corporations are an artificial person and/or a legal balance of a contractual relationship is disrupted due person, and therefore require someone (representative to an asymmetry of information, public intervention is organ) who (which) will make decisions on the sometimes necessary to restore the original equal corporation’s behalf and be responsible for managing relationship. Hence, this asymmetry of information in the corporation. contracting parties is considered as an important issue For whom do managers manage the corporation in a contractual or agency relationship. and to whom are they responsible? Consequently, managers as the shareholders’ It is commonly thought that managers are agents make a contract with shareholders as principles shareholders’ agents based on agency contracts and who own the corporation and are expected to are only responsible to the shareholders. Corporations efficiently manage the corporation as an agent of the are regarded as simply legal fiction that serves as a shareholders as principles in the corporate view nexus for a set of contracting relations among discussed in a contractual or agency theory. individuals (Jensen and Meckling, 1976, p.310). It is Therefore, the manager’s primary duty is to manage also viewed as a kind of private property. This is the corporation most efficiently to maximize profits based on the corporate view discussed in a contractual for the shareholders (see endnote 17). In this context, or agency theory. if the manager were to behave against the Contract is based on the principles of self- shareholders’ will, such a behavior would be regarded interest and self-responsibility (Jensen and Meckling, as inappropriate, and would therefore constitute a 1976; Frankel, 1983; Hodgson, 1988; Easterbrook and breach of contract. Fischel, 1991; Iwai, 2002 etc.) (see endnote 14). The In recent discussions on corporate governance, contract theory assumes that contracting parties are the mainstream view is that of maximizing rational economic men who try to maximize their own shareholder value. This view is mainly discussed profits (see endnote 15). In this contractual regarding corporate governance in the U.S. The issue relationship, the pursuit of self-interest is inevitably of governance for managers is to design incentives to accompanied by the principle of self-responsibility. ensure managers as agents behave properly toward 112

Corporate Ownership & Control / Volume 5, Issue 1, Fall 2007 shareholders. The best example of such incentives is entrusters’ trust and confidence, some kind of duty stock options as rewards for the managers. Even now, needs to be imposed on entrustees. In other words, the maximizing shareholder value leads to the entrustees must have ethical duties, or fiduciary improvement of corporate value, and ultimately to the duties, toward the entrusters. The fiduciary duties and enrichment of society as a whole. The relationship the abuse of authority or negligence are a twin between the corporation and society can be reduced to concept. The fiduciary duties impose some sort of the relationship between managers and shareholders. ethics on entrustees. However, corporations are not private entities Since ethics is a scarce resource, legal based on contracts with individuals but are social restrictions are deemed necessary to maintain institutions or public institutions of society. entrusters’ trust and confidence. Specifically, some Therefore, the social responsibilities as well as form of public intervention by judicial organizations sustainability of corporations are the greatest concerns or others is essential in a fiduciary relationship. In our of society. Corporate misdeeds, scandals, and society, for example, the concepts of “Checks and subsequent bankruptcy have an enormous impact on Balances” are widespread, and so public intervention public trust because they may lead to unemployment, is often implemented to prevent the abuse of authority economic damage, financial shock, the collapse of and negligence by entrustees. The core duties of existing business channels, and social confusion loyalty and due of care are also legally defined. (Drucker, 1950) (see endnote 18). In reality, there is Therefore, it is a key issue to consider how public no contractual relationship between managers and intervention should be implemented to maintain shareholders, and managers are not shareholder’ fiduciary relationships. agents (Boartright, 1991) (see endnote 19). These In actual corporations, corporations as public facts indicate that managers do not act on behalf of institutions of society place great importance on the the shareholders alone, and that the relationship relationship with society and/or stakeholders. between corporations and society cannot be reduced Stakeholders entrust the management of the to a contractual relationship between managers and corporation to its managers because there is a wide shareholders. If managers are not the agents of gap in knowledge and capability (a wide gap in shareholders, for what purpose do they exist, and to information processing ability) between managers and whom do they owe what obligation? stakeholders. This is a fiduciary relationship between