10. Financial Reporting and External Audit

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Financial Reporting and External Audit
Authors: Professor David F. Larcker and Brian Tayan,
Researcher, Corporate Governance Research Initiative
Stanford Graduate School of Business

The board of directors is responsible for ensuring the integrity of published financial statements. This includes working with management to set the parameters for accounting quality and internal controls, and retaining an external auditor to test financial statements for material misstatements.

This Quick Guide reviews the process by which the board carries out this function.

It provides answers to the questions:
• What does the audit committee do?
• How does it oversee financial reporting?
• How often do companies restate financials and why?
• What does the external audit do?
• Do auditors have agency problems?

For an expanded discussion, see Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences (Second Edition) by David Larcker and Brian Tayan (2015): http://www.gsb.stanford.edu/faculty-research/books/corporate-governance-matters-closer-look-organizational-choices

Buy This Book: http://www.ftpress.com/store/corporate-governance-matters-a-closer-look-at-organizational-9780134031569

For permissions to use this material, please contact: E: corpgovernance@gsb.stanford.edu

Copyright 2015 by David F. Larcker and Brian Tayan. All rights reserved.

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10. Financial Reporting and External Audit

  1. 1. David F. Larcker and Brian Tayan Corporate Governance Research Initiative Stanford Graduate School of Business FINANCIAL REPORTING & EXTERNAL AUDIT
  2. 2. FINANCIAL REPORTING • Accurate financial reporting is critical for the efficiency of capital markets and the proper valuation of securities. • It allows the board and investors to make an informed evaluation of strategy, business model, and risk. • It also allows the board to structure compensation appropriately and award performance-based compensation knowing that predetermined targets were met. • It is the role of the audit committee to ensure the accuracy of reports. – Sets parameters for quality, transparency, and controls. – Hires external auditor to test for misstatement.
  3. 3. • The audit committee has a broad range of responsibilities: – Oversee financial reporting and disclosure – Monitor choice of accounting principles – Hire and monitor the external auditor – Oversee internal audit function – Oversee regulatory compliance – Monitor risk • To ensure that its work is free from management influence: – All committee members must be independent – All members must be “financially literate” – One member must be a “financial expert” • The Sarbanes Oxley Act of 2002 mandates these requirements. THE AUDIT COMMITTEE
  4. 4. • The audit committee establishes guidelines that dictate the quality of accounting used in the firm: • Quality: the degree to which accounting figures precisely reflect changes in financial position, earnings, and cash flow. • Transparency: the degree to which the company provides details that supplement and explain accounts reported in statements and filings. • Internal controls: the processes and procedures that ensure transactions are accurately recorded, financial statements reliably produced, and company assets protected from theft. ACCOUNTING QUALITY 90% of audit committee members believe they are effective or very effective in overseeing management’s use of accounting. KPMG (2009)
  5. 5. • Despite the confidence among committee members, evidence suggests companies are not as effective as they believe in preventing abuse. • Companies are much less likely to report a small decrease in earnings than a small increase. • Managers make small manipulations in accounts so that net income figures are rounded up rather than down. • Companies that beat earnings with “low-quality” earnings have better short-term but worse long-term performance. ACCOUNTING QUALITY: EVIDENCE In any given period, about 20% of firms manage earnings. Among them, the average level of earnings management is 10%. Burgstahler and Dichev (1997); Carslaw (1988); Malenko and Grundfest (2014); Bhojraj, Hribar, Picconi, and McInnis (2009); Dichev, Graham, Harvey, and Rajgopal (2013)
  6. 6. • A restatement occurs when a material error is found in the company’s previously published financials. • 700 to 1,700 U.S. public companies restate each year. FINANCIAL RESTATEMENTS 3% 4% 7% 10% 11% 13% 13% 14% 23% 30% 0% 10% 20% 30% CONTINGENCIES LEASES COST OF SALES DEPRECIATION & AMORTIZATION TAXES INVESTING STOCK-BASED COMPENSATION REVENUE RECOGNITION FINANCING ACCRUALS & RESERVES REASON FOR RESTATEMENT (2003-2012) Scholz (2014)
