The Role of Big4 in promoting IFRS

The audit of IFRS reports is one of the major services provided by the international accounting networks. This is because they possess necessary knowledge and skills, which could be used all over the world. However, there are negative moments in this process, which could be illustrated by conclusion made by Sucher and Alexander (2002) in their research:

     “Given their power over both the production and audit of IAS accounts, the Big Five firms play a very large role in interpreting and implementing IAS standards in a particular country.  This raises issues of power and responsibility with respect to compliance with IAS that need to be addressed clearly by the IASB”

So this post is going to address this issue and point out on existing problem especially in emerging markets.

Illustrations

The issue was substantially researched by Sucher and Alexander (2002) based on the example of Russia and by Sucher and Jindrichovska (2004) in study of situation in Czech Republic.

The problem is that companies in emerging economies suffer from lack of knowledge and expertise in preparation of IFRS accounts. The probable solution could be to hire IFRS specialist or to outsource reporting process. But on the one hand there is a shortage of qualified and experienced professionals in emerging markets. On the other hand, outsourcing by one and afterwards auditing by another independent firm are seen as superfluous costs. Finally, these companies opt into simple solution – they ask audit firms both to prepare and audit their IFRS accounts. This state of things as honourable auditors we can’t tolerate, can we?

Sucher and Alexander (2002) illustrated the situation by remark of one of Big Five (at the moment of research) interviewees:

“As you know we do not prepare accounts for our clients – it is an independence issue….however, we do provide a degree of assistance….. Some accountants in enterprises crunch the numbers (for IAS) and others say, ‘look guys we pay you to do it.  It is a fairy tale’”

It is not only willingness to save money, the issue is also related with the perception of an audit as no-value-adding activity. Interviewees in Czech Republic complained that the earlier Big 4 audit firm provided such package of services while the latest Big 4 auditors refuse to do this (Sucher and Jindrichovska 2004). One of the Big 4 auditors (interviewee) added fuel to the fire:

“Some financial managers and accountants [in enterprises] do not know what is going on [with IFRS]. They are only the passive receivers. In [X audit firm], there are templates that transform Czech accounting to IAS. The knowledge is kept in the audit company. It is big business [for the audit firm]. You can train companies to do the supporting sheets hut the final bit is done by the audit firm.”(Sucher and Jindrichovska 2004).

Meanwhile, management of the companies would always be keen on saving costs on such things like audit. It is quite likely that such kind of cosy relations are more beneficial to audit firms. At least they could have separated audit and accounting team, but according to research it would be too costly for audit firms and they end up by assigning one team of people to do both jobs, which is a shame.

Problems

The basic issue which arises here is how far should we trust financial statements prepared in emerging markets? To what extent this practice spread in other emerging countries, where corporate governance and law enforcement are not developed enough? I think that it is highly probable that similar “reporting-auditng” is practiced in China, where local management is rather pushy in accounting issues (see Deloitte’s case).

The other question how can we deal with the issue in sensible way. For example, one is audit manager and one is doing audit of IFRS reports of Brazilian company. The resourceful Brazilian finance director provides auditor with financial statements (FS) essentially based on Brazilian GAAP, but with name of IFRS on its face. The trick is that you will do honest auditing, spot discrepancies from real IFRS and provide list of adjustments which need to be done J It is foxy tactic, isn’t it?

What do you think about truthfulness of IFRS accounts of companies from emerging markets listed on global stock exchanges? Have you faced approach mentioned above in your reporting or auditing practice? How to discourage auditors from doing that especially in the context of coming “pure-audit-firms” legislation? Please share your knowledge and experience.

References

Sucher, P. and Alexander, D. (2002) IAS: Issues of Country, Sector and Audit Firm Compliance in Emerging Economies (London: Centre for Business Performance of the Institute of Chartered Accountants in England and Wales).

Sucher P., and Jindrichovska I. (2004) Implementing IFRS: A Case Study of the Czech Republic. EAA, Accounting in Europe, Vol. 1, pp. 109-141.

Audit in Politics: Russia vs Yukos vs PwC

There have been two events in recent days which triggered me to write post on this subject. First, last week The Economist published the article about auditing in China. Second, the recent decision of European Court of Human Rights (ECHR) regarding the Yukos vs. Russia case.

