Auditors’ turn to needle Greece

Greece, Greece, Greece… all types of economists, political analysts, simply dilettantes, and  pseudo specialists are trying to comment on the issue of sovereign debt, Eurozone and the role of Greece in this mess. So I think it is time for us, accountants and auditors to make our pedantic and diligent (as we always do ;) contribution to process of pointing finger at Greece J

I have been recently interested in IFRS adoption in different countries and implications of this rather painful process. There are remarkable research papers dedicated to this topic, among which is study by Siqi Li (2010), who analyses impact of IFRS implementation on the cost of equity capital in Europe. I am going to use his analysis to raise some issues about Greece.

Lots of Requirements and No Enforcement

The author of research took into consideration the fact that effective implementation of IFRS depends on country’s institutional arrangements. In other words, benefits from mandatory IFRS adoption in terms of reduction in the cost of equity are expected to be sensitive to whether the new rules are effectively enforced (Li 2010). So, the scholar compared the European countries using such variables as law enforcement (utilizing studies by La Porta et al. (1998); Leuz et al. (2003)), additional disclosures and inconsistencies in standards. This interesting and appealing analysis was presented in Table 5 of his study, which is attached to this post.

Following observations could be made from this table.

First, the best “mutual friends”, Germany and Greece, are among top 4 countries, which had the greatest number of inconsistencies between local GAAP and IFRS. So here we see that Greece is not alone in it is remoteness from modern accounting practice. If you noticed, Spain is leader in terms of inconsistencies with IFRS.  

Second, considering the number of additional disclosures required per IFRS, Greece as well as Spain remain under our focus as leaders of the list. Germany occupied middle ranks. This shows that financial statements of the Greek and Spanish entities based on local GAAP were less transparent than the other European countries. Even newly accepted Poland and Czech Republic did better job in a convergence process.

Finally, according to the table the worst enforcement ratings belong to Greece, Italy, Spain, and Portugal. Does it remind you something? The problems with sovereign debt and liquidity touched exactly the same list of countries. I wonder if investment analysts use the enforcement ratings as factor to hedge investments of their clients, it would be good thing to do so.

But what can we infer from Greece’s ratings? Having the biggest number of inconsistencies and necessity of additional disclosures under IFRS the country faced huge challenge to enforce accurate financial reporting. On the other hand, low level of legal enforcement and development of institutions impeded this process.

This pattern of reasoning might leads us to the same conclusion regarding Greek tax system. As my Greek acquaintances evidence that the tax and legal system in Greece is overcomplicated and not easy to comply with. Thus, in the situation of low level of law enforcement, the efforts to evade taxes might be rather successful.  As a result this impacts tax collectibility and ability of country to meet its debt service obligations.

Quite another issue is the level of indebtedness of the Greek private businesses, particularly banks. Given the information above, can we rely on their IFRS financial statements and do they reflect actual financial position of businesses?

By the way

Kebab mix

By the way, I do not have anything against Greece or Greek people. In fact, last week I was in Greek restaurant and had fabulous dish of mixed kebab, which comprised of chicken, pork, and lamb meat as well as sheftalia… yummm, delicious! J

References

La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny. 1998. Law and finance. The Journal of Political Economy 106 (6): 1113–1155.

Leuz, C., D. Nanda, and P. Wysocki. 2003. Earnings management and investor protection: An international comparison. Journal of Financial Economics 69 (3): 505–527.

Li, S. 2010. Does Mandatory Adoption of International Financial Reporting Standards in the European Union Reduce the Cost of Equity Capital. The Accounting Review 85 (2):  607-636

Nobes, C., ed. 2001. GAAP 2001: A Survey of National Accounting Rules Benchmarked Against International Accounting Standards by Andersen, BDO, Deloitte Touche Tohmatsu, Ernst & Young, Grant Thornton, KPMG, PricewaterhouseCoopers. New York, NY: J Wiley & Sons.

Pure Audit

There were lots of fuss last month over audit business separation from the rest of consultancy. Indeed, The Economist, Accountancy Age and other business media decided to pay attention to this hot topic.

Actually, I can not say I was much surprised by this news. The idea emerged in European Commission (EC) at the end of 2010, when so called Green Paper was issued. In my overview of this discussion paper in February this year I emphasised, that EC used in their report categories like “pure audit firms” and “inspection units”.

In this post I am going to contemplate some aspects of pure audit.

No problems?

There is no problem for existence of pure audit firms except for initial stages of industry restructuring. I am sorry for Big 4 and other audit firms, but restructuring should cause painful changes in their business model.

There are some other issues of interest. For example, are brands for audit and consultancy going to have same name? What it if consultancy business would collapse or in other way would be able to damage the auditors’ reputation? Would the business be allowed mutual investment, e.g. Deloitte consultancy owns audit and audit owns consultancy? So at this point we reach the level of problems which usually attributed to banking business. The idea of banks ring-fencing has been discussed rather massively in UK this autumn and Glass-Steagall act recalled as well.

