Accounting, Auditing, and Assurance Services
The purpose of this blog is to
provide definitions of accounting, auditing, and assurance services. In
addition, the relationship between accounting, auditing, and assurance services
will be explained and examples will be provided.
Accounting services can be
defined as the preparation and analysis of financial information which is
reported to internal and external users via financial statements. Auditing
services involve evaluating the reliability and credibility of financial
information, as well as "the systems and processes responsible for
recording and summarizing that information" (Messier, Jr., Glover, &
Prawitt, 2006, p. 5-6). Assurance services can be defined as independent
professional services that evaluate the reliability, credibility, relevance, and
timeliness of information in order to improve the quality of information for
decision makers (Messier, Jr. et al., 2006, p. 15). Assurance services may or
may not be associated with financial information.
Relationship
The relationship between
accounting and auditing can be compared to the relationship between an author
and editor. Like the author, the accountant creates the material, in this case
financial statements and reports. Like the editor, the auditor examines the
material and suggests changes and corrections that must be made in order to
meet the reliability and credibility requirements specified by the company and
outside agencies, such as the Financial Accounting Standards Board (FASB).
Assurance services take things one step further by examining the material to
insure it meets relevance and timeliness requirements.
Examples
Examples of accounting services
include services provided by accounts payable employees, accounts receivable
employees, staff accountants, and the accounting manager or controller. Some
specific services performed by these individuals include keying invoice
information into an accounting program, processing timely payment of invoices,
recording receipt of payment for products sold, reconciling inventory usage and
receipts, and creating financial statements. Examples of auditing services
include services performed by the internal audit staff and the external audit
company, usually a CPA firm. Some specific services performed by these
individuals include determining the reliability and credibility of accounting
reports and financial statements, and assessing risk control in various areas.
Examples of assurance services
include services performed by the external audit company. Some specific
services performed by these individuals include determining the relevance and
timeliness of accounting reports and financial statements, and reviewing
company internal controls to assess the effectiveness of those controls. As
previously mentioned, assurance services may or may not be associated with financial
information. Assurance services that are associated with financial information
include auditing internal controls or reviewing historical financial
statements. Assurance services that are not associated with financial
information include Nielsen television ratings and information about businesses
that is provided by the Better Business Bureau.
Financial Statements
Financial statements are the
backbone of a businesses financial accounting. There are four different types
of financial statements which include balance sheets, income statements,
retained earnings statements, and statement of cash flows. This information is
used by internal employees as well as external sources to make decisions for
the company's future. Understanding how to use these financial statements are
vital to the success of your company's financial future. This introduction will
help you get a general idea of how and who uses them. Even if you outsource
this portion of your business you should still understand how it works.
Income statements are used to
report the success or failure of the company's operation for a period of time.
This is usually done on a monthly basis. This statement lists the company's
revenues followed by the company's expenses. Expenses can include salaries,
supplies, rent, insurance, interest, and depreciation expenses. Investors will
buy or sell their stocks based on the company's financial future and this
statement provides that information.
Retained earnings is the net
income retained in the corporation. Therefore, the retained earnings statement
simply shows the amounts and causes of changes and retained earnings during the
period. This statement is calculated on the monthly bases and enclose the
company's net income and dividends. This statement allows users to evaluate
dividend payment practices. Most investors will invest in a company that has a
history of paying high dividends. This statement allows investors to determine
if they want to invest in a business.
Assets and claims to those assets
at a specific point and time is reported on a balance sheet. This information
is used by creditors to analyze the likelihood of being repaid. They carefully
look at the company's liabilities and assets to make the decision. Liabilities
can include notes payable, accounts payable, interests payable, unearned
revenue, and salaries payable. In addition, the statement will house the
company stockholders' equity.
Finally, I will introduce the
statement of cash flows. This statement provides financial information about
the cash receipts and cash payments for a business. It reports the cash effects
of a company's operating, investing, and financing activities. It shows them
any increase or decrease in cash, and any cash that is left at the end of the
period. This statement is used to show what is happening to a company's most
important resources. It answers the questions:
How was cash used?
Where did cash come from?
Was there any change in the cash
balance during the period?
Recommendations for
Shareholder Financial Statements
Financial accounting is
considered to be a nonmanufacturing cost (Atkinson, Kaplan, Matsumura, &
Young, 2009). These costs are flexible as one month we may have 200
shareholders and the next we may have 10,000 shareholders so with that being
said the cost must be flexible and able to meet the growing needs of a growing
company.
We know that our company must
follow the general accepted accounting practices (GAAP). This is a set of
principles that are used by companies to compile financial statements.
"The GAAP are imposed on companies so that investors have a minimum level
of consistency in the financial statements they use when analyzing companies
for investment purposes" (Investaopedia, 2009). This means that
shareholder financial statements will be consistent with the companies' growth
and disclosures of pertinent consumer information.
