An Audit is an Examination

Sarbanes-Oxley Act

An audit is an examination and verification of a company's financial and accounting records. It also supports documents by a professional, such as certified public accountant. Until the 90's, the audits did not focused on controls like they do today. Because of the early 21st century scandals of Enron Corp, WorldCom Group Inc., and Tyco International the investors trust in the United States corporations started to diminish. These scandals occurred because the major accounting firms failed to detect fraud in their accounting audits and because of conflicts between ethics and loyalty held by the directors. In order to avoid corporate fraud and restore the confidence in financial markets the Congress signed into law the Sarbanes-Oxley Act (SOX) on July 30, 2002. This act created standards for corporate accountability as well as penalties for corrupt corporate behavior. The SOX established the creation of the Public Company Accounting Oversight Board (PCAOB). This board is composed of five members and it is responsible for oversight of financial statement audits of publicly-traded corporations and the establishment of auditing standards in the United States of America. “The SOX sets forth eleven specific reporting requirements that companies and executive boards must follow, and requires the Securities and Exchange Commission (SEC) to oversee compliance” (investorswords.com, 2009). The SOX requires that the Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs) of all public companies, as well as foreign issuers with U.S., to certify quarterly and annual reports. It minimizes the “periodic filing deadlines from 45 to 35 days for quarterly reports and from 90 to 60 days for annual reports. The companies also have to report any deficiencies in internal controls to their audit committees and independent auditors” (SSRN). The members of the audit committee must be part of the board of directors and independent of corporate management. The audit committee is responsible for selection, compensation, and oversight of the corporation's independent auditor. The audit committee must include a member who is a financial expert. A financial expert is defined as someone who has an understanding of generally accepted accounting principles, internal controls, financial statements, and audit committees and who has experience preparing, auditing, analyzing, or evaluating financial statements. The audit committee must approve of any services provided by the independent auditor, particularly those that are not directly related to the financial audit. These services must be disclosed in reports to the SEC. A corporation's independent auditor must provide timely information to the audit committee about important accounting practices and policies adopted by corporate management. Debates between the auditor and management about alternative practices or policies are also required. Any disagreements between the auditor and management about these matters must also be disclosed to the audit committee. The auditor must attest to and report on management's assessment of a corporation's internal controls. The auditor is responsible for examining the client firm's internal control system and verifying that the system is adequate to provide reasonable assurance of reliable financial reporting information. The auditor expresses an opinion concerning management's assertions about its internal control system. This opinion is based on the results of the auditor's assessment and appears in a report that accompanies the company's audited financial statements. This report is in addition to the auditor's attestation concerning the financial statements themselves. A whistleblower is a person that brings up a misconduct or bad behavior of a company. With the enactment of the SOX “internal and external whistleblower protection has been extended to all employees in publicly traded companies for the first time. The provisions of Sarbanes-Oxley make it illegal to discharge, demote, suspend, threaten, harass or in any manner discriminate against whistleblowers. The passage of this act has created an environment in which many organizations have realized the importance of instituting ethics policies and codes of conduct to address issues related to unethical or illegal conduct”. (Santa Clara University, 2009) “Many private companies, although not legally required to do so, are improving controls and documentation using recommendations contained in the 2002 Sarbanes Oxley Law. Better governance procedures and strengthened ethics and codes of conduct are the other major reported benefits” (basel-ii-risk.com, 2009). This fact concludes that since the implementation of the SOX the disclosure of financial information has increased. SOX is one of the regulations that help a company and its auditors to be more ethical. As of today, wealthy companies need to have the confidence of the shareholders as well as the general public. It's very important to the government that public companies are regulated because of best practices and rules. This fact is very significant to help protect the economy.

