1 Financial Reporting Relevance to Corporate Governance

2 Financial Reports Chairman’s Report Chairman’s Report Financial Statements Financial Statements Income Statement Income Statement Cash Flow Statement Cash Flow Statement Statement of changes in Equity Statement of changes in Equity Balance Sheet Balance Sheet Notes Notes

3 Notes to Accounts Accounting methods and policies used Accounting methods and policies used Greater details of summarized figures Greater details of summarized figures Statutory disclosures Statutory disclosures Changes in accounting policies / impact Changes in accounting policies / impact Details of off-balance sheet items, if any Details of off-balance sheet items, if any

4 Qualities of Financial Statements Clear & understandable Clear & understandable Reliable & honest Reliable & honest No frauds No frauds No window dressing No window dressing Properly audited Properly audited Compliant with laws/ rules/ practice Compliant with laws/ rules/ practice

5 Functions of Fin Statements Information Function Information Function Stakeholders Stakeholders Control Function Control Function Board Board Owners Owners Planning Planning Management Management

6 Investors’ Interest in Financial Statements Instrument ratings Instrument ratings Shares Shares Bonds Bonds Buy / sell / hold decisions Buy / sell / hold decisions Pricing / valuation of the company Pricing / valuation of the company Acquisitions Acquisitions Mergers Mergers

7 Key Issues Why would management want its financial statements to be untrue? Why would management want its financial statements to be untrue? Consequences of unreliable financial statements Consequences of unreliable financial statements Role & independence of external auditors Role & independence of external auditors How can reliability be assured? How can reliability be assured? No sudden collapse in near future No sudden collapse in near future

8 Misleading Statements Deliberate false picture of the company Deliberate false picture of the company Improper accounting policies Improper accounting policies Revenue and expense recognition Revenue and expense recognition Capital and revenue expenditure Capital and revenue expenditure Income and liability distinction Income and liability distinction Creating complexities in financial statements Creating complexities in financial statements

9 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

10 Case 2: Misuse of Accounting Policies Revenue recognition Revenue recognition Book revenue before earning it to increase profits Book revenue before earning it to increase profits Defer revenue to reduce profits Defer revenue to reduce profits Expense recognition Expense recognition Defer expenses to increase profits Defer expenses to increase profits Make unreal provisions to reduce profits Make unreal provisions to reduce profits

11 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 the capital costs

12 Case 4: Playing with credits  Show higher profits by treating liabilities as incomes, e.g.  An advance from a client/taxes may be credited to revenue.  A loan may be channeled through a SPV and treated as income  Show lower profits by treating revenue as a liability, e.g. Microsoft.

13 Case 5: Change in Accounting Policy A company can alter its profit figures through change in accounting policy and deliberately omit to mention the change of policy in notes, or omit to give the correct impact of the change. Examples:  Valuation Basis  Depreciation Basis

14 Case 6: Complicating Fin Statements A 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.

15 Responsibility for health of Financial Statements The Board The Board Management (including internal auditor) Management (including internal auditor) External Auditors External Auditors External Bodies External Bodies Regulators: KSE/SECP Regulators: KSE/SECP Accounting bodies: ICAP/ICMAP Accounting bodies: ICAP/ICMAP Trade associations Trade associations

16 The Board’s Role Importance of NEDs Importance of NEDs Significance of INEDs Significance of INEDs Audit Committee Audit Committee

17 Management’s Role Management draws accounting policies, keep accounts and prepares financial statements. Management draws accounting policies, keep accounts and prepares financial statements. Management has most to gain or lose from the defects of 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. Hence, management needs highest degree of monitoring in this aspect.

18 External Auditors’ Role Every one depends on external auditors’ report. Every one depends on external auditors’ report. Independence of external auditors must be assured: Independence of external auditors must be assured: Rotating them regularly Rotating them regularly Not giving them any other business Not giving them any other business Granting them full access to all records Granting them full access to all records Limiting their relationship with management Limiting their relationship with management

19 External Audit: Purpose Only purpose is to obtain an opinion. Only purpose is to obtain an opinion. External auditors is not supposed to fix the financial statements. External auditors is not supposed to fix the financial statements. Report: Report: Unqualified Unqualified Qualified Qualified Disclaimer Disclaimer Adverse Adverse

20 Audit Report: Scope Clarify basis of forming an opinion Clarify basis of forming an opinion Proper records have been kept Proper records have been kept Financial statements: Financial statements: are in accordance with the records are in accordance with the records reflect a true and fair view of the profit & position reflect a true and fair view of the profit & position comply with the laws comply with the laws

21 Errors and Frauds Difference is only of intent Difference is only of intent Both result in: Both result in: Incorrect use of accounting policies, Incorrect use of accounting policies, Omission of facts, or Omission of facts, or Misinterpretation of facts Misinterpretation of facts Basic responsibility to prevent and detect errors/frauds lies with management, not external auditor. Basic responsibility to prevent and detect errors/frauds lies with management, not external auditor.