  7. 7. • A restatement can occur because of human error, aggressive accounting, or fraud. • The reasons for restatement have implications on the quality of controls in the company and the steps needed to remedy. REASONS FOR RESTATEMENTS • Some evidence that financial fraud is correlated with weak governance, including: ‒ Few outside directors ‒ Low director stock ownership ‒ Busy boards ‒ Fewer accounting meetings ‒ Fewer financial experts on audit committee • However, evidence is not conclusive. Others have found no relation to size, composition, and experience of board or to frequency of meetings. • Companies exhibit 5% median stock price decline following announcement of restatement; decline is 20% if due to fraud. Beasley (1996); Farber (2005); COSO (2010); Palmrose, Richardson, and Scholz (2004)
  8. 8. • Researchers have put tremendous effort into developing models to detect fraud—with limited success. • One set of models measures accounting quality in terms of “abnormal accruals” (the degree of divergence between reported net income and actual cash flows). • Another set of models analyzes both accounting and governance data. This improves success rate slightly. • Recently, researchers have explored linguistic analysis of CEO and CFO speech. This also improves success rate. • Still, accuracy in these models is low (less than 10%). MODELS TO DETECT MANIPULATION Beneish (1999); GMI Ratings (2013); Larcker and Zakolyukina (2012)
  9. 9. • The external audit assesses the validity and reliability of publicly reported financial information. • Because management is responsible for preparing financial reports, shareholders expect an objective third party to provide assurance that the information is accurate. • Despite public expectations, it is not the explicit objective of the audit to identify fraud. • Instead, 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. EXTERNAL AUDIT
  10. 10. 1. Audit preparation: Determine scope of audit. Identify areas requiring special attention. 2. Review estimates and disclosure: Sample key accounts. Test managerial assumptions. Independently verify estimates. 3. Fraud evaluation: Review opportunity for fraud. Examine incentives for fraud. Use “professional skepticism.” 4. Assess internal controls: Examine design. Identify weaknesses. Focus on key accounts and unusual transactions. 5. Conclude: Review findings with audit committee. Express an opinion to accompany the financial statements. EXTERNAL AUDIT PROCESS
  11. 11. • Given the importance of the audit, much attention has been paid to factors that might impact audit quality. • Potential issues include: 1. Industry consolidation 2. Conflict when auditor provides non-audit services 3. Conflict when former auditor is hired as CFO 4. Auditor rotation • What impact, if any, do each of these have on the likelihood of future restatement or fraud? AUDIT QUALITY
  12. 12. • In the late 1980s, there were eight major accounting firms. Currently there are four (the “Big Four”) (+) Scale of audit firms matches the scale of companies (+) Expertise by industry and region (+) Expertise by function (tax, audit, systems, etc.) (-) Inadequate number of firms to choose among (-) Decreased competition might lead to increased fees 1. INDUSTRY CONSOLIDATION • 60% of large companies believe there is an inadequate number of audit firms. Fewer than 25% of small companies believe this. • Audit fees have risen, but this is likely due to greater cost of compliance with SOX, greater scope, more expensive personnel. • Splitting up Big Four would reduce expertise and decrease quality. GAO (2008)
  13. 13. • Sarbanes Oxley prohibits auditors from performing certain non-audit services. (+) Reduces potential conflict of interest (+) Might improve auditor independence (+) Company cannot “retaliate” if it disagrees with auditor (-) Auditor has expertise in company procedures (-) Might be cheaper for company 2. NON-AUDIT SERVICES • No evidence that this practice hurts audit quality (measured by abnormal accruals, earnings conservatism, failure to issue qualified opinion, or future restatement). • Congress did not take into account this disconfirming evidence, even though it was widely understood at the time. • Majority of companies do not believe the benefits outweigh the costs. Romano (2005); Alexander, Bauguess, Bernile, Lee, and Marietta-Westberg (2013)