Management And Stockholder Wealth

A stockholder is known as a shareholder. A shareholder is one that owns or holds shares of stock. Shareholder wealth is defined by the market value of the shareholders' common stock holdings. Total shareholder wealth is the number of shares outstanding multiplied by the market price per share. Shareholder wealth maximization is impersonal and distant. It states a clear guide for managers to make decisions and to recognize the risk that joins each decision. “To maximize shareholder wealth, a company must earn more than its cost of common equity. How much it can earn will depend upon the nature of the industry and whether the individual firm can develop a competitive edge in its own market.” (Gillespie,2010) By identifying and analyzing the company's target market, shareholder's can recognize potential opportunities for success and profitability. The shape of the economy also impacts stockholder wealth. When the economy is in an upward motion, shareholders tend to make more money. However, if in a downward motion, constraints are placed upon shareholders. Childs (1997) states “there are two things to consider in order maximizing the shareholders wealth: 1) earn a return above the cost of common equity, and 2) put more capital to work at that higher return. High earnings without growth can improve shareholder wealth, but this fact alone won't raise stock prices.” Earnings that are larger than the cost of common equity represent greater profit margins. As a result of putting more capital to work, the shareholders wealth will maximize. This action can be referred as distribution of capital. When financial managers distribute capital they must watch the changes of the return on common equity and they have to be aware of the risks they might encounter. Maximizing the shareholders wealth is the primary goal of the financial managers. This goal “assumes that managers operate in the best interests of stockholders, not themselves, and do not attempt to expropriate wealth from lenders to benefit stockholders. Stockholder wealth maximization also assumes that managers do not take actions to deceive financial markets in order to boost the price of the firm's stock.” (Baker, 2009) It is assumed that managers with a primary goal of shareholder wealth maximization are able to make successful decisions for the long-term life of the company. They consider both the short and long term effect of decisions and as a result the market value of the company increases. Sometimes there are conflicts between the interests of the shareholders and the interests of the management. Historically, management avoided the possibilities of maximizing the stockholder wealth. Today management has to consider the shareholders in their decisions and try to achieve the success of the company and the shareholders. The company is motivated to maximize the shareholders wealth by stock option incentives. Stock option incentives are a type of employee stock option that can be granted only to employees and confer a U.S. tax benefit. It is very hard to have a balance that satisfies the management of a company and shareholders. Overall, the shareholder wealth is good for the company because it goes hand in hand with the profitability of the company.

The Case For Social Responsibility And Ethical Behavior

Social responsibility is the obligation of a business to make decisions and take actions that will improve the welfare and interests of society as well as the business. In other words, social responsibility is quite important to the society, business, and individual. In order to accomplish this obligation, businesses today have placed an emphasis on the environment and economic sustainability. Sustainability means to satisfy today's needs without compromising future needs. Social responsibility is a process where an industry invests back into society. For instance, the industry can provide donations, academic scholarships, employment, environmental programs, or promote the development of other businesses. “Companies are now challenged by stakeholders including customers, employees, investors and activists to develop a blueprint for how they will sustain economic prosperity while taking care of their employees and the environment.” (asyousow.com 2010) These ideologies contribute to the economic wealth of society and maximize a company's profit. Due to the contribution of economic wealth to society, a company takes on more of a human characteristic. Ethical behavior is the conduct that is morally accepted as good and right. In the workplace, ethical behavior refers to the manner in which an organization expects their employees to behave. Most organizations have formulated documents, referred to as codes of conduct or codes of ethics, which set out the accepted behaviors within the work place. There are six concepts that must be considered in the creation of a code of conduct: ethics, values, morals, integrity, character, and laws. These codes of conduct/ethic consist of a set of rules and regulations that the employees and the organization have to follow. A professional code of ethics is a promise to act in a manner that protects the public's well-being. A professional code of ethics informs the public what to expect of a company and its employees. Codes of ethics must be specific enough to express the intended conduct. However, they must avoid being so authoritarian that the employees' interpretation becomes an excuse for noncompliance. Also, codes must be general enough to avoid encouraging defensive management, where an employee becomes unable to act and make decisions fearing that any action will be unethical. “Establishing an ethical standard for business conduct involves more than a written policy. The most compelling support for an ethical standard is adherence to and enforcement of that standard by those who institute it, and by those for whom it is written. More than briefings and policies handed out to every single employee, our behavior, practice, and deeds are the foundation for creating an ethical standard and making it stick.” (bomi) The potential for unethical behavior in business is everywhere. Ethical dilemmas are rarely simple. Several conflicting issues may be linked, and several parties may be involved. The solution for an issue might be perceived as unethical to some while to others it isn't. This could be related to the fact that each employee has their own set of personal ethics that can spill over into the workplace. It is extremely important to have and implement codes of conduct/ethics. In general, an organization should be both socially responsible and ethical. To comply with the social responsibility each day many companies are taking measures to be more “green” in other words pro environment. Also, every time there is a disaster like the one in Haiti, companies find a way to help and motivate society. The generosity by these companies can be interpreted as its public image. A company's ethics will set an example to the employees and a challenge to the competition.

