Accounting Information Systems 9th Edition
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  • PWC 2001 (Annual) Securities Litigation Study 2001 of 483 308 IPO for nondisclosure of commissions received by underwriters
  • % growing but actual number decreasing from 1998
  • Revenue recognition – the main problem is channel stuffing where revenue is recognized on products sold into the distribution channel even though that product has not actually been sold to an end user and is subject to a possible return by the distributor BIGGEST OFFENDERS ARE SOFTWARE COMPANIES
  • Most accounting lawsuits are for audits. 2ed – provides that the SEC may suspend any accountant that it finds who lacks the qualifications to represent others, has engaged in unethical or improper professional conduct, or has willfully violated any of the Federal Securities law 2e allows SEC to permanently ban from practice, temporarily ban, public censure
  • From Chuck Landes – State of Audit Profession There is no one simple answer to the question: what went wrong? But it is a question we must begin to answer as we take the necessary steps to restore investor confidence. For executives of Enron, WorldCom, and yes, for some auditors, part of the problem was simple greed or arrogance. Part of the problem was the pressure of a market in which the difference of a penny or two in earnings could lead to the difference of a billion or two in market cap. Part of the problem is the financial reporting model itself: The proper treatment of many issues is not clear, such as off-balance-sheet activity. Financial statements are not written in plain English. And management has not been required to disclose estimates and accounting policies. Part of the problem too is a GAAP model with too many rules that leaves too little room for principle-based judgment. And even where GAAP does allow for such judgment, far too many preparers don’t exercise it – opting for a form of “connect-the-dots” accounting that doesn’t necessarily draw a full and complete picture of a company.
  • And part of it is the fact that institutional investors and other market professionals have not traditionally provided feedback to the AICPA’s standard-setting process. In retrospect, we could and should have done more to solicit it. Now, we must demand it. There was in some cases a failure of some auditors to step up to their own responsibility. And some auditors have been inclined to assume good intent. Most of those who make up the leadership of corporate America are honest, with the interests of their shareholders foremost in mind. But an auditor must carry a standard of professional skepticism into each and every audit. As President Reagan said of arms negotiations with the Soviets “Trust, but verify.” That’s our obligation to shareholders. Clearly, part of the problem was some inherent weaknesses in disciplinary and monitoring processes for the profession. And part of it is the threat – real or perceived – of auditor dependency on fees from major clients. And there are some problems with an auditor’s dependency on fees from large clients. Unqualified auditor – did not know what a contract receivable was, then or now. Andersen . Calpers accused Andersen of superficial auditing job.
  • Disclosure of amounts began in 2002 – with SEC
  • No” means protecting the public interest by rejecting unsound corporate accounting practices. “ No” means reducing the risk of deceit and fraud. “ No” means ensuring that audited statements are not just accurate, but illuminating. “ No” means questioning and challenging management. When justified, it means rejecting management’s accounting decisions. Saying “no” means saying “yes” to protecting the public interest. Only if auditors are fully prepared to say “no” will investors be fully prepared to say “yes.” “ No” is not always easy to say. But obscured by the recent focus on our profession is the fact that auditors say it every day. These stories rarely come to light – because an auditor prevails on clients to do the right thing.
  • From Internal Auditor – the three Cs of fraudulent financial reporting 10/01/2002 Conditions – deliberately mislead FS users Aggressiveness – meet analysts forecasts Cohesiveness, loyalty, blind trust – increase the likelihood of cooking the books and subsequent cover-ups, decrease whistle blowing Blind trust, ineffective controls – less effective in preventing and detecting fraud
  • So there were many things that worked together to create the situation we’re now in. Congress responded quickly to these problems and the business reporting failures.
  • The Sarbanes-Oxley Act brings a new regulatory environment for the CPA profession and affects not just the largest accounting firms, but any CPA actively working as an auditor of a publicly traded company or in the financial management area of a public company. It creates the new five-member Public Company Accounting Oversight Board (PCAOB). This Board oversees and investigates the audits and auditors of public companies, and can sanction both firms and individuals for violations of laws, regulations and rules. The board allows only two members to have experience as a CPA. The chairperson must not have practiced accounting during the five years preceding his/her appointment. The Board has the authority to set or adopt and enforce auditing standards for public companies. It is also empowered to inspect the auditing operations of public accounting firms that audit public companies. It can impose disciplinary and remedial sanctions for violations of the board’s rules, securities laws and professional auditing standards. The Board is funded by public companies through mandatory fees. Accounting firms that audit public companies must register with the Board (“registered firm”), and pay registration and annual fees.
