Corporate financial reporting scandals have become a global phenomenon with every major country that qualifies as an economic powerhouse having her fair share. Every time there is a major scandal, investor’s confidence is shaken to its foundation, and this could often lead to an economic meltdown if such scandal relates to a big player.
In 2002, following the collapse of Enron and Worldcom amongst others, the United States of America (US) introduced the Sarbanes Oxley Act (SOX) and subsequently created the Public Company Accounting Oversight Board (PCAOB) to improve Corporate Governance (CG) and Financial Reporting Practices (FRP). Malaysia developed the Malaysian Code of Corporate Governance (MCCG) in 1999 and enforced it in 2001. In 2006, Saudi Arabia introduced reforms to enhance the CG practices of companies registered in the kingdom. The objectives of the CG resolution were to enhance the efficiency of market mechanisms, build investor’s confidence, and to provide a machinery to help in evaluating the performance of firms.
Financial Reporting Failures
Shareholders have often been short-changed by corporate financial reporting malpractices throughout the 21st century. We have witnessed the collapse of many seemingly successful large firms in the world’s largest economy, the United States. Companies such as Enron, Tyco, and WorldCom have collapsed disastrously on the back of financial reporting failures. Examination of these firms’ controlled environment revealed several illegal corporate activities such as fraudulent accounting practices and executives’ self-dealing transactions. Market participants lost confidence in public firms’ financial statements and the external auditors who attest to their reliability.
These corporate reporting failures have come to Nigeria. We cannot forget in a hurry the case of Cadbury Nigeria Plc who manipulated their stock position to deceive shareholders a few years ago. The development is reminiscent of the popular “Enron Saga” and the “WorldCom.”
Management’s responsibility for financial statements is a key requirement after the collapse of many seemingly successful corporations. Significant market corrections have also taken place recently in many emerging capital markets. As a result, investors lost a significant part of their wealth, and confidence in business corporations and their underlying financial reporting system. The case of the defunct Bank PHB, Spring Bank, Oceanic Bank, Afribank, Intercontinental Bank and the struggling Union Bank are all too familiar. The market is yet to recover from the shock arising from the sudden collapse of seemingly healthy banks.
We have recorded accounting records falsification even in the most developed economy of the world, including the United States. Corporate governance has witnessed wide spread abuse. We are still at a loss as to how these companies were able to overstate their profits without eyebrows being raised by “financial experts” in the US.
To regain investors’ trust, regulators across the globe have taken legislative actions to enrich reliability and transparency in corporate financial reporting. To this effect, Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs) of companies are now required to certify their financial statements and attest to the effectiveness of the internal control system and disclosures of their companies. Overall, the anticipated impact of this act is to increase reliability of financial statements and the information they include and, thus, reducing investors’ risk in relying on reported accounting information.
Legislators in the US were so concerned and disturbed like most of us were. They evaluated the effects of this saga on investors’ confidence in the American economic and investment environment. As a result, an Act –SARBANES OXLEY was passed to impose additional responsibility on companies’ management and external auditors. The Act further imposes additional disclosure requirement and punishment for erring managers and external auditors. The most obvious of the provision of this act is the creation of an “oversight board” (the PCAOB) to register, regulate, control and monitor the conducts of the external auditors, ensuring that they comply with every letter in the Act. The purpose of all these is to protect the vulnerable investors, ensuring effective corporate governance, and introducing “checks and balances” for all players.
Financial Reporting Failures And The “Big Four”
It would be recalled that in the last decade, executive white-collar malpractices bordering on false financial reporting was reported following the exit of the late Rufus Giwa of Lever Brothers Nigeria Plc (Now Unilever Plc) and Bunmi Oni of Cadbury Nigeria Plc, who was later cleared by a Lagos High Court four years after. Remarkably, the recent sack of the management of five banks by the Central Bank Governor over actions deemed detrimental to the interests of depositors and creditors brings to the fore once again the incidence of white-collar fraud, crimes and financial malpractices in Nigeria’s private sector. All these companies were audited by some of the leading accounting firms: KPMG, Deloitte, Earnst & Young and PricewaterhouseCoopers (PwC). These four firms are traditionally known as the ‘big four,’ down from the ‘big five’ since 2002 after the collapse of the Accounting firm, Arthur Andersen.
Recent Accounting Scandals and Their Auditors
The National Audit Office of China on June 1, 2012 published the financial audit report of 15 state-owned enterprises (SOEs) operated directly by the Chinese central government. All of the companies that were audited were found to be engaged in irregular financial practices and disciplinary violations. Traditionally, the so-called Big Four audit firms –PwC, Ernst & Young, KPMG and Deloitte are hired by a large number of SOEs in China to conduct annual audits. The indictment of the financial reporting conduct of these SOEs was a direct indictment of these big firms.
The Chinese National Audit Office reported that China National Petroleum Corporation (CNPC), Sinopec, China Southern Power Grid (CSG), and SinoSteel Corporation are companies that have engaged in relatively greater amount of and more prominent irregular practices. The irregular practices include misuse of funds, overstating earnings, understating assets with improper accounting practices, concealing information about overseas investment activities, evading taxes, excessive bonuses and forged invoices. The audit reports showed that CNPC and Sinopec together reported about 2.8 billion yuan less combined profit than actual numbers. SinoSteel inflated sales revenue by about 20 billion yuan. While all the SOEs subjected to the new audit revealed financial malpractices –arguably some of them with hundreds of billions of questionable yuan – the audit firms should have discovered the irregularities before arriving at the position that their “books have been properly kept.”
