Lectures 5-7 - Lecture notes 5-7 PDF

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Lecture 5 Demand for audit The Policeman Theory Auditing was focused on arithmetical accuracy (numbers add up) and on prevention and detection of fraud. If mistakes were found-managers would be punished. Popular 1940s US. Weakness is its inability to explain the shift of auditing to ‘verification of truth and fairness of the financial statements’. The Lending Credibility Theory: Primary function of auditing is the addition of credibility to the financial statements. The theory as such is unable to explain the various other functions the users of financial statements expect the auditor to assume as part of attestation function. Audited accounts are more reliable than non-audited bc managers may be biased when producing their own accounts (lenders would often ask for audited accounts before giving loan) The Theory of Inspired Confidence: Developed in the late 1920s by the Dutch professor Theodore Limperg. The demand for audit services is the direct consequence of the participation of outside stakeholders (third parties) in the company. The auditor should act in such a way that he does not disappoint the expectations of a ‘rational outsider’, while, on the other hand, he should not arouse greater expectations in his report than his examination justifies. Audits give wider confidence to all stakeholders. Agency Theory-Managers are agents of shareholders; independent review of accounts makes sure no funny business on managers part. Shareholder  Board of Directors  Management  Company operations Costs of an agency relationship are monitoring costs (the cost of monitoring the agents-audit), bonding costs (the costs, incurred by an agent, of insuring that agents will not take adverse actions against the principals e.g job elsewhere) and residual loss (effective loss that results despite the bonding and monitoring costs incurred e.g theft). Reasons for audit  Legally required due to turnover, staff, size of company  Listed on stock exchange  Voluntary Core regulatory audit principles  Well defined accounting and auditing principles and standards  Legal requirements for firms to adhere to these standards when preparing audit  Enforcement system for preparers of statements to comply with standards e.g fines, prison time  Effective corporate governance to encourage proper preparation  Effective education and training for auditors Legal liability of auditors  common law; (e.g negligence)  civil liability under statutory law;  criminal liability under statutory law;  liability for members of professional accounting organisations. Punishments for auditors 1. a fine; 2. a reprimand (either oral or written) published in the gazette, hugely embarrassing; 3. a suspension for a limited period of time (e.g. 6 months); or 4. a lifetime ban from the profession. Suggested solutions to auditor liability  Cap on fines e.g Germany  Proportional liability  Limited liability partnerships (to protect personal wealth of partners)  Exclude high-risk audits  Make insurance of audit liability compulsory Going concern In most national regulations, auditors need to determine whether the audited entity is able to continue as a going concern (a business that is operating and making a profit). SOX and Internal controls

The United States Sarbanes–Oxley Act of 2002 requires that company officers certify that internal controls are effective and requires that an independent auditor verify management’s analysis. Section 404 of the Sarbanes–Oxley Act requires each annual report of a company to contain an ‘internal control report’ which should: 1. State the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting. 2. Contain an assessment, as of the end of the fiscal year, of the effectiveness of the internal control structure and procedures for financial reporting. 3. Companies must select suitable criteria against which it may evaluate the effectiveness of internal controls for authorization, safeguarding assets and properly recording of transactions. 4. An independent auditor attests to any difference between management’s assertions under 404 and the audit evidence on internal controls. Occurrence of fraud  ISA 240 – the responsibility for the prevention and detection of fraud and error rests with both those charged with the governance and the management.  ISA 210 states that in planning and performing audit procedures and in evaluating and reporting the results, auditors should consider the risk of misstatements leading to fraud.  In planning the audit, the auditor must assess the risk that material fraud or error has occurred.  It is public expectation for auditor’s objective to find fraud. But it is the job of management to find fraud, and the objective of auditors to find assurance that statements are free from misstatement due to error or fraud/ designing and executing the audit in such a way that there is a reasonable expectation of detecting material illegal acts SOX restrictions on auditors  Auditors must report to the audit committee.  The lead audit partner and audit review partner must be rotated every five years.  A second partner must review and approve audit reports.  It is a felony (serious crime) with penalties of up to 20 years in jail to willfully fail to maintain ‘all audit or review work papers’ for seven years.  Auditors are prohibited from offering certain information system and accounting services to clients