  • In the area of standards setting, the Board can issue standards or adopt standards set by other groups or organizations, for audit firm quality controls for the audits of public companies. These standards include: auditing and related attestation, quality control, ethics, independence and “other standards necessary to protect the public interest.” The Board has the authority to set and enforce audit and quality control standards for public company audits. The Act also has provisions that would allow the SEC to have oversight, governance and funding of the Financial Accounting Standards Board. The Act includes some scope of services restrictions. It lists eight types of services that are “unlawful” if provided to a publicly held company by its auditor-- I’ll discuss what these are in a moment. It also has one catch-all category authorizing the board to determine by regulation any service it wishes to prohibit. Other non-audit services—including tax services—require pre-approval by the audit committee. Pre-approved non-audit services must be disclosed to investors in periodic reports.
  • The Sarbanes-Oxley Act prohibits auditors of publicly held companies from offering these services.
  • The law increases the liability for CPA firms that audit publicly held companies. This is because the statute of limitations for the discovery of financial statement fraud has been extended to five years from occurrence or two years for discovery. It was previously one year from discovery and three years from occurrence. The Act omitted language that was in earlier legislation that said that the Board’s finding that an audit of an issuer met or failed to meet any applicable quality standard “shall not be construed . . . as indicative of compliance or noncompliance” with securities laws, or with any standard of liability arising thereunder. In regards to Internal Controls, the Act now requires every audit report to describe the auditor's testing of the company's internal control structures, including a specific notation about any significant defects or material noncompliance found on the basis of such testing. In addition, management must now assess and make representations about the quality of internal controls and auditors will attest to and report on those representations. It also specifies that this report must be part of the audit and not a separate engagement.
  • The relationship between accounting firms and their audit clients is different under the new law. Now, auditors will report to and be overseen by a company’s audit committee, not management. Financial statements filed with the SEC must be certified by the CEO and CFO. The certification must state that the financial statements and disclosures fully comply with provisions of the Securities Exchange Act and that they fairly present, in all material respects, the operations and financial condition of the issuer. Maximum penalties for willful and knowing violations of this section are a fine of not more than $500,000 and/or imprisonment of up to 5 years. In addition, criminal penalties for securities fraud have been increased to 25 years. It is now a felony with penalties of up to 10 years to willfully fail to maintain “all audit or review workpapers” for at least five years. The SEC will establish a rule covering the retention of audit records and the Board will issue standards that compel auditors to keep other documentation for seven years. Also, it is a felony with penalties of up to 20 years to destroy documents in a federal or bankruptcy investigation.
  • The provisions of the Sarbanes-Oxley Act have several implications. The lead audit partner and audit review partner must be rotated every five years on public company engagements. But it COULD require mandatory rotation of ALL partners on an audit engagement. Also, the law makes auditors responsible for “testing” issuers’ compliance with laws and for reporting potential violations. The Board’s broad powers could bring some duplication with the SEC. For example, the Board COULD enforce securities laws. Of particular concern is the cascade effect that the scope of services restrictions could have on small businesses and accounting firms. I will talk more about this in a moment.
  • So there were many things that worked together to create the situation we’re now in. Congress responded quickly to these problems and the business reporting failures.
  • Sherry— I made some changes to this slide
  • From financial management applications must step up to increased accountability and regulation by paul hamerman CIO oct 11, 2002

Accounting Information Systems 9th Edition Presentation Transcript

  • 1. Fraudulent Financial Reporting
  • 2. A little Insight into CEOS….
    • A survey by Starwood Hotels & Resorts showed that 82% of CEOs admit to cheating at golf.
    • The same percentage hate others who do the same.
  • 3. 2002 Top 100 Accounting Firms
    • Public Accounting Report (Firm: Reported Revenues)
      • PriceWaterhouseCoopers: $8,056.5M
      • Deloitte & Touche: $6,130M
      • Ernst & Young: $4,485M
      • KPMG: $3,171M
      • Grant Thorton: $432.5
      • BDO Seidman: $353M
      • BKD: $210.9M
      • Crowe, Chizek & Co.: $204.7M
      • McGladrey & Pullen: $203M
      • Moss Adams: $163M
    Dropping Out: Andersen #5 in 2001
  • 4. Fun Facts
    • Economic Theory predicts there will be how many Big Accounting firms?
