© Martin E Taylor 1

Financial Reporting Scandals in the U.S. and Their Impact on the Financial Reporting Value Chain

© Martin E Taylor 2

Sarbanes-Oxley Strikes Again•Enron

•Skilling gets 24 years

WorldComBernie 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 Taylor 3

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 Taylor 4

The Fraudulent Financial Reporting Hall of Shame

WorldCom Improper capitalization of expenses

or losses

Cendant Fictitious revenue

© Martin E Taylor 5

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 Taylor 6

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 Taylor 7

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 Taylor 8

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 Taylor 9

Improper Revenue Recognition

Bill and hold sales Holding books open Multiple element contracts (Xerox) Fictitious revenue Improper valuation of revenue

© Martin E Taylor 10

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 Taylor 11

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 Taylor 12

Earnings Restatements

© Martin E Taylor 13

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 Taylor 14

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 Taylor 15

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 Taylor 16

Internal Auditors

Independence?? Operational versus Financial Audits Outsourcing the Internal Audit

Function

© Martin E Taylor 17

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 18The Economist , November 9th-15th, 2013

© Martin E Taylor 19

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 Taylor 20

Analysts

Conflict of Interest Settlement

$1.4 billion settlement against Bear Stearns, Morgan Stanley, JP Morgan Chase

© Martin E Taylor 21

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 Taylor 22

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 Taylor 23

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 Taylor 24

Other Regulators

Stock Exchanges New York Stock Exchange NASDAQ

State Regulators

© Martin E Taylor 25

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 Taylor 26

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 Taylor 27

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 Taylor 28

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/

© Martin E Taylor 29

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 Taylor 30

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 Taylor 31

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 Taylor 32

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/companyinformation/corporategovernance/committees/audit.mspx

© Martin E Taylor 33

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 Taylor 34

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 Taylor 35

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 Taylor 36

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

© Martin E Taylor 37

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 Taylor 38

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 Taylor 39

The Sarbanes-Oxley Act Effect on Analysts

Financial analysts cannot be involved in marketing securities

© Martin E Taylor 40

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 Taylor 41

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 Taylor 42

Criticisms of The Sarbanes-Oxley Act

Legislation similar to SOX has been adopted in other countries

Japan (J-SOX) China (C-Sox)

© Martin E Taylor 43

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 Taylor 44

Other Topics and Developments

Corporate Social Responsibility Triple Bottom Line Reporting

Economic Social Environmental

Integrated Reporting Dodd-Frank Legislation

© Martin E Taylor 45

Other Topics

Financial Statement Presentation Market to Market Revenue Recognition Leases Pensions Intangible Assets