From 1993 to 2001, Targus employed KPMG as its global auditor as well as its business and tax consultants. Between this period, Targus’ then CFO, William Anthony Lloyd, embezzled over $40 million from Targus by utilising the company's credit facilities and cash for his personal benefit. In attempting to hide his embezzlement unknown to the company, Lloyd created false and fraudulent entries into the company’s books and records, all of which went undetected by KPMG during numerous statutory audit of the company.
Targus alleged that KPMG had completely audited its financial statements and met its professional obligations; Targus would have been alerted to Lloyd’s embezzlement years before August 2001 and would not have suffered significant financial loss. Instead, according to Targus, KPMG recklessly and negligently performed Targus audit and failed to carry out the most basic audit procedures. Targus claimed that KPMG had assigned incompetent, inexperienced, and in some instances, unlicensed accountants to supervise and manage its audit.
Lessons: The risks are still with us. The foot soldiers deployed by most large audit firms are often trainees and neophytes, and they are relied upon to undertake the basic but most important check. The Partners of these firms bear overall responsibility for an audit engagement but often spend more time in managing relationships than in seeking out audit evidence.
There Are Still More Cases
In 2000, Cast Art Industries LLC, a Califonia-based manufacturer and distributor of pottery, dishware and giftware, while preparing for its merger with Papel Giftware Inc retained KPMG to review the books of its merger candidate from 1997 to 1999. After the merger, Cast Art's officials discovered that Papel had overstated its revenues and sales. Two years after Cast Art bought Papel, it went under, largely because of the debt it incurred in purchasing the company that was worth little or nothing. In October 2008, it was found that KPMG, in providing its audit review to Cast Art, failed to mention large-scale accounting irregularities that undercut the target company's value. The Superior Court of New Jersey found that KPMG's negligence in auditing Papel's financial statements, which Cast Art relied on in proceeding with the merger, was a substantial factor in Cast Art's failure.
And just when you think the ‘big four’ were tightening their risk management processes and improving their quality assurance processes, undetected financial reporting failures continue to be reported.
Navistar sued their former auditors, Deloitte & Touche, in 2011 for fraud, fraudulent concealment, breach of contract, and malpractice. They claimed that Deloitte lied about its competency in performing audit, and the company had to restate its financial statements for 2002 to 2005.
Lehman Brothers was reported to have hidden toxic assets off balance sheet in order to continue reporting a profit. Ernst & Young were auditors to Lehman brothers.
PricewaterhouseCoopers was fined a record £1.4 million for "very serious" misconduct over its audit of JP Morgan Securities (JPMSL). The independent arbitrators found PwC guilty of wrongly reporting to the Financial Services Authority that JPMSL had complied with client money rules, which govern the segregation and protection of client funds. PwC did not detect the error for six years.
Auditor Independence And The Rest Of Us
The purpose of an audit is to enhance the credibility of financial statements by providing written attestation from a trusted and credible source that the books of an enterprise are what they say they are. That is a lay man’s definition of audit. Over the years, auditing has evolved greatly as a profession, growing in leaps as industries emerged following the Industrial Revolution.
Thus, audit became a business. Indeed most of today’s ‘big four’ firms evolved with the growth of the major corporations of the world as they followed them around the globe while those multinationals expanded.
Today, the Auditor is no different from a business man seeking to profit from his business. The big firms continue to struggle to balance the profit motive against the requirement of an auditor to be independent (in judgment) and be seen to be independent. Andersen stopped being an audit firm because a convicted felon cannot issue a legal opinion in the US.
In Nigeria, the Auditor is yet to face such scrutiny, but he would sooner or later. The society would like to know how Air Nigeria and some companies under Global Fleet collapsed; how some of the largest telecommunication companies such as Zoom Mobile, which employed a large number of Nigerian youth, is moribund. The auditor’s parish is the society. Where he misleads the investing public in his technical opinions, the consequence could be grave for the economy of the sphere of influence of the auditor’s clients.
The 2008 financial crisis highlighted considerable shortcomings in the global audit system. According to a study by the Association of Chartered Certified Accountants (ACCA) Singapore and the Securities Investors Association Singapore (SIAS), investors want more information in companies’ financial statements. Firstly, the survey found that the audited financial statement of a company is one of the ultimate sources of information used by investors to guide their investment decisions.
This is why accounting itself is evolving. Today, ‘understandability’ is a major characteristics expected to be exhibited by a financial statement prepared in accordance with the framework of the International Accounting Standards Board (IASB).
Investors are interested in the details of a company’s internal controls and risk management framework, as well as the existence and quality of assets. Clearly, according to David Gerald, President and CEO of the SIAS, “Investors want assurance that a company’s processes are sound before they make an investment decision. They want to be able to piece together sufficient information to put financial numbers in context. Of even greater interest to investors, is the disclosure of nonfinancial information. Having access to information about a company’s corporate governance practices and Corporate Social Responsibility (CSR) issues, among others, would help them in making investment decisions.” No wonder investors continue to flock to the city-state of Singapore.
While the levels of disclosure are a good indication of what investors want from companies, implementing them may not be practical for all businesses because of the cost implications. Small and medium-sized enterprises, in particular, will face hefty cost issues, and extensive disclosures may even be detrimental to companies that, for some reasons, are unable to live up to investors’ expectations.
To further strengthen investors’ confidence in financial reporting, there was the need to develop high quality accounting standards that would be uniformly applied by the corporate world irrespective of their country of origin. It is a global world and investors only move where the money is. It is important that financial performance is measured in a uniform language. Today, the International Financial Reporting Standards (IFRS) is the official reporting standards for most companies listed in a stock exchange anywhere in the world except the United States. This is why we congratulate Nigeria on its adoption of the IFRS. It is our hope that the many IFRS “Consultants” do not see this as another con act. The investing public is waiting.