    • Three
  • 5. Fraudulent Financial Reporting
    • Keep 2 things in mind:
    • Most costly fraud
    • Restatements associated with fraud have cost investors over $100B in the last sixish years (Hilzenroth, 2001)
    • Perpetrated by management
  • 6. Number of Securities Class Action Lawsuits 2001 :308 IPO PWC 2001 (Annual) Securities Litigation Study
  • 7. % Lawsuits with Accounting Allegations PWC 2001 (Annual) Securities Litigation Study
  • 8. 10- Accounting Issues PWC 2001 (Annual) Securities Litigation Study
  • 9. Securities Class Action Lawsuits -2001
    • 53% involved FS restatement
    • 10% dismissed
    • On average, settled in 4 years
    • biggest industries –
      • computer services (32%) followed by
      • telecommunications (11%)
    • Most filed in NY (IP0) or CA (hitech)
    • 2/3 firms listed on NASDAQ
    PWC 2001 (Annual) Securities Litigation Study
  • 10. Securities Class Action Lawsuits $$$$ PWC 2001 (Annual) Securities Litigation Study $23.7M/7.5M 69 ACCTG $6.2M/3.9M 40 2001 NON ACCTG $18.3M/7M 157 ACCTG $7.8M/3.6M 104 1996-2000 NON ACCTG Avg/Median Settlement Settled Cases Year
  • 11. Securities Class Action Settlements
    • 2000 study by Bajaj, Mazumdar, Sarin
    • Table 4: Settlement amount and time
      • Longer = more $$$
    • Table 12: Settlement statistics by co-defendant type
      • Accounting/Underwriting mean/ median much higher
      • To settle or not settle? Why?
      • E&Y: Cendant settlement= HUGE
    • Table 13: Settlement statistics by allegation type
    • Table 16: Want to sue? Milberg, Weiss, Berhad, Hynes & Lerach
      • 31% of all filings
  • 12. Types of Audits & Lawsuits
    • Compilation: prepares FS without any testing, no assurance AT ALL
    • Review: few substantive tests (inquiry, analysis, discussion), limited assurance
      • Can you believe the FS?
    • Audit: in accordance with GAAS, positive assurance
    Most Lawsuits SEC 2ed – Rules of Practice 2(e)
  • 13. What went wrong? Corporate culture and reporting model
    • Simple greed or arrogance
    • Market pressure on short-term
    • earnings
    • Lack of transparency or timely
    • disclosures in the reporting model
    • Lack of mandated disclosures on management’s accounting policies
    • Too many rules leading to connect the dots accounting and auditing – rules vs principle
    Chuck Landes – State of Audit Profession
  • 14. What went wrong? The work of auditors
    • Some not stepping up to their responsibilities
    • Some assumed good intent on part of mgmt
    • Inherent weaknesses in our disciplinary and monitoring processes
    • Unqualified/inexperienced auditors
    • Close relationship with client (leave for companies they audit)
    • Materiality judgments????
      • Waste Mgmt- Andersen decided 12% misstatements immaterial
    Chuck Landes – State of Audit Profession
  • 15. What went wrong? The work of auditors
    • Movement to “business advisory role”
    • Make Audits Pay: Leveraging the Audit into Consulting Services (AICPA, 1999)
    • Auditor dependency on fees from major clients – especially non-audit fees
      • KPMG: Motorola $3.9M/$62.3M
      • E&Y: Sprint $2.5M/$63.8M
      • PWC: AT&T $7.9M/$48.4M
    EQUALS CAVE IN TO CLIENTS
  • 16. What saying NO means
    • Auditors need to just say NO
    • Rejecting unsound corporate accounting practices
    • Reducing the risk of deceit and fraud through diligent inquiry
    • Ensuring that audited statements are not just accurate, but illuminating
    • Questioning management, challenging management
    • When justified – rejecting management’s accounting decisions
    ZERO TOLERANCE POLICY!!!! Chuck Landes – State of Audit Profession
  • 17. Fraudulent Financial Reporting
    • (Internal) Auditors need to predict & uncover financial statement fraud using the three Cs.
    • Conditions : pressure to meet analysts’ earnings forecasts
    • Corporate Structure :
      • aggressiveness, arrogance
      • cohesiveness, loyalty, gamesmanship
      • control ineffectiveness, blind trust
    Internal Auditor (Oct 2002) – “The Three Cs of Fraudulent Financial Reporting” by Z. Rezaee
  • 18. Fraudulent Financial Reporting
    • Choice : managers should use ethical strategies
    • RED FLAGS for management
    • Personal wealth closely associated with company’s performance
    • Willing to take (illegal) personal risk for co. $$$
    • HIGH pressure to maximize shareholder value
    • Probability of fraud detection low
    • 1 = possibility, 2+ = high probability fraud occurred
    Internal Auditor (Oct 2002) – “The Three Cs of Fraudulent Financial Reporting” by Z. Rezaee
  • 19. What was the response of Congress?