Income Management (Income Smoothing)

Income management is a decision making strategy used to intentionally manipulate a company's earnings to match or achieve pre-determined financial results. Income management can be confused with the illegal activity of cooking the books. Cooking the books is when companies, like Enron, manipulate their financial statements and reports the wrong numbers. Income management is “primarily achieved by management actions that make it easier to achieve desired earnings levels through accounting choices from among GAAP [generally accepted accounting principles] and operating decisions” (Thompson, 2010) The excessive use of income management can lead to financial fraud. Historically, different companies have incurred in financial fraud because they improperly recorded revenues, recorded uncollectible sales, hided losses and expenses. The primary purpose of this strategy is income smoothing. Income smoothing is one phrase commonly used to describe income management. Income Smoothing reflects economic results as management wishes them to look. This results in lower earnings quality because net income does not represent the economic performance of the business for the period. Albrecht (2006) concludes that “There are two types of income smoothing streams naturally smooth and intentionally smooth by management.” Intentionally smooth management can be real or artificial. The real is when management restructures the ways of generating revenues to produce a smooth income stream. The artificial is when financial manager controls the income inconsistency over the years. This can be accomplished by shifting income from good years to bad years. Future income may be shifted to the present year or vice versa. In a similar manner, income can be modified by shifting expenses or losses from period to period. Income smoothing is a technique that has been observed in many industries. For example, the banking industry has accelerated their income smoothing techniques by “excluding the reserve for loan-loss from Tier I capital, and by restricting the amount which applies even to Tier II capital, the new system reduces the potential cost associated with understating the provision for loan-loss during periods of low earnings.” (Rivard, 2003) Also it is “commonly observed in developing countries, but they may come at a cost in terms persistent poverty” (Dercon, 2002). Like any other financial technique, it has its risks. The abuse of this technique it can lead to bankruptcy and fraud, but on the other hand it can be rewarding to the managers and business.

Financial Statement Ratio Analysis: What The Numbers Mean

Financial statement analysis is a method that identifies financial strengths and weaknesses of a company by establishing a relationship between the balance sheet and the income statement. Financial statements are necessary to meet reporting obligations and for management decision purposes. An important tool of the financial statement analysis is the ratio analysis. The ratio analysis is a tool used to measure a company's profit performance. It is a calculation of the current year's numbers compared with the previous year's numbers. The ratio analysis can also be used to compare a company's profit performance versus its competitors. The ratio analysis is classified into four categories: profitability ratios, asset utilization ratios, liquidity ratios, and debt utilization ratios. Profitability ratios measure a company's returns over a time frame. A company should have the ability to earn profits and grow during a long time period. When a company has a positive profitability, it means that it is being successful. For example: Microsoft started in a car garage and now is one of the biggest profitable companies of America. Asset utilization ratios measure how quickly a company's turnovers are compared to its competency. They can also be used to evaluate how active are the assets. A company that knows how to use their assets effectively will keep their investors happy. By using their assets effectively, the company will earn more sales per dollar of inventory. Liquidity ratios measure the ability of a company to meet short term obligations when they are due. If a company is not able to meet short term obligations, it will have to file for bankruptcy. The current assets and liabilities of a company is the focus of liquidity ratios. Debt utilization ratios are used to evaluate a company's debt position with regard to its asset base and earning power. This measure gives an idea of a company's leverage along with the potential debt risk of its debt. The lower the debt ratio means that a company has low total debt in comparison to its asset base. The higher debt ratio means that a company is in danger of becoming insolvent and going bankrupt. Accounting for management.com (2010) states that the ratio analysis has five advantages: 1. Simplifies financial statements: It simplifies the comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of the business. 2. Facilitates inter-firm comparison: It provides data for inter-firm comparison. Ratios highlight the factors associated with successful and unsuccessful firm. They also reveal strong firms and weak firms, overvalued and undervalued firms. 3. Helps in planning: It helps in planning and forecasting. Ratios can assist management, in its basic functions of forecasting, Planning, co-ordination, control and communications. 4. Makes inter-firm comparison possible: Ratios analysis also makes possible comparison of the performance of different divisions of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past and likely performance in the future. 5. Help in investment decisions: It helps in investment decisions in the case of investors and lending decisions in the case of bankers etc. The different end users of these statement analyses will give different priorities to the statements. An experienced analyst will look at all the statements but with different degrees of attention. All of these statements are important to achieve the success and goals of the company. These statement analyses are also very important because they explain the status of the company to the investors.

Operating Leverage

Operating leverage is a measure of the extent to which fixed assets and associated fixed costs are being used in a company. The purpose of leverage is to find a way to increase the value or impact of a resource. “Operating leverage can substantially increase the size of the operation and the potential income from that operation. However, it also creates a substantially higher risk exposure because equity is spread thinly and the ability to absorb losses is reduced.” (Hofstrand, 2008) Operating leverage is more useful to the owners, because it shows them a percentage of returns rather than an index. The operating leverage is large in companies that have a high proportion of fixed operating costs in relation to variable operating costs. The higher the degree of operating leverage the greater the potential danger from forecasting risks. If a relatively small error is made in forecasting sales it can result into large errors in cash flow projections. A business that sells millions of products a year is more independent on each individual sale. On the contrary operating leverage is lowest in companies that have a low proportion of fixed operating costs in relation to variable operating costs. An easy way to show the operating leverage of a company is the break-even point graphic. This graphic shows the relationship between the fixed and variable cost and the total revenue and cost. The break-even pint analysis holds very important information for the company and investors. Companies with large amounts of fixed operating costs have high break-even points and high operating leverage. Variable costs in these companies tend to be low and both the contribution and unit contribution margin is high. In other words, the higher the gross margin the more leverage the company will have. These numbers can help to analyze if a company is meeting its goals and to deduct if it is being successful. The less fixed cost a company has the more return it will have. Operating leverage is widely used in the farming industry. For example, operating leverage helps farmers decide if it is better to rent or buy the land. Usually a multinational company's income is so high that they can increase it by expanding to other parts of the country and maintaining the low profit facilities. Operating leverage is important to small and large industries because it helps them to make better decisions and it gives them the necessary information of the operations' profitability.

