Auditing - Key Concepts PDF

Module 3 Auditing Key concepts Learning objectives After studying this section, you should • Understand the concept of accounting quality • Know how auditing is supposed to ensure accounting quality • Understand why and how accounting information can be falsified • Understand the concept of audit...

Module 3 Auditing Key concepts Learning objectives After studying this section, you should • Understand the concept of accounting quality • Know how auditing is supposed to ensure accounting quality • Understand why and how accounting information can be falsified • Understand the concept of audit quality • How auditing function is organized in firms 2 Financial reporting and accounting quality • Accurate financial reporting is critical for all those stakeholders who use financial statements in their decision making ˗ Equity and debt investors in the capital markets ˗ Suppliers ˗ Tax authorities • Accounting quality has many dimensions, but ultimately it is about whether financial reports are useful in a decision-making. Important concepts include: ˗ Minimum requirement for accounting quality is that financial reports precisely reflect changes in financial position, earnings, and cash flow ˗ Transparency, which refers to the degree to which the company provides details that supplement and explain accounts reported in statements and filings. ˗ Internal controls, which refer to the processes and procedures that ensure transactions are accurately recorded, financial statements reliably produced, and company assets protected from theft 3 Can we rely on published financial reports? • Evidence shows that the financial reports of listed firms are generally of high quality and are useful for decision making • However, there are companies are not as effective as they believe in preventing abuse by management ˗ Companies are much less likely to report a small decrease in earnings than a small increase (earnings management) ˗ Managers make small manipulations in accounts so that net income figures are rounded up rather than down (earnings management) ˗ Firms must disclose financial restatement, i.e. a material error is found in the previously published financial statements ˗ Accounting frauds occur, although they are very rare among listed firms • Unintentional errors are also possible and some reporting decisions require significant judgment which may go wrong 4 Research Evidence Earnings management in bankrupt firms • Xu et al. (2021) argue that continuously engaging in real earnings management in a financially distressed firm leads to corporate bankruptcy, or at least speed up the failing process Financial reporting quality • Latridis (2010) finds that the implementation of IFRS reduces the scope for earnings management, is related to more timely loss recognition and leads to more value relevant accounting measures • Feng et al., (2010) investigates why CFOs become involved in material accounting manipulations and finds that 1) CFOs cannot tolerate the pressure from CEO and 2) do not seek their personal financial gains 5 Market Watch Dec. 27, 2021, 06:56 AM Clarivate PLC disclosed Monday that it concluded last week that recent financial statements should "no longer be relied upon" because of an error found in those statements. The financial statements which will need to be restated are the quarterly periods ending Sept. 30, June 30 and March 31 and for the year ended Dec. 31, 2020. The company, which helps customers discover, protect and commercialize their inventions, said the error relates to the accounting of an equity plan included in the CPA Global business combination, which was completed on Oct. 1, 2020, in which certain awards made by CPA global were incorrectly included as part of the acquisition accounting. The company concluded that most of the awards should have been recognized as stock-based compensation charges, with expenses seen up to $185 million. Clarivate Plc is a global information, analytics, and workflow solutions company. The Company provides content, analytics, professional services, and workflow solutions that enable users across government and academic institutions, life science companies, and research and developmentintensive corporations to discover, protect and commercialize their innovations. www.reuters.com 6 From earnings management to accounting frauds 1. The term