Accounting and Accountability by David C. Jones (Chartered Public Finance Accountant, Chartered...

Accounting and Accountability by David C. Jones

(Chartered Public Finance Accountant,Chartered Certified Accountant (UK)

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Accounting and Accountability:Breakdowns and Controls

[Out of Balance: Accounts Balance in Form Only, Not in

Substance]

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Resources and Results The concepts of “Resources” and “Results,”

when applied to overall accounting principles, were originally devised, for teaching and illustrative purposes, by David C. Jones. For example, in his definitive textbook “Municipal Accounting for Developing Countries,” the following appears (p2):

“An accountant records and interprets variations in financial position. He records, in money values, the results of variations during any period of time, at the end of which he can balance Net Results (of past operations) against Net Resources (available for future operations)”.

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Resources and Results These theories, developed by the author, are grounded

in principles enunciated by (inter alia) eminent British writer and (government) district auditor, Carson Roberts and from a US book, 'Accounting principles and practice', by Hatfield, Sanders and Burton.

They have also been interpreted by a former president of the Chartered Institute of Public Finance and Accountancy, Mr. J.B.Woodham, Borough Treasurer, and later Chief Executive, of Middlesborough and of Cleveland County, England.

Woodham refers to “Resources” as “What” accounts (what one owns and what one owes) and “Results” as “How” accounts (how the changes in resources came about). The concepts fit very neatly with those relating to (on the one hand) balance sheets and (on the other hand) income and expenditure accounts.

International Accounting Standards are fully consistent with these theories.

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The Balance of Accounting (1)

LIABILITIES(WHAT ISOWED)

ASSETS(WHAT ISOWNED

HOW DID THEIMBALANCE

COME ABOUT?

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The Balance of Accounting (2)

NEGATIVE (-)RESOURCESPOSITIVE (+)

RESOURCES

POSITIVE (+) ANDNEGATIVE (-)

RESULTS

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The Balance of Accounting (3)

RESOURCES [BALANCE SHEET]

RESULTS [INCOME & EXPENDITURE ACCOUNT]

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The Balance of Accounting (4)

RESOURCES

RESULTS

DEBIT

DEBIT

CREDIT

CREDIT

Resources always equal Results

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Principles of AccountingRESOURCES

RESULTS

ASSETSLANDPERMANENT WORKSWORKS UNDER CONSTRUCTIONBUILDINGS EQUIPMENT & MACHINERY

LIABILITIESLONG TERM LOANS

INCOMEREVENUE FROM OPERATIONS: SALES FEES AND CHARGES RENTS (SUBSIDIES)

EXPENDITUREOPERATIONMAINTENANCEADMINISTRATION & TAXESRENTDEPRECIATIONINTEREST

CAPITALCONTRIBUTED CAPITAL(SHARES OR GRANTS)RETAINED EARNINGS

MONETARY INVESTMENT

INVENTORIES (STORES)WORK IN PROGRESSCUSTOMERS (RECEIVABLES)BANK & CASH

TEMPORARY LOANSBANK OVERDRAFTSTAXES PAYABLEDIVIDENDS PAYABLESUPPLIERS (PAYABLES)

SHAREHOLDERS DIVIDENDS

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If standard practices are followed, an internal control should conform, without exception or discrete human intervention, to the logic of:

“If THIS happens, then THAT will inevitably and automatically occur.”

If standard practices are NOT followed, this will always be obvious and thus immediately preventable, correctable and reportable.

A significant internal weakness is where there is collusion, or the over-riding of authority by superiors, to by-pass specific control systems.

INTERNAL CONTROLS 10

Person Primarily Responsible for Internal Control: You!

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Domain of Difference Internal Auditor External Auditor

SCOPE Determined by management (but also influenced by management’s concern for legal compliance).

Determined by statute, and also by standard practices and principles applicable to the entire accounting and auditing professions.

