© martin e taylor1 financial reporting scandals in the u.s. and their impact on the financial...
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© Martin E Taylor 1
Financial Reporting Scandals in the U.S. and Their Impact on the Financial Reporting Value Chain
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© Martin E Taylor 2
Sarbanes-Oxley Strikes Again•Enron
•Skilling gets 24 years
WorldComBernie Ebbers Found Guilty; Sentenced to over 20 years in prison
Cendant Corp. Chairman Walter Forbes sentenced to 12 years and seven months in prison and ordered to pay $3.275 billion in restitution
Etc., etc., etc.
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The Fraudulent Financial Reporting Hall of Shame
Health South “family meetings” to make EPS target Decreased operating expenses Reduced amount due under
“contractual adjustments” Took an optimistic view of what
health care providers would pay
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The Fraudulent Financial Reporting Hall of Shame
WorldCom Improper capitalization of expenses
or losses
Cendant Fictitious revenue
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The Fraudulent Financial Reporting Hall of Shame
Enron Improper use of off balance sheet
transactions to overstate earnings and understate debt
Rite Aid Overstated Inventory and understated Cost of Goods Sold
Adelphia Treated company as their “piggy bank”. Did
not disclose related party transactions
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Financial Reporting Value Chain
CEO/CFO > Board of Directors > Audit Committee > Internal Auditors
> External Auditors > Analysts >
Users
Regulators: SEC, State Regulators, Stock Exchanges
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CEO/CFO
Earnings management Many companies “smoothed”
earnings Companies manipulated net income
to improve earnings per share Accrual based earnings management Real earnings management Earnings classification shifting
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Why Management Misrepresents Financial Results
Creating business opportunities Satisfy loan covenants Increase equity financing Attract business partners
Satisfy personal greed Enhance job security Increase personal wealth (stock
options) Obtain a higher pay check
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Improper Revenue Recognition
Bill and hold sales Holding books open Multiple element contracts (Xerox) Fictitious revenue Improper valuation of revenue
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Improper Expense Recognition
Capitalization of expenses Deferral of expenses (improper) Overstating inventory Understating Cost of Goods Sold Understating Allowance for Bad
Debts Failure to record asset impairments
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CEO/CFO Other “gimmicks” by public companies
included “big bath” charges Drawing on “cookie jar” reserves Abusing materiality Improper capitalization of expenses Channel stuffing Round trip transactions
Companies were under extreme pressure from Wall Street analysts to exactly meet quarterly expectations
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Earnings Restatements
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Earnings Restatements (cont’d)
Restatements by U.S. Public Companies: 2006 - 1,523 (peak) 2007 - 1,270 2008 - 869 2009 - 708 2010 - 790 2011 - 787 2012 - 768 ? Could it be that SOX is working??
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Earnings Restatements (cont’d)
Examples of common restatements Cash flow classifications Tax issues Compensation problems (e.g.,
backdating of stock options) Expense recognition Revenue recognition
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Board of Directors and Audit Committee
Corporate governance Board of Directors – Audit Committee
– Family and Friends Sinecure
“an office or position that requires or involves little or no responsibility, work, or active service”
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Internal Auditors
Independence?? Operational versus Financial Audits Outsourcing the Internal Audit
Function
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External Auditors
Independent?? Trends
25 years ago: 8 Big Accounting Firms Today: 4 Big Accounting Firms
25 years ago: audit 75% of fees; consulting 25% of fees
10 years ago audit 25% of fees; consulting 75%
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External Auditors: Consultants or Auditors??