Financial Leverage

Financial leverage is how much the company use borrowed money instead of the equity of its operations. The higher the debt a company has the greater the financial leverage. In other words, it indicates the quantity of debt a company use in its capital structure. Capital structure is the relationship between assets, debt, and equity. “Leverage allows greater potential returns to the investor than otherwise would have been available but the potential loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.” (Pandey, 2010) Financial leverage is very important for managers in the decision-making process of investing in operations. Financial leverage can maximize the stockholders wealth by increasing debt and equity. “A low cost debt with low interest would increase the return of equity relative to the return of assets.” (Scott, 2010) On the other hand, it is not good for the company to have a high debt because it diminishes the return of equity. Companies that are high in financial leverage might find it difficult to make payments on their debt in times of trouble and also difficult to borrow money from lenders. “Financial leverage can be used for stimulating profit and growth, but it is more likely for companies in the stage of birth and youth.” (Johns, 2010) Two companies may have the same operating leverage, but the use of financial leverage can be different. The stimulation of profit and growth of the companies will be different. That is why companies compare the effect that different plans might have in the company's earnings. Like in operating leverage, the plans will cross at some point. Beyond that point managers can decide which plan will give them the best earnings. The degree of financial leverage helps managers to analyze which plan has more leverage. The plan that has the larger financial leverage is the best option for the company because they will have better earnings per share. Financial leverage is good to a certain point. It is true that it can maximize the stockholders wealth, but the higher the debt the larger the financial risk. It also can influence other innovative decisions, like changes in technology and other expanding chances. Financial leverage is one method that can be used in combination with others to achieve and improve a company's profitability and market value.

Determining The Correct Mix Between Debt And Equity Financing

Debt financing is money borrowed from a source with the agreement that it will be paid back in a certain time. In other words, this is a loan. This type of financing can be made in two ways which are short term (less or equal than one year) and long term (more than one year). “The lending party does not gain ownership of the business.” (Valdez, 2005) Some lending institutions require small business to guarantee the loan. Debt financing has its advantaged and disadvantages. The advantages of debt financing are maximum control of the business, the interests are deductible, and the debt will end after period of time. The disadvantages are the interests can be so high that it will be hard to pay back, the investors may get scared by the debt, and lenders will look closely at the business. Equity financing is an exchange of money for a piece of ownership of the business. This money is introduced directly to the operations. It is a form of financing that does not involve debt. There are many sources of equity financing that include personal savings, investments by relatives, friends, employees, or other business partners. The most common source, however, are professional investors known as venture capitalists. Venture capital is a private equity given at an early stage of a business. The advantages of equity financing are the ability to receive money in exchange of equity, no monthly payment required, and the cash flow can be used to improve the business. On the other hand, its disadvantages are the loss of interest of the investors and the loss of ownership. If the business is a partnership “this type of financing would likely be in the form of an owner's contribution and would appear on the balance sheet as owner's equity. If the business is incorporated anyone contributing equity capital would receive shares in the business.” Equity financing allows the operation to consider further debt financing in the future, if needed. Increasing equity improves the business operation's security in most cases. Convertible debt is a mix of debt and equity financing. It starts as debt financing, and as the business grows it changes to equity financing. Convertible debt is a loan that can be changed into equity if there's future financing or if the lender decides to change it. If venture capital is expected to be needed in the future this is a good alternative. This option eliminates the need of a appraisal of the company. “Convertible debt eliminates the risk of a down round (an investment round with a share price lower than the previous round).”(Advani, 2006) The investors can receive a discount off the share price negotiated by the lender. The decision of what type of financing will diverge depends on the type of company and expectations. Business owners need a good knowledge of the options that are available in order to choose between debt or equity financing. It is a smart move that they search for an expert opinion to give them guidance. A small company will prefer debt financing versus a big company that will prefer equity financing. A company that has big expectations and projections of growing may consider a convertible debt.

Cite this page