earnings management is used to describe managers intervening in the reporting of their own financial performance, including practices that are ˗ Legal, violate no accounting rules or principles, and are generally viewed as ethical (e.g. timing asset sales to book gains in years with lower profits, and to book losses in years with higher profits) ˗ Legal, violate no accounting rules or principles, but might violate accepted standards of disclosure (e.g. giving year-end quantity discounts to major customers, generating sales, but failing to disclose that they inflate current earnings) • Note that firms are supposed to manage their earnings in order to make earnings more informative for stakeholders – not to mislead them! 7 From earnings management to accounting frauds 2. Negligent or grossly negligent financial reporting refers to practices such as unwittingly failing to comply with GAAP ˗ Negligence involves managers or auditors making unintentional errors due to factors such as inadequate experience, training, knowledge, supervision or effort ˗ Gross negligence involves reckless disregard for accepted standards 3. Fraudulent financial reporting refers to the practices such as knowingly failing to comply with GAAP ˗ Fraud is a more serious transgression, defined loosely as intentional wrongdoing 8 Why do managers commit to financial reporting fraud? • Managers face many financial incentives to meet performance expectations: ˗ Gaining earnings-based bonuses ˗ Increasing their promotion prospects ˗ Avoiding a decline in the value of their stocks, stock appreciation rights, and options ˗ Avoiding a downgrade of the company’s debt and debt covenant violations ˗ Avoiding restrictions on dividend payments ˗ Avoiding corporate bankruptcy • Managers also have many non-financial motives for committing to fraud ˗ Maintaining the esteem of one’s peers • Financial frauds appear to share three properties ˗ Inability to meet performance expectations ˗ Personal costs of failing to meet expectations ˗ Being able to convincing oneself that real performance will improve soon 9 Why do managers commit to financial reporting fraud? • In an extended boom period in the economy, high growth becomes built into performance expectations such as ˗ Earnings and revenue forecasts ˗ Share prices ˗ Investment decisions • Lax governance practices likely develop in a long boom, because corporate monitors (boards, auditors, analysts, media and regulators) come to accept high growth as normal ˗ A risk of “falling asleep” when business is doing well • After the boom busts, growth suddenly falters, and many managers are unable to meet expectations 10 Example: Lehman Brothers (2008) • Lehman was the 4th biggest investment bank in the US • Lehman had predominately long-term assets and largely short-term liabilities • It funded itself through short-term financing ˗ The confidence from its counterparties was critical • After the demise of Bearn Stearns in March 2008, Lehman was considered as the next possible bank to fail ˗ Lehman needed more confidence and the company began to “paint” a misleading picture of its financial condition • During 2008 Lehman asserted that it had a sufficient liquidity pool • However, it did not disclose that by June 2008 significant components of this liquidity pool had become difficult to monetize 11 Example: Lehman Brothers (2008) • In Sept 10, 2008, Lehman announced that it was projecting a $3.9 billion loss for Q3 of 2008 • By September 12, the liquidity pool only contained $2 billion of liquid assets • This was two days before Lehman had reported a liquidity pool of $41 billion • During the weekend Sep12-14, the US government reported that it did not have the legal authority to make a direct capital investment in Lehman and Lehman’s assets were not sufficient enough to support a loan large enough to avoid collapse • Sep15, 2008, Lehman filed for Chapter 11 bankruptcy protection • Lehman’s demise had an effect on the financial system and it triggered a crisis of confidence, which leads to the global financial crises 12 Audit committee • Boards are supposed to ensure reliable financial reporting (see Module 1) ˗ Board has many legal duties including the duty of care and duty of supervision • Audit committee within the board handles and prepares all accounting-related matters for full board meetings ˗ Establishes all the required