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Transparency & investor protection Implications for accounting and auditing Barcelona, October 18, 2013 Oriol Amat UPF Programme 1.Introduction 2.Assessing solvency and forecasting bankruptcy 3.Misleading information 4.Conclusions 1

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Transparency & investor protection Implications for accounting and auditing

Barcelona, October 18, 2013 Oriol Amat UPF

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Programme

1.Introduction 2.Assessing solvency and forecasting bankruptcy 3.Misleading information 4.Conclusions

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  • Investor protection
  • Solvency listed companies and brokers (8.000

companies)

  • Markets in Financial Instruments Directive (MiFID)
  • Avoiding market abuse
  • Insider trading
  • Price manipulation:

Misleading information Irregular orders

1.Introduction

Objectives of an exchange supervisor:

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2.Assessing solvency and forecasting bankruptcy

  • Sample: 80.000 companies (good and bad)
  • 40 ratios
  • Ratios with more predicting power:

x1 = Current assets/ Current liabilities x2 = Equity/ Assets x3 = Net profit/ Assets x4 = Net profit / Equity

  • Discriminant function:

>0: Good Z = -3,9 + 1,28 x1+ 6,1 x2+ 6,5 x3+ 4,8 x4 <0: Bad

Source: Amat, O. et al (2012): Análisis de operaciones de crédito, Profit, Barcelona

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Example: Supermarket company in bankruptcy 2009

2002 2003 2004 2005 2006 2007 2008

x1 CA/CL

0,71 0,69 0,66 0,65 0,61 0,57 0,61

x2 Equity / Assets

0,34 0,34 0,33 0,32 0,30 0,31 0,28

x3 Net profit / Assets

0,07 0,08 0,06 0,02 0,01 -0,03 -0,04

x4 Net profit / Equity

0,16 0,18 0,14 0,04 0,03 -0,09 -0,12

Z

  • 3,9 + 1,28 x1+ 6,1 x2+ 6,5 x3+ 4,8 x4

0,306 0,441 0,02

  • 0,79 -1,08
  • 1,91 -2,25

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Source: Guy Carpenter, Standard & Poor’s, Bloomberg data

100 200 300 400 500 600 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 10 20 30 40 50 60 70 80 Lehman 5 yr senior CDS spread in bps (left hand scale) Lehman share price (right hand scale)

Long-term issuer credit rating: ‘A+’, Outlook stable 2 Jun: ‘A’ , Outlook negative 15 Sep: Lehman files for bankruptcy; S&P assigns SD (selective default) rating

Lehman Brothers (bankruptcy losses: 639.000 million $)

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3.Misleading information

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Accounts manipulation

Accounting practices Real transactions Legal Earnings management Anticipating or delaying real expenses or income... Illegal Accounting treatments not allowed Illegal transactions...

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Changes in a company’s net profit according to the accounting criteria of several countries (2008) Changes in a company’s net profit according to the accounting criteria of several countries (2008)

More used More Less criteria conservative conservative criteria criteria More used More Less criteria conservative conservative criteria criteria

Spain 100

  • 23

166 Germany 133

  • 31

140 U.K. 162 71 194 USA 167 86 211 Spain 100

  • 23

166 Germany 133

  • 31

140 U.K. 162 71 194 USA 167 86 211

Accounts manipulation and earnings management

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100.000 200.000 300.000 1 2 3 4

Real net profit Reported net profit

Example of profit smooting Example of profit smooting

Accounts manipulation and earnings management

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Financials statements

  • Changes in valuation rules
  • Differencies between net profit and cash flow from operations
  • Too much debt

Ratios

  • Important changes in ratios compared with industry
  • Z formula to forecast manipulations

Other signals

  • Change of auditor
  • Problems with debt covenants
  • Too much complex operations with third parties
  • Problems in the Board of Directors or in the Auditing Committee
  • Personality of leaders: language in meetings…

Signals of manipulation

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  • The challenge of predicting bankruptcy
  • Accounting regulations: increasing room for earnings

management

  • The challenge of predicting earnings management
  • Key role of auditors and accountants

4.Conclusions

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Example of differences between earnings before taxes and cash flow from operations

2011 2010 EBT +64,7 +49,6 Depreciation and accruals

  • 153,6
  • 16,6

CFO

  • 88,9

+33,0

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Example: Rights Thierry Henry

May 14, 2010, Barça and Giants sign a private contract selling the player for 0 euros. The value of the asset was 13 million euros. UEFA and the player accepted the deal after June 30, 2010.

Reason for provision at June 30, 2010 Reasons for not provisioning at June 30, 2010

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Example of big bath

2002 2003 2004 2005 2006 2007 2008 2009 2010 Earnings according to the auditors +7,2

  • 63,8

+1,4 +36,7 +32,9 +6,8 +10 +6,6

  • 77,1

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New board Accounts restated Accounts restated New board Some days before the change in the Board, an auditor’s report draft reported a profit of 11