APPROACH To ensure that accounting and financial systems are efficient and providing management with effective control, and accurate material information, as well as competent outputs and outcomes

To satisfy himself (herself) that financial statements to be presented to the shareholders/owners of a business (or by a public authority) present a true and fair view of its entire activities and of its entire financial situation.

RESPONSIBILITY To management To shareholders/owners and (in public entities) to the government & public.

Internal and External Audit

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Audit of Financial Statements

Compliance Audit (OR)

Performance Audit

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Audit of Financial Statements

Accounting Principles Used Auditing Standards Applied Qualifications – Matters about which the Auditor is not

completely satisfied Reasons why the statements cannot be fully (or even

partially) certified Subject to the above qualifications, the Auditor certifies

[expresses a satisfactory opinion about] the statements[OR]

Because of the above reasons, the Auditor is unable to certify [express a satisfactory opinion about] the statements

[THEN] Auditor certifies (or not, as the case may be!) that

The Financial Statements fairly present: Financial Position [Resources] and Income and Expenditure [Results]

Auditor signs and designates authority

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Corporation Audit Opinion

OpinionIn our opinion the statement of accounts has been prepared in accordance with [appropriate accounting standards designated or described]. It presents fairly the financial position of [the corporation] at 31 December 20_1 and of its income and expenditure for the year then ended.CertificateWe have carried out the audit of accounts in accordance with the requirements of the [appropriate legal provisions] and the [appropriate code of audit practice] emanating from [or issued by] the [institute or entity concerned].

Signature and Designation of Authority

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A CPA was hired to be an expert witness in a civil fraud case. The opposing attorney asked a seemingly simple question: “Would you please define ‘fraud’ for the jury?” The CPA replied, “Do you want to know the legal definition or my definition?” The attorney countered, “You mean there is a difference?”

The expert’s answer provoked a snicker from the judge and jury, and the CPA’s credibility went downhill from there. Before the cross-examination was over, the expert was made to look like an idiot. The truth is, the CPA knew a lot about accounting and he was well-versed in the facts of the case, but he knew little about the legal aspects of fraud—a crucial element for an antifraud witness. As a result, the case was lost.

Court Expert Opinion 16

[English] Common Law Larceny

A person steals who, without the consent of the owner, fraudulently and without a claim of right made in good faith, takes and carries away anything capable of being stolen with intent, at the time of such taking, permanently to deprive the owner thereof;

[Codified into the Larceny Act of 1916]

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Dishonesty [English Law]

In determining whether the prosecution has proved that the defendant was acting dishonestly, a jury must first of all decide whether, according to the ordinary standards of reasonable and honest people, what was done was dishonest. If it was not dishonest by those standards, that is the end of the matter and the prosecution fails. If it was dishonest by those standards, then the jury must consider whether the defendant himself must have realised that what he was doing was, by those standards, dishonest. In most cases, where the actions are obviously dishonest by ordinary standards, there will be no doubt about it. It will be obvious that the defendant himself knew that he was acting dishonestly.

Regina v Ghosh [1982] COURT OF APPEAL, CRIMINAL DIVISION (UK)

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Accounting Scandals:Breakdowns in Corporate

GovernanceDefinition of Theft

In the criminal law, theft (also known as stealing) is the illegal taking of another’s property without that person's freely-given consent. As a term, it is used as shorthand for all major crimes against property, encompassing offences such as burglary, embezzlement, larceny, looting, robbery, trespassing, shoplifting, intrusion, fraud (theft by deception) and sometimes criminal conversion. In some jurisdictions, theft is considered to be synonymous with, or has replaced, larceny.

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Accounting Scandals:Breakdowns in Corporate

GovernanceDefinition of Fraud

“All multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth. It includes all surprises, tricks, cunning or dissembling, and any unfair way which another is cheated.” Source: Black’s Law Dictionary, 5th ed., by Henry Campbell Black, West Publishing Co., St. Paul, Minnesota, 1979.