These financial statements help
us maintain a relationship with our shareholders. The requirements made by our
shareholders help guide our company to achieve our goals, in this case our
expansion and adding another line of products (Course Materials, 2003). This is
why we must offer our shareholders quarterly statements. They must be kept
abreast of our business practices, our growth and development of possible other
lines of antiques.
It seems that if our external
accountant is not examining the financial statements we are sending to our
shareholders then we must beware that she may be operating outside the lines of
the GAAP.
The following recommendations
will help us to prevent any future negligence on this matter. The first thing
we must do is have the general accepted auditing standards (GAAS) put into
force in our company. The second thing we should do is have a financial
statement auditor come in, that uses the GAAS, and they can help us reduce the
probability of missing material information (Investapedia, 2009). This will
help us supply our shareholders with better information and this will assure
that our external accountant is doing her job correctly. An "auditors can
take into account all current and where appropriate, prospective auditing, accounting,
and reporting regulations and guidance. They can help us make sure we are in
compliance with all regulations, give us advice on controls and processing
system weakness, confirm accounting treatments , give us increased monitoring
of prospective accounting and regulatory changes, give us an independent review
of externally reported information and go over accountants reports"
(PriceWaterhouseCoopers, 2009).
In conclusion if we can open
ourselves up to some small accounting changes we can keep our present clients
happy and in turn gain more future clients through word of mouth from our
present ones. The better and more professional our business looks the better
the type of clientele we will attract. By following the GAAP and by having an
auditor come in we can reduce cost, increase profitability, improve customer
services and expand our business as planned.
The Financial
Statements as Tools for Planning and Control
Periodically created financial statements reflecting the
historical economic transactions of the company can serve the organization and
its shareholders through internal application and analysis of the data as well
as through their general purpose of external reporting. Internal analysis of
the financial data presented in the organization's financial statements differs
from the analyses of external users, as the internal purposes are geared toward
operational planning and controlling. Used externally, the financial statements
provide the user with an overall view of the operational performance of the
company. However, applied internally, more specific details can be added to the
financial data to provide the managers specific performance and operational
data that meets the informational needs associated with planning and
controlling activities. The lack of regulation associated with using this
economic data internally allows the organization to reorganize the data in such
a way that provides essential, customized economic data that will assist in
appropriately adjusting operational strategies to further the organization
toward its goals. Reports and information that assist management with problem
solving, improvement strategies, activity based management, added-value
assessment, and analysis of the value chain can all be created using the balance
sheet, income statement, statement of cash flows, and statement of owner's
equity (CTU Online, 2008).
The financial position of a company is reflected in the
balance sheet. The balance sheet provides a periodic view of the organization's
assets, liabilities, and owner's equity (Horngren, Harrison, & Bamber,
2005). Inventory accounts represented on the balance sheet include three
separate inventory classifications: raw materials, work in process, and
finished goods (Garrison, Noreen, & Brewer, 2008). The information included
in the balance sheet, including specific inventory classifications, can be
broken down to more specific products, asset categories, business divisions,
even specific equipment categories and processes to provide greater insight into
performance and progress of the many different operational areas (CTU Online,
2008).
The income statement reflects the revenues and expenses
incurred from operations over a specific period of time, communicating the
resulting profit or loss (SMBTN, 2007). Used internally, income statements can
provide performance information relative to specific products, product lines,
processes, or divisions within the company (CTU Online, 2008). Cost structure
is essential to profitability, therefore specific cost information is
imperative to appropriate operations planning. Restructuring and reassigning
costs by their behavioral patterns creates a contribution margin income
statement. The contribution margin income statement represents the resources
remaining to cover fixed expenses after variable expenses are accounted for
(Edmonds, Edmonds, Tsay, & Olds, 2006). The benefit of reclassification and
reorganization of costs to management, as they plan for future periods and work
to control costs and increase profitability, is that it provides profitability
information as it relates to the different processes and products. This
facilitates more informed and intelligent decision-making regarding pricing,
price adjustments, product line development and eliminaqion of productsuor
processes tuat are unprofituble and drain on resources created by more
profitable products and processes.
