5 Financial Reporting and External Audit

Financial Reporting and External Audit
Semester A, 2022-2023
FB5690, City University of Hong Kong
© 2021 City U of HK All rights reserved 1

Information Asymmetry
Akerlof (1970)
The market for used cars
Car A: $ 3,000
Car B: $ 1,600
Car C: $ 200
The sellers know the quality and value but the buyers do not.
What might happen?

Buyers are willing to pay a price no more than the average value of all
used cars if they do not know the quality of each car.
To break even (Payment=E(Value))
Is this an equilibrium?
Sellers of good cars would not enter the market because of anticipating
such results; thus only the worst cars are in the market.
The whole market virtually collapses if the extent of information

asymmetry is serious.

Information asymmetry: the sellers know better about the quality of

products than the buyers.
Examples: used car markets, job hunting, stock offerings, etc.
Stock prices decline upon the announcements of new share offerings.

because of information asymmetry, some stocks are overvalued, while others
are undervalued.
undervalued firms are reluctant to issue new shares.
new share offering announcements signal to the market that those offering
firms are overvalued.

Information Disclosure
Sunshine is the best disinfectant.
To effectively monitor managers, outsiders & insiders need information

about the company.
e.g., shareholders can reward or penalize managers based on operating
performance disclosed in annual reports.
Outside investors also need information to evaluate securities value.

e.g., before the passage of SOX, securities regulations in US are mainly
about information disclosure.

Hang Seng Bank Case
“More Specifics Would Help Hang Seng Bank”
(Oct 3, 2008, Dow Jones Newswires)
Washington Mutual Bank: the 6th largest bank in the U.S., and the
largest savings and loan association. It filed for bankruptcy on Sep 26,
2008 amid the financial crisis.
Several local banks in Hong Kong held debt issued by WaMu, and are
likely to incur losses because of its bankruptcy.
Hang Seng announced that it held WaMu debt but did not disclose the
details; instead, it suggested that the exposure was ‘immaterial’.

Hang Seng Bank Case
The stock price of Hang Seng declined by about 9% on a single day, or

the market value is reduced by about 15 billion, although its exposure to
WaMu debt could be a small fraction of its asset base.
Dah Sing Bank provided detailed information about its exposure to

WaMu, and the stock price declined by about 9% upon the
announcement.
Both banks experienced a similar magnitude of stock price decline

although WaMu debt is a much smaller portion of assets in Hang Seng
than in Dah Sing.
The lesson: no disclosure makes people to assume the worst.

Information Disclosure
Information disclosure made by public companies

 Mandated disclosure: disclosure required by legislation or regulatory
agencies
Prospectus at stock offerings
Annual reports, interim reports
Corporate governance report
 Voluntary disclosure: disclosure above the mandated minimum

Management forecast
Press releases
Conference calls
Internet sites

Financial Reporting
Annual report
It is regulated.
Includes financial statements, footnotes, management discussion and
analysis.
Major financial statements: income statement, balance sheet, and cash flow
statement.
Regulation of financial reporting

Financial reporting is regulated by accounting standards, e.g., GAAP
(Generally Accepted Accounting Principles) and IFRS (International
Financial Reporting Standards).
Accounting standards regulate the reporting choices available to
management in presenting the firm’s financial statements.
Regulation reduces processing costs for financial statement users by
providing a commonly accepted language that managers can use to
communicate with investors.

Financial Reporting
Accurate financial reporting is critical for the efficiency of capital

markets and the proper valuation of securities.
It allows the board and investors to make an informed evaluation of

strategy, business model, and risk.
It also allows the board to structure compensation packages

appropriately and award performance-based compensation knowing that
predetermined targets were met.
It is the role of the audit committee to help to ensure the accuracy of

reports:
Sets parameters for quality, transparency, and controls.
Hires external auditor to test for misstatement.

