What are financial reports

1
What are financial reports?

• And why should anyone care what the auditors
  think?

2
Three types of OpinionsUnqualified, qualified
Adverse

• Unqualified (aka Clean)
• We believe these financial statements are (1)
  fairly presented in (2) accordance with GAAP (3)
  consistently applied
• Normal result of an audit
• When problems are later found, there is a
  restatement and explanation

3
Three types of OpinionsUnqualified, qualified
Adverse

• Qualified
• We believe these financial statements are (1)
  fairly presented in (2) accordance with GAAP (3)
  consistently applied except for (4) List
  Exceptions
• Qualified opinions may result from legitimate
  operations
• Often are a result of contingent claims
• E.g., large class-action lawsuits such as
  Monsanto dealt with for Asbestos

4
Three types of OpinionsUnqualified, qualified
Adverse

• Adverse
• We DO NOT believe these financial statements are
  (1) fairly presented in (2) accordance with GAAP
  (3) consistently applied THE AUDITORS DISAGREE
  WITH List Exceptions
• Very rare results from a breakdown of
  communications with the client

5
SarbanesOxley Act of 2002

• Public Company Accounting Reform and Investor
  Protection Act of 2002
• commonly called SOX or SarBox
• United States federal law passed in response to
  a number of major corporate and accounting
  scandals including those affecting Enron, Tyco
  International, and WorldCom (now MCI). These
  scandals resulted in a decline of public trust in
  accounting and reporting practices.
• Named after sponsors Senator Paul Sarbanes
  (DMd.) and Representative Michael G. Oxley
  (ROh.),
• Act was approved by the House by a vote of 423-3
  and by the Senate 99-0.
• The legislation is wide ranging and establishes
  new or enhanced standards for all U.S. public
  company Boards, Management, and public accounting
  firms.
• The Act contains 11 titles, or sections, ranging
  from additional Corporate Board responsibilities
  to criminal penalties, and requires the
  Securities and Exchange Commission (SEC) to
  implement rulings on requirements to comply with
  the new law.
• Establishes a new quasi-public agency, the Public
  Company Accounting Oversight Board, which is
  charged with overseeing, regulating, inspecting,
  and disciplining accounting firms in their roles
  as auditors of public companies.
• The Act also covers issues such as auditor
  independence, corporate governance and enhanced
  financial disclosure.

6
Monsanto

• INDEPENDENT AUDITORS REPORT
• To the Members of Renessen LLC
• Bannockburn, Illinois
• We have audited the accompanying consolidated
  balance sheets of Renessen LLC (A Development
  Stage Company) (the Company) as of August 31,
  2003, December 31, 2002 and 2001 and the related
  consolidated statements of operations, members
  interest (deficiency) and cash flows for the
  eight months ended August 31, 2003 and for each
  of the three years in the period ended
  December 31, 2002, and the cumulative period from
  January 7, 1999 (date operations commenced)
  through August 31, 2003. These consolidated
  financial statements are the responsibility of
  the Companys management. Our responsibility is
  to express an opinion on these financial
  statements based on our audits.
• We conducted our audits in accordance with
  auditing standards generally accepted in the
  United States of America. Those standards require
  that we plan and perform the audit to obtain
  reasonable assurance about whether the financial
  statements are free of material misstatement. An
  audit includes examining, on a test basis,
  evidence supporting the amounts and disclosures
  in the financial statements. An audit also
  includes assessing the accounting principles used
  and significant estimates made by management, as
  well as evaluating the overall financial
  statement presentation. We believe that our
  audits provide a reasonable basis for our
  opinion.
• In our opinion, such consolidated financial
  statements present fairly, in all material
  respects, the financial position of the Company
  at August 31, 2003, December 31, 2002 and 2001,
  and the results of its operations and its cash
  flows for the eight months ended August 31, 2003
  and for each of the three years in the period
  ended December 31, 2002, and the cumulative
  period from January 7, 1999 (date operations
  commenced) through August 31, 2003 in conformity
  with accounting principles generally accepted in
  the United States of America.
• The accompanying consolidated financial
  statements have been prepared assuming that the
  Company will continue as a going concern. As
  described in Note 2, the Companys recurring
  losses from development stage activities and the
  Members minimum funding commitment expiring on
  January 31, 2004 raise substantial doubt about
  its ability to continue as a going concern.
  Managements plans concerning these matters are
  also described in Note 2. The consolidated
  financial statements do not include any
  adjustments that might result from the outcome of
  this uncertainty.
• /s/ DELOITTE TOUCHE LLP
• Chicago, Illinois
• September 25, 2003

