Lecture Five

Financial Reporting and External Audit

 Information Asymmetry

• Akerlof (1970)

• The market for used cars

Car A: $ 3,000

Car B: $ 1,600

Car C: $ 200

• The sellers know the quality and value but the buyers do not.

• What might happen?

 Information Asymmetry

• Buyers are willing to pay a price no more than the average value of all used cars if
they do not know the quality of each car.
• To break even (Payment=E(Value))

• Sellers of good cars would not enter the market because of anticipating such
results; thus only the worst cars are in the market.

• The whole market actually collapses if the extent of information asymmetry is

serious.
 Information Asymmetry
• Information asymmetry: the sellers know better about the quality of products than
the buyers

• Examples: used car markets, stock market

• Stock prices decline upon the announcements of new share offerings

-- because of information asymmetry, some stocks are overvalued, while others are
undervalued
-- undervalued firms are unwilling to issue new shares
-- new share offering announcements signal to the market that those offering firms
are overvalued
 Information Disclosure

• To effectively monitor managers, outsiders need information

about the company
e.g., shareholders can reward or penalize managers based on operating
performance disclosed in annual reports

• Outside investors also need information to evaluate securities

value
e.g., before the passage of SOX, securities regulations in US are mainly
about information disclosure
 Hang Seng Bank Case

 Washington Mutual Bank (WaMu): the 6th largest bank in the U.S., and the
largest savings and loan association. It filed for bankruptcy on Sep 26, 2008
amid the financial crisis
 Several local banks in Hong Kong held debt issued by WaMu, and are likely
to incur losses because of its bankruptcy
 Hang Seng announced that it held WaMu debt but did not disclose the
details; instead, it suggested that the exposure was ‘immaterial’
 The stock price of Hang Seng declined by about 9% on a single day, or the
market value is reduced by about 15 billion, although its exposure to
WaMu debt could be a small fraction of its asset base

 Dah Sing Bank provided detailed information about its exposure to WaMu,
and the stock price declined by about 9% upon the announcement

 Both banks experienced a similar magnitude of stock price decline although

WaMu debt is a much smaller portion of assets in Hang Seng than in Dah
Sing

 The lesson: no disclosure makes people to assume the worst

 Information Disclosure

• Information disclosure made by public companies

 Mandated disclosure: disclosure required by legislation or
regulatory agencies
• Prospectus at stock offerings
• Annual reports, interim reports

 Voluntary disclosure: disclosure above the mandated

minimum
• Management forecast
• Conference calls
• Press releases
• Internet sites
 Financial Reporting
• Annual report
 Includes financial statements, footnotes,
management discussion and analysis
 Major financial statements: income statement,
balance sheet, and cash flow statement

• It is highly regulated!
 Financial Reporting
• Regulation of financial reporting
 Financial reporting is regulated by accounting standards,
e.g., GAAP (Generally Accepted Accounting Principles) and
IFRS (International Financial Reporting Standards)
 Accounting standards regulate the reporting choices
available to management in presenting the firm’s financial
statements
 Regulation reduces processing costs for financial statement
users by providing a commonly accepted language that
managers can use to communicate with investors
 Financial Reporting
• Accounting standards are important for

Investors
Government
Management
 Financial Reporting
• Accurate financial reporting is critical for the efficiency of capital markets and
the proper valuation of securities.
• It allows the board and investors to make an informed evaluation of strategy,
business model, and risk.
• It also allows the board to structure compensation packages appropriately
and award performance-based compensation knowing that predetermined
targets were met.
• It is the role of the audit committee to help to ensure the accuracy of
reports:
• Sets parameters for quality, transparency, and controls.
• Hires external auditor to test for misstatement.
 The Audit Committee
• https://www.youtube.com/watch?v=xck2T-LZ5nw

• The audit committee has a broad range of responsibilities:

• Oversee financial reporting and disclosure
• Monitor choice of accounting principles
• Hire and monitor the external auditor
• Oversee internal audit function
• Oversee regulatory compliance
• Monitor risk

• To ensure that its work is free from management influence:

• All committee members must be independent
• All member must be “financially literate”
• One member must be a “financial expert”

• The Sarbanes Oxley Act of 2002 mandates these requirements.

 Accounting Quality
The audit committee establishes guidelines that ensure the quality of accounting used
in the firm:

1. Quality: the degree to which accounting figures precisely reflect changes in

financial position, earnings, and cash flow.

2. Transparency: the degree to which the company provides details that supplement
and explain accounts reported in statements and filings.

3. Internal controls: the processes and procedures that ensure transactions are
accurately recorded, financial statements reliably produced, and company assets
protected from theft.

90% of audit committee members believe they are effective or

very effective in overseeing management’s use of accounting
KPMG (2009)
 What does this tell us?
4000

3500

3000

2500

2000
number of firms

1500

1000

500

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

• Using sample with ROA ranging from[-0.08 to 0.07] .