managers and stakeholders which is different from a 3.3 Fiduciary relationship and corporate contractual relationship. In the relationship between governance: corporate view corporations and society, greater emphasis is placed on such a fiduciary relationship. Managers are the corporation’s “fiduciaries” (Iwai, Building up public trust has been a prime task of 1999; 2002). Fiduciaries are those who have been corporations in recent years, because, as is well entrusted by others to perform certain duties on their known, their misdeeds and scandals have eroded the behalf (Frankel, 1983; Iwai, 1999; 2002; Higuchi, trust of society. CSR is one of their initiatives to 1999 etc.) (see endnote 20). Unlike a contractual or restore trust and confidence. In order to achieve this, agency relationship, in a fiduciary relationship one corporations must at least control the negative aspect party is entrusted by the other party to perform certain of CSR. It is also important for managers to fulfill tasks on its behalf. If the parties involved cannot build their fiduciary duties in order to maintain the fiduciary a contractual relationship, or otherwise there exist an relationship with society (see endnote 21). Fiduciary asymmetry of information as well as a wide gap in duties are the duties that have been entrusted to information processing ability between the two someone to perform only for entrusters. Of the parties, one party (entrustee) must be entrusted by the fiduciary duties, the most fundamental ones are “the other party (entruster) to perform them. A fiduciary duty of loyalty,” “the duty of care,” and relationship is, in other words, a dependency “accountability.” The duty of loyalty requires relationship which is built especially when there is fiduciaries to loyally perform their duties only for the inequality between the two parties, such as an entrusters’ interests rather than their own. The duty of asymmetry of information and a gap in information care requires fiduciaries to perform their duties with processing ability, where the entruster grants a certain proper care even if performing such duties is not degree of authority to the entrustee to perform certain beneficial to them. Accountability requires fiduciaries tasks. Thus, maintaining the entruster’s confidence is to explain business details to the entrusters. Of course essential in a fiduciary relationship. Therefore, the providing information is not enough in it. These three concept of a fiduciary relationship is essentially impose some sort of integrity and ethics on them. The different from that of a contractual relationship. Enron and WorldCom cases in the U.S., the Royal In order to maintain such a fiduciary relationship, Ahold case in Holland, the Parmalat case in Italy, the entrustees require ethics, which includes loyalty, Kanebo and Livedoor cases in Japan and so on of integrity, and the due of care Abuse of authority and corporate fraud are excellent examples of managers negligence by entrustees may greatly damage the who disregarded their fiduciary duties. This is because interest of entrusters, and, indeed, this often happens. a fiduciary relationship includes the problem that In order to avoid this situation and maintain 113

Corporate Ownership & Control / Volume 5, Issue 1, Fall 2007 managers hold a delegated power that is susceptible to managers’ behaviors should be monitored and abuse (Frankle, 1983). controlled. Corporations bear social responsibilities toward In order for shareholders to check and control stakeholders while managers are the fiduciaries of managers’ behaviors, information disclosure or corporations. Therefore, the managers have fiduciary financial statements need to be provided to the duties toward the stakeholders. Fulfilling fiduciary shareholders. Armed with such information, duties is essential if managers are to gain the trust of shareholders can effectively monitor and control the society. Fiduciary duties are the core of corporate managers’ behaviors. However, such financial governance designed to ensure the implementation of statements may be inaccurate, or falsified CSR. In order for corporations to fulfill CSR and for intentionally by the managers. It is virtually them to be trusted by society, the managers must not impossible for the shareholders to directly check the only fulfill fiduciary duties, but also be checked about credibility of financial statements. When the whether they are performing such duties managers provide financial statements, they are most appropriately. Actually, the “duty of loyalty”, “the likely to agree to provide evidence that the due of care”, and “accountability”, which are the most information has been carefully prepared to avoid fundamental ones of fiduciary duties, are also legally accidental errors and has been free of intentional defined. Public intervention is regarded as necessary manipulation (Jensen and Meckling, 1976; Wallace, and is implemented in actual governance. In other 1980, p.19) (see endnote 22). Therefore, independent words, as above stated, human integrity and ethics are auditing is necessary as an effective means of a scarce resource, and therefore the behavior of enhancing the credibility of financial statements. managers must be monitored and checked in order to Independent auditing serves to reduce agency costs maintain a fiduciary relationship. which inevitably arise from an agency relationship between managers and shareholders. 