CRITICAL ANALYSIS OF THE
AUDITING PROFESSION AND
ITS FUTURE
Christa Walsh, Jennifer Watson, Christopher
Keuleman, Stephanie Howatt, Greg
Sheremeta and Mark Allen
THE INSURANCE
HYPOTHESIS AND
MARKET PRICES
article by
Krishnagopal Menon & Daid D. Williams
Auditors Liability to Shareholders
Auditors can be sued by investors if ALL of the following
are present:
- There was a material misstatement in the published FS
- Investor losses are caused by a reliance on these
statements
- Auditors did not perform the audit with “due care” (onus of
proof on auditors)
Can be seen by investors as a type of insurance against
relying on materially misstated financial statements
Investor’s “Insurance”
Recent and Current Cases
• KPMG in May 2010 settled a class-action litigation brought by several
pension funds for its audits of Countrywide Financial Corp agreeing to
pay $24 million
• Deloitte & Touche LLP in September 2010 won dismissal of a federal
securities lawsuit brought by Fannie Mae stock investors alleging they
were misled about the mortgage financier’s subprime mortgage risk
• PwC won a dismissal in a case accusing them of hiding risks at
insurer American International Group Inc.
Investor’s “Insurance”
A Change in Trend:
- In recent years auditors have become more careful in
limiting their liability
- Many lawsuits were filed against auditors as a result of
the financial crisis in 2008 but very few have resulted in
payouts to investors
This change in trend may limit the value that shareholders
could assign to this “insurance” against relying on
statements that are materially misstated
Investor’s “Insurance”
Do Investors assign a value to the right to recover
investment losses from the auditor?
Investor’s “Insurance”
Do Investors assign a value to the right to recover
investment losses from the auditor?
Literature has suggested that a valued attribute of audits is
implicit insurance
Investor’s “Insurance”
Study examines the effect on stock prices of Laventhol &
Horwath (L&H) clients of two related events:
1) Disclosure of auditors bankruptcy
2) Appointment of a successor auditor
Hypothesis
Study hypothesis:
Investors assign value to right to recover losses from
auditor making it a component of stock price that will
vary with likelihood that it will be exercised
i) increases with previously incurred price declines
ii) greater for IPOs
Hypothesis and Tests
• HI: Laventhol & Horwath (L&H) clients’ security prices
declined relative to the market on the disclosure of L&H’s
bankruptcy.
• If it is observed that the population as a whole (non-L&H
clients and L&H clients) experienced negative abnormal
returns than HI is supported.
• This finding would be consistent with the insurance
hypothesis, but also would be consistent with other
explanations presented earlier (ex. quality of monitoring).
Hypothesis and Tests
• H2: L&H clients whose securities sustained recent losses
experienced more negative abnormal returns on the
disclosure of L&H’s bankruptcy than other L&H clients,
and these returns were correlated with the magnitude of
the previously sustained losses.
• H3: For L&H clients whose securities sustained recent
losses, IPO clients experienced more negative abnormal
returns on the disclosure of L&H’s bankruptcy than L&H
clients with seasoned securities.
Hypothesis and Tests
• If abnormal returns are associated with losses incurred by
seasoned securities and IPO’s in the bankruptcy period,
and if more negative abnormal returns are associated with
IPO losses than H2 and H3 can be supported.
• This still does not eliminated the possibility of negative
returns being associated with monitoring uncertainties.
If negative returns are associated with monitoring
uncertainties than a price increase should be experienced
upon favourable resolution of this issue.
Sample Selection
• H1: a sample of all publicly traded U.S. companies was
used
• H2 & H3: a sample of publicly traded companies audited
only by L&H
• Criteria:
-CRSP archive data available
-data available on firms auditor
-trading price had to be at least $0.25
-no dividend or earnings announcements
Test Data
• Non-L&H clients in the sample consisted of 4,523 firms
and L&H-audited firms consisted of 127
• L&H-audited firms were smaller, on average, with a mean
market value of $77.9 million versus $895.9 million
• L&H- audited firms were well diversified, representing 78
different industries with largest representation from
pharmaceuticals
Speculation
• If H2 is correct, firms that experienced stock price
declines would be likely to have more negative returns on
the bankruptcy disclosure than other firms.
• If H3 is correct, the effect of losing the right to recover
losses from L&H should be more pronounced in IPOs
than seasoned securities.
Findings
• Returns for L&H clients were significantly more negative
than for other firms, supporting Hypothesis 1.
• Returns for seasoned and IPO L&H clients also show
significant negative returns when compared to the
corresponding firms associated with non-L&H auditors.