© Martin E Taylor 18The Economist , November 9th-15th, 2013
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Analysts
Investment banks lent money to companies
The bank’s Research Department then recommended stock purchases in the same company to which it lent money (conflict of interest)
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Analysts
Conflict of Interest Settlement
$1.4 billion settlement against Bear Stearns, Morgan Stanley, JP Morgan Chase
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The SEC
The SEC (Securities and Exchange Commission) administers the 1933 and 1934 Securities Exchange Acts
Public companies that issue securities (stock or debt) must file a registration statement with the SEC
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The SEC
Important documents that companies are required to file with the SEC include 8K – significant events affecting the
company 10Q – unaudited quarterly filings 10K– audited annual filing of financial
statements plus other information
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The SEC
The SEC delegated the promulgation of Accounting Standards to the FASB (Financial Accounting Standards Board)
The AICPA (American Institute of Certified Public Accountants) promulgated Auditing Standards
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Other Regulators
Stock Exchanges New York Stock Exchange NASDAQ
State Regulators
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The Sarbanes-Oxley Act
Also known as the “US Public Company Accounting Reform and Investor Protection Act of 2002”
Law passed by the American Congress
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The Sarbanes-Oxley Act Effect on Management
Certification of Financial Statements by CEO and CFO
Criminal penalties for corporate fraud
Disclosures required for off-balance sheet transactions
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The Sarbanes-Oxley Act Effect on Management
Special rules regarding pro forma disclosures
Loans to company executives are prohibited
Requires forfeiture of executive bonuses and equity gains if the financial statements must be restated (clawbacks)
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The Sarbanes-Oxley Act Effect on Corporate Governance
Code of Ethics Companies must develop a Code of
Ethics for the CEO and CFO Code of Ethics must be available for
viewing by the public Amendments or waivers to the Code
of Ethics must be disclosed IBM link to Corporate Governance
http://www.ibm.com/investor/governance/
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The Sarbanes-Oxley Act Effect on Corporate Governance
All audit committee members must be independent (non-executive) directors
External auditors shall be appointed by the audit committee
Audit committees must establish procedures to deal with accounting, auditing and internal controls
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The Sarbanes-Oxley Act and Internal Control Evaluation The Board must adopt an audit standard to
implement the internal control review required by section 404(b). This standard must require the auditor evaluate whether the internal control structure and procedures include records that accurately and fairly reflect the transactions of the issuer, provide reasonable assurance that the transactions are recorded in a manner that will permit the preparation of financial statements in accordance with GAAP, and a description of any material weaknesses in the internal controls.
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The Sarbanes-Oxley Act Effect on Corporate Governance
At least one member of the audit committee must have significant financial knowledge
The audit committee will approve non-audit work performed by its external auditor
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The Sarbanes-Oxley Act Effect on Corporate Governance
Although not specifically required by Sarbanes-Oxley, many have recommended that the position of CEO and Chairman of the Board not be held by the same person
Link to Microsoft Audit Committee charter and responsibilities calendar http://www.microsoft.com/about/companyinformation/corporategovernance/committees/audit.mspx
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The Sarbanes-Oxley Act Effect on Internal Auditors
The internal audit function may no longer be outsourced to external auditors
Although not specifically required by the Act, internal auditors have become a valuable resource in helping companies comply with SOX
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The Sarbanes-Oxley Act Effect on External Auditors
Public Companies Accounting Oversight Board (PCAOB) Under SEC administration oversight Mission is to oversee the audit of
public companies All auditors of public companies must
register with the PCAOB
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The Sarbanes-Oxley Act Effect on External Auditors
Auditors of public companies must Identify their public audit clients List fees for audit and non-audit
services Explain their audit quality control
procedures Identify criminal, civil, and
administrative/disciplinary proceedings against the firm
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The Sarbanes-Oxley Act Effect on External Auditors
Inspection of CPA firms PCAOB will annually inspect firms with
more than 100 public companies Others every 3 years Firms Registered with the PCAOB
http://pcaobus.org/Pages/default.aspx
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The Sarbanes-Oxley Act Effect on External Auditors
Restrictions on Certain Services to Clients bookkeeping, financial systems design, appraisal and evaluation, actuarial, internal audit, management functions, human resources, broker/dealer, investment banking and legal
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The Sarbanes-Oxley Act Effect on External Auditors
Partner rotation 5 years for audit partner and second
reviewing partner Conflict of interest – audit firm may
not audit a public company whose officers worked for the company in the previous year
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The Sarbanes-Oxley Act Effect on Analysts
Financial analysts cannot be involved in marketing securities
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Criticisms of The Sarbanes-Oxley Act
Internal control requirement is difficult to implement
Too costly, particularly for smaller firms
SEC estimated SOX cost at $98,000 per company
Actual average cost/company: $2 – 3 million
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Criticisms of The Sarbanes-Oxley Act
Start up companies may go overseas to raise capital
U.S. stock exchanges losing business to London and Hong Kong
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Criticisms of The Sarbanes-Oxley Act
Legislation similar to SOX has been adopted in other countries
Japan (J-SOX) China (C-Sox)
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Requirements for an Effective Financial Reporting System
Quality Accounting Standards U.S. GAAP; IFRS
Effective Corporate Governance Audit committee
Quality Auditing Standards PCAOB, IFAC
Effective Enforcement Mechanism SEC, Oversight of IASB by independent
organization
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Other Topics and Developments
Corporate Social Responsibility Triple Bottom Line Reporting
Economic Social Environmental
Integrated Reporting Dodd-Frank Legislation
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Other Topics
Financial Statement Presentation Market to Market Revenue Recognition Leases Pensions Intangible Assets