processes and guidelines to ensure high accounting quality in the firm • Audit committee has a broad range of responsibilities ˗ Oversee financial reporting and disclosure and ˗ Monitor choice of accounting principles ˗ Hire and monitor external auditors ˗ Oversee internal audit function ˗ Oversee regulatory compliance ˗ Monitor risk management 13 External auditors • The external audit assesses the validity and reliability of financial reporting by reviewing the firm’s financial statements and its procedures • Management is responsible for preparing financial reports • Shareholders expect an objective third party to provide assurance that the information in financial reports is accurate • Despite common believe, it is not the explicit objective of the audit to identify fraud • The objective is to express an opinion on whether statements comply with accounting standards • Auditors express an “unqualified opinion” if it finds no reason for concern. • To fulfill their tasks, external auditors • Conduct interviews with the firm’s employees and confirm with the firm’s customers and clients • Make their own observations of the firm’s assets and check sample balancesheet transactions 14 Internal auditors • • • • • Report to audit committee of the board Oversee the firm’s financial and operating procedures Check the accuracy of the financial record-keeping Implement improvements with internal control Ensure compliance with accounting regulations 15 Audit quality • Given the importance of the audit, it is easy to understand that much attention has been paid to factors that might impact audit quality • Industry consolidation • Auditor rotation • Auditor’s personal characteristics • What impact, if any, do each of these have on the accounting quality and even the likelihood of future restatement or fraud? • Industry consolidation • In the late 1980s, there were eight major accounting firms • Currently there are four (the “Big Four”: Deloitte, EY, KPMG and PWC) • (+) Scale of audit firms matches the scale of companies • (+) Expertise by industry and region and by function (e.g. tax) • (-) Inadequate number of firms to choose among • (-) Decreased competition might lead to increased fees 16 Audit quality • Auditor rotation • Auditor rotation is the practice of periodically changing external audit firms • (+) New auditor might be more independent • (+) New auditor has fresh perspective • (-) Costly to change audit firms or audit teams • (-) New auditor has a steep learning curve Research evidence: • Audit rotation leads to increased audit informativeness, higher earnings quality and lower cost of equity capital • Mandatory audit rotation leads to greater audit quality • Audit rotation have a positive impact on audit quality, positive effect on auditors’ independence and negative impact on client specific knowledge See Krishnan and Zhang (2019) and Lennox et al., (2014). 17 Audit quality • Auditor’s personal characteristics • Auditors are all highly qualified experts who must pass a CPA exam to become a certified auditor, meaning that they are supposed to provide high quality auditing • Auditing is a highly regulated, internally monitored and standardized teamwork, which should leave little room for auditors’ personal characteristics • However, a recent evidence shows that auditors are also human beings and their personal characteristics do matter at their work • Even audit quality is affected by their personal characteristics Research evidence: • Risk-prone auditors as measured by their criminal convictions accept lower audit quality • More capable auditors as measured by their intelligent quotations (IQ) produce better quality auditing See Amir et al. (2014), Kallunki et al. (2019). 