22 Auditors’ Liability No liability to outsiders No liability to outsiders Caparo Industries Case Caparo Industries Case Bannerman Case Bannerman Case Disclaimers now abound Disclaimers now abound

23 Professional Monitors of External Auditors Accounting Standards from IFAC Accounting Standards from IFAC Ethical Standards from ESB Ethical Standards from ESB Audit Standards from APB (UK) Audit Standards from APB (UK) Investigation & Discipline Board (UK) Investigation & Discipline Board (UK) Review Board (UK) Review Board (UK) Public Company Accounting Oversight Board (Sarbanes-Oxley Act) in USA Public Company Accounting Oversight Board (Sarbanes-Oxley Act) in USA ICAP and SECP in Pakistan ICAP and SECP in Pakistan

24 Guidelines to Audit firms Do not rely on one client for major part of firm’s fee revenue. Do not rely on one client for major part of firm’s fee revenue. No linkages with clients No linkages with clients Non-audit services should not be given (or at least be restricted) to clients Non-audit services should not be given (or at least be restricted) to clients

25 Non-Audit Work Taxation Taxation Investigations (for acquisitions, etc.) Investigations (for acquisitions, etc.) General consultancy on new projects General consultancy on new projects Systems development Systems development Low-balling Low-balling

26 How to control non-audit work No restriction on audit firms – leaving it to their professional judgment. No restriction on audit firms – leaving it to their professional judgment. Total prohibition on non-audit work. Total prohibition on non-audit work. Partial prohibition on non-audit work, defined either by nature of work, or level of approval. Partial prohibition on non-audit work, defined either by nature of work, or level of approval.

27 Rotation of External Auditors Rotation of audit firm – as prescribed by Pakistan laws Rotation of audit firm – as prescribed by Pakistan laws Rotation of partners within the same firm. Rotation of partners within the same firm. Different partners for different tasks Different partners for different tasks Appointment by open tender Appointment by open tender

28 Objectives of Fixing Financial Statements Managing Position Managing Position Managing Profits Managing Profits

29 Managing Position To meet rules and regulations To meet rules and regulations To meet lenders’ covenants To meet lenders’ covenants To portray better picture to public To portray better picture to public Keep assets or liabilities off balance sheet Keep assets or liabilities off balance sheet Window dressing Window dressing Misclassification of items Misclassification of items

30 Earnings Management To keep share price stable, or rising To keep share price stable, or rising To meet market expectations To meet market expectations To maintain dividend payout pattern To maintain dividend payout pattern Smoothening needs Smoothening needs Hidden (misclassified) reserves Hidden (misclassified) reserves

31 Creative Accounting Standards do not cover every thing. Standards do not cover every thing. There is always more than one correct way of handling things There is always more than one correct way of handling things Legitimate and dishonest intentions Legitimate and dishonest intentions Outright fraud: double set of books Outright fraud: double set of books

32 Directors Responsibilities To prepare accounts To prepare accounts To prepare directors’ report To prepare directors’ report Balanced and understandable assessment Balanced and understandable assessment State of affairs; going concern State of affairs; going concern Outline directors’ Outline directors’ To make legal disclosure To make legal disclosure To present the above to shareholders To present the above to shareholders To file returns To file returns

33 Voluntary Disclosures Future events or plans Future events or plans Changes in administration or policy Changes in administration or policy Achievements Achievements Concerns Concerns

34 Role of Audit Committee To monitor the integrity of financial statements To monitor the integrity of financial statements To review internal controls & audit To review internal controls & audit To review risk management systems To review risk management systems To approve terms & remuneration of external auditors To approve terms & remuneration of external auditors To ensure independence of external Auditors To ensure independence of external Auditors

35 External Auditor & Audit Committee Negotiations with external auditor Negotiations with external auditor Verifies suitability of the external auditor Verifies suitability of the external auditor Their resources, qualifications, independence, past record Their resources, qualifications, independence, past record Ensures independence Ensures independence Linkages, non-audit work Linkages, non-audit work Rotation, former employees of audit firm Rotation, former employees of audit firm Audit firm’s performance, ethics Audit firm’s performance, ethics Discusses report / management letter with external auditor Discusses report / management letter with external auditor

36 Audit Cycle Audit plan / internal / external Audit plan / internal / external Discussion of audit plan with auditors Discussion of audit plan with auditors Contact during audit Contact during audit Review of findings, major issues Review of findings, major issues Oversee all correspondence with external auditors Oversee all correspondence with external auditors Representations letter Representations letter Management letter Management letter

37 Thank you