In our paper, The Effect of Audit Committee Industry Expertise on Monitoring the Financial Reporting Process, forthcoming in The Accounting Review, we examine the impact of audit committee (AC) industry expertise on the AC’s effectiveness in monitoring the financial reporting process. Despite the increased responsibilities, authority, independence, and financial expertise requirements placed on ACs by the Sarbanes-Oxley Act (SOX), ACs may, nonetheless, lack sufficient industry expertise to understand and thus properly monitor complex industry specific accounting issues. For instance, expertise in the retail industry may assist ACs to ensure that companies take an adequate write-down of inventory when their products face potential obsolescence. Similarly, revenue recognition, a prominent area of accounting manipulation (Beasley et al. 2000, 2010), entails an evaluation and understanding of the earnings process, which is tied to a company’s business processes that are often industry specific.
Posts Tagged ‘Audits’
I want to commend the NACD on its mission to “advance exemplary board leadership” with the compelling vision of aspiring to “a world where businesses are sustainable, profitable, and trusted; shareowners believe directors prioritize long-term objectives and add unique value to the company; [and] directors provide effective oversight of the corporation and strive to deliver exemplary board performance.”
Audit committees are instrumental in achieving this vision and maintaining public trust and investor protection through their oversight of corporate financial reporting and auditing. I would also like to recognize the important role and difficult jobs that each of you have as audit committee members in these oversight functions, as well as the many other areas that are being assigned to audit committees during a time of ever increasing business complexity and risk.
In our paper, Do Fraudulent Firms Engage in Disclosure Herding?, which was recently made publicly available on SSRN, we present two new hypotheses regarding the strategic qualitative disclosure choices of firms involved in potentially fraudulent activity. First, these firms have incentives to herd with industry peers in order to escape detection. Second, these firms have incentives to locally anti-herd with the same peers on specific aspects of disclosure consistent with achieving fraud-driven objectives. We use text-based analysis of firm disclosures and compare disclosures across firms involved in SEC enforcement actions to benchmarks based on industry, size and age, and also to each firm’s own disclosure before and after SEC alleged violations.
We hypothesize that firms involved in potentially fraudulent activity face tensions when providing qualitative disclosures to the Securities and Exchange Commission, the agency tasked with enforcing anti-fraud laws. Our focus is on the Management’s Discussion and Analysis section of the 10-K, which is where managers have a high level of discretion to describe the key issues facing their firms and to describe their performance in detail. A primary motive is to escape detection, and managers who assume that the SEC is less likely to scrutinize disclosures that resemble industry peers, or that such disclosure is less likely to raise red flags, have incentives to herd with industry peers. On the other hand, the same objectives that lead managers to commit fraud may also provide incentives to anti-herd in their disclosure from industry peers. However, these latter incentives are likely more localized, and anti-herding would be predicted only on disclosure dimensions that might help managers to achieve these objectives.
Today, the Public Company Accounting Oversight Board (“PCAOB”) proposed for public comment two audit standards that, if adopted, would significantly change the audit report model, and dramatically expand the auditor’s responsibilities in reporting on management’s disclosures outside the financial statements. PCAOB Chairman Doty remarked that the proposed standards—running to almost 300 pages—mark a “watershed moment” for auditing in the United States.
The first proposal—The Auditor’s Report on an Audit of Financial Statements—moves well beyond the traditional audit report and would require the following additional statements:
You may not hear this too often from people outside your profession, but I have always had a passion for accounting and auditing. I think this has its roots in the time I spent with my father, who was a CPA and the CFO of a publicly-held company; he helped me begin to understand just how important accounting is to business and the financial system. Of course, in my more than two decades with the SEC, which included close to a decade in the Division of Corporation Finance, I have developed a deeper and more complete understanding of the critical role accounting and auditing professionals play in our capital markets.
And today, I am pleased to see that we are working to adapt and expand that role to serve investors and other stakeholders even more effectively in the years ahead, by addressing critical issues at a moment of great change and important progress in the worlds of finance and accounting.
Ernst & Young supports effective audit committees and believes that audit committee transparency can promote greater investor confidence in financial reporting. A number of companies currently disclose more information about their audit committees than is required under relevant rules. With this post, we seek to alert audit committees and other stakeholders to current disclosure practices, and also to proposals that have been made for additional disclosures, in order to facilitate consideration and discussion.
Going Beyond the Minimum
Audit Committee Transparency
In general, investor demand and regulatory changes are driving boards of directors of public companies to be more transparent about their activities.
More specifically, investor interest – and policy debate around the role of audit committees and auditor independence – are generating discussion about audit committee disclosures that go beyond the minimum requirements. For example:
As you know, over the past couple of years, together with the board members and staff of the Public Company Accounting Oversight Board, I have been working to enhance the reliability of the external audit function and its usefulness to U.S. capital markets.
I will start off with an overview of some of the more significant issues confronting the audit profession. And then I’d like to open a more interactive discussion.
I. Corporate Governance Has Evolved to Suit the Needs of Capital Markets.
I have known many of you for years. I have watched and admired how you have navigated the many changes we have seen in both the energy industry and corporate governance.
Many of us have gained significantly more experience than we expected in identifying, addressing and preventing future threats to corporate success, such as differences in cultural expectations and business practices around the world and at home. Enron had a profound effect on Houston.
As this morning’s discussion demonstrated, you recognize that your work is never done. There is no perfect governance regime for all time.
The NASDAQ Stock Market LLC (Nasdaq) recently filed with the Securities and Exchange Commission (SEC) a proposed rule  requiring listed companies to establish and maintain an internal audit function.  The SEC is soliciting comments on the proposed rule through March 29, 2013. 
Under the proposed rule, the internal audit function would be required to provide management and the audit committee with ongoing assessments of the company’s risk management processes and system of internal control. In addition, new Rule 5645 would require the audit committee to:
- meet periodically with the company’s internal auditors (or other personnel responsible for this function); and
- discuss with the outside auditors the responsibilities, budget, and staffing of the company’s internal audit function.
Companies would be permitted to outsource their internal audit function to a third-party service provider other than their independent auditor. For companies that choose to outsource this function, Nasdaq has stated that the company’s audit committee maintains sole responsibility to oversee the internal audit function and may not allocate or delegate this responsibility to another board committee.
According to Nasdaq, the proposed rule is designed to:
I. High Quality, Independent Auditing is Critical to Our Economic Success.
As I have learned in this job, getting the accounting right is indeed not the same thing as getting the auditing right. My sense from accountants I talk to is that auditing is receiving well-deserved attention in its own right.
Our economic success depends on the confidence of the users of capital and the providers of capital alike. Corporate managers hire internal accountants — many of you here today — to ensure they have accurate and detailed information on which to base management decisions. Managers ignore opportunities to glean trends and insights from this data at their peril.
Mistakes in this information can send a company into a business line or market that squanders resources. We now know that the true cost of financial misstatement is much greater than stock market fallout, concomitant lawsuits and insurance claims.
I would like to talk about capital formation and the critical role that accountants play in that process. I want to particularly focus on capital formation from the investor’s perspective. Too often, the investor perspective is lost in the discussion over capital formation. The companies, lawyers, and investment bankers that often dominate this discussion often see regulation only as an obstacle to be overcome. They focus the discussion on how to raise money quicker and more cheaply — but seem to forget that the money raised comes from the pockets of hard-working Americans. The capital raising process should not make investors more vulnerable, and attempts to raise money quicker and more cheaply should not come at the investor’s expense. I want to put the focus on investors and examine how protecting investors facilitates capital formation by enhancing confidence, promoting integrity, and fostering transparency.