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Getting Control (USA)

The Sarbanes-Oxley Act of 2002 

Assessing control deficiencies now is adocumented process required of management.Section 404 Compliance in the Annual Report

BY MICHAEL RAMOS

[http://www.aicpa.org/pubs/jofa/oct2004/ramos.htm]

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Accounting Scandals:Breakdowns in Corporate

GovernanceREMAINDER OF SLIDE-SHOW

[Slightly Modified and Updated]

Presented (at Reston – Virginia) by Dr. Richard Brownlee

Darden Graduate School of Business Administration

University of VirginiaJune 3, 2004

[Reproduced by Permission]

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QuestionWhat do the following organizations have

in common?

Xerox Sunbeam

Tyco

(Etc.)

Micro-Strategy

Freddie Mac

Parmalat

WorldCom

Enron

(Etc.)

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Answer!

They all experienced major accounting scandals which were due, at least in part, to serious

breakdowns in corporate governance.

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Enron At the time, Enron’s bankruptcy was the

largest ever in the U.S. Alleged (subsequently proven) massive

accounting fraud Serious misuse of Special Purpose Entities

(SPEs) in order to inflate revenues and profits and to keep large amounts of debt off the company’s balance sheet

Unwillingness to produce balance sheets Self-enrichment of top executives Falsification & destruction of documents

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Enron

Substantial breakdowns in corporate governance Internal controls External auditors Board of directors Financial institutions Analysts Regulators

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The Sarbanes-Oxley Act of 2002

“The most significant piece of legislation to hit the securities field

since 1933-1934.”

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Background to the SOX Act

After Enron (Dec. 2001)… Senator Sarbanes (D-Maryland) introduced a

tough bill in the senate, with new penalties for financial fraud

Rep Oxley (R-Ohio) introduced a milder bill in the house, saying that Enron was a “one-off” case

But then came WorldCom (July 2002) and support for anything less than significant legislation evaporated

Since that time, there has been significant pressure for some of its “more onerous” proposals to be modified or relaxed!

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Who Does the SOX Act Affect?

External auditors Internal auditors Boards of directors and their

committees Top executives Senior managers Attorneys, both internal and external Regulators

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Provisions of the SOX Act

The CEO and CFO must certify that the reports the Company files with the SEC are fair But they can only make that representation if the line

managers assure them that their units’ financials are fair

The CEO and the CFO must certify that the Company has a system of internal controls, and that it is effective, as of the year end But again, they can only make that representation if the

line managers assure them that their units’ control system is effective

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Implementation of the SOX Act – A.S.2.

Since auditors began using A.S.2., companies complained that its interpretations created burdensome audits, by promoting “work for work's sake” and encouraging a “rigid checklist” approach.

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Implementation of the SOX Act – A.S.2.

as the Sarbanes-Oxley Act of 2002 celebrates its five-year anniversary, its supporters appear to feel very comfortable in singing its praises.

"I give Sarbox high scores," says Dana Hermanson, a professor of accounting at Kennesaw State University, in Georgia. "It promotes accountability on many levels, and its provisions make tremendous sense."

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Implementation of the SOX Act – A.S.2.

Hermanson says that corporate "whining over Section 404" has obscured and even "tainted" the salutary effects of Sarbox.

"One reason that 404 has proved so costly," he says, "is that many companies simply had lousy internal controls."

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Implementation of the SOX Act – A.S.2.

Nonetheless, on May 24, 2007, the Public Company Accounting Oversight Board (PCAOB) voted, unanimously, to replace its controversial internal-control A.S.2 with A.S.5.

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Implementation of the SOX Act – A.S.5.

AS5 requires auditors to: take a top-down, risk-based approach; and, focus only on areas that could lead to a

material misstatement.

The PCAOB also: eliminated several "unnecessary" procedures; made the standard scalable for companies of

all sizes and complexity; and, simplified the text.

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Implementation of the SOX Act – A.S.5.

