CRITICAL ANALYSIS OF THE AUDITING PROFESSION AND ITS FUTURE Christa Walsh, Jennifer Watson, Christopher Keuleman, Stephanie Howatt, Greg Sheremeta and.

CRITICAL ANALYSIS OF THE AUDITING PROFESSION AND ITS FUTURE Christa Walsh, Jennifer Watson, Christopher Keuleman, Stephanie Howatt, Greg Sheremeta and Mark Allen

THE INSURANCE HYPOTHESIS AND MARKET PRICESarticle by

Krishnagopal Menon & Daid D. Williams

Auditors Liability to Shareholders

Auditors can be sued by investors if ALL of the following are present:

- There was a material misstatement in the published FS- Investor losses are caused by a reliance on these

statements- Auditors did not perform the audit with “due care” (onus of

proof on auditors)

Can be seen by investors as a type of insurance against relying on materially misstated financial statements

Investor’s “Insurance”

Recent and Current Cases

• KPMG in May 2010 settled a class-action litigation brought by several pension funds for its audits of Countrywide Financial Corp agreeing to pay $24 million

• Deloitte & Touche LLP in September 2010 won dismissal of a federal securities lawsuit brought by Fannie Mae stock investors alleging they were misled about the mortgage financier’s subprime mortgage risk

• PwC won a dismissal in a case accusing them of hiding risks at insurer American International Group Inc.

Investor’s “Insurance”

A Change in Trend:

- In recent years auditors have become more careful in limiting their liability

- Many lawsuits were filed against auditors as a result of the financial crisis in 2008 but very few have resulted in payouts to investors

This change in trend may limit the value that shareholders could assign to this “insurance” against relying on statements that are materially misstated

Investor’s “Insurance”

Do Investors assign a value to the right to recover investment losses from the auditor?

Investor’s “Insurance”

Do Investors assign a value to the right to recover investment losses from the auditor?

Literature has suggested that a valued attribute of audits is implicit insurance

Investor’s “Insurance”

Study examines the effect on stock prices of Laventhol & Horwath (L&H) clients of two related events:

1) Disclosure of auditors bankruptcy

2) Appointment of a successor auditor

Hypothesis

Study hypothesis:

Investors assign value to right to recover losses from auditor making it a component of stock price that will vary with likelihood that it will be exercised

i) increases with previously incurred price declines

ii) greater for IPOs

Hypothesis and Tests• HI: Laventhol & Horwath (L&H) clients’ security prices

declined relative to the market on the disclosure of L&H’s bankruptcy.

• If it is observed that the population as a whole (non-L&H clients and L&H clients) experienced negative abnormal returns than HI is supported.

• This finding would be consistent with the insurance hypothesis, but also would be consistent with other explanations presented earlier (ex. quality of monitoring).

Hypothesis and Tests• H2: L&H clients whose securities sustained recent losses

experienced more negative abnormal returns on the disclosure of L&H’s bankruptcy than other L&H clients, and these returns were correlated with the magnitude of the previously sustained losses.

• H3: For L&H clients whose securities sustained recent losses, IPO clients experienced more negative abnormal returns on the disclosure of L&H’s bankruptcy than L&H clients with seasoned securities.

Hypothesis and Tests• If abnormal returns are associated with losses incurred by

seasoned securities and IPO’s in the bankruptcy period, and if more negative abnormal returns are associated with IPO losses than H2 and H3 can be supported.

• This still does not eliminated the possibility of negative returns being associated with monitoring uncertainties.

If negative returns are associated with monitoring uncertainties than a price increase should be experienced upon favourable resolution of this issue.

Sample Selection• H1: a sample of all publicly traded U.S. companies was

used• H2 & H3: a sample of publicly traded companies audited

only by L&H

• Criteria:-CRSP archive data available-data available on firms auditor-trading price had to be at least $0.25

-no dividend or earnings announcements

Test Data• Non-L&H clients in the sample consisted of 4,523 firms

and L&H-audited firms consisted of 127

• L&H-audited firms were smaller, on average, with a mean market value of $77.9 million versus $895.9 million

• L&H- audited firms were well diversified, representing 78 different industries with largest representation from pharmaceuticals

Speculation• If H2 is correct, firms that experienced stock price

declines would be likely to have more negative returns on the bankruptcy disclosure than other firms.

• If H3 is correct, the effect of losing the right to recover losses from L&H should be more pronounced in IPOs than seasoned securities.