4. Changing corporate view and auditing Thus, independent auditing has been introduced to support a good agency relationship between 4.1 Conventional view of independent managers and shareholders (support of a contractual auditing relationship) by enhancing the credibility of financial statements. Independent auditing is designed to As stated above, corporations are private entities enhance the credibility of financial statements, based on a contractual relationship among individuals. assuming that the primary users of independent This is the corporate view in a contractual or agency auditor’s report are shareholders. theory, which helps to explain the mechanism of Independent auditing partially performs the corporate activities. function of governing managers for shareholders by A contractual relationship can be regarded as an monitoring and controlling their behavior in corporate agency relationship between principals and agents. activities to enhance the credibility of financial Since shareholders, who are the owners of the statements (Lee, 1993). It also plays an important role corporation, and managers are in an agency in facilitating the building of a contractual and/or relationship, managers must efficiently manage the agency relationship (Sunder, 1997). In this context, corporation as the shareholders’ agents in order to independent auditing is essential to corporations as a maximize profits for them. nexus for a set of contracting relations among This contractual or agency theory provides an individuals (Jensen, 1983). effective approach to the theoretical study of independent auditing. Currently, numerous studies 4.2 Impact of CSR on independent based on this corporate view are being conducted auditing (Jensen and Meckling, 1976; Wallace, 1980; DeAngelo, 1981; Watts and Zimmerman, 1983, 1986; Independent auditing is likely to change in response to Sunder, 1997, etc.). changes in social views as well as corporate views. As explained in section 3.2, an agency From the foregoing discussions on the relationship relationship assumes both shareholders as principals between corporations and society, CSR is likely to and managers as agents to be rational economic men have two kinds of impact on independent auditing. who do their best to maximize their self-interest. One impact is to expand the users of independent However, an asymmetry of information exists auditor’s report from shareholders to stakeholders. between shareholders and managers. Therefore, a The other impact is to shift the focus of the moral hazard arises, namely that the managers are governance of managers from a contractual more likely to behave opportunistically, knowing that relationship to a fiduciary relationship. the shareholders have only imperfect information The first aspect is the users of independent about the managers’ behaviors. Agency costs may auditor’s report. Independent auditors must clarify also arise inevitably to avoid loss from the moral their assumed users of independent auditor’s report so hazard. Because there is such a potential conflict that they express their opinions (Mautz and Sharaf, between shareholders and managers, greater attention 1961). This is also important in developing theories should be focused on the issue of governance, or how on independent auditing. 114

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Although most auditing textbooks list of public intervention. Hence, Independent auditing is shareholders, creditors, bankers, governments, an essential of the system of corporate governance. regulatory agencies, the general public and so on The concept of CSR discussed thus far (what is called stakeholders) as the users of reconsiders the conventional concept of auditing. independent auditor’s report, shareholders are assumed to be the primary users, based on which the 4.3 Contribution to independent auditing conventional independent auditing theories have been constructed. Recent issues related to CSR which have been taking Corporations as public institutions of society place in Japan, Europe and so on raise not only the basically bear social responsibilities toward problem of corporate misdeeds and scandals but also stakeholders, placing greater importance on the such larger questions as “For what and for whom do relationship with them rather than on the relationship corporations exist?” and “Do corporations fully live with shareholders. Indeed, stakeholders bear some up to social expectations and trust?” Inappropriate risks by being involved in corporate activities and are corporate management itself may cause a corporation highly interested in corporate fraud and going to lose public trust. Therefore, each corporation needs concerns. On the other hand, stakeholders require to redefine its corporate ethics and monitoring and independent auditors’ active involvement in corporate check system to rebuild public trust. In earning the fraud and going concern issue on the ground of many trust of