Peeling away financial reporting issues one layer at a time

Do Survey Results Mean that External Audits Don’t Protect Against Earnings Manipulation? (What a Surprise!)

The results of a recent E&Y survey investigating financial manipulation must stun even the most cynical observers of accounting practice,:

  • Of the board members and senior management surveyed from companies in Europe, Middle East, India and Africa (EMEIA), 42% stated that their company’s sales and/or costs had been manipulated in the past fiscal year. 
  • The above percentage varies somewhat between companies in “developed” versus “rapid-growth” markets, but this does not blunt the overall impression of rampant financial statement manipulation.
  • “In the financial services sector — where regulatory action has been intense [and should be a deterrent] — 9% of respondents had seen revenues recorded before they should have been; 7% were aware of underreporting of costs [it’s not clear if this should total to 16%, or if there is some overlap]; and 9% knew of customers being sold unnecessary products to meet short-term sales targets.”

WOW.  The actual numbers are probably even worse than what has been reported; because it stands to reason that at least some survey respondents would be cautious about admitting their company did a bad thing, even in the context of a confidential survey.

The leader of the study was David Stulb of EY’s Fraud Investigation & Dispute Services practice.  He was interviewed on CNBC, where he openly acknowledged that he was surprised by the results; and that they were probably much higher than similar surveys of U.S. companies would find.

What Does it All Mean?  

I feel somewhat bad about the wet blanket I am about to throw over the public service that EY provides when it commissions surveys and produces reports with important information. But, I can’t help thinking about how self-serving motives might have affected what was — and what was not — reported.  (Really. I can’t help it.  It’s just the way I was wired.)

I can’t help thinking that E&Y conducts these types of studies to brand itself a thought leader on issues relating to fraud prevention, bribery and corruption. There is nothing wrong with that; but, it seems that in this case EY is walking a tightrope.  On the one hand, EY is attempting to induce potential clients to consider engaging consultants to help design and implement controls for reducing business risk from bribery, fraud, etc.  On the other hand, EY has  to be careful not fall off the wrong side of that tightrope.  The survey appears to have been conducted,  and the report was written, such that nothing should explicitly suggest that audit quality (i.e., EY’s flagship product) could be part of the problem; or stated another way, that the audit profession should be doing a better job of reducing business risk through the audit itself — without charging more fees to do what they should be doing already.

I have discussed this in the past, that the path to higher quality audits boils down to two things.  First, auditors should stick to verification of facts; hence, they should eschew passing judgment on the reasonableness of management’s estimates and purporting to be able to know management’s state of mind for goodness sake.   Second, accounting standards should be written such that auditors can stick to verifying facts.

And, speaking of accounting standards, the results of EY’s survey provide more strong evidence that efforts at convergence of IFRS and U.S. GAAP can’t possible do more than smear lipstick on a pig.  On top of all the other reasons why comparability is an unrealistic goal, add rampant financial manipulation to the mix.

As to current convergence projects, an important takeaway from the EY report is the additional evidence provided that management of financial services cannot be trusted to report honestly when it counts.  The latest proposals to modify loan impairment accounting provide for more degrees of freedom to management, despite the fact that we continually receive evidence that fewer degrees of freedom in accounting standards is what bankers deserve.

I also wonder whether EY gathered any data that they are not reporting.  If independent academic researchers had designed the survey, surely they would have seen that the question of differences across auditing firms was begging to be addressed.  If EY collected that sort of data, it chose not to report it; if EY didn’t collect it, that tells another interesting story.

* * * *

I wish that it had occurred to the CNBC interviewers to ask Mr. Stulb what his report indicates about audit quality in the countries studied.  They missed an opportunity to point out to their viewers the bitter irony that one of the four biggest purveyors of external audit services also makes money from marketing an antidote to failed audits.

4 Comments

  1. Reply cubby May 16, 2013

    How could auditors possibly only sign off on facts, and not any judgments or estimates? Only very isolated areas of the financial statements are purely fact based. Cash is one that springs to mind. Almost everything else on the balance sheet incorporates judgment.

    • Reply Tom Selling May 16, 2013

      In short, I don’t believe that an auditors opinion on the financial statements taken as a whole is worth very much. They can very cash, contractual amounts of receivables and payables, quantities of inventory, and similar items. Beyond that, I think that outside appraisers should provide valuations for assets and liabilities that are presented. The auditors could also verify that the appraisers meet independence requirements, and that they performed the procedures they said they would perform. I know this is very different vision for an audit, but frankly, the current system costs too much and doesn’t provide enough diagnosticity to be worth the cost.

  2. Reply IV May 17, 2013

    Interesting piece. When I was in college I thought IFRS was an intelligent approach — but only a brief experience with the “real world” made it apparent that IFRS allows for significantly more cheating by management due to its increased reliance on some contrived judgment spectrum rather than arbitrary rules. The contrived judgment spectrum seemed intellectually better than the arbitrary rules.

    Lo and behold, only a few year out and I completely disagree with my former self. The rules of GAAP my be arbitrary but at least it makes it obvious when management is cheating. The flexibility of IFRS will invariably be used to cheat (see “Moral Mazes”) and that cheating might then be backed up with accounting reasoning which would be allowable under IFRS but not under GAAP.

    I never thought I would be a proponent of arbitrary conventions but I am convinced GAAP will lead to less cheating than IFRS. Human beings will cheat but lets not give them an artistic license to it with IFRS. We ought to bind managements feet with GAAP (although, we ought to get rid of some the the regulatory burden put in place with SOX).

    Sure wish EY’s survey results were lower, they are a bit depressing.

    • Reply cubby May 28, 2013

      I would bet the correlation between deliberate misstatement of earnings and the accounting standard system being followed (whether GAAP, IFRS or any other) is negligible. I would expect to see at least some correlation with (1) dishonest management; and (2) weak, under-regulated auditors. There are plenty of examples of (1) causing problems with US GAAP filers.

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