• In regards to the monitoring uncertainties, the statistics
suggested a more favourable reaction from the market
when firms formerly audited by L&H chose Big 6 auditors
opposed to when they selected non-Big 6 auditors.
Conclusion
• In conclusion, the statistics showed that the value of the
expected value of the insurance coverage varied with the
magnitude of losses previously sustained by the security
and with the security’s classification either as IPO or
seasoned security.
• In the perspective of the investor, the auditor is viewed as
a guarantor of the financial statements. They may be
willing to pay a premium for the right to recover potential
losses.
Impact on Current Practice
• Auditors have started to price their product to reflect this
insurance service.
• Auditors don’t only consider audit business risk but client
business risk.
• Skills have been developed to assess the riskiness of a
client from the standpoint of potential litigation since 1990.
This has resulted in an increase in rejection of certain
clients or raising audit prices based on riskiness.
THE POWER OF
AUDITORS
article by
Christine Wiedman
Earnings Management
• “A purposeful intervention in the external financial
reporting process, with the intent of obtaining some
private gain”
• As opposed to merely facilitating the neutral operation of the
process
• Research-focus on total accruals
Accruals
• The difference between net income before extraordinary
items and cash flows from operations
• Changes in noncash working capita accounts and
noncash income statement items
• Researchers attempt to break accruals into two
components:
• Non-discretionary component (naturally arises from the company’s
economic activities)
• Discretionary (managed) component
Tradeoffs
• Earnings management can impair the perceived quality of
a firm’s earnings
• Consequences: stock price declines, lawsuits, dismissal,
civil and criminal penalties
• Because of these costs, earnings management is most
likely to occur when perceived benefits exceed the costs
Earnings Manipulation Reasons
• Income-increasing earnings management exists:
• Prior to both IPOs and seasoned equity offerings
• In both cases, firms that manipulate earnings tend to underperform
after the IPO or equity offering year
• Before stock-for-stock mergers to increase stock price
• If there is a run of previous earnings increases
• To avoid small losses (and report a small profit instead)
• Arises from the “psychologically important distinction between
positive numbers and negative numbers”
• To meet analysts’ forecasts
Economic Consequences?
• Investors and FS users are misled by earnings
management to some extent
• Factors that strengthen quality of financial reporting:
• Corporate governance
• Board independence
• Audit committee expertise
• Role of the auditor
• Auditor independence
Article Suggestions
• Corporate governance
• Regulations regarding disclosure, board structure, audit committee
• Board independence
• If a majority of the audit committee is independent, earnings
manipulation is significantly lower
• Audit committee expertise
• Experts are more likely to identify issues related to less prominent,
but recurring activities
• Literates are more likely to raise issues prominent in the business
media ad nonrecurring in nature
• Role of the auditor
• Auditors of high-accrual firms more likely to issue modified opinions
• Auditor independence
GETTING THE PRICE
RIGHT
article by
Sati P. Bandyopadhyay & Jennifer L. Kao
Getting the price right
• In recent years, regulators in many
countries have taken initiatives to enhance
competition in the audit market.
• Do higher fees equal monopolies or brandname reputation
• Regulatory interventions only desirable if
premiums are the result of monopoly.
Getting the price right
• Other issues:
• Auditors market concentration and fees
• Higher fees in higher markets
• Client’s market power
Market Competition
• Changes to professional or government regulations may
provide the external impetus necessary to alter the
underlying competitive environment
• Craswell, Francis and Taylor (1996) examined the
competitive effect on audit fees charged by different-sized
audit firms
• Big Six audit fee premiums are for brand-name reputation
rather than because of monopoly/oligopoly power.
Market Competition
• 1991 legislative amendment to section 86 of the Ontario
Municipal Act governing the appointment of municipal
auditors
• Alleviated legal action as well as change the
characteristics of the market in which firms compete
• Average and median real audit fees were mostly higher
for the Big Six auditors than for other auditors, both before
and after the amendment of Section 86, even after
controlling for the effects of audit fee determinants and
audit specialization
Supply Structure
• The relation between price and supplier market structure
is the primary concern of classic oligopoly theories in the
microeconomic literature
• Focused on how concentrated audit markets were in
different industries and whether that concentration was
stable over time.
• Findings suggest that a sharing of benefits by audit firms
with their clients, realized from economies of scale.
• Findings also suggest audit fees were significantly similar
to the way supplier market concentrations is measure
Demand Structure
• Monopsony theory predicts that when the supply of resources
is price inelastic, buyers may exercise varying degrees of
influence over the setting of price to bring it to a level below
what would otherwise occur in a more competitive market
• An auditor was said to be dependent on his or her client if a
significant portion of its total revenue came from that client.