• Divided into 30 groups (the size of each is 0.005)
• The 17th group consists of firms with ROA ranging from 0 to
0.005.
 Accounting Quality
• Some evidence suggests companies are not as effective as they
believe in preventing abuse by management.
• Companies are much less likely to report a small decrease in earnings
than a small increase.
• Managers make small manipulations in accounts so that net income
figures are rounded up rather than down.
• Companies that beat earnings with “low-quality” earnings have
better short-term but worse long-term performance.

Burgstahler and Dichev (1997); Carslaw (1988); Grundfest and Malenko (2009); Bhojraj, Hribar, Picconi, and McInnis (2009)
 Financial Restatements
• A restatement occurs when a material error is found in the company’s previously
published financials. 200 to 500 U.S. public companies restate each year.

• A restatement can occur because of human error, aggressive accounting, or fraud.

• The reasons for restatement have implications on the quality of controls in the
company and the steps needed to remedy.

• Some evidence that financial fraud is correlated with weak

governance:, including

• Few outside directors

• Low director stock ownership
• Busy boards
• Fewer accounting meetings
• Fewer financial experts on audit committee

• Companies exhibit 5% median stock price decline following

announcement of restatement; decline is 20% if due to fraud.

Beasley (1996); Farber (2005); COSO (2010); Palmrose, Richardson, and Scholz (2005)
 Models to Detect Manipulation
• Researchers have put tremendous effort into developing models to detect fraud—
with limited success.

• One set of models measures accounting quality in terms of “abnormal accruals”

(the degree of divergence between reported net income and actual cash flows).

• Another set of models analyzes both accounting and governance data. This
improves success rate slightly.

• Recently, researchers have explored linguistic analysis of CEO and CFO speech.
This also improves success rate.

Still, precision in these models is low (less than 10 percent).

Beneish (1999); Audit Integrity (2010); Larcker and Zakolyukina (2010)
 External Audit
• The external audit assesses the validity and reliability of publicly reported
financial information.
• Unintentional errors are possible
• Wrong judgments may occur
• Managers may intentionally misrepresent financial information to
benefit themselves: e.g., manipulate earnings to gain more bonus

• Hence, auditors play an important governance role

 External Audit
• Because management is responsible for preparing financial reports,
shareholders expect an objective third party to provide assurance
that the information is accurate.

• The objective of an audit is to express an opinion on whether

statements comply with accounting standards. Auditors express an
unqualified or clean opinion if it finds no reason for concern;
otherwise they issue unclean or modified opinions.
 External Audit Process
1. Audit preparation: Determine scope of audit. Identify areas requiring special attention.

2. Review estimates and disclosure: Sample key accounts. Test managerial assumptions.
Independently verify estimates.

3. Fraud evaluation: Review opportunity for fraud. Examine incentives for fraud. Use
“professional skepticism.”

4. Assess internal controls: Examine design. Identify weaknesses. Focus on key accounts and
unusual transactions.

5. Conclude: Review findings with audit committee. Express an opinion to accompany the
financial statements.
 Audit Quality
• Accounting firms
 Big International Audit Firms: PWC, Deloitte, Ernst & Young, KPMG

• Determinants of audit quality

 Auditor ability: the likelihood that a breach is discovered by an audit firm
 Auditor independence: the likelihood that an audit firm reports the
breach
 Audit Quality
• The chance to discover irregularities depends on the auditor’s abilities, the
audit procedures employed, the extent of sampling etc.

• Audit quality is on average higher for big audit firms

 A client’s economic significance to an auditor affects auditor
independence: a single client is less important to big auditors than to
small auditors
 Big auditors provide better training to their staff and thus have greater
abilities to discover breaches of accounting standards
 Audit Quality
• Given the importance of the audit, much attention has been paid to factors
that might impact audit quality.

• Potential issues include:

• Industry consolidation
• Conflict when auditor provides non-audit services
• Conflict when former auditor is hired as CFO
• Auditor rotation

• What impact, if any, do each of these have on the likelihood of future

restatement or fraud?
 1. Industry Consolidation

In the late 1980s, there were eight major accounting firms. Currently there are four (the “Big
Four”)

• (+) Scale of audit firms matches the scale of companies

• (+) Expertise by industry and region
• (+) Expertise by function (tax, audit, systems, etc.)

• (-) Inadequate number of firms to choose among

• (-) Decreased competition might lead to increased fees
• 60% of large companies believe there is an inadequate number of
audit firms. Fewer than 25% of small companies believe this.

• Audit fees have risen, but this is likely due to greater cost of
compliance with SOX, greater scope, more expensive personnel.

• Splitting up Big Four would reduce expertise and decrease quality.

GAO (2008)
 2. Non-Audit Services

Sarbanes Oxley prohibits auditors from performing certain non-audit services.

• (+) Reduces potential conflict of interest

• (+) Might improve auditor independence
• (+) Company cannot “revenge” if it disagrees with auditor

• (-) Auditor has expertise in company procedures

• No evidence that this practice hurts audit quality
(measured by abnormal accruals, earnings conservatism,
failure to issue qualified opinion, or future restatement).

