BUSINESS COMMENTARY

Waves of Change: Fraudulent Financial Statements – Whose responsibility?

By Rohan Chambers,
M.Sc., C.A., C.I.A., C.P.A.
Chair, Department of Business Studies –
University College of the Cayman Islands

Monday,  July 04, 2005

This article is part of the ‘Waves of Change’ series written by members of the Department of Business Studies at the University College Cayman Islands. www.ucci.edu.ky

The financial sector in the Cayman Islands requires vast amounts of information upon which to make strategic investment decisions. The quality of the information being analyzed can make the difference between substantial gains and disappointing losses. Having reliable and verifiable financial information is central to the success of the financial sector.

When investors put their hard earned savings into a company they expect to reap benefits in the future. Deciding upon which companies to invest in quite often requires a substantial amount of financial analysis to determine the current and potential performance of companies. The major source of information from which one can conduct analysis is the financial statements of a company.

The credibility of financial statements depends on the quality of the analysis when they are being prepared. And credible financial information is crucial to investor confidence and, in turn, efficient and growing capital markets.

It has long been established that the responsibility of financial statements rests with the management of a company. However, many are of the opinion that the financial statements are the responsibility of the external auditors. This misconception has been widely known as the ‘expectation gap’.

The ‘expectation gap’ refers to the difference between what many think external auditors should be doing, and what their role really is. The most common misconception contributing to this gap is that many people think that the external auditor’s role is to discover all errors and fraudulent activity. This, in fact, is not the case.

The external auditor’s real role is to form an independent opinion on the veracity of the financial statements. The responsibility of errors and fraud in the company’s financial reporting rests with the management, not the external auditor.

The external auditor, however, should perform tests which are designed to detect any material errors and fraudulent activity.

The failures of, for example, Enron and WorldCom in the U.S. during 2002 prompted the U.S. Congress to shrink the ‘expectation gap’ through passing the Sarbanes-Oxley Act. The requirements of Sarbanes-Oxley calls for the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO) of companies registered with the U.S. Securities and Exchange Commission to assess and publicly report on the quality of its internal controls over their financial reporting.

Sarbanes-Oxley also requires the external auditor to publicly attest to management’s internal control report, as well as to analyze and report on the effectiveness of the company’s internal controls over financial reporting, and publicly disclose any weaknesses discovered.

Therefore, the external auditor now has to go a step further and address the internal controls over and above what used to be required of them during the normal course of an audit. This obviously places a greater onus on the external auditor to discover errors and fraud which occurs as a result of a breakdown in the company’s internal controls.

Sarbanes-Oxley was signed into U.S. law less than two weeks after the WorldCom bankruptcy. Since then, auditing fees have increased because of the increased responsibilities of auditors, and corporate costs have increased due to the more stringent requirements of internal controls.

‘The detection of material fraud is a reasonable expectation of users of audited financial statements. Society needs and expects assurance that financial information has not been materially misstated because of fraud. Unless an independent audit can provide this assurance, it has little if any value to society.’

This statement by the Public Companies Accounting Oversight Board (PCAOB) represents a dramatic change in auditors' responsibility for detecting fraudulent financial reporting. The PCAOB is a private-sector, non-profit corporation, created as a result of the passing of Sarbanes-Oxley to oversee the auditors of public companies. Its intent is to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports.

The PCAOB now requires that auditors be registered with them. This implies that auditors could be de-registered if they do not faithfully comply with the new standards set by Sarbanes-Oxley.

Previously, American Institute of Certified Public Accountants (AICPA) auditing standards required auditors to plan and perform an audit to provide reasonable assurance of detecting material misstatements, including those caused by fraud.

Today, the message is clear: auditors must assume greater responsibility for detecting fraud. However, Sarbanes-Oxley, by requiring that the CEO and CFO certify the annual and quarterly financial statements, has placed even more responsibility upon the company’s management. Specifically, Sarbanes-Oxley requires that the CEO and CFO certify that management has reviewed the statements and attest that, to the best of their knowledge, the statements are fairly represented. They must also attest that statements contain no untrue material facts or omit any material facts.
Just as importantly, management must disclose any deficiencies to their audit committee and to the auditor. These deficiencies must be part of the internal control report which the auditor must certify. Management must also report on any changes in internal controls that are the result of management’s identification of deficiencies.

As much as having to report on deficiencies in internal controls may detract potential investors, reporting how any identified deficiencies have been resolved provides evidence that management is willing to institute transparent internal controls that lead to accurate, and reliable financial information being available to current and potential investors.

Sarbanes-Oxley represents a ‘wave of change’ in Cayman’s financial services community. Many Cayman auditing firms have clients that are registered with the U.S. Securities and Exchange Commission. The firms, and their Cayman auditors, must comply with the increasing demand for transparency and accountability in business.

The author welcomes comments, at rchambers@ucci.edu.ky

Back...