Incoming cash receipts and outgoing cash payments are
reported in the statement of cash ulows. Fluctuatiuns in cash duriug the
reportinu period are evident in the cash flow statement. Inflows and outflows
are classified into three specific business activities: operating, investing,
and financing activities. Operating activities will generate revenues,
associated expenses, and any gains or losses, directly influencing the net
income as provided from the income statement. Current assets and liabilities
are also directly influenced by operating activities, further impacting the
company's balance sheet. Long term assets are increased and decreased through
investment activities, and all purchases and sales relative to long term
assets, as well as loans to others and collections on loans, are reported as
investment activities on the cash flow report for the period. Obtaining cash
for launching or funding continuing operations for the business are classified
as financing activities. Issuance of stock, borrowing money from a bank or
other lender, the purchase and sell of treasury stock, and paying dividends to
shareholders are all considered financing activities and are reported as such
on the statement of cash flows. When analyzing the statement of cash flows, it
is generally a good sign for long-term success if the majority of the cash
flows associated with business activity are generated through operating activities.
If the majority of the cash flow is generated through financing activities,
that should represent only a short-term situation, as financing should not
persist and investors will begin to demand a return. If the organization's
reported investing activities make up the majority of cash flows for any given
period, that is typically interpreted as a bad sign, as it could signal
business troubles through sales of long-term assets (Horngren, et al.).
Understanding how to correctly classify and analyze operational inflows and
outflows will assist management in spotting problem areas and restructuring to
maximize on organizational potential.
All changes occurring within a specific reporting period are
shown on the statement of owner's equity. Equity increases from investment and
income, and decreases from withdrawals and losses as they relate to the owners
or shareholders of the company and are communicated in this financial statement
(Horngren, et al.). Information relative to the income or increase in value as
experienced on the ownership level is essential to ensuring future funding and
investment opportunity.
The different financial statements discussed are used
together and separately in numerous ways to assist management in planning and
controlling future operations as the specific data resulting from analysis
provides the information needed to make the operational changes required for
improved overall organizational efficacy. Financial statement analysis as
applied to managerial accounting practices will focus on horizontal analysis,
vertical analysis, and ratio analysis (CTU Online, 2008).
Horizontal, or trend analysis, is the analysis of the data
for a specific financial statement item as reported over a period of time,
showing year to year or quarterly changes in terms of dollars or percentage of
change. Trend percentages can be calculated when multiple periods are reviewed
and compared against the chosen base year (Garrison, et al.). Both the dollar
changes and percentage changes associated with the specific areas of analysis
on the financial statements must be given consideration as to not allow one of
the results to be given unearned significance (Winicur, 1993). For instance, a
specific dollar amount may not be correctly judged in its significance when not
viewed in relation to actual percentage of change. Realizing the trends
associated with the specific focus of analysis assists in setting more
realistic goals for the future and preparing a budget that more closely
reflects the most likely scenario for operational performance. Proper planning
and budgeting, as produced through horizontal analysis, will ensure that all
necessary resources are available to meet the anticipated demands of the
organization.
Vertical financial statement analysis focuses on the
relationships of the many different elements within the financial statement for
a single reporting period. Vertical analysis produces a percentage
representative of the portion of the individual items or activities as they
relate to a larger, or overall item, activity, or view of the statement.
Vertical analysis of an income statement might reflect the total percentage of
sales associated with individual corporate divisions or products. Likewise,
those items could be shown as a percentage relative to the total costs, or
compared to other product costs for the period. Sales are often compared
against a benchmark percentage taken from specific industry data, helping to
assess organizational performance and compare actual progress with budgeted or
anticipated progress. Vertical analysis of the balance sheet would convey items
in terms of their percentage of total assets or total liabilities. This
information is often used to compare organizational performance to industry
averages and against anticipated goals. Managers and/or analysts also use
vertical analysis to construct common-size financial statements, standardizing
the financial information by giving it a common base or common perspective.
Common size statements provide the user with a greater understanding of
relationships among the many different elements of the financial statement such
as sales and expenses, assets and equities, or cash flows and changes in cash,
further facilitating wise decisions as all dependent factors are considered
(Plewa & Friedlob, 2002).
Results from both horizontal and vertical analysis are
employed to create pro-forma financial statements and budgets for use within
the organization. The evident trends and interdependent relationships help
management create financial statements reflecting anticipated performance for
future operating periods. Also known as the projected income statement, or
projected balance sheet, these statements communicate to management the
anticipated production and operational needs of the organization that they
might appropriately secure and allocate all necessary resources, human,
financial, material or otherwise (Atkinson, et al.). Financing must be secured,
cash must be available for inventory purchases and all payments, and all goals
and expectations must be well communicated to everyone in the organization to
provide a point of reference for future operational decision-making activities
(Edmonds, et al.). Pro forma statements and budgets will also reflect the
impact of intended process or product changes within the company, providing
users and planners with a view of how these changes will directly affect the
financial reports once implemented. The ability to analyze these potential
changes further serves management in the decision making process as the
value-added principle is applied. The master budget and all divisional budgets
will convey goals and expectations for operational efficacy within the
different departments of the organization and provide a means of measure by
which to gauge progress and performance.
