Acct 351 Class Presentation

1. Li Yuen Yung Wong Wai Kit Wong Yik Yin Acct 351 Class Presentation

2. Agenda • Audit Risk Model • Reasons for high audit risk in China • Inherent Risk (IR) • Control Risk (CR) • Detection Risk (DR) • Conclusion • Recommendation

3. Audit Risk Model

4. Audit Risk Model IR CR DR

5. Audit Risk Model • Inherent Risk (IR) • Risk of material misstatement assuming the company has no internal controls • Control Risk (CR) • Risk that a material misstatement is not detected by internal controls • Detection Risk (DR) • Risk that an auditor would not detect material misstatement using analytical procedures or substantive tests

6. Risk of material misstatement assuming the company has no internal controls Inherent Risk

7. Reasons for high inherent risk • Management integrity • Company characteristics • Companies’ choice on auditors • Legal environment and corporate governance

8. Management Integrity • 62% CFOs cited ‘integrity’ as the top criteria in choosing accounting firms • 38% cited integrity not in top 3 • 3% choose auditors who submit to client’s opinion

9. Company Characteristics • Many State-owned Enterprises (SOE) • In 2003, 76% of listed com are SOEs • Weaker incentives to reduce information asymmetries • Banks discrimination • Insurance function of Chinese government

10. Companies’ Choice on auditors • Choose small and local audit firms • Small and local firms dominates market • 54% in 2003 • Small and local firms • Less independent • Easier to collude with • Why?

11. Choice on auditors • Small firms • More dependent on audit fee on single com • Smaller potential loss from being caught • Local firms • Close relationships with local com

12. Legal environment • Weak legal culture and enforcement system • PRC GAAP, but not follow • Information disclosure are not timely and accurate, and not easily understandable by investors. • Prevalent of false accounts

13. Risk that a material misstatement is not detected by internal control Control Risk

14. Reasons for high control risk • Insider Control of Corporate Affairs • Weak Supervisory Board

15. Reasons for high control risk • Insider Control of Corporate Affairs • Control is mainly by insider-managers • insider-managers controlled and supported in various forms by Communist Party not act in the interest of the shareholders • Communist Party can exert a critical influence on company affairs. • Eg. the use of listed companies as guarantors to borrow money from banks • As a result, internal control become useless

16. Reasons for high control risk • Weak Supervisory Board in listed company • A group of individuals chosen by the stockholders to hire and supervise the executive directors, managers and CEO • required by the Company Law in China • however, loosely defined monitoring role over the board of directors and managers • Supervisors are not involved in the selection of directors and managers and have no means of disciplining them • ineffective governance and supervising role

17. Risk that an auditor would not detect material misstatement using analytical procedures or substantive tests Detection risk (DR)

18. Reasons for high detection risk • Few and weak regulatory bodies • Generally poor quality of auditors • Low penalty • Compensation from higher fee for both audit and non-audit services

19. Reasons for high detection risk • Few and weak regulatory bodies • 2-digits GDP growth in the past few years • Increasing number of companies listed • Increasing number of financial statement stated • Although local accounting firms started to merge • Still large amount of small and medium size firms which are difficult to monitor • Only 2 government agencies in China • China Securities Regulatory Commission • Ministry of Finance

20. Reasons for high detection risk • Generally poor quality of auditors • Perception of junior auditors • No experience, but work hard • No understanding of client’s industry and background • Non-sampling errors from audit in China is more common • Not able to construct effective procedures and apply procedures effectively • Due to time constraints and demanding deadline, more susceptible to material misstatement

21. Reasons for high detection risk • Low penalty • Protection to bigger firms • Scandals of China Life with KPMG • Cost of take risky project is low • Compared to penalty from other countries

22. Reasons for high detection risk • Compensation from higher fee for both audit and non-audit services • Even accounting firms think that a prospective clients is not decent and have poor reputation • Higher fee from both audit and non-audit service will compensate the increased audit risk • Cost-Benefit analysis • Accept the engagement if benefits is greater the cost of taking the risk • Illustrated by following example

23. Detection risk • Example: • Audit fee: $1mil • Probability of false account: 50% • Probability of false account being caught: 10% • Fine if get caught: $10mil

24. Detection risk • Expected value of project = 1mil – 10mil *0.5*0.1 = 0.5mil • As the expected value is positive, accounting firms in China will still take project even the audit risk is high

25. Conclusion China High Audit Risk in China

26. Recommendations • Improving internal control • Implementing CEO Certification - requires that the CEO to prepare a statement to accompany the audit report to certify the appropriateness and fairness of the financial statements. • Adopt Corporate Governance Guidelines, and Code of Business Conduct and Ethics – raise the ethical standards of the management

27. Recommendations • Improving audit quality and independence • Strengthening Legal Liabilities and Enforcement – increase penalty • raise the ethical standard of auditor – education and training • create strong and independent regulatory bodies – more resources and power should be allocated