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10-1
Fraudulent
Financial
Reporting
10-2
A little Insight into CEOS….
A survey by Starwood Hotels & Resorts showed that 82% of CEOs admit to cheating at golf.
The same percentage hate others who do the same.
10-3
2002 Top 100 Accounting Firms Public Accounting Report (Firm: Reported Revenues)
1. PriceWaterhouseCoopers: $8,056.5M
2. Deloitte & Touche: $6,130M
3. Ernst & Young: $4,485M
4. KPMG: $3,171M
5. Grant Thorton: $432.5
6. BDO Seidman: $353M
7. BKD: $210.9M
8. Crowe, Chizek & Co.: $204.7M
9. McGladrey & Pullen: $203M
10. Moss Adams: $163M
Dropping Out:
Andersen #5
in 2001
10-4
Fun Facts
Economic Theory predicts there will be how many Big Accounting firms?
Three
10-5
Fraudulent Financial Reporting
Keep 2 things in mind: Most costly fraud Restatements associated with fraud
have cost investors over $100B in the last sixish years (Hilzenroth, 2001)
Perpetrated by management
10-6
Number of Securities Class Action Lawsuits
050
100150200250300350400450500
1996 1997 1998 1999 2000 2001
Lawsuits
2001 :308 IPO
PWC 2001 (Annual) Securities Litigation Study
10-7
% Lawsuits with Accounting Allegations
0
10
20
30
40
50
60
1996 1997 1998 1999 2000 2001
Acctg
PWC 2001 (Annual) Securities Litigation Study
10-8
Accounting Issues
0
10
20
30
40
50
60
70
2000 2001
Understatementof LB
RevenueRecognition
Purchase Acctg
Overstatement ofAssets
Other
Estimates
PWC 2001 (Annual) Securities Litigation Study
10-9
Securities Class Action Lawsuits -2001
53% involved FS restatement 10% dismissed On average, settled in 4 years biggest industries –
computer services (32%) followed by telecommunications (11%)
Most filed in NY (IP0) or CA (hitech) 2/3 firms listed on NASDAQ
PWC 2001 (Annual) Securities Litigation Study
10-10
Securities Class Action Lawsuits $$$$
Year
Settled
Cases
Avg/Median
Settlement
1996-2000 NON ACCTG 104 $7.8M/3.6M
ACCTG 157 $18.3M/7M
2001 NON ACCTG 40 $6.2M/3.9M
ACCTG 69 $23.7M/7.5M
PWC 2001 (Annual) Securities Litigation Study
10-11
Securities Class Action Settlements
2000 study by Bajaj, Mazumdar, Sarin Table 4: Settlement amount and time
Longer = more $$$ Table 12: Settlement statistics by co-defendant type
Accounting/Underwriting mean/ median much higher To settle or not settle? Why? E&Y: Cendant settlement= HUGE
Table 13: Settlement statistics by allegation type Table 16: Want to sue? Milberg, Weiss, Berhad,
Hynes & Lerach 31% of all filings
10-12
Types of Audits & Lawsuits
Compilation: prepares FS without any testing, no assurance AT ALL
Review: few substantive tests (inquiry, analysis, discussion), limited assuranceCan you believe the FS?
Audit: in accordance with GAAS, positive assurance
Most Lawsuits
SEC 2ed – Rules of Practice 2(e)
What went wrong? Corporate culture and reporting model
Simple greed or arrogance Market pressure on short-term
earnings Lack of transparency or timely
disclosures in the reporting model Lack of mandated disclosures on
management’s accounting policies Too many rules leading to connect the dots
accounting and auditing – rules vs principle
Chuck Landes – State of Audit Profession
What went wrong? The work of auditors
Some not stepping up to their responsibilities Some assumed good intent on part of mgmt Inherent weaknesses in our disciplinary and
monitoring processes Unqualified/inexperienced auditors Close relationship with client (leave for
companies they audit) Materiality judgments????
Waste Mgmt- Andersen decided 12% misstatements immaterial
Chuck Landes – State of Audit Profession
10-15
What went wrong? The work of auditors
Movement to “business advisory role”
Make Audits Pay: Leveraging the Audit into Consulting Services (AICPA, 1999)
Auditor dependency on fees from major clients – especially non-audit feesKPMG: Motorola $3.9M/$62.3ME&Y: Sprint $2.5M/$63.8MPWC: AT&T $7.9M/$48.4M
EQUALS
CAVE IN
TO CLIENTS
What saying NO means
Auditors need to just say NO
Rejecting unsound corporate accounting practices Reducing the risk of deceit and fraud through
diligent inquiry Ensuring that audited statements are not just
accurate, but illuminating Questioning management, challenging
management When justified – rejecting management’s
accounting decisions
ZERO TOLERANCE POLICY!!!!