Although ratio analysis is more commonly used by investors or
other external decision makers with a potential stake in operations and
performance, management within the organization will want to know how well they
are performing and how they are viewed externally. Understanding organizational
performance as it is viewed by others provides management with information
relative to the desired level of performance in all areas in which the company
might be evaluated. Problem areas are recognized through understanding this
performance, providing opportunity to correct these areas and present the
company as a more desirable investment opportunity (CTU Online, 2008).
Countless ratios are applied to the data on the financial statements to
determine profitability, operational efficiency, financial leverage, liquidity,
asset use, and market value (Atkinson, Kaplan, & Young, 2005). Financial
ratios provide specific numeric values or percentage values that answer
questions related to the organization's ability to repay debts, how quickly
finished inventory is sold, or how much each shareholder has earned over the
purchase price of their stock. It is obvious that specific information such as
this will be needed by those judging the organization's potential for success,
and easily understood that knowledge of these specific elements within the
organization provide us with financial performance targets.
From appropriate pricing and product selection practices, through
projecting operational expectations, the role of financial statements and their
inclusive data is evident in successful completion of the many responsibilities
of the manager and the continual success of the organization. Planning a
strategy for success and procuring all necessary resources to attain
organizational objectives, and having the specific cost information for
products and processes allowing managers to better control operational
activities and achieve optimal efficiency are significant elements in the
organization's efforts toward continual improvement and increasing value and
stability.
International Accounting: Convergence and SEC's
Acceptance of International Financial Reporting Standards
A debit is still a debit no
matter what country. A credit is a credit around the world. The fundamentals of
accounting may be universal, but specific rules and pronouncements are not.
Historically, United States Generally Accepted Accounting Principles (GAAP) has
differed from United Kingdom GAAP has differed from Australian GAAP and so on.
This may have worked when businesses operations were primarily domestic, but,
in today's increasing global business environment, this creates confusion and
tedious work for accountants. The lack of a universal accounting system is highly
debated. In the United States, there are two main issues surrounding
differences between U.S. GAAP and foqeign GAAP, nameuy that of Europu. The
first ofuthese issues is the recent ruling by the Securities and Exchange
Commission to permit the filing of financial statements prepared under
International Financial Reporting Standards (IFRS). The reconciliation of these
foreign-prepared financial statements with U.S. GAAP will no longer be a
requirement. The second issue surrounds the convergence efforts of the United
States' Financial Accounting Standards Board (FASB) and the International
Accounting Standards Board (IASB). These two bodies are working toward
establishing a more uniform set of financial accounting standards.
Why are International Financial
Reporting Standards such a hot button issue at the moment? They aqe different
frum U.S. GAAP. U.u. GAAP are ruleu-based; IFRS are principles based. American
accountants are accustomed to (more or less) clearly defined rules, and not the
more subjective IFRS. IFRS, although there are many similarities between them
and U.S. GAAP, would drastically alter the way accountants their field.
Accounting would be less about rote memorization and more about critical
thinking (Cabrera, 2008).
Currently, approximately 100
countries either require or allow the use of IFRS . Sir David Tweedie, Chaiman
of the IASB, estimates that this number will have risen to 150 within the next
five years. Approximately another twenty will continue under their current
GAAP-based systems (Pickard, 2007). This means that roughly 75% of the world
will be operating under the same basic accounting system. If the United States
does not make some move toward IFRS, whatever that move may be, it will be left
behind. The world is going in one direction; it is only wise for the U.S. to
move in that same direction.
SEC's Acceptance of IFRS
Historically, the SEC has
required that firms with international operations reconcile their financial
statements with U.S. GAAP. Any corporation wishing to be listed on a U.S. stock
exchange was required to reconcile its financial statements with U.S. GAAP
(GAAP, 2007). This is true regardless if the corporations prepared their
financial statements in accordance with IFRS or any other set of accounting
standards. However, in December 2007 issued a ruling that it would begin
accepting financial statements prepared in accordance with IFRS. These new
rules apply for financial statements issued for fiscal years beginning after
November 15, 2007. The rules were effective as of March 4, 2008 (Cabrera,
2008).
The SEC's decision applies only
to financial statements prepared according to IFRS as issued by theqInternational Aucounting Standauds Board (IASB)u Financials prepared wiqh
regional varuations of IFRS ure specificallyuexcluded from the SEC ruling. If
the election not to reconcile is made, then the SEC requires a special
disclosure in the notes to the financial statements. This disclosure must
indicate that the financial statements were prepared in accordance with the
IFRS issued by the IASB. The company must also provide an auditor's report
attesting to this, just as it would if the financial statements were prepared
under U.S. GAAP (SEC, 2008).
