7 Creative Accounting and Auditing Flashcards
6 red flags in financial statements
- Earnings maintained through acquisitions
- Longer useful lives for non-current assets
- High earnings but low cash flow
- Accounts receivable and inventory increase more quickly than sales revenue
- Regular non-recurring charges
- R&D or advertising expenses decrease relatively to revenue
For all: CONTEXT important
Good matching techniques (3)
Only costs of good sold are matched to sales revenue, not the full costs of producing or buying inventory during the period.
Costs of buying plant are not expensed when incurred.
Employee pension costs are recorded as an expense in the period that employees generate revenues, not when they are paid (in retirement).
Why are only the costs of goods sold matched to sales revenue?
As gross margin (revenue - cost of good sold) measures the value added from trading with customers.
How are costs of buying plant treated?
(2)
The cost is “capitalised” on the balance sheet and depreciated over years when the plant produces revenues.
Depreciation is a method of matching the cost of plant to the revenues the plant generates.
Poor matching techniques
(2)
R&D development expenditures are expensed when incurred, instead of matching to (subsequent) revenues they generate.
Advertising and promotion costs are expensed when incurred, instead of matching to (subsequent) revenues they generate.
Poorest matching technique example
Earnings management practice
E.g. estimating useful lives for plant assets that are too long: depreciation is understated.
What do we mean by quality of earnings?
This is the quality of reported (i.e. recognised) statements based on the content and relevance of information disclosed.
When does quality of earnings decrease?
- Accounting regulation distorts economic reality (e.g., poor matching) and imposes restrictions on management (flexibility in accounting rules may increase quality).
- Management uses discretionary choices to manipulate financial disclosure (flexibility may decrease quality…)
Effects of flexibility of accounting practices (looser rules)
Contradictory outcomes: trade-off between discretionary management decisions and economically relevant information
How does management use reporting discretion?
Consequences of this?
Management uses its reporting discretion to produce financial statements that place management’s performance in a particular light.
- Often reducing the ability of financial statements to fairly represent the financial performance and conditions of the company
- Long-term consequences in valuation (forecasting)
What is meant by fraud?
What does it boil down to?
Gross violation of accounting standards, fictitious transactions, misappropriation of assets etc.
It is all about corporate governance.
UK CGC 2018
Issued by?
Emphasis on?
Issued by the Financial Reporting Council (FRC)
Spirit of the Code rather than its letter.
Main priciples of the UK CGC 2018
- Leadership
- Effectiveness
- Accountability
- Remuneration
- Relations with shareholders
UK CGC 2014
What comes under leadership?
(4)
- Headed by an effective board which is collectively responsible for the long-term success of the company.
- Clear devision of responsibilities. No one individual should have unfettered powers of decision.
- Chairman is responsible for leadership of the board, ensuring effectiveness.
- Non-executive directors should constructively challenge and help develop proposals on strategy.
UK CGC 2014
What comes under effectiveness?
(6)
- Board and committees have a balance of skills, experience, independence and knowledge of the company to effective carry out decisions.
- Formal, rigorous and transparent procedure for the appointment of new board directors.
- Sufficient time is allocated by board members to carry out their responsibilities.
- Induction and regular skills updates and refreshers.
- Board should undertake a formal and rigorous annual evaluation of its own performance.
- All directors should be submitted for re-election at regular intervals.
UK CGC 2014
What comes under accountability?
(3)
- Board presents a fair, balanced and understandable assessment of the company’s position and prospects.
- Board should maintain sound risk management and internal control systems.
- Establish formal and transparent arrangements for considering corporate reporting, risk management and internal control principals and maintain an appropriate relationship with the company’s auditors.
UK CGC 2014 & 2018
What comes under remuneration?
(5)
- Remuneration should be designed to promote the long-term success of the company
- Formal and transparent procedure - no director should be involved in deciding his or her own remuneration
- Take into accounting workforce remuneration and related policies.
- Formulaic calculations of performance-related pay should be rejected.
- They should apply discretion when the resulting outcome is not justified.
UK CGC 2014
What comes under shareholder relationship?
(2)
- A dialogue with shareholders based on the mutual understanding of objectives.
- General meetings to communicate with investors and to encourage their participation.
What areas did UK CGC 2018 change?
Workforce and stakeholders, culture, succession and diversity.
UK CGC 2018
What comes under workforce and stakeholders?
(2)
- Provision to enable greater board engagement with the workforce to understand their views.
- Boards describe how they have considered the interests of stakeholders when performing their duty.
UK CGC 2018
What comes under culture?
Boards create a culture which aligns company values with strategy and to assess how they preserve value over the long-term.
UK CGC 2018
What comes under succession and diversity?
(5)
- Constructive challenge to promote diversity - emphasising a need to refresh boards and undertake succession planning.
- Boards should consider the length of term that chairs remain in post beyond nine years.
- Strengthens the role of the nomination committee on succession planning and establishing a diverse board.
- The importance of external board evaluation.
- Nomination committee reports should include details of the contact the external board evaluator has had with the board and individual directors.
How do employees play a part in governance?
(3)
- They are in a position to identify misreporting and fraud.
- More effective in reporting anomalies than auditors and regulators (Dyck et al. 2010).
- Employee whistle-blowing has real effects for companies (Call et al. 2017; Bowen et al. 2010).
Two elements of the pricipal-agent problem?
Who is whom?
Principal = stakeholders. Agent = directors.
- Information aymmetry
- Self-interest
What do auditors do?
Auditors provide an independent opinion to shareholders on whether the financial statements provide a ‘true and fair’ view.
What can audit opinion be?
(5)
- Unqualified (‘clean’)
- Qualified
- Adverse
- Disclaimer of opinion
- No opinion
- Insufficient evidence
- Express no opinion
Audit independence and audit quality
Indpendence in mind and in appearance.
However, there are threats to this independence (for fraud).
Safeguards in place to prevent this.
What is meant by AQR?
Who performs it?
AQR = Annual Audit Quality Review
Performed by the FRC.