The Audit Committee
The audit committee has a broad range of responsibilities:

Oversee financial reporting and disclosure
Monitor choice of accounting principles
Hire and monitor the external auditor
Oversee internal audit function
Monitor risk
Oversee regulatory compliance
To ensure that its work is free from management influence:

All committee members must be independent
All members must be “financially literate”
One member must be a “financial expert”
The Sarbanes-Oxley Act of 2002 mandates these requirements.

Accounting Quality
The audit committee establishes guidelines that dictate the quality of

accounting used in the firm:
1. Quality: the degree to which accounting figures precisely reflect changes
in financial position, earnings, and cash flow.
2. Transparency: the degree to which the company provides details that

supplement and explain accounts reported in statements and filings.
3. Internal controls: the processes and procedures that ensure transactions

are accurately recorded, financial statements reliably produced, and
company assets protected from theft.
90% of audit committee members believe they are effective or
very effective in overseeing management’s use of accounting.
A survey of 169 CFOs reveals that about 20% of firms

manipulate earnings to misrepresent economic performance
(Dichev, Graham, Harvey, and Rajgopal, 2013)

What does this tell us?
4000
3500
3000
2500
2000
number of firms
1500
1000
500
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Using sample with ROA ranging from[-0.08 to 0.07] .

Divided into 30 groups (the size of each is 0.005)
The 17th group consists of firms with ROA ranging from 0 to 0.005.

Accounting Quality
Some evidence suggests companies are not as effective as they believe

in preventing abuse by management.
Companies are much less likely to report a small decrease in earnings than a
small increase.
Managers make small manipulations in accounts so that net income figures
are rounded up rather than down.
Companies that beat earnings with “low-quality” earnings have better short-
term but worse long-term performance.
Burgstahler and Dichev (1997); Carslaw (1988); Grundfest and Malenko (2009); Bhojraj et al. (2009)

Financial Restatements
A restatement occurs when a material error is found in the company’s

previously published financials.
A restatement can occur because of human error, aggressive accounting, or

fraud.
The reasons for restatement have implications on the quality of controls in the
company and the steps needed to remedy.
In 2006, 53% of 1,784 restatements were serious; in 2012, 35% of 738

restatements were serious.
• Companies exhibit 9.2% average stock price decline following announcement of

restatement; the decline is 20% if due to fraud.
• 38% of restatements are associated with litigation, including litigation actions
against the company, officers, directors, and auditors. The likelihood of litigation
increases with the fraudulent nature of restatements.
• Evidence regarding the effect of corporate governance on restatement is not
conclusive: Difficulty in measuring intentional misstatements.
Palmrose, Richardson, and Scholz (2004); Dechow, Ge, and Schrand (2010)

Models to Detect Manipulation
Researchers have put tremendous effort into developing models to

detect fraud—with limited success.
One set of models measures accounting quality in terms of “abnormal

accruals” (the degree of divergence between reported net income and
actual cash flows).
Another set of models analyzes both accounting and governance data

(Audit Integrity 2010). This improves success rate slightly.
Still, precision in these models is low (less than 10 percent).
Recently, researchers have explored linguistic analysis of CEO and CFO

speech (Larcker and Zakolyukina 2012). This also improves success
rate.
Less “I”; more “anyone”, “nobody”, and “everyone”.
More extreme positive emotions; fewer extreme negative emotions.
Less certainty; less likely to refer to shareholder value.

External Audit
Because management is responsible for preparing financial reports,

shareholders expect an objective third party to provide assurance that
the information is accurate.
The external audit assesses the validity and reliability of publicly

reported financial information.
Unintentional errors are possible.
Wrong judgments may occur.
Managers may intentionally misrepresent financial information to benefit
themselves: e.g., manipulate earnings to gain more bonus.

External Audit
The objective of an audit is to express an opinion on whether

statements comply with accounting standards. Auditors express an
unqualified or clean opinion if it finds no reason for concern; otherwise
they issue an unclean or modified opinion.
Hence, auditors play an important governance role.