Readings  Issues that auditors struggle with when understanding and testing internal controls in audits of all sizes, including: 1. deciding whether to test the operating effectiveness of controls; 2. determining what constitutes a deviation and the tolerable deviation rate, and then dealing with deviations; 3. revising the control risk assessment, and the effect of a revision on other audit procedures; and 4. balancing the results of controls testing with substantive procedures.  The survey cites problem areas as including the audit of general IT controls, a lack of specialist IT expertise, and ‘tests of one’ as opposed to testing systems in more than one type of situation.  Some audit regulators are now recruiting IT specialists. Standard-setters, such as the IAASB, have recognised that auditing standards need to be modernised and firms are putting more resource into this area, as well as developing their data analytics capabilities.  In smaller, less complex audits, there is often a theoretical decision to be made regarding whether to test the operating effectiveness of controls. It is very common in smaller audits for a fully substantive approach to be taken even though there are controls that could be tested, because it is quicker and easier. Sometimes though, this is simply a legacy of past practice and it may be worth reviewing the approach from time to time. Work to update and document the auditor’s understanding of the design and implementation of controls has to be performed annually regardless, and that work can be leveraged if controls are tested.  When extrapolation of deviations from the application of a control procedure across the population exceeds the tolerable level, and/or further testing fails to provide evidence that supports an alternative conclusion that can be reconciled to the original evidence, auditors must conclude that the control is not operating effectively. This affects the control risk assessment, other tests of controls in the same area (there may be compensating controls), and subsequent substantive procedures. Substantively testing information from

poorly controlled systems is an increasingly important issue in larger, more complex audits, as well as smaller audits.

Scandals Lecture 6 Common aspects of scandals  Arise due to fear for job security, greed  Lack of internal controls, lack of proper auditing and management, lack of strategy/ corporate governance

Rationalisation = justification of dishonest actions. Incentive = need money, greed, job security Opportunity = having position to do so

Explaining scandals- CRIME acronym  Cooks-who? Usually top management  Recipes-how? Accounting manipulation techniques, e.g taking advantage of judgement-based accounting tools such as fair value. If auditors have conflict of interest, firms can get away with it. Asset misstatementlargest no of cases is inventory-stock counts only consider a sample-potential for fraud. Bad debts-may be tempted to not write them off, so seems you receive income that you don’t. Loans, investments, cash can be overstated (e.g 1 mil in the Cayman islands that doesn’t exist). E.g enron used complex calculations when doing fair value; made hard for auditors to check.  Incentives-why? Covering up bad performance, personal greed  Monitoring-how they got away with it? Failure of board, auditors complacent/ lack of independence, errors may not be material so not required to check, lax laws, auditors too close to firm, poor internal controls  End results-consequences? Fine, jail, personal wealth seized, sanctioned, firm disbanded (both client and auditors), changes to law and financial reporting.

Lecture 7 ‘Earnings management is the choice by a firm of accounting policies so as to achieve some specific manager objective (Scott, 1997, p32) Creative accounting is Applying inappropriate accounting policies or entering into complex or “special purpose” transactions with the objective of making a company’s financial statements appear to disclose a more favourable position. Motivation for accounting manipulation Society: Manipulating profit = Less tax to govt so less money for society Funds Provider: Better profit = more chance of getting loans Manager: Better profit = better bonuses and salary, share options - perhaps they have a stake in firm and so benefit from this. Types of accounting manipulation It can be outside the limits of the law (fraud) It can be within the limits of the law:  Earnings Management (targets EPS by fixing level, smoothing variance for stability, big bath accounting: reduce current EPS to increase future EPS, i.e show lower profit so that in future you can use the profit you didn’t disclose causing the share price to appreciates)  Creative accounting: debt/ equity ratio Some would argue EM is a good thing due to profit smoothing- mask the volatility of earnings and reassure investors who might have been alarmed by rapid fluctuations in earnings, financial statement transparency and efficiency AM Methods SoPoL  Revenue recognition:  Front-ending revenue in long-term contracts  Sale or return transactions (smaller % of return prediction)  Fabrication of revenues (imaginary customers)  Recording revenues prematurely= managers in the late 1990s appear to have characteristically ‘stolen’ earnings from future periods in order to create an earnings spike that potentially could not be sustained (due to the pressure on these firms to show a high rate of earnings growth)  Expenses:  Capitalising own costs e.g. interest, development costs Assets  choice of depreciation policies (less depreciation of assets to incur less expense and for assets to be worth more)

 stock/inventory valuations (forge higher sales thus less inventory and less costs of obsolescence/storage or inflate value of inventory for higher asset value)  asset impairment reviews (Less impairment of assets so less expense, higher asset value)  manipulation in acquisitions/mergers e.g. establishing ‘fair values’ for assets acquired (easy in a merger to inflate value of assets to appear higher in worth (as its very subjective). Especially intangible assets- very hard to determine value of a brand for example.  Recording fictitious assets Liabilities  off-balance sheet debt in special-purpose entities (shift debt to a firm that you don’t consolidate)  related party transactions (show lower liability through lower interest rate or lower debt value)  provisions/estimates:  bad debts - especially in banks, be very optimistic to show higher profit  lower claims provisions e.g. in insurance companies  pensions of your employees (show less pension cost)  restructuring and ‘cookie jar’ reserves, often arising in acquisitions/mergers e.g this year I’m doing well so I’ll reduce profit by inflating provision for doubtful debt and next year if I do worse than expected, take funds from the jar.