The article in The Economist considers the issue which happened between Deloitte and Longtop, a Chinese company once listed in NYSE. Here is remarkable abstract:

     “… After signing off Longtop’s financial statements for several years, the firm smelled trouble during its audit for the financial year that ended in March. Its subsequent questions did not go down well at Longtop, which seized some of Deloitte’s papers and threatened to keep Deloitte staff from leaving company premises. Deloitte quit as auditor, and Longtop’s shares ended up being delisted from the New York Stock Exchange in August.”

Subsequently, SEC issued subpoena for Deloitte’s audit working papers in relation to Longtop. After Deloiite’s refusal to cooperate the PCAOB threatened to decertify its Chinese division.

Medvedev and Putin

Several features of the above case look like Yukos-PwC affair which I would like analyse in several following articles. Yukos-PwC matter is perfect case for audit, accounting, tax and business ethics studies. It is rather complicated and requires accurate consideration of all facts. I am going to cover audit related professional and ethical issues. In this post I will give brief overview of the issue.

Essence of Issue

Yukos was one of the largest Russian oil companies with successful growth strategy and was listed on the LSE. However the company eventually had to file for bankruptcy (2006) after the Russian Ministry of Taxation proved in court (in 2003) that Yukos’ tax evasion amounted around $28 billion. The hypotheses standing behind this case are as follows:

1.      Tax evasion. This is obvious: company tried to pay less taxes using illegal schemes;

2.  Politically motivated expropriation of the company. The major shareholders and top-managers of Yukos, Mr. Khodorkovsky and Mr. Lebedev, were arrested in 2003 with criminal charges including tax evasion, fraud, forgery and embezzlement of assets. Meanwhile it is believed that Khodorkovsky and Lebedev had political ambitions and tried to influence state parliament by financing both left-wing and right-wing parties. Eventually, Mr. Putin being the president of Russia (now prime minister) decided to punish these independent oligarchs.

Khodorkovsky and Lebedev

The issue is that both hypotheses might be truthful partially. The fact is that similar tax evasion models were used at those time (and now used also) by almost all oil and gas companies in Russia and the only company which carried its part of punishment was Yukos. Nevertheless, I do not want to focus on this dispute, I am interested in the role of auditors in all this mess and here they come…  

Involvement of the Russian PwC firm

Unfortunately, PwC was an auditor of Yukos, acted as advisor on tax strategy, worked closely with Kodorkovsky on financial and accounting issues. After years of cooperation with client, PwC decided to withdraw its audit opinions in 2007 issued in respect of Yukos consolidated financial statements for 10 years from 1995 to 2004!

The Russian PwC office claimed that during tax investigation the prosecutors revealed new facts, which managers of Yukos misrepresented during previous audits. So what facts were revealed? The level of cooperation with client on tax issues was so close that there are significant doubts about this?

The other peculiar matter is that PwC-Cyprus has not withdrawn its audit opinions in respect of Yukos Cuprus subsidiaries.

Third, there are beliefs that Russian PwC was a coerced into opinion revocation by the Russian authorities.

Questions

Finally, based on the above overview I would like to raise following questions in my further blog posts:

·      What were the audit evidences, which had dramatic impact on PwC’s opinion?

·      Could Yukos case raise the same concerns of PCAOB about reliability of the Russian PwC audit working papers as in case Deloitte-Longtop affair?

·      Might the significant share of audit fees incoming from state owned giant company, Gazprom, somehow impact PwC’s decision?

·      What are ethical stances behind PwC deed?

The specialists, blogers who would like to contribute to the discussion of this issue and probably post their own article in “Audit is Cool” blog are welcomed (please send me message) or you can just leave your comment.

PS: Funny Reality

Here is the real phrase from Russian court ruling on the second case against Khodorkovsky and Lebedev (p. 613):

“… Khodorkovsky and Lebedev kept two sets of financial accounts (reporting per Russian Accounting Principles and US GAAP) and concealed from shareholders consolidated financial reports, by publishing them only in English language…”

This funny words were noticed by my friend in Livejournal, tema57 J

Sources:

The Economist. 2011. Auditing in China.September 17

The Wall Street Journal.2010. Oil Tycoon Says PWC Caved to Pressure. September 7

Financial Times.2010. Russia:Chain retraction. September 6.