External Audit Process
1. Audit preparation: Determine scope of audit. Identify areas requiring

special attention.
2. Review estimates and disclosure: Sample key accounts. Test

managerial assumptions. Independently verify estimates.
3. Fraud evaluation: Review opportunity for fraud. Examine incentives for

fraud. Use “professional skepticism”.
4. Assess internal controls: Examine design. Identify weaknesses. Focus

on key accounts and unusual transactions.
5. Conclude: Review findings with audit committee. Express an opinion to

accompany the financial statements.

Audit Quality
Accounting firms
Big international audit firms: PWC, Deloitte, Ernst & Young, KPMG
National or local audit firms
Determinants of audit quality

Auditor ability: the likelihood that a breach is discovered by an audit firm.
Auditor independence: the likelihood that an audit firm reports the breach.

Audit Quality
The chance to discover irregularities depends on the auditor’s

capabilities, the audit procedures employed, the extent of sampling, etc.
Audit quality is on average higher for big audit firms

Big auditors provide better training to their staff and thus have greater
abilities to discover breaches of accounting standards.
A client's economic significance to an auditor affects auditor independence:
a single client is less important to big auditors than to small auditors.

Audit Quality
Given the importance of the audit, much attention has been paid to
factors that might impact audit quality.
Potential issues include:

Industry consolidation
Conflicts when auditor provides non-audit services
Conflicts when former auditor is hired as CFO
Auditor rotation
What impact, if any, does each of these have on the likelihood of future
restatement or fraud?

1. Industry Consolidation
In the late 1980s, there were eight major accounting firms. Currently
there are four (the “Big Four”)
(+) Scale of audit firms matches the scale of companies
(+) Expertise by industry and region
(+) Expertise by function (tax, audit, systems, etc.)
(–) Inadequate number of firms to choose among
(–) Decreased competition might lead to increased fees
• Splitting up Big Four would reduce expertise and decrease quality.
• 60% of large companies believe there is an inadequate number of

audit firms. Fewer than 25% of small companies believe this.
• Audit fees have risen, but this is likely due to greater cost of
compliance with SOX, greater scope, more expensive personnel.
GAO (2008)

1. Industry Consolidation
Evidence from China

70 domestic audit firms had licenses to audit listed firms (2004).
As per size, largest domestic audit firm (Li Xin) was less than one fourth of
the smallest international Big4 audit firm.
Distribution of mergers
Type of mergers 2005 2006 2007 2008 2009 Total
Acquired by international Big 4 2 0 0 1 0 3
Acquired by domestic Big 10 0 1 1 2 5 9
Merger between 2 small audit firms 0 0 2 4 0 6
• A 15.47% reduction in audit hours.

• Audit fee increases only for the mergers in which acquirers are Big 4.
Gong, Li, Lin & Wu (2016)

2. Non-Audit Services
Sarbanes-Oxley prohibits auditors from performing certain non-audit

services.
(+) Reduces potential conflict of interest
(+) Company cannot “retaliate” if it disagrees with auditor
(+) Might improve auditor independence
(–) Auditor has expertise in company procedures
(–) Might be cheaper for company
• No evidence that this practice hurts audit quality (measured by

abnormal accruals, earnings conservatism, failure to issue
qualified opinion, or future restatement).
• Congress did not take into account this disconfirming evidence,

even though it was widely understood at the time.
Romano(2005)

3. Former Auditor as CFO
A company might decide to offer a job in finance, treasury, or internal

audit to a member of the external auditing team.
(+) Auditor is familiar with company business and internal practices
(+) Company is familiar with auditor working style and expertise
(+) Reduces hiring costs, training cost, and risk of failure
(–) Auditor might have allegiance to former employer
(–) Auditor knows internal controls, which might facilitate fraud
SOX requires that former auditors undergo a one-year “cooling-off”

period before accepting an offer to work for a former client.
• Mixed evidence.
• Some studies find decrease in earnings quality when
company hires former auditor as CFO.
• Others find no relation between source of hire and
earnings quality.
Romano(2005)