Discretionary expenditure = investment/ salary rises

Who is to stop Accounting manipulation  company law, accounting standards, regulators (e.g. SEC in USA, FCA in UK) always evolving  auditors  internal governance mechanisms (varied people in audit committee, both execs and non execs to have fresh eyes and not too much power in few hands), remuneration committee- reduce or remove salary link to profit to reduce manipulation, perhaps make salary fixed, link bonuses to other criteria)  analysts (including credit ratings agencies)-can identify firms that do accounts manipulation: rate them poorly/present them as risky firms  investors: 2 types of investors-institutional vs non-involved. Institutional = more power in decisions Auditor’s impact  Some studies have found that clients of big firm auditors are less likely to practise EM, have irregularities, disagreements between big 4 auditor and client about EM more likely.  UK and US auditors specifically big 4 appear to have a stronger bias to conservatism in reporting profits than auditors in France and Germany, particularly in more stringent investor protection environments  For the comparability of earnings, not only the standardisation of financial reporting is important but also the standardisation of enforcement mechanisms as embodied in the national audit environment and the quality of audit firms  companies in countries with flexible audit quality regimes report significantly higher absolute values of discretionary accruals compared to companies in countries with strict audit quality regimes.

Auditors don’t always prevent all EM even when they’re aware of it - they tend to be reluctant to challenge accounting treatments where accounting rules are imprecise and difficult to prove fraud – to retain client They must:  Understand the pressures on directors and management to deliver specific level of earnings  Act with even greater scepticism when circumstances are encountered that may be indicative of aggressive earnings management  Communicate openly and frankly with those charged with governance. 

Readings  a dispersed ownership system, characterized by strong securities markets, rigorous disclosure standards, high share turnover, and high market transparency, in which the market for corporate constitutes the ultimate disciplinary mechanism; and  a concentrated ownership system, characterized by controlling blockholders, weaker securities markets, high private benefits of control, and lower disclosure and market transparency standards, but with a possibly substitutionary role played by large banks and non-controlling blockholders  executive compensation abruptly shifted in the United States during the 1990s, moving from a cash-based system to an equity-based system. More importantly, this shift was not accompanied by any compensating change in corporate governance to control the predictably perverse incentives that reliance on stock options can create.  Financial economists have found a strong statistical correlation between higher levels of equity compensation and both earnings management and financial restatements  In the case of most European corporations, there is a controlling shareholder or shareholder group. 1 Why is this important? A controlling shareholder does not need to rely on indirect mechanisms of control, such as equity compensation or stock options, in order to incentivize management. Rather, it can rely on a ‘command and control’ system because, unlike the dispersed shareholders in the USA, it can directly monitor and replace management. Hence, corporate managers have both less discretion to engage in opportunistic earnings management and less motivation to create an earnings spike (because it will not benefit a management not compensated with stock options).  Concentrated ownership encourages a different type of financial overreaching: the extraction of private benefits of control. Ownership may be diluted through public offerings, and then a coercive tender offer or squeeze-out merger is used to force minority shareholders to tender at a price below fair market value.  Parmalat’s fraud essentially involved the balance sheet, not the income statement. It failed when a €3.9 billion account with Bank of America proved to be fictitious. 2 At least, $17.4 billion in assets mysteriously vanished from its balance sheet. Efforts by its trustee to track down these missing funds appear to have found that at least €2.3 billion were paid to affiliated persons and shareholders. 3 In short, private benefits appear to have siphoned off to controlling shareholders through related party transactions. Speaks to lack of a monitoring structure in making corporate insiders accountable, weak corporate governance scandals in Italy as a whole, highly concentrated market, controlling shareholder was the Tanzi family, Italian structure for a shareholder to closely monitor senior management-> reduces agency theory but takes away minority shareholder rights, creates opportunities for shareholders to divert resources for themselves. 4 of of 13 board of directors linked by family ties.  What this contrast shows is that controlling shareholders may misappropriate assets, but have much less reason to fabricate earnings.  Even the role of the auditor differs in a concentrated ownership system. The existence of a controlling shareholder necessarily affects auditor independence. In a dispersed ownership system, corporate managers might sometimes ‘capture’ the audit partner of their auditor (as seemingly happened at Enron). But the policy answer was obvious (and Sarbanes–Oxley quickly adopted it): rewire the internal circuitry so that the auditor reported to an independent audit committee. However, in a concentrated ownership system, this answer works less well because the auditor is still reporting to a board that is, itself, potentially subservient to the controlling shareholder.  Why earnings management differs internationally: 1 2 3

-Code law: capital markets less active, funding from banks, low litigation risk, earnings management more prevalent -Common law: diverse base of investors, developed equity markets, dispersed ownership, strong investor rights=less earnings management. high risk of litigation...