Would accounting ethical codes change accordingly I wonder? I suggest that previous projects of employee who used to work for consultancy should be checked to avoid independence problems.

Refocusing reforms

Would this reform change anything in current governance structure? Frankly saying I am in a huge doubt. This is because connection between consulting and audit segments should be totally cut to make changes relatively effective. The questions I set above should be answered by US and European policy makers.

Why not refocus our attention on shareholders? Let me speculate a bit on this subject. Shareholders are major users of auditors’ work, audit reports are addressed to them. It is obvious that shareholders (principals) hire one type of agents (auditors) to check quality of work and truthfulness of other agents (managers). The idea should be simple: shareholders should win or lose from the decision of hiring good or bad auditor. In more broad view this would include stakeholders for public interest entity.

Thus, I would propose idea of introduction mechanism according to which shareholders would be able to participate more actively in the process of selection and approving annual auditor. First, it might include creation of separate audit (governance) expenses reserve/fund, which would be used by shareholders for audits without consent of managers. Second, introduction of information systems in the process of auditor selection and dealing with audit reserve money by shareholders. Third, opportunity of minority shareholders to use resources of audit reserve and appoint additional auditors in case of any need. Yes, I honestly think that possibility of the second opinion is appropriate tool to discipline first auditors and fully appropriate if shareholder wants to have alternative view of professional. Fourth, the arrangements for other stakeholders’ participation should be made. For example, banks might want the opinion to be issued by PwC, government wants to appoint local audit firm, shareholders have more belief in KPMG’s report. You are welcome! If all of these interested (and powerful enough) parties have money to pay different auditors for their independent audit projects (not joined audit) then why not let them embark for this journey. Again, the idea is that stakeholders should bear risks of doing nothing and doing something.      

In Denial? I told you so! J

Here is small anecdote in the end. On 13^th of September UK PwC Twitter account posted following: “Best question about our performance last year wins an iPad. First read our Annual Report?”. Being cautious auditor and willing to get free iPad (probably to do iAudit J ) I read their annual report. As I did not find even a word in their strategy on how PwC UK is going to tackle coming audit regulations I twitted in response:

PwC guys ignored my question… and plans to impose regulations on audit firm rotation revealed at the end of September. I told you so! J   

Audit Procedures: Subsequent Events

The subject of subsequent events is always relevant both for accounting students and professionals. The risk is quite high due to broad definition of “adjusting event” category in IAS 10:

     “An event after the reporting period that provides further evidence of conditions that existed at the end of the reporting period, including an event that indicates that the going concern assumption in relation to the whole or part of the enterprise is not appropriate.”

The assessor of ACCA F8 paper, Steve Collings, wrote good article on this issue and I am going to highlight some moments and give examples in this post

Going Concern – No Conditions

Insolvent?
Going Concern issue!

As could be noticed from definition IFRS requires that some conditions should preexist for event to be adjusting. For the purpose of provision accruals IAS 37 specifies those conditions:

• Reliable estimation of obligation;
•  Obligation (conditions) whether constructive or legal existed at year end;
• Transfers of money are expected with regards to this event.

For example, the CEO of well-known oil company gave a promise to clean any mess caused by his company on the 31^st of December. The oil spill happened on 5^th of January and as a result all expenditures required to clean the oil should be undertaken by company no matter if there is any special legislation.

Quite another situation with going concern issue. No special conditions required to acknowledge that company is not going concern anymore. The roots of this in concept of IFRS which assumes that observation of standards gives true and fair results only if company is going concern.

Examples

In my practice I had some issues related with subsequent events. For example, warehouse full of food (inventory) was burned. The issue was that it happened someday around the year end, it happened near the Siberian forest so it was difficult to access the warehouse. Finally, after thorough investigation it was found out that it happened after the year end, the matter was material so I had to disclose this issue in the notes to inventory section.

The other issue was as follows. My client has signed the management representation letter where he confirmed that he had disclosed all information, including environmental matters. Meanwhile, after a week the representation letter was signed but before the audit report signature it got known that local authorities started the investigation regarding recent air pollution committed by company. Eventually, the pollution had immaterial implications, but there are several lessons to be learned from that. First, the management representation letter should be signed the date closest to audit report, but bear in mind that this could become an issue incase of multilocation audit. It requires additional coordination efforts to make management of subsidiary sign the representation letter the date nearest to the date of audit report. Second, the procedures requiring review of outside information (newspapers, journals, databases) about the client should not be ignored, to be done thoroughly and client should be questioned in case of material issues. Third, even if the news/management answers evidently show that conditions did not exist at the year end, there is still necessity to check reason of pollution (in my example), whether there was a concealment with management involvement.

Timeline

I provide you with timeline of dates relevant for auditor in detection of events affecting audit procedures and actions to be undertaken in accordance with ISA 560.