4. Auditor Rotation
Auditor rotation is the practice of periodically changing external audit

firms.
(+) New auditor might be more independent
(+) New auditor has fresh perspective
(–) Costly to change audit firms or audit teams
(–) New auditor has to learn company procedures from scratch
• Very little evidence that auditor rotation is cost-effective or that it

improves audit quality.
• However, auditor resignation (auditor quits because of disagreement

with management) might be a warning sign of fraud.
• Investors should also be alert of opinion shopping.
Cameran, Merlotti & Di Vincenzo (2005); Whisenant, Sankaraguruswamy & Raghunandan (2003)

CASE: Arthur Andersen
Arthur Anderson once was among the big 5 accounting firms in the
world.
Before it ‘voluntarily relinquished’, it had offices in 84 countries and

85,000 employees; the income was as large as $9.3 billion a year.
In early this century, several of its clients were involved in massive

accounting scandals and AA itself was found guilty of obstructing
justice.
On August 31, 2002, AA issued a statement that it has voluntarily

relinquished.

Arthur Andersen: The Rise
Integrity: gain reputation

The founder, Arthur Anderson, in the first year (1913) in business, refused
to approve a set of questionable books of a railroad.
It resigned all of its clients in the savings and loan industry before the very
accounting tricks AA refused to bless led to a series of massive failures and
several criminal convictions.
Consistency: tightly control the quality of audit

‘one firm one voice’,
open offices only
no joint accounting firms
in-house training facilities
consistency in appearance

Arthur Andersen: The Failure
Andersen Consulting and conflicts between consulting and audit

businesses
It began as a way to help its clients.
It became more profitable than audit business in 1970s; however, the audit
side still controls the management.
One former CEO, Kapnick, suggested a spin-off of the consultants into a
separate firm as a solution; he was rejected by audit partners and
abandoned as a result.
The audit side set up its own consulting divisions and urged its partners to
increase clients and revenues.
In April 1997, the audit and consulting sides contested for the control of
AA but both failed; later that year, the consulting side decided to split off
from AA.

The stress of growth and revenues over quality: reluctant to walk away
from big clients with questionable accounts.
One partner, Carl Bass, was removed from the Enron account at the
request of the client, after he challenged Enron’s accounting practice.
Weakened internal quality control.

Public Review Board made up of outside experts was discontinued after the
split of the audit and consulting parts.
The power of Professional Standards Group (PSG) was severely diminished
after its suggestion to expense stock options was overruled in 1992.

Negligence of independence
The Independence and Ethics Office did not interfere in the close
relationship between AA’s auditors and Enron; indeed, the close relationship
with Enron was commended by partners as a model for other audit clients.
Hubris
AA was confident that it could turn auditors into salespeople without
undermining auditor independence.
Even after being involved in a series of accounting scandals before Enron
and WorldCom, it considered each an isolated incident for which it bore no
responsibility instead of reviewing its practice.

CASE: AWC (CPA) Limited
AWC (CPA) Limited: Hong Kong audit firm
AWC LLP: affiliated firm in New York
Client: Kandi Technologies
What went wrong?

Company’s cash held by chairman and an employee in their personal
accounts.
Recorded sales with Dinji as related party transaction with Kandi USA 
failed to assess the risk of material misstatement due to fraud.
Etc.

PCAOB’s Disciplinary orders

AWC (CPA) Limited: revoked PCAOB registration with $10,000 civil money
penalty
Albert Wong: engagement partner for audits in 2010-2012
– Barred from being an associated person of a registered public accounting firm
– $10,000 civil money penalty
Martin Wong: reported to Albert Wong and was censured
AWC LLP: suspended PCAOB registration for 1 year
Clive Chung: engagement quality reviewer for Kandi audits
Lam Shan Mui: engagement quality reviewer for Kandi audits
– Limitation placed on activities he can perform in connection with public company
audits
– Required to complete additional professional education related to ethics and
independence requirements