Khodorkovky and Lebedev Communication Center:

·       http://www.khodorkovskycenter.com

·       http://www.khodorkovsky.ru/

Q&A from the defense team on the PwC investigation - A Q&A with the defense team inrelation to PwC's withdrawal of 10 years of its YUKOS audits

ECHR. 2011. Case of OAO neftyanaya kompaniya Yukos v. Russia. Applicationno. 14902/04

Second Case Ruling Khodorkovsky and Lebedev.2010

Group Audit: Practice Considerations

During preparation for Advanced Audit exam I have decided to update my knowledge about group audits (GA). I read two rather technical and a bit of boring articles in Student Accountant magazine by Lisa Weaver and Graham Fairclough. In real life the topic is very interesting and might require some imagination from people who have never been working in auditing, nevertheless participating in group (also referred as ‘multi-location audit’) audit to understand group auditing process.

In this article I would like to share my experience about several elements of multi-location audit.

Planning stage of group audit

In my subjective opinion planning stage plays more important role for GA than for audit of standalone financial statements. The reason is complexity of 2 elements of system:

·       Business relations within the audited company, inter-company relations, related party issues;

·        Accounting process accompanying these relations.

As a result of planning stage we will be able to identify the scope of audit, nature of procedures on final audit stage and resources needed accomplish our goal.

If the whole audit of group is undertaken by one audit firm, then all audit work would be split between consolidation audit team (i.e. ‘group auditor’ as referred in Fairclough’s article) and location audit team (component auditor if the auditor is other audit firm).

Participation in planning process of group audit gives strategic view on audit process. Understanding business is really essential at planning stage and the function of each company within the group need to be identified. For example, common type of gold mining holdings in Russia is as follows:

·        Mining entities themselves - the companies which extract gold;

·        Factories, gold processing plants (sometimes included within mining company);

·        Servicing catering companies: extraction of natural resources is often carried out in ‘hard-to-get’ places. The workers live there temporarily in camps and services like canteen, hotels, utilities need to be provided by mining company or outsourced;

·        Finance/holding companies. Their function in the group is to establish control and governance over the group, provide finance, management services.

·        Offshore companies, these companies often used to minimize taxes paid by company in country of operation. They are established in jurisdictions with soft tax regimes in countries like British Virginia Islands. It might be not legal so some companies play quite risky games with their tax authorities. Be aware about this auditing tax section.

Materiality

The planning materiality (PM) of group and each location is often discussed on focus audit team meetings and the decision of partners is communicated by consolidation team to local teams.  PM calculation has some specifics here, because it has to be allocated for each subsidiary depending on size of subsidiary/location. The size is usually measured based on subsidiary’s contribution to group assets, revenues or net incomes. I have presented below the table with possible size of subsidiary and assigned percentage of allocation:

Communication and interaction

The communications between consolidation and local audit team is critical during whole audit process. On the one hand, the consolidation team is able to emphasize only critical problems which help to concentrate local audit teams on risky areas, on the other hand, consolidation team can solve issues related with client, e.g. raise issue that one of subsidiary the local management is reluctant to give necessary information to local audit team.

Work in consolidation audit team is a bit of everything:

·       Administrative work: coordination of local audit teams, communications with client on corporate level, allocation of tasks and consolidation all essential information;

·        Audit work itself: consolidation team has to audit consolidation process and accounting issues related with consolidation/group accounting such as goodwill, inter-company eliminations, fair values allocations, non-controlling interests and etc.

·        Review of local audit team’s working papers and establish additional procedures to ensure that audit risk decreased;

·        Checking accuracy of final financial statements and reporting forms which have to be submitted to SEC (e.g.  10-K in US) in case client-company is listed.

In military language the consolidation audit team is army headquarters.

Participation in group audit

I was lucky that in the beginning of my audit career that I was able in to participate in big audit project of NYSE listed company. It was great experience to be part of the well elaborated and strategically well-considered audit process. The focus on planning stage gives very good understanding of both audit process itself and client as business and strict requirements to documentation might give you an idea how to formalize your understandings of complicated issues.

In summary, I would like to advise to anyone who is working in audit firm to try to take part in group audit, both as a member of consolidation and local audit team.  

References

Fairclough, G. (2011). Group Auditing. Student Accountant. April 2011, p. 1-6

Weaver, L. (2008). Objectives and Responsibilities. Student Accountant. March 2008, p. 72-75.

Event Study: Audit Report Announcements

Event study methodology is widely used in researches dedicated to the impact of audit opinion on investors’ decisions. This methodology requires specification of date of audit opinion announcement, date when the information about type of audit opinion becomes available to public. This date is event and days (allowed to capture pre- and post- effects) around the date are ‘event window’ (Campbell et al. 1997). See illustration of Time Line:

Source: Campbell, J.Y., Lo, A.W. and MacKinlay, A.C. (1997). The Econometrics of Financial Markets. Princeton, NJ: Princeton University Press, p. 157.