18 Research evidence on auditors’ risk-taking • Amir, Kallunki and Nilsson (2014) ˗ Do certified auditors have crime convictions? ˗ If so, how does this affect audit quality and pricing? • It is often assumed that auditors (unlike all other people) are homogenous individuals with similar personal characteristics • An auditors’ crime convictions could be used as a proxy for her propensity to take risk in personal matters • Amir et al. (2014) report results on how an auditor’s crime convictions reflect their willingness to take audit risks, too • Results are as follows: 19 Research evidence on auditors’ risk-taking • Auditors with criminal convictions are more likely to be males employed in non-Big-N audit firms ˗ Males take more risks than females ˗ Big-N audit firms are less tolerant of risk-taking auditors and have a stricter screening policy for their employees • Firms with major shareholders who have been convicted of crimes are more likely to appoint auditors with criminal convictions • Auditors with criminal convictions engage in high-risk audits and charge higher audit fees after controlling for other audit-risk variables 20 Research evidence on auditors’ risk-taking Title Act on Criminal Responsibility for certain Traffic Offences Road Traffic Promulgation Convictions All Big-N Non -Big-N 14 11 3 14 10 4 Vehicle Ordinance 7 6 1 Theft, robbery, other stealing 5 4 1 Fraud, Other Acts of Dishonesty, Crimes Inflicting Damage 4 4 0 Total crime convictions Suspected of crimes Total convictions/ suspicions … … 53 43 11% 10% 7 7 1.5% 1.6% 60 50 Example Drunken or reckless driving Various traffic-related crimes Various traffic related crimes Shoplifting, robbery Fraud, Damage to public property Penalty Range Fines to 2 years in prison Fines Fines Fines to 10 years in prison Up to 6 years in prison … 10 18.5% 0 0% 10 Swedish certified auditors’ crime convictions. Amir et al. (2014) 21 Research evidence on auditors’ risk-taking Variable GENDER AGE CLIENTS BIGN_AUD STOCKHOLM INCOME Convicted/Suspected Auditors Other Auditors Convicted (N = 53) Suspected (N = 7) Total (N = 60) (N = 422 ) Mean Median Mean Median Mean Median Mean Median 0.96 1.00 50.19 50.50 10.15 6.00 0.77 1.00 0.42 0.00 1,443.07 1,061.21 0.86 1.00 46.89 47.67 10.14 7.00 0.86 1.00 0.29 0.00 1,325.27 909.38 0.95 1.00 49.80 50.50 10.15 7.00 0.78 1.00 0.40 0.00 1,429.33 1,048.70 0.81 1.00 46.95 47.00 7.40 4.00 0.87 1.00 0.47 0.00 1,096.92 836.26 Difference between ‘Total’ and ‘Other auditors’ t-test Wilcoxon-test 2.69++ 2.67++ 2.44+ 2.49++ 2.23+ 2.23+ -1.95* -2.00+ 1.04 -1.04 2.83++ 2.54++ Means/Medians by categories of criminal activity. Amir et al. (2014) 22 Research evidence on auditors’ risk-taking Number of Convicted/Suspected Auditors Appointed by a Firm CONV_DIR CONV_OWNER CURRENT LEVERAGE PB SIZE LNAUFEE Zero (N = 1,048) One (N = 482) Two or more (N = 58) At least one (N = 540) Difference between ‘Zero’ and ‘At least one’ Mean Median 0.28 0.25 0.26 0.00 2.27 1.77 0.16 0.13 2.95 2.21 6.75 6.56 0.27 0.14 Mean Median 0.30 0.29 0.34 0.00 1.98 1.73 0.19 0.17 2.69 2.01 6.87 6.46 0.44 0.26 Mean Median 0.35 0.32 0.40 0.00 1.83 1.63 0.25 0.25 2.79 1.65 7.30 7.43 0.88 0.90 Mean Median 0.31 0.23 0.35 0.00 1.96 1.72 0.19 0.18 2.70 2.00 6.91 6.69 0.49 0.34 t-test Wilcoxon test -2.83++ -2.88++ 3.62++ 3.60++ 3.60++ 1.67* -4.10++ -4.05++ 1.99+ 2.69++ -1.57 -1.30 -2.78++ -2.74++ Characteristics of Firms Appointing Convicted/Suspected Auditors. Amir et al. (2014) 23 Bibliography • Amir, Eli & Juha-Pekka Kallunki & Henrik Nilsson (2014), “The Association between Individual Audit Partners’ Risk Preferences and the Composition of their Client Portfolios”, Review of Accounting Studies 19:1, pp. 102-133. Published Online: DOI 10.1007/s11142-013-9245-8. • Feng, M., Ge, W., Luo, S., & Shevlin, T. (2011). Why do CFOs become involved in material accounting manipulations?. Journal of Accounting and Economics, 51(1-2), pp. 21-36. • Gunny, K. A. (2010). The relation between earnings management using real activities manipulation and future performance: Evidence from meeting earnings benchmarks. Contemporary Accounting Research, 27(3), pp. 855888. • Kallunki, Jenni & Juha-Pekka Kallunki & Lasse Niemi & Henrik Nilsson (2019), “IQ and Audit Quality: Do Smarter Auditors Deliver Better Audits?”, Contemporary Accounting Research 36:3, pp. 1373-1416. • Krishnan, G., & Zhang, J. (2019). Do investors perceive a change in audit quality following the rotation of the engagement partner?. Journal of Accounting and Public Policy, 38(2), pp. 146-168. • Latridis, G. (2010). International Financial Reporting Standards and the quality of financial statement information. International Review of Financial Analysis, 19(3), pp. 193-204. • Lennox, C. S., Wu, X., & Zhang, T. (2014). Does mandatory rotation of audit partners improve audit quality?. The Accounting Review, 89(5), pp. 1775-1803. • Xu, C., Zhang, H., Hao, J., & Guo, L. (2021). Real earnings management in bankrupt firms. Journal of Corporate Accounting & Finance, 32(2), pp. 22-38. 24