society, each corporation must at least control recent corporate misdeeds and scandals. Therefore, the negative aspect of CSR. To control it, each independent auditing must take stakeholders, as the corporation needs to strengthen corporate governance users of independent auditor’s report, into with a full understanding of the core of corporate consideration. governance. Thus, the system by which managers can The second aspect is the governance of managers. fulfill their fiduciary duties as well as the system of The degree of contribution of independent auditing to monitoring (and checking) them are needed. the governance of managers varies depending on Although it is possible for each stakeholder to whether the managers and the shareholders are in a monitor and check the fiduciary duties of managers, contractual relationship or in a fiduciary relationship. the ability to monitor and check managers’ behavior is In a contractual or agency relationship, limited because there is an asymmetry of information independent auditing is used to enhance the credibility as well as a wide gap in knowledge and capability (a of financial statements and its scope is limited to this wide gap in information processing ability) between function. The handling of corporate fraud and going managers and stakeholders. Therefore, independent concerns both of which are currently important issues auditor with independence and expertise plays an in independent auditing, is not necessarily included in important role to complement the checking function this relationship. of managers’ fiduciary duties. In independent Since managers are not the agents of auditing, the important function of governing shareholders, it is difficult to discuss the governance managers is performed by checking and controlling of managers based on a contractual relationship (Iwai, their fiduciary duties, which is the core function of 2002). Therefore, it is necessary to examine this issue corporate governance. Because independent auditing, in terms of a fiduciary relationship. In order to which functions as a controller of society, plays an maintain a fiduciary relationship, managers need to important role to build the trust of relationship fulfill their fiduciary duties. However, it is impossible between corporations and society, and has its for the stakeholders to check or review the managers’ objective that serves essentially for corporate fiduciary duties directly. Furthermore, they cannot governance. Hence, independent auditing contributes control the managers based on financial statements to checking and controlling the negative aspect of nor maximize profits for themselves, because they CSR, which are minimum requirements for have far less knowledge and capability concerning corporations. Independent auditing also contributes to corporate activities than the managers. Therefore, a stakeholders who bear some risk by being involved in means of checking the fiduciary duties of managers is corporate activities and are highly concerned about needed. such risks. In addition, independent auditing should Throughout history, auditing has been a clearly be involved in the process of corporate activities recognized means of checking the fidelity of because the concept of CSR places emphasis not only fiduciaries or entrustees (Brown, 1905). Since on results but also on process. stakeholders want to know what the managers have Although the Cadbury report (1992) and EC been doing, monitoring or checking their behaviors is Green paper (1996) indicate that independent auditing required in auditing. In other words, independent lead to supporting the functions of shareholders’ auditing does not serve to reduce agency costs which governance, the possible roles of independent auditing inevitably arise from an agency relationship between as statutory auditing in corporate governance designed managers and shareholders, but is publicly and legally to ensure the implementation of CSR can be summed expected to check the managers’ fiduciary duties. up as follows in this paper. Independent auditing is statutory auditing and a sort (1) Independent auditing enhances the credibility of financial statements. This role allows 115

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stakeholders to check the activities of managers because they know that their fiduciary based on financial statements whose credibility duties will be checked independently and has been enhanced by independent auditing. In objectively by independent auditors. In other words, independent auditing lead to other words, independent auditing supporting the functions of stakeholders’ contributes to corporate governance by governance in order to control the behaviors of deterring managers’ behaviors. managers. (3) Independent auditing contributes to rebuilding (2) Independent auditing checks and controls the the relationship of trust (see endnote 24) between fiduciary duties of managers, and performs the corporations and society. It not only reinforces a important function of governing managers. The fiduciary relationship between corporations and following are some of the involvements of existing stakeholders by checking and controlling independent auditing