1 Financial Reporting Relevance to Corporate Governance.
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Transcript of 1 Financial Reporting Relevance to Corporate Governance.
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Financial Reporting
Relevance to
Corporate Governance
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Financial Reports
Chairman’s Report Financial Statements
Income Statement Cash Flow Statement Statement of changes in Equity Balance Sheet Notes
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Qualities of Financial Statements
Clear & understandable Reliable & honest
No frauds No window dressing Properly audited Compliant with laws/ rules/ practice
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Functions of Fin Statements
Information Function Stakeholders
Control Function Board Owners
Planning Management
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Investors’ Interest inFinancial Statements
Instrument ratings Shares Bonds
Buy / sell / hold decisions Pricing / valuation of the company
Acquisitions Mergers
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Key Issues
Why would management want its financial statements to be untrue?
Consequences of unreliable financial statements
Role & independence of external auditors
How can reliability be assured? No sudden collapse in near future
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Misleading Statements
Deliberate false picture of the company Improper accounting policies
Revenue and expense recognition Capital and revenue expenditure Income and liability distinction
Creating complexities in financial statements
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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
Book false gains through sale-purchase back.
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Case 2:Misuse of Accounting Policies
Revenue recognition Book revenue before earning it to increase
profits Defer revenue to reduce profits
Expense recognition Defer expenses to increase profits Make unreal provisions to reduce profits
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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
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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.
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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
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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.
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Responsibility for health ofFinancial Statements
The Board Management External Auditors External Bodies
Regulators: KSE/SECP Accounting bodies: ICAP/ICMAP Trade associations
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The Board’s Role
Importance of NEDs Significance of INEDs Audit Committee
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Management’s Role
Management draws accounting policies, keep accounts and prepares 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.
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External Auditors’ Role
Every one depends on external auditors’ report.
Independence of external auditors must be assured: Rotating them regularly Not giving them any other business Granting them full access to all records Limiting their relationship with
management
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External Audit: Purpose
Only purpose is to obtain an opinion. External auditors is not supposed to fix
the financial statements. Report:
Unqualified Qualified Disclaimer Adverse
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Audit Report: Scope
Clarify basis of forming an opinion Proper records have been kept Financial statements:
are in accordance with the records reflect a true and fair view of the profit &
position comply with the laws
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Errors and Frauds
Difference is only of intent Both result in:
Incorrect use of accounting policies, Omission of facts, or Misinterpretation of facts
Basic responsibility to prevent and detect errors/frauds lies with management, not external auditor.
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Auditors’ Liability
No liability to outsiders Caparo Industries Case Bannerman Case
Disclaimers now abound
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Professional Monitors of External Auditors
Accounting Standards from IFAC Ethical Standards from ESB Audit Standards from APB (UK) Investigation & Discipline Board (UK) Review Board (UK) Public Company Accounting Oversight
Board (Sarbanes-Oxley Act) in USA ICAP and SECP in Pakistan
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Guidelines to Audit firms
Do not rely on one client for major part of firm’s fee revenue.
No linkages with clients Non-audit services should not be given
(or at least be restricted) to clients
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Non-Audit Work
Taxation Investigations (for acquisitions, etc.) General consultancy on new projects Systems development Low-balling
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How to control non-audit work
No restriction on audit firms – leaving it to their professional judgment.
Total prohibition on non-audit work. Partial prohibition on non-audit work,
defined either by nature of work, or level of approval.
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Rotation of External Auditors
Rotation of audit firm – as prescribed by Pakistan laws
Rotation of partners within the same firm. Different partners for different tasks
Appointment by open tender
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Objectives of Fixing Financial Statements
Managing Position Managing Profits
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Managing Position
To meet rules and regulations To meet lenders’ covenants To portray better picture to public
Keep assets or liabilities off balance sheet Window dressing Misclassification of items
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Earnings Management
To keep share price stable, or rising To meet market expectations To maintain dividend payout pattern Smoothening needs
Hidden (misclassified) reserves
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Creative Accounting
Standards do not cover every thing. There is always more than one correct
way of handling things Legitimate and dishonest intentions Outright fraud: double set of books
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Directors Responsibilities
To prepare accounts To prepare directors’ report
Balanced and understandable assessment State of affairs; going concern Outline directors’ expectations
To make legal disclosure To present the above to shareholders To file returns
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Voluntary Disclosures
Future events or plans Changes in administration or policy Achievements Concerns
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Role of Audit Committee
To monitor the integrity of financial statements
To review internal controls & audit To review risk management systems To approve terms & remuneration of
external auditors To ensure independence of external
Auditors
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Audit Committee Issues
Composition All NEDs Majority INEDs Chairman of the company not a member
Duration Frequency of meetings
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Nature of Audit Committee
It is not an executive body. It does not draw up accounting policy; its
role is only to review and oversee. It does not perform internal or external
audit. It reports to the Board, not management. It issues advice to management, not
directives. Committee can go to shareholders
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Internal Audit
If formal internal audit department exists, it reports to Audit Committee.
If no formal internal audit department exists, Audit Committee can recommend establishment of one, or suggest other measures.
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External Auditor & Audit Committee Negotiations with external auditor
Verifies suitability of the external auditor Their resources, qualifications, independence, past
record
Ensures independence Linkages, non-audit work Rotation, former employees of audit firm Audit firm’s performance, ethics
Discusses report / management letter with external auditor
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Audit Cycle
Audit plan / internal / external Discussion of audit plan with auditors Contact during audit Review of findings, major issues Oversee all correspondence with
external auditors Representations letter Management letter
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AC and whistleblowing
In absence of any other formal avenue, Audit Committee may handle whistleblowing cases.
Set up process of handling these cases. Set up mechanism for investigation and
follow up.
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Thank you