Most importantly, according to many critics of AS2, the new standard:

“…eliminates the requirement of auditors to give an opinion on the adequacy of management's process on evaluating internal controls…”

The SEC, also, eliminated that requirement in its changes to Section 404 on May 23.

The standard is less prescriptive, no longer stressing mandatory terms, such as "must" or "should," so as to be more “principles-based.”

[http://www.cfo.com/article.cfm/9244601/c_2984368/?f=archives]

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Financial Statement Certification

The CEO and CFO must certify in each period filing that the financial information:

“does not contain any untrue statement of a material fact”

and

“fairly presents in all material respects the financial condition and results of

operations of the issuer.”

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What Does “Fairly Presents” Mean?

Will our ASSETS produce future benefits related to their cost or value? Receivables, Inventory, Property, Goodwill?

Do our LIABILITIES report all of the amounts we expect to pay out? Supplier payables, benefits owed, lease commitments, short-

term and long-term debt, bank overdrafts?

Is all of the REVENUE we reported really earned and also only attributed to the periods wherein related expenses are incurred?

Have we recorded all of our EXPENSES for the period? Have we described the critical ASSUMPTIONS underlying

our financial reports, and have we fully stated and correctly described any and all significant CONTINGENCIES?

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Management’s Annual Internal Control Report

A statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting for the company;

A statement identifying the framework used by management to evaluate the effectiveness of this internal control; 

Management's assessment of the effectiveness of this internal control as of the end of the company's most recent fiscal year; and

A statement that its auditor has issued an attestation report on management's assessment

[SEC 9/25/03]

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An Internal Control System Is…

By law....it is a process that provides reasonable assurance regarding the reliability of financial reporting for external purposes. It includes policies and procedures that:

- provide for maintenance of records that reflect the company’s transactions

- provide assurance that transactions are recorded in accordance with GAAP

- provide assurance that assets are protected against theft or fraud

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What are Internal Controls?

Broadly, there are five interrelated components in a control system:1. Control environment (how do people feel?)2. Risk assessment (what could go wrong?)3. Control activities (procedures to control

against risks)4. Information and communication (timely

feedback, truth-telling)5. Monitoring (ongoing assessment of the

environment, and the risks, and the effectiveness of the procedures)

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THE most important component

of any control system is the Control Environment…

The Tone at the Top of the corporation and of its operating

units

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Implementation of the SOX Act – A.S.5.

"Putting a discussion of fraud risk and fraud-risk controls at the beginning of the standard should make clear to auditors the importance of assessing fraud risk throughout the audit process…”

"While even the strongest of internal-control frameworks cannot provide absolute assurance that fraud will be prevented or detected, a strong control environment should help to reduce instances of fraud…"

[PCAOB chairman Mark Olson]

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Source: UTC Annual Report 2001

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Source: UTC Annual Report 2002

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Corporate Governance

At the heart of many of the recent accounting scandals has been the failure of corporate governance structures, including the inability and/or unwillingness of boards of directors to execute their duties responsibly, both individually and collectively

Despite the heightened interest in and awareness of the importance of effective corporate governance, there continues to be a general lack of understanding of the principles underlying such governance.

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The Corporation For businesses of significant size, the

corporation has become the dominant form of organization. So, what is it?

A corporation is… A legal entity that has status independent of

its owners These features make corporations

attractive… Unlimited life Limited liability of the owners Easy transfer of ownership Corporate, registered, identification

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The Role of the Board of Directors

The responsibility for governing the affairs of the corporation belongs to its board of directors.

The board’s authority is derived from the corporation’s shareholders, whom they represent, as specified in certain governing documents, which include…

Articles of incorporation Bylaws Shareholder agreements Corporate law

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The Responsibilities of the Board of Directors

Board responsibilities are specified in terms of “duties”…

Fiduciary duty Duty of loyalty and fair dealing Duty of care Duty not to entrench Duty of supervision

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Source: http://www.pg.com/about_pg/sectionmain.jhtml

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Source: http://www.pg.com/about_pg/sectionmain.jhtml

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