Why?
Failed to perform engagement quality review with objectivity
Chung was active member of engagement team and performed audit procedures
AWC (CPA) and Albert Wong were not independent of Kandi for 2012
Partner of AWC LLP provided non-audit services to Kandi

Conclusions
The audit committee plays an important role in ensuring the integrity of

financial reporting by working with management to determine standards
for quality, transparency, and controls.
The audit committee also hires and oversees the work of the external
auditor.
There are few reliable models that the board can use to detect
accounting manipulation.
Audit committee effectiveness likely depends not only on qualification

but engagement.
Superficial constraints on auditors (such as rotation, cooling-off periods,

and prohibition of non-audit services) are not likely to improve earnings
quality.

5 Financial Reporting and External Audit

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Financial Reporting and External Audit

© 2021 City U of HK All rights reserved 1

The market for used cars

What might happen?

© 2021 City U of HK All rights reserved 2

The whole market virtually collapses if the extent of information

© 2021 City U of HK All rights reserved 3

Information asymmetry: the sellers know better about the quality of

Examples: used car markets, job hunting, stock offerings, etc.

Stock prices decline upon the announcements of new share offerings.

© 2021 City U of HK All rights reserved 4

Sunshine is the best disinfectant.

To effectively monitor managers, outsiders & insiders need information

Outside investors also need information to evaluate securities value.

© 2021 City U of HK All rights reserved 5

“More Specifics Would Help Hang Seng Bank”

(Oct 3, 2008, Dow Jones Newswires)

© 2021 City U of HK All rights reserved 6

The stock price of Hang Seng declined by about 9% on a single day, or

Dah Sing Bank provided detailed information about its exposure to

Both banks experienced a similar magnitude of stock price decline

The lesson: no disclosure makes people to assume the worst.

© 2021 City U of HK All rights reserved 7

Information disclosure made by public companies

 Voluntary disclosure: disclosure above the mandated minimum

© 2021 City U of HK All rights reserved 8

Regulation of financial reporting

© 2021 City U of HK All rights reserved 9

Accurate financial reporting is critical for the efficiency of capital

It allows the board and investors to make an informed evaluation of

It also allows the board to structure compensation packages

It is the role of the audit committee to help to ensure the accuracy of

© 2021 City U of HK All rights reserved 10

The audit committee has a broad range of responsibilities:

To ensure that its work is free from management influence:

The Sarbanes-Oxley Act of 2002 mandates these requirements.

© 2021 City U of HK All rights reserved 11

The audit committee establishes guidelines that dictate the quality of

2. Transparency: the degree to which the company provides details that

3. Internal controls: the processes and procedures that ensure transactions

A survey of 169 CFOs reveals that about 20% of firms

© 2021 City U of HK All rights reserved 12

Using sample with ROA ranging from[-0.08 to 0.07] .

© 2021 City U of HK All rights reserved 13

Some evidence suggests companies are not as effective as they believe

© 2021 City U of HK All rights reserved 14

A restatement occurs when a material error is found in the company’s

A restatement can occur because of human error, aggressive accounting, or

In 2006, 53% of 1,784 restatements were serious; in 2012, 35% of 738

• Companies exhibit 9.2% average stock price decline following announcement of

© 2021 City U of HK All rights reserved 15

Researchers have put tremendous effort into developing models to

One set of models measures accounting quality in terms of “abnormal

Another set of models analyzes both accounting and governance data

Recently, researchers have explored linguistic analysis of CEO and CFO

© 2021 City U of HK All rights reserved 16

Because management is responsible for preparing financial reports,

The external audit assesses the validity and reliability of publicly

© 2021 City U of HK All rights reserved 17

The objective of an audit is to express an opinion on whether

Hence, auditors play an important governance role.

© 2021 City U of HK All rights reserved 18

1. Audit preparation: Determine scope of audit. Identify areas requiring

2. Review estimates and disclosure: Sample key accounts. Test