With the adoption of this rule
comes an important question: how will American investors be able to understand
financial statements prepared under IFRS? Many differences exist between
financial statements prepared in accordance with U.S. GAAP and those prepared
in accordance with IFRS. Titles of the statement itself, categories of assets
(e.g. current vs. non-current), and layout are three important differences. A
balance sheet in the United States isustill a balanceusheet abroad, but in
certain sutuations (such as for a cash basis reporting entity rather than an
accrual basis entit), other terminulogy is used (Bullandi, 2007). uategories
of assets may be referred to by different names. An important example of this
is the category of assets referred to as "property, plant, and
equipment" in the U.S., but is more commonly referred to as "fixed
assets" overseas. In addition, rules for determining current versus
non-current assets and liabilities differ slightly between GAAP and IFRS.
Furthermore, the format and layout of the balance sheet is virtually opposite
under the two sets of standards. For example, under U.S. GAAP, assets are
reported in order of decreasing liquidity; the opposite is true under IFRS
(Bellandi, 2007). These differences, although seemingly minute, could affect an
investor's interpretation of financial statements. Assuming that a principal
reason for filing annual reports with the SEC is to provide stockholders with
information about the company and that information is only useful if it is
understandable, should the SEC allow financials prepared in accordance with
IFRS?
Similarly, if the financial
statements of one company are prepared in accordance with U.S. GAAP, but the
financial statements of another company are prepared in accordance with IFRS,
are they still considered comparable? Isn't a primary reason for having
standards to enhance the comparability of whatever the standards apply to? Many
experts have expressed concern that the elimination of the reconciliation
requirement will decrease the comparability of financial statements (Cheney,
2008). Most experts believe that the scope of this SEC ruling will eventually
be expanded to include U.S. companies, not just multinational corporations. The
SEC has made a proposal to this effect, but there has yet to be an official
ruling on the issue (GAAP, 2007).
"A One GAAP World"
Some professionals feel that the
elimination of the reconciliation requirement may be a catalyst toward
convergence. They feel that this may cause a competition between the two
standards boards to produce the "better" set of standards (Heffes
& De Mesa Graziano, 2007). However, continuation of the current convergence
efforts is believed to be the least likely of all possible "IFRS in the
U.S." scenarios (Cabrera, 2008). Tweedie believes that the mutual
understanding between the IASB and the FASB that neither board's standards are
perfect is what will move convergence forward. He states that in many cases the
changes will only be minimal, but, in other cases, both boards' standards are
outdated. In these situations, the FASB and the IASB are planning on working
together to write new standards.
The move toward convergence began
in 2002 with the Norwalk Agreement between the IASB and the FASB (Pickard,
2007). That was six years ago, and convergence is an oft-misunderstood concept.
Both Americans and Europeans hear the word and think that it means IFRS is
morphing into U.S. GAAP, and less often, that it means the opposite. However,
convergence is more about the two most important authoritative bodies
developing two sets of accounting standards that are markedly similar. As
mentioned earlier, one important difference exists between U.S. GAAP and IFRS:
the former is rules-based, the latter is principles-based.
Furthermore, convergence poses
questions outside the realm of accounting standards. The SEC oversees the FASB;
a similar organization oversees the IASB. Who will oversee the governing body
of a truly-international IFRS? Will the two standards boards continue to
co-exist or will they somehow merge? (Dzinkowski, 2008). If the move is made
toward IFRS, a change in accounting education must occur. Currently, IFRS are
taught at only a handful of colleges and universities and are not covered on
the CPA exam. The costs to alter both accounting curriculum and the Uniform CPA
exam would be astounding. Management Information Systems would need to updated
and/or replaced (Cabrera, 2008).
Currently, a more unlikely event
is the outright adoption of IFRS by the FASB as a replacement for GAAP as it
stands. However, this is highly unlikely as there are several issues paramount
to the FASB that have yet tq be resolved beuween the two bouies. These
priuarily include accounting for business combinations, fair value accounting,
income taxes, earnings per share, and financial statement presentation. Americans
are unwilling to simply give up their accounting system2as we know it tu adopt
a set austandards whereusome methodologies may be inferior. Alternately, a set
of IFRS based on U.S. GAAP has been suggested; however, this is also unlikely.
Europeans are also unwilling to give up their accounting methods (Dzinkowski,
2008).
What Will Happen Next?
How likely is a United States
move to International Financial Reporting Standards? According to most experts,
very. Most assert that it is only a matter of time before the U.S. moves to
IFRS. In fact, the SEC held a roundtable discussion in December 2007 and the
consensus was that the U.S. is headed in that direction. The question of U.S.
adoption of IFRS is no longer "what if?" but "when?". Some
cite this date as 2011 (though it is in fact yet to be determined), when
Canada, India, and Korea are making the transition from their local GAAP to
IFRS. The SEC's ruling is considered to be a move in the direction of U.S.
adoption of IFRS. Will the face of accounting as Americans know it change
forever? Will the accounting students of tomorrow be studying IFRS instead of
GAAP? The answers to these questions have not been written yet, but they will
be and soon, and American accountants must be prepared for the answer, whether
they like it or not.
