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Financial Reporting

Relevance to

Corporate Governance

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Financial Reports

Chairman’s Report Financial Statements

Income Statement Cash Flow Statement Statement of changes in Equity Balance Sheet Notes

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Qualities of Financial Statements

Clear & understandable Reliable & honest

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

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Functions of Fin Statements

Information Function Stakeholders

Control Function Board Owners

Planning Management

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Investors’ Interest inFinancial Statements

Instrument ratings Shares Bonds

Buy / sell / hold decisions Pricing / valuation of the company

Acquisitions Mergers

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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

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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

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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

Book false gains through sale-purchase back.

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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

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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

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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.

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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

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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.

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Responsibility for health ofFinancial Statements

The Board Management External Auditors External Bodies

Regulators: KSE/SECP Accounting bodies: ICAP/ICMAP Trade associations

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The Board’s Role

Importance of NEDs Significance of INEDs Audit Committee

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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.

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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

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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

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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

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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.

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Auditors’ Liability

No liability to outsiders Caparo Industries Case Bannerman Case

Disclaimers now abound

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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

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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

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Non-Audit Work

Taxation Investigations (for acquisitions, etc.) General consultancy on new projects Systems development Low-balling

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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.

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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

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Objectives of Fixing Financial Statements

Managing Position Managing Profits

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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

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Earnings Management

To keep share price stable, or rising To meet market expectations To maintain dividend payout pattern Smoothening needs

Hidden (misclassified) reserves

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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

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Directors Responsibilities

To prepare accounts To prepare directors’ report

Balanced and understandable assessment State of affairs; going concern Outline directors’ expectations

To make legal disclosure To present the above to shareholders To file returns

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Voluntary Disclosures

Future events or plans Changes in administration or policy Achievements Concerns

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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

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Audit Committee Issues

Composition All NEDs Majority INEDs Chairman of the company not a member

Duration Frequency of meetings

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Nature of Audit Committee

It is not an executive body. It does not draw up accounting policy; its

role is only to review and oversee. It does not perform internal or external

audit. It reports to the Board, not management. It issues advice to management, not

directives. Committee can go to shareholders

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Internal Audit

If formal internal audit department exists, it reports to Audit Committee.

If no formal internal audit department exists, Audit Committee can recommend establishment of one, or suggest other measures.

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External Auditor & Audit Committee Negotiations with external auditor

Verifies suitability of the external auditor Their resources, qualifications, independence, past

record

Ensures independence Linkages, non-audit work Rotation, former employees of audit firm Audit firm’s performance, ethics

Discusses report / management letter with external auditor

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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

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AC and whistleblowing

In absence of any other formal avenue, Audit Committee may handle whistleblowing cases.

Set up process of handling these cases. Set up mechanism for investigation and

follow up.

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Thank you