Transcript CG Lecture 7.pptx

By: 1. Kenneth A. Kim
John R. Nofsinger
And
2. A. C. Fernando
7th Lesson
Last lecture review
◦ We have discussed how financial position of a
company can be examined through different ways.
◦ Accounting records are different for managers and
public financial statement.
◦ Reasons for the difference between financial
accounting and managerial accounting are either to
show the wrong financial position of the company
or to use the company’s money by the management
for their personal interests.
◦ Normally, we face different problems that may
occur in accounting.


Here come the role of an auditor to check
their errors by the accountants.
There are different types of auditors
◦ Independent auditor
◦ Internal auditor
◦ Government auditor

Big 4.

Lecture Outlines
◦ The changing role of accountants-managing
earnings i.e. accountants will act as a profit-centers
◦ Through managing earning methods, accountants
can release the pressure of managers as well as
analysts.
◦ Window dressing and smooth earnings are another
technique used by accountants to show the
favourable financial condition of the company.
◦ Price manipulation is acceptable to some extend
but it should not violate the law becoming
fraudulent acts.

End of the story is that investors as well as stock
holders will have to suffer with all these techniques
used by accountants and management.

Single accounting firm should not allowed to conduct
audit as well as consulting activities for a single firm

Main reason is the conflict of interest between
auditors and consultants.
The Changing role of Accounting – Managing
Earnings

Accountants role has been changed for the last
two decades i.e.
◦ Instead of simply providing information to insiders and
outsiders, accountants act as a profit- centers.
◦ Accounting departments are asked to increase profits
through implication of accounting methods.
◦ Different methods often lead to different levels of
reportable profits.

This process of reporting of profit is called managing
earnings.

E.g. 1. Pressure on accountants from managers to
meet internal targets.

Managers wants accountants to show increase revenue
and decrease cost because it may lead to a raise or a
bonus for the CEO and other managers.

2. Pressure on accountants from Analysts to meet
external targets.
(
Company_____Investment Banks-Financial Analysts_____Investors)
◦ Analysts make predictions about firms profitability
measured by earning per share (EPS).
◦ If firm fails to meet these expectations, then the share
price will decline.
◦ So, the pressure is on accountants to make any sort of
arrangement which can be “window dressing”.

What is window dressing?
◦ Window dressing is a set of actions or
manipulations with financial or other information in
financial documents (financial statements, reports,
etc.) to make this information look more attractive
to its users. Even though window dressing can
occur at any time, it is commonly used at the end of
a period e.g. normally banks managers ask their
friends to deposit their money for a short period of
time to have attractive financial position etc; etc.

Other examples of window dressing by
companies may include advertising, selling, and
marketing. In these cases, window dressing
occurs when positive characteristics of products
or services are a little exaggerated to increase
demand for them while negative characteristics
are not mentioned or kept hidden.

Another example of variations in accounting
method is called smooth income.
◦ An erratic pace profit generated by business is
being divided into number of years.
 Give shareholders a sense reduced risk.
 Can easily handle with the analysts predictions.
 Good for managers to show consistent revenue on the
board meeting.
 Good to deal with the government regulations like
taxation.
 etc; etc.
From Manipulation to Fraud

A question often asked is how much can
companies manipulate accounting figures
before they cross the line into fraud?
◦ E.g. Selling goods/assets at high price to its own
subsidiary, where as the book value is very low and
so on.
◦ Therefore, the firm book large capital gain and
profits go up, which is not actual.


The subsidiary capitalizes the cost of the
truck by reporting lower earning in each of
the future years in which the truck cost is
depreciated.
Accountants are under pressure from the
management side;
◦ To show maximum profit by any mean
◦ To show less shortfalls

What about the investors or stock holders?

There is a difference between capital investment
and operating expenses e.g. On June 25, 2002,
WorldCom disclosed that roughly $3.8 billion had
been improperly booked as capital investments
instead of operating expenses.
◦ Capital investment
 Capital investment may also refer to a firm's acquisition of
capital assets or fixed assets such as manufacturing plants
and machinery
◦ Operating expenses
 A category of expenditure that a business incurs as a
result of performing its normal business operations.


There is a clear line between legal accounting
manoeuvring and accounting fraud.
Accountants and auditors are responsible for
this fraudulent act but one should not ignore
the role of management in all this.
Auditors as Consultants


Business consulting firms typically advice firms
on tactical issues, such as how to enter a new
market and strategic issues, such as acquiring or
spinning off other firms.
For example, McKinsey & Company
◦ Advises more than half of the Fortune 500 firms
◦ 7,700 consultants in 84 locations worldwide and
generated $3.4 billion revenue
◦ Representing more than 40 percent market share of the
consulting business.


One potential problem for a firm’s
shareholders occur when a consulting firm
conducts auditing services for the company.
The income for conducting an audit is far
lower than the fees earned for consulting.


It is intended to separate auditors and
consultants, prohibit accounting firms from
providing both auditing and consulting
activities to the same company.
The conflict of interest of consultants and
auditors are the main reason.

International Perspective
◦ Compared to accounting systems used
internationally, the system in the US is quite
rigorous to protect shareholders rights.
◦ In the recent study of 31 countries, the US was
found the best legal environment to discourage
earnings manipulations and smoothing.
◦ Australia, Ireland, Canada, and the UK also have
good investor protection and enforcement histories.

Summary
◦ A & A play very important role in corporations.
◦ Companies are legally bound to hire A & A to have
crystal clear financial position of a company
because its not their money.
◦ Companies face two types of interactions as far as
accounting practices are concerned. Accounting for
management and for outside world.

Normally company keeps two types of records in the
shape of Financial Accounting and Managerial
accounting- which normally do not match.

A single company always must have single financial
position, so how is it possible to have two different
accounting records.

Different accounting records means the element of
frauds in the company.
◦ We have discussed how financial position of a
company can be examined through different ways.
◦ Accounting records are different for managers and
public financial statement.
◦ Reasons for the difference between financial
accounting and managerial accounting are either to
show the wrong financial position of the company
or to use the company’s money by the management
for their personal interests.
◦ Normally, we face different problems that may
occur in accounting.


Here come the role of an auditor to check
there errors by the accountants.
There are different types of auditors
◦ Independent auditor
◦ Internal auditor
◦ Government auditor


Big 4
The changing role of accountants-managing
earnings i.e. accountants will act as a profitcenters
◦ Through managing earning methods, accountants
can release the pressure of managers as well as
analysts.
◦ Window dressing and smooth earnings are another
technique used by accountants to show the
favourable financial condition of the company.
◦ Price manipulation is acceptable to some extend
but it should not violate the law becoming
fraudulent acts.
◦ End of the story is that investors as well as stock
holders will have to suffer with all these techniques
used by accountants and management.


Single accounting firm should not allowed to
conduct audit as well as consulting activities
for a single firm
Main reason is the conflict of interest
between auditors and consultants.
The End