in the fiduciary duties of the fiduciary duties of managers but also helps managers: expand to a fiduciary relationship between ① Independent auditing is involved in corporations and potential stakeholders. detecting and preventing the fraud or illegal Independent auditing corrects managers’ acts of managers. Detecting their fraud or mistakes including fraud, errors and illegal acts, illegal acts and preventing them lead to the and leads corporations in the right direction, thus role of monitoring and controlling their functioning as a controller of society. fiduciary duties. Actually, independent How independent auditing can contribute to auditing detects and prevents material corporate governance has been discussed. The system misstatements caused by fraud, errors, and of corporate governance will clearly be reinforced by illegal acts. In the future, it is thought to be independent auditing. Independent auditing plays an necessary to actively detect and prevent important role in fulfilling CSR and corporate fraud or illegal acts that will cause material governance. Independent auditors as well as managers misstatement. are entrusted by stakeholders. Independent auditing as well as corporations as public institutions of society ② Independent auditing is involved in needs to contribute to public interest corporate management or administration. In the future, Corporations need to increasingly CSR reduces corporate risks through support independent auditing because it plays an management system, internal control important role in corporate governance. In general, system, risk management system, independent auditing fee is regarded as a “cost” in compliance system which are essential corporations. On the other hand, CSR is an elements of corporate governance. “investment” in sustained corporate development Managers are responsible for building, (Japan Association of Corporate Executives, 2003). using, and improving such systems. Thus, it is necessary to regard independent auditing Evaluating and reporting the findings of fee as not a “cost” but an “investment” in sustained auditing lead to the role of checking and corporate development. controlling the fiduciary duties of managers. These are actually performed in some 4.4 Contribution to auditing system auditing practices. For example, auditing of internal control over financial reporting will Although independent auditing contributes to perform in conjunction with auditing of corporate governance, it alone cannot adequately financial statements by same independent contribute to fulfilling CSR and corporate auditors (so -called performance of an governance. In order for independent auditing to integrated auditing) soon in Japanese contribute to corporate governance effectively, practices. mutually complementary systems to independent ③ Independent auditing is involved in business auditing may be required. Such systems include risk which may suppress the continued Japanese corporate auditors (or audit committee) and progress of each corporation. CSR reduces internal auditing which play an important role in such risks and it is managers’ responsibility complementing independent auditing (see endnote to cope with various business risks and 25). For example, today, it is necessary for Japanese maintain their corporate brands (see endnote corporate auditors (Kansayaku) to fulfill their duties 23). Since auditors nowadays are involved with a basic viewpoint to the establishment and in going concerns, they are involved in operation of the system of good corporate governance. business risk in some sense. Independent And, it is desirable for corporate auditors to prevent auditors’ active involvement in business risk corporate misdeeds and scandals and to ensure and leads to their role of checking and safeguard sustained growth and development of their controlling the fiduciary duties of managers. corporation as their fundamental duties. The main ④ Independent auditors indirectly control scope of activity of corporate auditors is “audit of managers. Managers are more likely to director’s performance of duties”, “audit of decision- fulfill their fiduciaries duties with integrity making of board of directors”, “audit of status of 116

Corporate Ownership & Control / Volume 5, Issue 1, Fall 2007 internal control systems”, “monitoring of independent auditors”, and “audit of financial reporting system”. Independent Auditing In addition, internal auditing has the functions of both auditing activities and consulting activities. Of course, internal auditors need to accomplish both auditing activities and consulting activities in the Corporate governance main scope of activity which is risk management, （Negative aspect of CSR ） Fiduciary control, and the process of governance. It is desirable duties that internal auditing is not only conventional compliance auditing and risk-based auditing but also the auditing designed to verify the effectiveness of the Auditing of process of risk management, control system, and Internal Corporate Auditors governance as its mission. Auditing Each auditing, which is independent auditing, corporate auditors (or audit committee) and internal Figure 1. Contribution of Auditing System to