Chuck Landes – State of Audit Profession
10-17
Fraudulent Financial Reporting
(Internal) Auditors need to predict & uncover financial statement fraud using the three Cs.
Conditions: pressure to meet analysts’ earnings forecasts
Corporate Structure: aggressiveness, arrogancecohesiveness, loyalty, gamesmanshipcontrol ineffectiveness, blind trust
Internal Auditor (Oct 2002) – “The Three Cs of Fraudulent Financial Reporting” by Z. Rezaee
10-18
Fraudulent Financial Reporting Choice: managers should use ethical strategies
RED FLAGS for management• Personal wealth closely associated with
company’s performance• Willing to take (illegal) personal risk for co. $$$• HIGH pressure to maximize shareholder value• Probability of fraud detection low
1 = possibility, 2+ = high probability fraud occurredInternal Auditor (Oct 2002) – “The Three Cs of Fraudulent Financial Reporting” by Z. Rezaee
What was the response of Congress?
The Sarbanes - Oxley Act:Oversight Board
New Public Company Accounting Oversight Board (PCAOB)
5 members – only 2 CPAs (& only 2) Power to set auditing rules, inspect firms and
discipline wrongdoers Funding from accounting firms and
registrants
The Sarbanes - Oxley Act:Standard Setting PCAOB has authority to “adopt, amend, modify, repeal or reject”
standards Includes provisions for SEC oversight, governance and funding
of FASB
Independence/Scope of Services Proscribes eight specific services to public company audit clients Gives PCAOB authority to prohibit others Other nonaudit services not banned must be pre-approved by
audit committee
The Sarbanes - Oxley Act: Banned Services
Bookkeeping Information
systems design and implementation
Appraisals or valuation services
Actuarial services Internal audits
Broker/dealer and investment banking services
Legal or expert services related to audit services
Management and human resources services
Other services as determined by the board
HARSH PENALTIES
The Sarbanes - Oxley Act:
Liability Concerns Statute of limitations extended to 5 years from
occurrence or 2 from discovery No specific language on non-preclusive effect
Reporting on Internal Controls Requires auditor to report on internal controls
assertions Must be part of audit - not separate engagement
The Sarbanes - Oxley Act:
Corporate Governance Mandates audit committee oversight of audits Requires CEO/CFO certification of reports Prison terms of up to 10 years for senior executives
Workpaper Retention Auditors to retain documents in support of report for 7 years. 5 yr retention requirement under “criminal fraud accountability”
Overview of the Potential Impact New rules could require mandatory rotation of
all partners on audit engagements. New auditor responsibility for “testing” issuers’
compliance with laws and reporting on “potential” violations.
The new Board could have the authority to enforce securities laws, duplicating SEC’s powers.
State legislative/regulatory proposals could “pile on” and/or conflict with Federal laws.
10-26
The mess continues…..
Public Company Accounting Oversight Board (PCAOB) – William Webster resigns after it is revealed he headed an audit committee of U.S. Technologies that is being sued by investors for fraud.
SEC Chairman – Harvey Pitt resigns because of Webster
What was the response of the accounting profession?
10-28
Recently Issued Standards
SAS No. 95, Generally Accepted Auditing Standards
SAS No. 96, Audit Documentation SSAE No. 11, Attest Documentation SAS 97, Reports on the Application of
Accounting Principles SAS 98, Omnibus 2002
10-29
Auditors role in Fraud Previous standard: SAS 82
required specific assessment of the risk of material misstatement of FS attributable to fraudulent financial reporting
Consideration of 40 specific fraud factors New standard: SAS 99 (Oct 2002)
Part of anti-fraud movement Auditor is responsible for providing reasonable
assurance that the FS are free of material misstatement whether caused by error or fraud
Also responsibility place on board of directors and audit committee
10-30
Auditors Role in Fraud
Forensic accountant = fraud auditor
Work for FBI, public accounting firms, IRS, insurance organizations
Certified Fraud Examiner: requires passage of Uniform CFE Examination
10-31
AICPA Initiatives Institute for Fraud Studies with the University of
Texas and Association of Certified Fraud Examiners
calling for revision of auditing standards to provide public notice of internal control weaknesses
Will create enhanced attestation standards for CPAs to report on corporate anti-fraud programs
Will work with FASB for better reporting and disclosure standards
10-32
Impact on AIS
Large ERP vendors: equipped to handle reporting requirements as long as controls in place. Software vendors respond to regulatory changes with updates.
Disparate/fragmented/legacy systems: more interfaces/reconciliation procedures increasing risk of material errors (as well as the time required to close books)
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