Financial Reporting Relevance to Corporate Governance 1 Financial Reports Chairman’s Report Financial Statements Income Statement Cash Flow Statement Statement of changes in Equity Balance Sheet Notes 2 Notes to Accounts Accounting methods and policies used Greater details of summarized figures Statutory disclosures Changes in accounting policies / impact Details of off-balance sheet items, if any 3 Qualities of Financial Statements Clear & understandable Reliable & honest No frauds No window dressing Properly audited Compliant with laws/ rules/ practice 4 Functions of Fin Statements Information Function Stakeholders Control Function Board Owners Planning Management 5 Investors’ Interest in Financial Statements Instrument ratings Shares Bonds Buy / sell / hold decisions Pricing / valuation of the company Acquisitions Mergers 6 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 7 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 8 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 9 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 10 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 11 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. 12 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 13 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. 14 Responsibility for health of Financial Statements The Board Management (including internal auditor) External Auditors External Bodies Regulators: KSE/SECP Accounting bodies: ICAP/ICMAP Trade associations 15 The Board’s Role Importance of NEDs Significance of INEDs Audit Committee 16 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. 17 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 18 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 19 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 20 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. 21 Auditors’ Liability No liability to outsiders Caparo Industries Case Bannerman Case Disclaimers now abound 22 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 23 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 24 Non-Audit Work Taxation Investigations (for acquisitions, etc.) General consultancy on new projects Systems development Low-balling 25 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. 26 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 27 Objectives of Fixing Financial Statements Managing Position Managing Profits 28 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 29 Earnings Management To keep share price stable, or rising To meet market expectations To maintain dividend payout pattern Smoothening needs Hidden (misclassified) reserves 30 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 31 Directors Responsibilities To prepare accounts To prepare directors’ report Balanced and understandable assessment State of affairs; going concern Outline directors’ To make legal disclosure To present the above to shareholders To file returns 32 Voluntary Disclosures Future events or plans Changes in administration or policy Achievements Concerns 33 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 34 External Auditor & Audit Committee Negotiations with external auditor Ensures independence Verifies suitability of the external auditor Their resources, qualifications, independence, past record Linkages, non-audit work Rotation, former employees of audit firm Audit firm’s performance, ethics Discusses report / management letter with external auditor 35 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 36 Thank you 37