  14. 14. • A company might decide to offer a job in finance, treasury, or internal audit to a member of the external auditing team. (+) Auditor is familiar with company and its procedures (+) Company is familiar with auditor working style (+) Reduces both hiring costs and risk of failure (-) Auditor might have allegiance to former employer (-) Auditor knows internal controls, might facilitate fraud 3. FORMER AUDITOR AS CFO • Mixed evidence. • Some studies find decrease in earnings quality when company hires former auditor as CFO. • Others find no relation between source of hire and earnings quality. Dowdell and Krishnan (2004); Geiger, North, and O’Connell (2005)
  15. 15. • 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 4. AUDITOR ROTATION • Very little evidence that auditor rotation is cost-effective or that it improves audit quality. • However, auditor resignation (auditor quits because of disagreement with management) might be a warning sign of fraud. Cameran, Merlotti, and Di Vincenzo (2005); Whisenant, Sankaraguruswamy, and Raghunandan (2003)
  16. 16. • The audit committee plays an important role in ensuring the integrity of financial reporting by working with management to determine standards for quality, transparency, and controls. • The audit committee also hires and oversees the work of the external auditor. • Still, there are few reliable models that the board can use to detect accounting manipulation. • Audit committee effectiveness likely depends not only on qualification but engagement. • Superficial constraints on auditors (such as rotation, cooling off periods, and prohibition of non-audit services) are not likely to improve earnings quality. CONCLUSIONS
  17. 17. KPMG. The Audit Committee Journey. Recalibrating for the New Normal. 2009 Public Company Audit Committee Member Survey. David Burgstahler and Ilia Dichev. Earnings Management to Avoid Earnings Decreases and Losses. 1997. Journal of Accounting and Economics. Charles A. P. N. Carslaw. Anomalies in Income Numbers: Evidence of Goal-Oriented Behavior. 1998. The Accounting Review. Nadya Malenko and Joseph A. Grundfest. Quadrophobia: Strategic Rounding of EPS Data. 2014. Rock Center for Corporate Governance at Stanford University Working Paper. Sanjeev Bhojraj, Paul Hribar, Marc Picconi, and John McInnis. Making Sense of Cents: An Examination of Firms That Marginally Miss or Beat Analyst Forecasts. 2009. Journal of Finance. Ilia D. Dichev, John R. Graham, Campbell R. Harvey, and Shivaram Rajgopal. Earnings Quality: Evidence from the Field. 2013. Journal of Accounting and Economics. Susan Scholz. Financial Statement Trends in the U.S.: 2003-2012. 2014 Center for Audit Quality. Mark S. Beasley. An Empirical Analysis of the Relation Between the Board of Director Composition and Financial Statement Fraud. 1996. Accounting Review. David B. Farber. Restoring Trust After Fraud: Does Corporate Governance Matter? 2005. Accounting Review. Mark S. Beasley, Joseph V. Carcello, Dana R. Hermanson, and Terry L. Neal. Fraudulent Financial Reporting 1998–2007: An Analysis of U.S. Public Companies. 2010. Committee of Sponsoring Organizations of the Treadway Commissions (COSO). BIBLIOGRAPHY
  18. 18. Zoe-Vonna Palmrose, Vernon J. Richardson, and Susan Scholz. Determinants of Market Reactions to Restatement Announcements. 2004. Journal of Accounting & Economics. Messod D. Beneish. The Detection of Earnings Manipulation. 1999. Financial Analysts Journal. GMI Ratings. AGR Model. 2013. David F. Larcker and Anastasia A. Zakolyukina. Detecting Deceptive Discussions in Conference Calls. 2012. Journal of Accounting Research. Government Accountability Office (GAO). Audits of Public Companies: Continued Concentration in Audit Market for Large Public Companies Does Not Call for Immediate Action. 2008. Roberta Romano. The Sarbanes-Oxley Act and the Making of Quack Corporate Governance. 2005. Yale Law Review. Cindy R. Alexander, Scott W. Bauguess, Gennaro Bernile, Yoon-Ho Alex Lee, and Jennifer Marietta-Westberg. Economic Effects of SOX Section 404 Compliance: A Corporate Insider Perspective. 2013. Journal of Accounting and Economics. Thomas D. Dowdell and Jagan Krishnan. Former Audit Firm Personnel As CFOs: Effect on Earnings Management. 2004. Canadian Accounting Perspectives. Marshall A. Geiger, David S. North, and Brendan T. O’Connell. The Auditor-to-Client Revolving Door and Earnings Management. 2005. Journal of Accounting, Auditing & Finance. BIBLIOGRAPHY
  19. 19. Mara Cameran, Emilia Merlotti, and Dino Di Vincenzo. The Audit Firm Rotation Rule: A Review of the Literature. 2005. SDA Bocconi Research Paper. J. Scott Whisenant, Srinivasan Sankaraguruswamy, and K. Raghunandan. Market Reactions to Disclosure of Reportable Events. 2003. Auditing: A Journal of Practice and Theory. BIBLIOGRAPHY

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