cg lecture8

8/3/2019 CG Lecture8

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Financial Reporting

Relevance to

Corporate Governance


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Financial Reports

Chairmans Report

Financial Statements

Income Statement

Cash Flow Statement

Statement of changes in Equity

Balance Sheet Notes


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Qualities of Financial

Statements

Clear & understandable

Reliable & honest

No frauds

No window dressing

Properly audited

Compliant with laws/ rules/ practice


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Functions of Fin Statements

Information Function

Stakeholders

Control Function

Board

Owners

Planning Management


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Investors Interest in

Financial Statements

Instrument ratings

Shares

Bonds

Buy / sell / hold decisions

Pricing / valuation of the company

Acquisitions Mergers


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Key Issues

Why would management want its

financial statements to be untrue?

Consequences of unreliable financialstatements

Role & independence of external

auditors

How can reliability be assured?

No sudden collapse in near future


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Misleading Statements

Deliberate false picture of the company

Improper accounting policies

Revenue and expense recognition

Capital and revenue expenditure

Income and liability distinction

Creating complexities in financialstatements


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Case 1:

Deliberate false picture

A Ltd wishes to show a higher profit. It can:

overvalue its closing stock.

Not make expense accruals

Not make various provisions

Bad debts / legal obligations

Investments revaluations Book false gains through sale-purchase

back.


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Case 2:

Misuse of Accounting Policies

Revenue recognition

Book revenue before earning it to increase

profits Defer revenue to reduce profits

Expense recognition

Defer expenses to increase profits

Make unreal provisions to reduce profits


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Case 3:

Playing with debits

Show a higher profit by

Capitalizing normal revenue expenses,

treating them as assets. Deferring start of depreciation or interest

expensing.

Show lower profits by expensing thecapital costs


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Case 4:

Playing with credits Show higher profits by treating liabilities

as incomes, e.g.

An advance from a client/taxes may becredited to revenue.

A loan may be channeled through a SPV

and treated as income

Show lower profits by treating revenueas a liability, e.g. Microsoft.


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Case 5:

Change in Accounting PolicyA company can alter its profit figures

through change in accounting policy and

deliberately omit to mention the changeof policy in notes, or omit to give the

correct impact of the change.

Examples:

Valuation Basis

Depreciation Basis


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Case 6:

Complicating Fin StatementsA company can make its financial

statements too complex for an average

investor to understand. In particular,having different accounting policies,

closing dates and natures of business

offers tremendous scope for play in

consolidated financial statements.


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Responsibility for health of

Financial Statements The Board

Management

External Auditors

External Bodies

Regulators: KSE/SECP

Accounting bodies: ICAP/ICMAP Trade associations


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The Boards Role

Importance of NEDs

Significance of INEDs

Audit Committee


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Managements Role

Management draws accounting policies,

keep accounts and prepares financial

statements. Management has most to gain or lose

from the defects of financial statements

Hence, management needs highest

degree of monitoring in this aspect.


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External Auditors Role

Every one depends on external auditors

report.

Independence of external auditors mustbe assured:

Rotating them regularly

Not giving them any other business

Granting them full access to all records

Limiting their relationship with

management


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External Audit: Purpose

Only purpose is to obtain an opinion.

External auditors is not supposed to fix

the financial statements.

Report:

Unqualified

Qualified

Disclaimer

Adverse


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Audit Report: Scope

Clarify basis of forming an opinion

Proper records have been kept

Financial statements:

are in accordance with the records

reflect a true and fair view of the profit &

position

comply with the laws


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Errors and Frauds

Difference is only of intent

Both result in:

Incorrect use of accounting policies,

Omission of facts, or

Misinterpretation of facts

Basic responsibility to prevent and detecterrors/frauds lies with management, not

external auditor.


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Auditors Liability

No liability to outsiders

Caparo Industries Case

Bannerman Case

Disclaimers now abound


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Professional Monitors of

External Auditors Accounting Standards from IFAC

Ethical Standards from ESB

Audit Standards from APB (UK)

Investigation & Discipline Board (UK)

Review Board (UK)

Public Company Accounting OversightBoard (Sarbanes-Oxley Act) in USA

ICAP and SECP in Pakistan


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Guidelines to Audit firms

Do not rely on one client for major part of

firms fee revenue.

No linkages with clients

Non-audit services should not be given

(or at least be restricted) to clients


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Non-Audit Work

Taxation

Investigations (for acquisitions, etc.)

General consultancy on new projects

Systems development

Low-balling


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How to control non-audit work

No restriction on audit firms leaving it

to their professional judgment.

Total prohibition on non-audit work.

Partial prohibition on non-audit work,

defined either by nature of work, or level

of approval.


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Rotation of External Auditors

Rotation of audit firm as prescribed by

Pakistan laws

Rotation of partners within the samefirm.

Different partners for different tasks

Appointment by open tender


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Objectives of Fixing

Financial Statements Managing Position

Managing Profits


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Managing Position

To meet rules and regulations

To meet lenders covenants

To portray better picture to public

Keep assets or liabilities off balance sheet

Window dressing

Misclassification of items


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Earnings Management

To keep share price stable, or rising

To meet market expectations

To maintain dividend payout pattern

Smoothening needs

Hidden (misclassified) reserves


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Creative Accounting

Standards do not cover every thing.

There is always more than one correct

way of handling things Legitimate and dishonest intentions

Outright fraud: double set of books


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Directors Responsibilities

To prepare accounts

To prepare directors report

Balanced and understandable assessment

State of affairs; going concern

Outline directors expectations

To make legal disclosure To present the above to shareholders

To file returns


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Voluntary Disclosures

Future events or plans

Changes in administration or policy

Achievements

Concerns


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Role of Audit Committee

To monitor the integrity of financial

statements

To review internal controls & audit To review risk management systems

To approve terms & remuneration of

external auditors

To ensure independence of external

Auditors


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Audit Committee Issues

Composition

All NEDs

Majority INEDs Chairman of the company not a member

Duration

Frequency of meetings


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Nature of Audit Committee

It is not an executive body.

It does not draw up accounting policy; its

role is only to review and oversee. It does not perform internal or external

audit.

It reports to the Board, not management.

It issues advice to management, notdirectives.

Committee can go to shareholders


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Internal Audit

If formal internal audit department exists,

it reports to Audit Committee.

If no formal internal audit departmentexists, Audit Committee can recommend

establishment of one, or suggest other

measures.


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External Auditor &

Audit Committee Negotiations with external auditor

Verifies suitability of the external auditor

Their resources, qualifications, independence, past

record

Ensures independence

Linkages, non-audit work

Rotation, former employees of audit firm

Audit firms performance, ethics

Discusses report / management letter with

external auditor


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Audit Cycle

Audit plan / internal / external

Discussion of audit plan with auditors

Contact during audit

Review of findings, major issues

Oversee all correspondence with

external auditors Representations letter

Management letter


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AC and whistleblowing

In absence of any other formal avenue,

Audit Committee may handle

whistleblowing cases. Set up process of handling these cases.

Set up mechanism for investigation and

follow up.


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Thank you

cg lecture8

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