auditing, play a key role in corporate governance. Corporate Governance Each auditing is mutually complementary relationship. However, conventionally, independent 5. Conclusion auditing, corporate auditors (or audit committee), and internal auditing didn’t effectively cooperate and It is necessary for us to reconsider an auditing based interact with each other as one auditing system. on the question, “What does an auditing bring to Consequently, when independent auditing, society?” corporate auditors (or audit committee), and internal CSR, corporate governance and auditing are auditing cooperate and interact with each other as one interactively related and cooperate with each other. In auditing system, it will be possible to contribute to order to fulfill CSR and to ensure sustained growth corporate governance effectively. To this end, it is and development, the corporation must establish and necessary to restructure the existing auditing system operate corporate governance. In order to achieve by reconsidering the roles of each auditing involved corporate governance effectively, auditing system so that they can contribute to fulfilling CSR and play an important role in corporate governance and corporate governance more effectively as one auditing then the implementation of CSR. In order for system (auditing network) (Figure 1). Exactly, managers to explain fulfilling their fiduciary duties to auditing system is corporate auditing. Corporations stakeholders, a role of auditing is very important. need to increasingly support auditing system because Auditing came into existence with the progress of it plays an important role in corporate governance. human civilization, and as public awareness of its In the future, it will be necessary to review the concept and methods grew, it became an essential part optimum form of independent auditing, and of socioeconomic activities. Auditing is a publicly eventually the optimum form of one auditing system recognized system that has formed through a social including corporate auditors (or audit committee) and process, and so it contributes to the fallibility and internal auditing. Furthermore, human resource limited rationality of human beings. That is, auditing development in auditing (especially, corporate corrects people’s mistakes including fraud, errors and auditors, the members of audit committee, and illegal acts, leading them in the right direction. It also internal auditors) is important future challenge in reinforces and expands the relationship between order for one auditing system to function effectively. corporations and stakeholders who have far less In other words, it is necessary to develop human knowledge and capability than corporations. Auditing resource with independence and expertise. is not only a medium to ensure a good relationship Finally, although the Cadbury report (1992) and between corporations and society in a true sense but the Hampel report (1998) in U. K., EC Green Paper also a social infrastructure to build up public trust as a (1996), auditing studies in Japan and so on social capital. Auditing as an institution enables the recommend that independent auditing strengthen stakeholders to secure autonomy as well as freedom in collaboration with audit committee (corporate their decision-making. auditors in Japan) to enhance the governance function By playing a key role in social control, auditing of independent auditing for shareholders, this paper contributes to the sound development of corporations takes strengthening of collaboration into consideration and society. By building up public trust, auditing is for stakeholders. In short, this paper suggests that essential to corporations and society. Auditing is a auditing system contributes to corporate governance publicly recognized social system and is a social under new corporate view. infrastructure. We need to increasingly understand the importance of auditing in corporations and society.

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43. Schossberger, E. (1994), “A New Model of Business: 5 The origin of Japanese CSR can be track to family creeds Dual-investor Theory”, Business Ethics Quarterly, of Japanese merchant (Shonin no Kakun) in the past about Vol.4, Issue.4, pp.459-474. 300 years. See Kurihama (2005) for details. 44. Sunder, S. (1997), Theory of Accounting and Control, 6 When considering CSR, it is necessary to strike a balance South Western College Publishing. between economic, social, environmental, and human 45. Taka, Iwao etc. (2002), Corporate Social aspects of CSR. Which aspect should be given priority is Responsibility: Demanding a new management view, less important (Japan Association of Corporate Executives, Japanese Standards Association (Nippon Kikaku 2003). Kyokai). (In Japanese) 7 In corporate governance, this leads to both enhancing 46. The Institute of Internal Auditors-Japan (2004), The corporate competitiveness and preventing corporate Internal Auditing Standards in Japan, misdeeds and scandals. http://www.iiajapan.com/kijunH16.htm. (In Japanese) 8 From the standpoint of social evolution or institutional 47. Wallace, W. A. 1980 “The Economic Role of the evolution, we can learn from history not because there are Audit in Free and Regulated Markets”, In Wallace, W. those who survived or succeeded but because there are those A. (1986), Auditing Monographs, 2nd Edition, who could not survive or failed. This is understandable from reprinted by PWS Kent Publishing. the historical repetition of corporate misdeeds and scandals 48. Watts, R. L. and Zimmerman, J. L. (1983), “Agency as well as the recent cases of Enron, WorldCom, Royal Problems, Auditing, and the Theory of the Firm: Some Ahold, Parmalat, Kanebo, Livedoor and so on. The history Evidence”, The Journal of Law and Economics, Vol. of corporate misdeeds repeats itself. 