• Reynolds and Francis (2000) found that auditors tended to
report in a manner that reflected a concern for reputation rather
than economic dependency on the client
• They found that, irrespective of how a client’s market power
was measure., audit fees were lower in markets where
municipal clients exercised considerable influence over their
incumbent auditors
Supply and Demand Structure
• Both supply and demand effects are likely to coexist in many
markets.
• Therefore, one might expect a dominant auditor to restrain its
pricing behaviour when face with a powerful audit client on the
demand side, resulting in a dimminished positive relation
between auditor market concentration and audit fees
• Conversely, when confronted with a few dominant auditors in
the market an auditee with condisderable market power might
be expected to extract smaller fee concessions from the
auditors than when the market was highly competitive.
• Findings show, positive audit fees are in association with
auditors market concentration. Where as, negative audit fees
are associated with client’s market power
Policy Implications
• Studies indicate that audit fees, Big Five or other, tend to
decline when competition intensifies, but the firms still
command audit fee premiums over other auditors.
• Premiums reflect brand- name reputation rather than
monopoly rents.
BEHIND CLOSED DOORS
AT WORLDCOM: 2001
article by
Kay E. Zekany, Lucas W. Braun, &
Zachary T. Warder
About WorldCom
• Founded in 1983 in Mississippi
• Started in Long Distance Discount Services, then moved
to telecommunications
• Growth driven through mergers and acquisitions
• Filed for bankruptcy protection on July 21, 2002
Major Players
• Bernard Ebbers – CEO
• Not a founder but major force in company
• Deal Maker
• Goal: Become No. 1 stock on wall street
• Scott Sullivan, CPA – CEO
• Company’s Number 2
• Pushed for similar goals of Ebbers
• Controlled Internal Audit
Major Players
• Cynthia Cooper, CPA – VP Internal Audit
• Reported directly to CFO
• Instructed to “contribute to bottom line”
• Arthur Anderson – External Auditor
• Rated WorldCom “Maximum Risk”
• Noted “Aggressive Accounting Policies”
• Did not bring up at BOD Meeting
• Issued clean opinion
What Happened?
• Video
What Happened?
• WorldCom reported misleading F/S through:
• Capitalizing cost of unused “off-net” capacity
• Defer costs associated with unused line capacity
• “Close the Gap” Opportunities
• Attempt to bring actual results inline with budgeted
• Future contract penalties as revenue
• Misappropriation of Internal Audit Resources
• 6 months creating ERP (schedules and trend analyses)
What Happened to WorldCom
• June 26, 2002 SEC begins investigation
• Filed for Bankruptcy Protection in July 21, 2002
• Renamed MCI and moved to Virginia in 2003
• Paid fines of almost 3 billion
• Creditors received 35.7 cents on the dollar
• February 2005 acquired by Verizon
What Happened to the Executives
• Bernard Ebbers (CEO) was found guilty of fraud,
conspiracy, and filing false documents
• Sentenced to 25 years in prison
• Scott Sullivan (CFO) was found guilty and testified against
Ebbers
• Sentenced to 5 years in prison
• Numerous others received smaller penalties including a
Comptroller and 3 accounting managers
Implications
• Scrutiny of the accounting profession
• Auditor Independence
• F/S Sign-off
• Audit Committee
Implications
• Scrutiny of the accounting profession
• Change in accounting environment
• Goal: Ensure proper accounting theories are applied;
eliminate fraud
• Means: Regulation & Oversight
• SOX
• Bill 198 (Ontario)
• Auditor Independence
• F/S Sign-off
• Audit Committee
Auditor Independence and CPAB
• "CPAB's mission is to contribute to public confidence in
the integrity of financial reporting of public companies in
Canada by promoting high quality, independent auditing.“
• Independence
• Registration with CPAB
• Quality Control
• Review of files by CPAB
Auditor Independence
• Want to eliminate conflicts of interest
• Threats
• Self-Interest
• Self-Review
• Familiarity
• Advocacy
• Intimidation
• Partner rotation every 5 years
• Limits on consulting services
Financial Statement Sign-off
• Makes top management responsible for the FS
• CEO or CFO sign-off
• Creates accountability and increases reliability of the
statements
• Reduces risk for the auditor
Audit Committee
• Role:
• Oversight and approval of external auditors
• Monitor financial reporting
• Composition:
• At least 3 independent directors
• Require financial literacy