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© Martin E Taylor1 Financial Reporting Scandals in the U.S. and Their Impact on the Financial Reporting Value Chain
© Martin E Taylor2 Sarbanes-Oxley Strikes Again Enron Skilling gets 24 years WorldCom Bernie 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.
© Martin E Taylor3 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
© Martin E Taylor4 The Fraudulent Financial Reporting Hall of Shame WorldCom Improper capitalization of expenses or losses Cendant Fictitious revenue
© Martin E Taylor5 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
© Martin E Taylor6 Financial Reporting Value Chain CEO/CFO > Board of Directors > Audit Committee > Internal Auditors > External Auditors > Analysts > Users Regulators: SEC, State Regulators, Stock Exchanges
© Martin E Taylor7 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
© Martin E Taylor8 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
© Martin E Taylor9 Improper Revenue Recognition Bill and hold sales Holding books open Multiple element contracts (Xerox) Fictitious revenue Improper valuation of revenue
© Martin E Taylor10 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
© Martin E Taylor11 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
© Martin E Taylor12 Earnings Restatements
© Martin E Taylor13 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??
© Martin E Taylor14 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
© Martin E Taylor15 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”
© Martin E Taylor16 Internal Auditors Independence?? Operational versus Financial Audits Outsourcing the Internal Audit Function
© Martin E Taylor17 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%
External Auditors: Consultants or Auditors?? © Martin E Taylor 18 The Economist, November 9 th -15 th, 2013
© Martin E Taylor19 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)
© Martin E Taylor20 Analysts Conflict of Interest Settlement $1.4 billion settlement against Bear Stearns, Morgan Stanley, JP Morgan Chase
© Martin E Taylor21 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
© Martin E Taylor22 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
© Martin E Taylor23 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
© Martin E Taylor24 Other Regulators Stock Exchanges New York Stock Exchange NASDAQ State Regulators
© Martin E Taylor25 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
© Martin E Taylor26 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
© Martin E Taylor27 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)
© Martin E Taylor28 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/ http://www.ibm.com/investor/governance/
© Martin E Taylor29 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
© Martin E Taylor30 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.
© Martin E Taylor31 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
© Martin E Taylor32 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/companyinf ormation/corporategovernance/committees/a udit.mspx http://www.microsoft.com/about/companyinf ormation/corporategovernance/committees/a udit.mspx
© Martin E Taylor33 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
© Martin E Taylor34 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
© Martin E Taylor35 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
© Martin E Taylor36 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 http://pcaobus.org/Pages/default.aspx
© Martin E Taylor37 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
© Martin E Taylor38 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
© Martin E Taylor39 The Sarbanes-Oxley Act Effect on Analysts Financial analysts cannot be involved in marketing securities
© Martin E Taylor40 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
© Martin E Taylor41 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
© Martin E Taylor42 Criticisms of The Sarbanes-Oxley Act Legislation similar to SOX has been adopted in other countries Japan (J-SOX) China (C-Sox)
© Martin E Taylor43 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
© Martin E Taylor44 Other Topics and Developments Corporate Social Responsibility Triple Bottom Line Reporting Economic Social Environmental Integrated Reporting Dodd-Frank Legislation
© Martin E Taylor45 Other Topics Financial Statement Presentation Market to Market Revenue Recognition Leases Pensions Intangible Assets
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