• Nevertheless, SOX banned auditors to provide non-audit

services to their clients.

Romano(2005), Kinney, Palmrose, and Scholz (2004), DeFond, Raghunandan, and Subramanyam (2002)
 3. Former Auditor as CFO

A company might decide to offer a job in finance, treasury, or internal audit to a member of
the external auditing team.

• (+) Former auditor is familiar with company and its procedures

• (+) Company is familiar with former auditor working style
• (+) Reduces both hiring costs and risk of failure

• (-) Former auditor knows internal controls, might facilitate fraud

• Mixed evidence.

• Some studies find decrease in earnings quality

when company hires former auditor as CFO.

• Others find no relation between source of hire

and earnings quality.

Dowdell and Krishnan (2004); Geiger, North, and O’Connell (2005)

 4. Auditor Rotation

Auditor rotation is the practice of periodically changing external audit firms.

• (+) New auditor might be more independent

• (+) New auditor has fresh perspective

• (-) Costly to change audit firms or audit teams

• (-) New auditor has a steep learning curve
• Very little evidence that auditor rotation is cost-
effective or that it improves audit quality.

• However, auditor resignation (auditor quits

because of disagreement with management) might
be a warning sign of fraud.
Cameran, Merlotti, and Di Vincenzo (2005); Whisenant, Sankaraguruswamy, and Raghunandan (2003)
NOBLE – case discussion
• Noble Group manages global supply chains in diverse sectors, from
commodities trading in metals, to raw materials for energy production
such as coal, oil and gas.
First report from Iceberg
• On 15 February, 2015, financial research firm Iceberg Research (“Iceberg”)
released a report questioning Noble’s accounting practices, alleging that
Noble’s classification of its associates hid huge impairments and exaggerated
the valuation of its associates to create the illusion of profit.

• Noble responded to Iceberg’s comments, citing its adherence to financial

reporting standards and the clean bill given by its auditors.

• Noble then cast doubt on Iceberg’s intent and credibility for choosing to
release the report anonymously without giving prior notification to Noble’s
management.
Second report from Iceberg
• Iceberg followed up with the release of a second report, which focused on
extraordinarily large size and growth rate of Noble’s mark-to-market (MTM)
valuations, highlighting the inherent risk of manipulation of these fair values due to
the wide discretion given to the company in determining the valuation inputs and
methods.

• Iceberg further criticized Noble’s auditor, Ernst & Young (EY), for its complicity in
giving Noble’s management the autonomy to judge the validity and appropriateness
of its valuation inputs.

• Noble went on the offensive, alleging that a former disgruntled employee was the
mastermind behind Iceberg’s accusations and that the group was in the process of
taking legal action against Iceberg.
Third report from Iceberg

• Iceberg then released a third report on Noble, bringing shareholders’

attention to Noble’s understatement of debt and key governance
issues within the company.
Corporate governance issues
• A number of independent directors on Noble’s board were given a large amount of shares
and share options as part of their remuneration.

• Many of the non-executive directors had a long tenure with Noble.

• Lack of diversity in the experience and expertise of the company’s directors given its
relatively large board size.

• The involvement of executive chairman Elman in the audit, remuneration and nominating
committees resulted in an outsized influence on the corporate governance of Noble.

• Most directors being based in Hong Kong despite Noble’s international operations and its
listing in Singapore, with no Singapore-based director on its board.
NOBLE’s fightback
• EY (Hong Kong) had been Noble’s auditor for more than two decades.

• With regards to the inputs and valuation models used to estimate the fair values
of Noble’s unrealized contracts, Iceberg alleged that EY took a passive stance,
placing the responsibility on Noble’s management to use their judgement to
determine the reasonableness and appropriateness of the inputs.

• Noble responded to the allegations of its valuation methods by setting up an

independent board committee consisting of existing members of its audit
committee, and appointing another accounting firm, PwC, to investigate the
appropriateness of its valuation methods in estimating its MTM. PwC’s verdict
was that the valuation methods used by Noble were consistent with industry
practices and accounting standards.
Iceberg’s response
• Iceberg was quick to dismiss PwC’s report, stating that the report had
failed to address the shareholders’ primary concern regarding the
true value of the MTM contracts.

• Major shareholders had divested their shares of Noble and Noble’s

co-founder, Harry Banga, had sold all his shares in the company.

• Several key executives had also left the company.

NOBLE’s improvement
• Nobel will have a non-executive chairman, and an addition of an
independent non-executive director with a background in
international commodities and futures trading to its board of
directors.

• A sub-committee, chaired by David Eldon, would be set up by Noble’s

board to identify the company’s new non-executive chairman.
Discussion Questions
• Discuss whether Noble’s auditor, Ernst & Young, had fulfilled its role
as an external auditor adequately. Should an external auditor be
involved in or be responsible for a company’s use of estimates and
assumptions in determining mark-to-market values?

• Iceberg criticized EY for being Noble’s auditor for a long period of

time. Would the adoption of mandatory audit firm rotation help to
make audit reports more reliable?