Chief Risk Officers Lessening Financial Accounting Corruption
In light of the recent corporate
scandals of Enron, WorldCom, Tyco, and others, the need has come for
corporation's to rethink accounting practices, auditing, and reform risk
management in order to protect investors and societies at large. The corruption
committed by these corporations stemmed from senior managements ability to
"facilitate secrecy and a lack of transparency" (Kimbro, 2002). It is
further noted that corruption comes in the form of bribes, kickbacks, and theft,
as well as misrepresentation of the financial accounting statements.
"Financial statements provide information about transactions and auditing
serves as a monitoring mechanism to check on the accuracy of this information
and to prevent and discourage financial misappropriations," (Kimbro, 2002)
but such checks and balances have been discarded. In addition, financial fraud
disrupts the distribution of resource allocation and furthers senior management
dependency on overstated numbers. The desire for senior management to overstate
the earnings on financial statements has continually increased since the
beginning of the 1990s (Alles & Datar, 2004). However, it was the
organizational structure of the company that led management into believing that
increased profits and bonuses paid with stock options, that afforded
"management a dominant incentive to boost short-term stock prices by
beating analysts' earnings expectations" (Alles & Datar, 2004). On the
other hand, analysts and investors view the corporate scandals "as the
consequences of a stock-market bubble. When the bubble burst, scqndals follow,
und, eventually, new regulation" (Coffee, 2005). Conversely, the collapse
of Enron and other major corporations was not due to stock market inefficiency,
but rather "other coexisting negatives such as a national mood of
indifference to the fate of others" (Pomeranz, 2004), corporate greed.
According to Flegm (2005), the past "28 years of the conceptual framework
and a plethora of rules, we have experiences the largest frauds of top
management history." Furthermore, according to Rockness & Rockness
(2005), the current scandals have achieved the "largest dollar level of
fraud, accounting manipulations, and unethical behavior in corporate history
and certainly the most economic scandals and failures since the 1920s." In
response, the U.S. Congress passed the Sabanes-Oxley Act (SOA) in 2002, calling
for reorganization of management control and risk reduction.
Over the past 80+ years, the
government has continually been trying to put an end to corporate corruption.
"Again and again the [government and the SEC] have attempted to control
such frauds with legislation-the 1933 and 1934 Securities and Exchange Acts,
the Foreign Corrupt Practices Act, and, most recently, the Sarbanes-Oxley Act.
[They] have failed to realize that [they] need an accounting base that is at
least audible" (Flegm, 2005). However, the government should be focusing
on top management fraud rather than financial accounting fraud. If we review
history, it is evident that the crises in financial accounting were due to top
management fraud. In order to counter top management fraud, the most important
provision of the SOA requires "that CEOs personally, and under penalty of
criminal law, certify to both the accuracy of their firm's financial statements
and the effectiveness of the firm's internal controls over financial
reporting" (Alles & Datar, 2004). Another important division of the
SOA is the creation of the Public Company Accounting Oversight Board (PCAOB),
which "its thrust is toward auditing standards and oversight of the public
accounts: Auditing standards are not the problem-execution of the standards
certainly is" (Flegm, 2005). Therefore, the governmeqt must pay partucular
attentiou to how the staudards are written because they determine one's
behavior towards financial reporting. The only way to achieve true reform is to
"explore the crises that lead to the current market and regulatory
reforms, the reforms themselves, and what will bring about [change]"
(Jennings, 2005). Finally, the passage of the SOA not only addresses the CEOs
and auditors, but also the board of directors, the CFO, and all other
management personnel responsible for the adequacy and accuracy of financial
statements. However, the SOA didn't stop at the responsibilities imposed upon
senior management, it also increased the penalties for acts of corporate
corruption-raised the maximum penalty for securities fraud to 25 years, raised
maximum penalties for mail and wire fraud to 20 years, created a 20 year crime
for destroying, altering or fabricating records in federal investigations, and
required preservation of key financial audit documents and e-mails for 5 years
with a 10 year penalty for destroying such documents (Rockness & Rockness,
2005).