I wrote about this kind of studies in audit area in one of my posts (click link) on February. The issue here is difficulty to identify correct date of event as this would influence the whole research. There are number of researchers who emphasized this issue, e.g. Craswell (1985), Martinez et al. (2004), Soltani (2000). Especially this problem arises when it is necessary to compare studies in different countries, i.e. jurisdictions.

In following paragraphs I want to discuss briefly the features on event identification process in different countries.

Anglo-Saxon system

The countries with a case law system are suggested here: USA, UK, Canada, Australia. I would consider two key relevant characteristics:

·        Work of stock exchange commissions (let us name ‘SEC’ all similar authorities) with financial/annual reports, e.g. US companies are obliged to file 10-K (which contains audited FS) within 90 days after fiscal year end and after filing 10-Ks almost immediately become available to public via US SEC site (see sec.gov)

·        Transparency, e.g. it is more common for US companies to announce audit opinions before the annual general meeting or 10-K filing date.

Reasonable methodic in date selection was used by Menon and Williams (2010). They chose earlier of:

(1)   10-K filing date;

(2)   Date of press release of financial statement and audit opinion.

Continental European (Roman) Legal tradition

Following could be outlined as features in relation to opinion announcements (based on example of France and Spain):

·        SEC do not make audited financial statement available to public as soon as possible (see below some peculiarities in Spain) with deadline of 90 days after fiscal year end;

·        Audited financial statement must be provided (France and Spain) to shareholders at least 15 days (or any other number of days prescribed by law to notify shareholders about AGM) before annual general meeting (AGM). At the same time reports are to be send to SEC and only after this they are to be published by SEC ;

·        Listed companies are reluctant to announce publicly audit opinions (Soltani 2000).

To solve this issue for French market Soltani (2000) defined and calculated results for following three event dates:

(1)   Date of audit opinion signature;

(2)   15 days before the AGM date (most precise as was mentioned by Soltani);

(3)   Average date between the (1) and (2)

Martinez et al. (2004) identified that law requires listed companies to file audited financial statements (FS) within Spanish SEC (which has to publish them aftermath) before the date of AGM announcement. So Martinez used the earlier of:

(1)   Date when Spanish SEC makes FS and audit reports available to public;

(2)   15 days before the AGM date.

Russian jurisdiction

Russian modern corporate laws also belong to continental legislation system with specifics of emerging market economy and socialistic overregulated past.

Following matters to be considered:

·        All open joint stock companies have to file their audited FS to Tax authorities within 90 days after year end, but Tax authorities must not release them to public (Accounting Law, ФЗ 129);

·        Audited FS must be distributed to shareholders at least 20 days before AGM (Open Joint Stock Companies Law, ФЗ 208);

·        Audited FS must be also included in the quarterly report of issuer (ежеквартальный отчет эмитента) for the first quarter, which must be issued not later than 45 days after 1^st Quarter end, i.e. 15^th of May,

·        Announcement about the issue of quarterly reports and AGM must be placed by companies on the state authorized news wire available to public via internet (State Provision about Disclosure Information by Issuers, Приказ ФСФР N 06-117/пз-н).

 So in selection correct event date it would be reasonable to consider the earlier of:

(1)   Announcement of 1^st Quarter report issue on statutory news wire;

(2)   20 days before the AGM date.

Conclusion

I hope above summary and considerations about Russia would help researchers involved in accounting/reporting area to do event studies. I am going to use these ideas in my coming dissertation and I would like my readers to share with me information about report release legislation in their countries.

References

Campbell, J.Y., Lo, A.W. and MacKinlay, A.C. (1997). The Econometrics of Financial Markets. Princeton, NJ: Princeton University Press.

Craswell, A. T. (1985) Studies of the information content of qualified audit reports, Journal of Business Finance and Accounting. No 12(1), pp. 93–115

Martinez, M., Martinez, A. and Benau, M. (2004). Reactions of the Spanish capital market to qualified audit reports. European Accounting Review. Vol. 13, No. 4, pp. 689-711.

Menon, K. and Williams D.D. (2010). Investor Reaction to Going Concern Audit Reports. The Accounting Review. Vol. 85, No. 6, pp. 2075-2105.

Soltani, B. (2000) Some empirical evidence to support the relationship between audit reports and stock prices – the French case. International Journal of Auditing. No 4, pp. 269–291.