Findings• Returns for L&H clients were significantly more negative

than for other firms, supporting Hypothesis 1.

• Returns for seasoned and IPO L&H clients also show significant negative returns when compared to the corresponding firms associated with non-L&H auditors.

• In regards to the monitoring uncertainties, the statistics suggested a more favourable reaction from the market when firms formerly audited by L&H chose Big 6 auditors opposed to when they selected non-Big 6 auditors.

Conclusion • In conclusion, the statistics showed that the value of the

expected value of the insurance coverage varied with the magnitude of losses previously sustained by the security and with the security’s classification either as IPO or seasoned security.

• In the perspective of the investor, the auditor is viewed as a guarantor of the financial statements. They may be willing to pay a premium for the right to recover potential losses.

Impact on Current Practice• Auditors have started to price their product to reflect this

insurance service.

• Auditors don’t only consider audit business risk but client business risk.

• Skills have been developed to assess the riskiness of a client from the standpoint of potential litigation since 1990. This has resulted in an increase in rejection of certain clients or raising audit prices based on riskiness.

THE POWER OF AUDITORSarticle by

Christine Wiedman

Earnings Management• “A purposeful intervention in the external financial

reporting process, with the intent of obtaining some private gain”• As opposed to merely facilitating the neutral operation of the

process• Research-focus on total accruals

Accruals• The difference between net income before extraordinary

items and cash flows from operations• Changes in noncash working capita accounts and

noncash income statement items• Researchers attempt to break accruals into two

components:• Non-discretionary component (naturally arises from the company’s

economic activities)• Discretionary (managed) component

Tradeoffs• Earnings management can impair the perceived quality of

a firm’s earnings• Consequences: stock price declines, lawsuits, dismissal,

civil and criminal penalties• Because of these costs, earnings management is most

likely to occur when perceived benefits exceed the costs

Earnings Manipulation Reasons• Income-increasing earnings management exists:• Prior to both IPOs and seasoned equity offerings

• In both cases, firms that manipulate earnings tend to underperform after the IPO or equity offering year

• Before stock-for-stock mergers to increase stock price• If there is a run of previous earnings increases• To avoid small losses (and report a small profit instead)

• Arises from the “psychologically important distinction between positive numbers and negative numbers”

• To meet analysts’ forecasts

Economic Consequences?• Investors and FS users are misled by earnings

management to some extent

• Factors that strengthen quality of financial reporting:• Corporate governance• Board independence• Audit committee expertise• Role of the auditor• Auditor independence

Article Suggestions• Corporate governance

• Regulations regarding disclosure, board structure, audit committee

• Board independence• If a majority of the audit committee is independent, earnings

manipulation is significantly lower

• Audit committee expertise• Experts are more likely to identify issues related to less prominent,

but recurring activities• Literates are more likely to raise issues prominent in the business

media ad nonrecurring in nature

• Role of the auditor• Auditors of high-accrual firms more likely to issue modified opinions

• Auditor independence

GETTING THE PRICE RIGHTarticle by

Sati P. Bandyopadhyay & Jennifer L. Kao

Getting the price right

• In recent years, regulators in many countries have taken initiatives to enhance competition in the audit market.

• Do higher fees equal monopolies or brand-name reputation

• Regulatory interventions only desirable if premiums are the result of monopoly.

Getting the price right• Other issues:

• Auditors market concentration and fees • Higher fees in higher markets• Client’s market power

Market Competition• Changes to professional or government regulations may

provide the external impetus necessary to alter the underlying competitive environment

• Craswell, Francis and Taylor (1996) examined the competitive effect on audit fees charged by different-sized audit firms

• Big Six audit fee premiums are for brand-name reputation rather than because of monopoly/oligopoly power.

Market Competition• 1991 legislative amendment to section 86 of the Ontario

Municipal Act governing the appointment of municipal auditors

• Alleviated legal action as well as change the characteristics of the market in which firms compete

• Average and median real audit fees were mostly higher for the Big Six auditors than for other auditors, both before and after the amendment of Section 86, even after controlling for the effects of audit fee determinants and audit specialization

Supply Structure • The relation between price and supplier market structure

is the primary concern of classic oligopoly theories in the microeconomic literature

• Focused on how concentrated audit markets were in different industries and whether that concentration was stable over time.

• Findings suggest that a sharing of benefits by audit firms with their clients, realized from economies of scale.