Currently, many corporations are
trying to comply with the Sarbanes-Oxley Act by restating financial statements
from previous years. Corporations, however, do not realize how these
restatements reflect on the investment community and the overall health of the
corporation. The U.S. witnessed an enormous increase in financial statement
restatements that begun in the late 1990s. "The U.S. General Accounting
Office (GAO) found that over 10 percent of all listed companies in the U.S.
announced at least one financial statement restatement between the period of
1997 and 2002. Later studies have placed the number even higher" (Coffee,
2005). Furthermore, chief financial officers, many in other countries,
"consider financial disclosure and corporate corruption to be serious
corporate problems long before the Enron debacle" (Barth, Trimbath, &
Yago, 2003). In addition, the majority of the CFOs "consider the lack of
disclosure to be a bigger issue than either corrupt business practices or a lack
of effective accounting guidelines" (Barth, Trimbath, & Yago, 2003).
The purpose of this paper is to
determine if the implementation of an ERM program and the appointment of a CRO
will lessen financial accounting corruption and protect investment
opportunities. A study conducted by the PricewaterhouseCoopers Endowment for
the Study of Transparency and Sustainability, before the Enron Debacle,
"found that the cost of equity capital decreases as the disclosure level
increases. Furthermore, it has been found that there is no association between
the cost of equity and the level of investor relations activities" (Barth,
Trimbath, & Yago, 2003). Other research concludes that financial
restatements carry severe consequence, which could result in "private
class action lawsuits, SEC enforcement proceedings, a major drop in stock
prices, and/or management reorganization" (Coffee, 2005). Previous
accounting standards, which were developed poorly, undefined, and unregulated,
were "subject to manipulation with accurate financial reporting easily
compromised to drive stock prices, meet loan covenants or attract new
investors" (Rockness & Rockness, 2005). This is still the standard
today, which leads many companies to restating financial statements. Professor
Jensen states, "In a situation like this once you discover you are not
going to meet the lower bound bonus hurdle, it pays to drag expenses from the
future into the present and to postpone whatever revenues you can to the future
so you are in great shape to meet the target next year. But, as this example
shows, it is not just accruals that are being manipulated: it is the real
operation decisions of the firm" (Benston, Bromwich, Litan, &
Wagenhofer, 2003). Finally, the failures of corporate responsibility has been
around for decades; however, the severity of the most recent scandals came to
the public view through whistleblowers, the sudden decrease in stock prices,
and other forms of financial reporting.
Participants
In response to these corporate
scandals, many companies are implementing enterprise risk management (ERM)
programs and creating a Chief Risk Officer (CRO) position, in addition to
current executive positions. An ERM helps senior management to assess,
evaluate, and control risk on a company-wide basis rather than within individual
business units. In addition, the ERM establishes an internal control mechanism
(Bove, 2003) that brings together all senior level management, through the CRO,
to discuss potential risks facing the organization and how to allocate capital
resources between those risks. As for the CRO, his duties are to effectively
communicate with all department managers, as well as the board of directors,
the CEO and CFO a bout all forms of risk and establish plans to carry out risk
reduction strategies (Banham, 2000). CROs are seen as today's saints in the
reforming of corporate governance (Fuschi, 2003). Furthermore, the creation of
a CRO position "signals both internally and externally that the company is
serious about integrating all of its risk management activities under a more
powerful senior-level executive" (Lam, 1999). According to John Roskopf,
senior Vice President at Willis of Illinois, states, "The problem with the
chief risk officer is that you have to adopt an enterprise risk management philosophy
in order to have a chief risk officer, and that is something that is not real
concrete, and the role of the chief risk officer is not really concrete"
(Hofmann, 2004). In addition, some CFOs find this new position to be
downgrading to their position. Conversely, Mr. Schaefer, Vice Presidunt of
Enterpriue Risk Managemeut for ABD Insurunce & Financial, states, "The
problem with a CFO assuming the role of CRO is that they may tend to look
primarily at financial risks and not coordinate activities with other parts of
the organization" (Hofmann, 2004). Corporate America can really benefit
from the creation of CROs. Such a position will take away the opportunity of
CEOs to "cook the books" (Alles & Datar, 2004) or stack the board
with those whom they have close relations with or those whom can be manipulated
easily.
In conjunction with the
Sarbanes-Oxley Act, the SEC and other federal agencies have required the
majority of the board of directors and auditors to be independent of the
company. When board members are independent of CEOs and CFOs, they are more
likely to question the activities of the corporation and are less fearful of
being replaced for operating ethically, (Schwartz, Dunfee, & Kline, 2005).
However, this was not the case with Enron's board, directors, and senior
management. In addition to Enron's senior-level managers, their external
auditor, Arthur Andersen, played a major role in its demise. Due to the action
of Arthur Andersen, the SOA has mandated the rotation of external auditors
every 5 years to prevent the formation of close and personal relations. In
addition the SOA and SEC limit the services that external auditors can perform
for the companies they audit.