  • 20. The Sarbanes - Oxley Act: Oversight Board
    • New Public Company Accounting Oversight Board (PCAOB)
    • 5 members – only 2 CPAs (& only 2)
    • Power to set auditing rules, inspect firms and discipline wrongdoers
    • Funding from accounting firms and registrants
  • 21. The Sarbanes - Oxley Act:
    • Standard Setting
    • PCAOB has authority to “adopt, amend, modify, repeal or reject” standards
    • Includes provisions for SEC oversight, governance and funding of FASB
    • Independence/Scope of Services
    • Proscribes eight specific services to public company audit clients
    • Gives PCAOB authority to prohibit others
    • Other nonaudit services not banned must be pre-approved by audit committee
  • 22. The Sarbanes - Oxley Act: Banned Services
    • Bookkeeping
    • Information systems design and implementation
    • Appraisals or valuation services
    • Actuarial services
    • Internal audits
    • Broker/dealer and investment banking services
    • Legal or expert services related to audit services
    • Management and human resources services
    • Other services as determined by the board
    HARSH PENALTIES
  • 23. The Sarbanes - Oxley Act:
    • Liability Concerns
    • Statute of limitations extended to 5 years from occurrence or 2 from discovery
    • No specific language on non-preclusive effect
    • Reporting on Internal Controls
    • Requires auditor to report on internal controls assertions
    • Must be part of audit - not separate engagement
  • 24. The Sarbanes - Oxley Act:
    • Corporate Governance
    • Mandates audit committee oversight of audits
    • Requires CEO/CFO certification of reports
    • Prison terms of up to 10 years for senior executives
    • Workpaper Retention
    • Auditors to retain documents in support of report for 7 years.
    • 5 yr retention requirement under “criminal fraud accountability”
  • 25. Overview of the Potential Impact
    • New rules could require mandatory rotation of all partners on audit engagements.
    • New auditor responsibility for “testing” issuers’ compliance with laws and reporting on “potential” violations.
    • The new Board could have the authority to enforce securities laws, duplicating SEC’s powers.
    • State legislative/regulatory proposals could “pile on” and/or conflict with Federal laws.
  • 26. The mess continues…..
    • Public Company Accounting Oversight Board (PCAOB) – William Webster resigns after it is revealed he headed an audit committee of U.S. Technologies that is being sued by investors for fraud.
    • SEC Chairman – Harvey Pitt resigns because of Webster
  • 27. What was the response of the accounting profession?
  • 28. Recently Issued Standards
    • SAS No. 95, Generally Accepted Auditing Standards
    • SAS No. 96, Audit Documentation
    • SSAE No. 11, Attest Documentation
    • SAS 97, Reports on the Application of Accounting Principles
    • SAS 98, Omnibus 2002
  • 29. Auditors role in Fraud
    • Previous standard: SAS 82
      • required specific assessment of the risk of material misstatement of FS attributable to fraudulent financial reporting
      • Consideration of 40 specific fraud factors
    • New standard: SAS 99 (Oct 2002)
      • Part of anti-fraud movement
      • Auditor is responsible for providing reasonable assurance that the FS are free of material misstatement whether caused by error or fraud
      • Also responsibility place on board of directors and audit committee
  • 30. Auditors Role in Fraud
    • Forensic accountant = fraud auditor
    • Work for FBI, public accounting firms, IRS, insurance organizations
    • Certified Fraud Examiner: requires passage of Uniform CFE Examination
  • 31. AICPA Initiatives
    • Institute for Fraud Studies with the University of Texas and Association of Certified Fraud Examiners
    • calling for revision of auditing standards to provide public notice of internal control weaknesses
    • Will create enhanced attestation standards for CPAs to report on corporate anti-fraud programs
    • Will work with FASB for better reporting and disclosure standards
  • 32. Impact on AIS
    • Large ERP vendors : equipped to handle reporting requirements as long as controls in place. Software vendors respond to regulatory changes with updates.
    • Disparate/fragmented/legacy systems : more interfaces/reconciliation procedures increasing risk of material errors (as well as the time required to close books)