26, No.3, pp. 613-633. 9 The discussion here is based on Friedman (1962, 1970). 49. Watts, R. L. and Zimmerman, J.L. (1986, Positive 10 This paper uses the term “managers” to designate both Accounting Theory Prentice Hall. directors and officers (management, corporate executives 50. Yamagishi, Toshio (1999), From assurance based etc.). society to trust based society: Where is the Japanese 11 See Carson (1993), Donaldson and Preston (1995), system hearing?, Chuo Koron Shinsha. (In Japanese) Clarkson (1998) and so on. 12 According to Clarkson (1998), mediating the concept of Endnotes stake by the concept of risk allows the two concepts to be one common ground, and stake is defined as a certain value 1 In the current CSR discussed mainly in Europe etc., that will take a risk. Those who take the risk are legitimate pressure from consumers and NGOs is the main driving stakeholders. See Clarkson (1998) for details. force behind the promotion of CSR. In Japan where social 13 See Kurihama (2005) for details. pressure is much weaker than that in Europe etc., economic 14 The discussion on contract is based on Jensen and circles (for example, the Japan Association of Corporate Meckling (1976), Frankel (1983), Hodgson (1988), Executives and Japan Business Federation etc.) play a Easterbrook and Fischel (1991) and Iwai (2002). See Jensen leading role in promoting CSR. However, it is true that, and Meckling (1976), Frankel (1983), Hodgson (1988), although domestic pressure is weaker, Japan is under social Easterbrook and Fischel (1991) and Iwai (2002) for details. pressure from outside the country such as t Europe etc. As 15 The concept of contract is theoretically based on a in Europe etc., Japan’s CSR is also based on independent contract or agency theory (Iwai, 2002). efforts. 16 Agency costs consist of monitoring cost, bonding cost, 2 In these years, more fraud by organizations than fraud by and residual cost. See Jensen and Meckling (1976) for individuals increases. In other words, the cases of fraud and details. illegal acts which are rooted in corporate culture and ethics 17 According to Maitland (1994), this view is a common increase. We should be fully aware of the seriousness of the belief. issues which are managers’ inadequate understanding and 18 Clarkson (1998) defines the corporation not as a nexus of reaction against their cases, or managers’ active contracts but as a nexus of risks. See Clarkson (1998) for involvement in their cases. details. 3 However, 75%of the CEOs answered that they have not 19 See Boartright (1991) for details. There may be some lost public trust. In addition, in Japan, for example, situations in which governance by shareholders is not either according to a questionnaire survey of Japan Institute of efficient or effective (Aoki, 2001). Social and Economic Affair (Keizai Koho Center) (2006), 20 The discussion on fiduciaries is based on Frankel (1983), Japanese livers answer a question about the social role and Iwai (1999, 2002) and Higuchi (1999). See Frankel (1983), responsibility of corporations as follow. Devoting core Iwai (1999, 2002) and Higuchi (1999) for details. business (99%), Environmental efforts (98%) Crisis 21 According to Christian Aid (2003), a British NGO, the management (97%), Corporate ethics (96%), Transparency key requirement in CSR is that managers fulfill and disclosure of management (95%) and so on. And they accountability or fiduciary duties, which will make answer that the trust of corporation drops by 25 % from the corporate activities more responsible. level of a year ago. These indicate that a lot of Japanese 22 In this theory, shareholders as rational economic men can livers share awareness of the issues of corporate misdeeds maximize their profits and control managers if they can trust and scandals. In order for corporations to restore public and utilize financial statements. Therefore, the managers ask trust, they answer Devoting core business (78%), Corporate for independent auditing. ethics (50%), Transparency and disclosure of management 23 For example, Japanese Auditing Standards actually (37%), Crisis management (34%), Environmental efforts include “serious deterioration of brand image” as business (26%) and so on. risk information. 4 Also in Japan, corporations seek CSR as a means of 24 See Yamagishi (1999) about the roles of reinforcing and rebuilding the trust of society. expanding the relationship of trust. 25 Conversely, corporate auditors (or audit committee) or internal auditing alone cannot adequately contribute to fulfilling CSR and corporate governance. 119