218 InManagersWeTrust
constrain managerial discretion somewhat. For these mechanisms to
be effective, however, the board of directors must assure that both
internal controls and external audits do this.
Internal financial reporting controls are designed to assure that
transactions are executed in accordance with management policy
and are recorded properly in the accounting records (and to assure
that assets are deployed only in accordance with management pol-
icy). They range from daily journal entries that are reviewed regularly
by others, to periodic taking of inventory, to procedures for review
of judgments concerning depreciation, to the articulation and review
of ris kmanagement policies. Some of these tools are required by
federal securities laws.
Within a corporation, both the board of directors and the man-
agers play a role in defining, implementing, and evaluating internal
controls. In principle, however, the chief and ultimate responsibility
for internal controls rests with the board of directors, both as a mat-
ter of common sense and as a matter of policy. Boards have a com-
parative informational advantage and greater motivation to police
managerial opportunism than managers do. This obligation entails
supervising the design of internal control systems and supporting
their administration.
The critical importance of internal controls to the integrity of
financial reporting is evidenced by the requirement that outside au-
ditors review them in connection with annual audits of a company’s
financial statements. This audit is intended to obtain objective as-
surance that the financial statements are relevant and reliable, based
on a general review of the financial statements and the underlying
day-to-day records and periodic summaries on which they are based.
The audit is a monitoring mechanism that lends credibility to
the financial statements. For that credibility to be meaningful, how-
ever, the auditor must wor kclosely with members of the board of
directors, and both the auditor and those directors must act with
diligence, independence, and awareness. Several challenges are
posed for a board and its audit committee.
First, an audit conducted by an independent firm does not
change the fact that a company’s management prepares the financial
statements and is responsible for them. The audit is a review of those
statements. The audit does not entail a review of every financial
transaction in which the company engaged during the period covered
by the financial statements. That is a practical impossibility for any
auditor and even more so for any audit committee. Businesses en-