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

Qualities of Financial Statements
Clear & understandable Reliable & honest 
  

No frauds No window dressing Properly audited Compliant with laws/ rules/ practice

3

Functions of Fin Statements
Information Function 

Stakeholders Board Owners Management

Control Function 


Planning 

4

Investors¶ Interest in Financial Statements Instrument ratings   Shares Bonds Buy / sell / hold decisions Pricing / valuation of the company   Acquisitions Mergers 5 .

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 6 .

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 7 .

8 . 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.Case 1: Deliberate false picture A Ltd wishes to show a higher profit.

Case 2: Misuse of Accounting Policies Revenue recognition   Book revenue before earning it to increase profits Defer revenue to reduce profits Defer expenses to increase profits Make unreal provisions to reduce profits Expense recognition   9 .

Case 3: Playing with debits Show a higher profit by Capitalizing normal revenue expenses. Deferring start of depreciation or interest expensing. Show lower profits by expensing the capital costs 10 . treating them as assets.

e. A loan may be channeled through a SPV and treated as income Show lower profits by treating revenue as a liability. 11 .g. An advance from a client/taxes may be credited to revenue. e. Microsoft.Case 4: Playing with credits Show higher profits by treating liabilities as incomes.g.

or omit to give the correct impact of the change. Examples: Valuation Basis Depreciation Basis 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.

13 . having different accounting policies. In particular. closing dates and natures of business offers tremendous scope for play in consolidated financial statements.Case 6: Complicating Fin Statements A company can make its financial statements too complex for an average investor to understand.

Responsibility for health of Financial Statements The Board Management External Auditors External Bodies    Regulators: KSE/SECP Accounting bodies: ICAP/ICMAP Trade associations 14 .

The Board¶s Role Importance of NEDs Significance of INEDs Audit Committee 15 .

Management¶s Role Management draws accounting policies. 16 . 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.

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 17 .External Auditors¶ Role Every one depends on external auditors¶ report.

External auditors is not supposed to fix the financial statements.External Audit: Purpose Only purpose is to obtain an opinion. Report:     Unqualified Qualified Disclaimer Adverse 18 .

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 19 .

Errors and Frauds Difference is only of intent Both result in:    Incorrect use of accounting policies. Omission of facts. 20 . not external auditor. or Misinterpretation of facts Basic responsibility to prevent and detect errors/frauds lies with management.

Auditors¶ Liability No liability to outsiders   Caparo Industries Case Bannerman Case Disclaimers now abound 21 .

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 22 .

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 23 .

Non-Audit Work Taxation Investigations (for acquisitions. etc.) General consultancy on new projects Systems development Low-balling 24 .

defined either by nature of work. Total prohibition on non-audit work. 25 . Partial prohibition on non-audit work. or level of approval.How to control non-audit work No restriction on audit firms ± leaving it to their professional judgment.

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 26 .

Objectives of Fixing Financial Statements Managing Position Managing Profits 27 .

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 28 .

Earnings Management To keep share price stable. or rising To meet market expectations To maintain dividend payout pattern Smoothening needs  Hidden (misclassified) reserves 29 .

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 30 .

going concern Outline directors¶ expectations To make legal disclosure To present the above to shareholders To file returns 31 .Directors Responsibilities To prepare accounts To prepare directors¶ report    Balanced and understandable assessment State of affairs.

Voluntary Disclosures Future events or plans Changes in administration or policy Achievements Concerns 32 .

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 33 .

Audit Committee Issues Composition    All NEDs Majority INEDs Chairman of the company not a member Duration Frequency of meetings 34 .

not management. its role is only to review and oversee. not directives. Committee can go to shareholders 35 . It does not perform internal or external audit. It does not draw up accounting policy. It reports to the Board. It issues advice to management.Nature of Audit Committee It is not an executive body.

Internal Audit If formal internal audit department exists. it reports to Audit Committee. or suggest other measures. Audit Committee can recommend establishment of one. If no formal internal audit department exists. 36 .

independence. ethics Ensures independence    Discusses report / management letter with external auditor 37 . non-audit work Rotation. past record Linkages. former employees of audit firm Audit firm¶s performance. qualifications.External Auditor & Audit Committee Negotiations with external auditor   Verifies suitability of the external auditor Their resources.

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 38 .

Set up mechanism for investigation and follow up. Audit Committee may handle whistleblowing cases. 39 . Set up process of handling these cases.AC and whistleblowing In absence of any other formal avenue.

Thank you 40 .

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