• Findings also suggest audit fees were significantly similar to the way supplier market concentrations is measure

Demand Structure• Monopsony theory predicts that when the supply of resources

is price inelastic, buyers may exercise varying degrees of influence over the setting of price to bring it to a level below what would otherwise occur in a more competitive market

• An auditor was said to be dependent on his or her client if a significant portion of its total revenue came from that client.

• Reynolds and Francis (2000) found that auditors tended to report in a manner that reflected a concern for reputation rather than economic dependency on the client

• They found that, irrespective of how a client’s market power was measure., audit fees were lower in markets where municipal clients exercised considerable influence over their incumbent auditors

Supply and Demand Structure • Both supply and demand effects are likely to coexist in many

markets. • Therefore, one might expect a dominant auditor to restrain

its pricing behaviour when face with a powerful audit client on the demand side, resulting in a dimminished positive relation between auditor market concentration and audit fees

• Conversely, when confronted with a few dominant auditors in the market an auditee with condisderable market power might be expected to extract smaller fee concessions from the auditors than when the market was highly competitive.

• Findings show, positive audit fees are in association with auditors market concentration. Where as, negative audit fees are associated with client’s market power

Policy Implications • Studies indicate that audit fees, Big Five or other, tend to

decline when competition intensifies, but the firms still command audit fee premiums over other auditors.

• Premiums reflect brand- name reputation rather than monopoly rents.

BEHIND CLOSED DOORS AT WORLDCOM: 2001article by

Kay E. Zekany, Lucas W. Braun, &

Zachary T. Warder

About WorldCom• Founded in 1983 in Mississippi• Started in Long Distance Discount Services, then moved

to telecommunications• Growth driven through mergers and acquisitions• Filed for bankruptcy protection on July 21, 2002

Major Players • Bernard Ebbers – CEO

• Not a founder but major force in company• Deal Maker• Goal: Become No. 1 stock on wall street

• Scott Sullivan, CPA – CEO• Company’s Number 2• Pushed for similar goals of Ebbers• Controlled Internal Audit

Major Players • Cynthia Cooper, CPA – VP Internal Audit

• Reported directly to CFO• Instructed to “contribute to bottom line”

• Arthur Anderson – External Auditor• Rated WorldCom “Maximum Risk”• Noted “Aggressive Accounting Policies”• Did not bring up at BOD Meeting• Issued clean opinion

What Happened?• Video

What Happened?• WorldCom reported misleading F/S through:

• Capitalizing cost of unused “off-net” capacity• Defer costs associated with unused line capacity

• “Close the Gap” Opportunities• Attempt to bring actual results inline with budgeted• Future contract penalties as revenue

• Misappropriation of Internal Audit Resources• 6 months creating ERP (schedules and trend analyses)

What Happened to WorldCom • June 26, 2002 SEC begins investigation• Filed for Bankruptcy Protection in July 21, 2002• Renamed MCI and moved to Virginia in 2003• Paid fines of almost 3 billion• Creditors received 35.7 cents on the dollar• February 2005 acquired by Verizon

What Happened to the Executives• Bernard Ebbers (CEO) was found guilty of fraud,

conspiracy, and filing false documents• Sentenced to 25 years in prison

• Scott Sullivan (CFO) was found guilty and testified against Ebbers• Sentenced to 5 years in prison

• Numerous others received smaller penalties including a Comptroller and 3 accounting managers

Implications• Scrutiny of the accounting profession

• Auditor Independence

• F/S Sign-off

• Audit Committee

Implications• Scrutiny of the accounting profession

• Change in accounting environment

• Goal: Ensure proper accounting theories are applied; eliminate fraud

• Means: Regulation & Oversight• SOX• Bill 198 (Ontario)

• Auditor Independence• F/S Sign-off• Audit Committee

Auditor Independence and CPAB• "CPAB's mission is to contribute to public confidence in

the integrity of financial reporting of public companies in Canada by promoting high quality, independent auditing.“

• Independence• Registration with CPAB

• Quality Control• Review of files by CPAB

Auditor Independence• Want to eliminate conflicts of interest• Threats

• Self-Interest• Self-Review• Familiarity• Advocacy• Intimidation

• Partner rotation every 5 years• Limits on consulting services

Financial Statement Sign-off• Makes top management responsible for the FS• CEO or CFO sign-off• Creates accountability and increases reliability of the

statements• Reduces risk for the auditor

Audit Committee• Role:

• Oversight and approval of external auditors• Monitor financial reporting

• Composition:• At least 3 independent directors• Require financial literacy