Results
So far we have explained the
legislation requiring more accountability and responsibility of ethical actions
to be taken into consideration by CEOs and other senior-level management. We
have established, briefly, reasons for independence of the board, directors,
and auditors. Finally, we have stated how an ERM program and CRO can add value
to a corporation's operational activities. Now we will examine whether or not a
CRO can lessen the financial corruption and unethical behavior of past
senior-level managers.
It has been proven, through the
recent collapse of Enron and other corporations, that senior management have
performed to improve their own well-being. Their lack of consideration for the
employees, investors, ethical responsibility, and society at large, only
enhances the probability that an ERM program and CROs will reinvent corporate
America and take it to higher standards. Earlier studies found that 156
companies had restated their earnings between 1999 and 2000 (Coffee, 2005).
Another study done by the Huron Consulting Group found that number to have
risen to 414 in 2004 (Coffee, 2005). Another study conducted by the General
Accounting Office (GAO) "found that the typical restating firm lost an
average 10 percent of its market capitalization over a 3-day trading period
surrounding the date of the restatement" (Coffee, 2005). Furthermore, the
GAO estimated the total market losses around $100 billion for these firms
(Liebenberg & Hoyt, 2003). In response to these studies, especially for the
financial industry and the energy industry, many corporations realized the
importance of getting a handle on risk adverse activiqies. "Today, tuere
are over 1u0 CROs, and newuannouncements are appearing every month. The rise of
the CRO is a parallel trend with the acceptance of ERM; together, they
represent a powerful force that is moving risk management to a higher
level" (Lam, 2001). Such a movement represents a brighter future for
corporations, investors and the community at large.
The rising number of ERM programs
and CRO appoints result not oqly from the recunt scandals, buu also because ou
a major breakdown in corporate governance and ethical behavior. "An
investigative committee of the Enron Board of Directors, the Powers Report,
emphasizes the executives lack of adherence to the Board's suggested policies
for maintaining the integrity of its risky [activities]" (Bove, 2003).
According to Short, Keasey, Hull, and Wright (1998) corporate governance is
defined as "the system by which companies are directed and
controlled." Furthermore, the Cadbury Report states "that a system of
good corporate governance allows board of directors to be free to drive their
companies forward, but exercise that freedom within a framework of effective
accountability" (Short, Keasey, Hull, & Wright, 1998). However,
accountability doesn't end with the board of directors. Audit committees also
need to demonstrate effective accountability by verifying that all internal
control mechanisms are operating properly and to their fullest capacity.
"The auditor control loop can be compromised if the auditing and consulting
relationships are not maintained separately" (Bove, 2003). External
auditing firms also play a major role in maintaining the integrity of the
corporations they audit, as well as their own corporation. External audits need
to be precise, well detailed and documented, and reviewed by the board's audit
committee before being approved. However, the internal auditing committee must
be able to recognize fraudulent reports and take appropriate action for
correcting them before they are submitted to the SEC. "In 1987, the
National Commission on Fraudulent Financial Reporting investigated ways to
detect and prevent fraudulent financial reporting" (Keinath & Walo,
2004). A study conducted by the Blue Ribbon Committee on Improving the
Effectiveness of corporate audit committees (BRC) found that "95% [of
internal auditors] reported that they discuss these statements with management
and auditors. Only 84% of the committees or committee chairs reviewed quarterly
statement and only 68% discussed these with management and external
auditors" (Keinath & Walo, 2004).
As noted earlier, the CRO is
changing the way corporations think and control risks. A study conducted by
Liebenberg & Hoyt (2003) examine how a corporations stock prices and
earnings are effected when a corporation appoints a CRO and implements an ERM
program. The results of the study indicate that corporations will enjoy far
more benefits from the appointment of a CRO. Furthermore, those corporations
will experience less volatility in earnings and stock prices, while achieving
greater financial stability and increased capital funding. When investors are
confident in the actions of senior management, they are more likely to invest
in that company.
Discussion
The research proves that the
implementation of an ERM program and the appointment of a CRO do lessen the
probability of financial corruption while protecting the investment community.
However, this is a fairly new area in the internal control system of corporate
governance, which needs to be explored further. Moreover, we can conclude that
corporations with ERM programs in place have better control over managing all
forms of risk facing companies today. Subsequently, we conclude that the
appointment of a CRO not only brings different solutions, for managing risks,
to the company, but also within the control loops, they are able to prevent
corruptive acts of the CEOs and CFOs. Furthermore, the investment community
will be able to re-establish confidence in the corporations that have these
control mechanisms in place. Finally, corporations that learn from past
scandals and adhere to current legislation will grow and prosper. As for the
legislation loop, la makers should be forward looking, that is, implementing
laws to prevent future scandals, rather than trying to correct the past.
Everyday, corporations and auditors that continuously seek to enhance their own
well-being will find more and more creative ways to manipulate the numbers and
inflate stock prices.