7
Monsanto SOX

• CERTIFICATIONS
• I, Terrell K. Crews, Executive Vice President and
  Chief Financial Officer of Monsanto Company,
  certify that
• 1. I have reviewed this transition report on Form
  10-K of Monsanto Company
• 2. Based on my knowledge, this report does not
  contain any untrue statement of a material fact
  or omit to state a material fact necessary to
  make the statements made, in light of the
  circumstances under which such statements were
  made, not misleading with respect to the period
  covered by this report
• 3. Based on my knowledge, the financial
  statements, and other financial information
  included in this report, fairly present in all
  material respects the financial condition,
  results of operations and cash flows of the
  registrant as of, and for, the periods presented
  in this report
• 4. The registrants other certifying officer and
  I are responsible for establishing and
  maintaining disclosure controls and procedures
  (as defined in Exchange Act Rules 13a-15(e) and
  15d-15(e)) for the registrant and have
•  a) Designed such disclosure controls and
  procedures, or caused such disclosure controls
  and procedures to be designed under our
  supervision, to ensure that material information
  relating to the registrant, including its
  consolidated subsidiaries, is made known to us by
  others within those entities, particularly during
  the period in which this report is being
  prepared
•  b) Reserved
•  c) Evaluated the effectiveness of the
  registrants disclosure controls and procedures
  and presented in this report our conclusions
  about the effectiveness of the disclosure
  controls and procedures, as of the end of the
  period covered by this report based upon such
  evaluation and
•  d) Disclosed in this report any change in the
  registrants internal control over financial
  reporting that occurred during the registrants
  most recent fiscal quarter (the registrants
  fourth fiscal quarter in the case of an annual
  report) that has materially affected, or is
  reasonably likely to materially affect, the
  registrants internal control over financial
  reporting and
• 5. The registrants other certifying officer and
  I have disclosed, based on our most recent
  evaluation of internal control over financial
  reporting, to the registrants auditors and the
  audit committee of registrants board of
  directors (or persons performing the equivalent
  function)
•  a) All significant deficiencies and material
  weaknesses in the design or operation of internal
  control over financial reporting which are
  reasonably likely to adversely affect the
  registrants ability to record, process,
  summarize and report financial information and
•  b) Any fraud, whether or not material, that
  involves management or other employees who have a
  significant role in the registrants internal
  control over financial reporting.
• Date November 25, 2003
•  /s/ Terrell K. CrewsTerrell K. CrewsExecutive
  Vice President and Chief Financial
  OfficerMonsanto Company

8
GM Auditor Report

• REPORT OF INDEPENDENT REGISTERED PUBLIC
  ACCOUNTING FIRM
• General Motors Corporation, its Directors, and
  Stockholders
• We have audited the accompanying Consolidated
  Balance Sheets of General Motors Corporation and
  subsidiaries (the Corporation) as of December 31,
  2005 and 2004, and the related Consolidated
  Statements of Income, Cash Flows, and
  Stockholders Equity for each of the three years
  in the period ended December 31, 2005. Our audits
  also included the Supplemental Information to the
  Consolidated Balance Sheets and Consolidated
  Statements of Income and Cash Flows and the
  financial statement schedule listed at Item 15
  (collectively, the financial statement
  schedules). These financial statements and
  financial statement schedules are the
  responsibility of the Corporations management.
  Our responsibility is to express an opinion on
  these financial statements and financial
  statement schedules based on our audits.
• We conducted our audits in accordance with the
  standards of the Public Company Accounting
  Oversight Board (United States). Those standards
  require that we plan and perform the audit to
  obtain reasonable assurance about whether the
  financial statements are free of material
  misstatement. An audit includes examining, on a
  test basis, evidence supporting the amounts and
  disclosures in the financial statements. An audit
  also includes assessing the accounting principles
  used and significant estimates made by
  management, as well as evaluating the overall
  financial statement presentation. We believe that
  our audits provide a reasonable basis for our
  opinion.
• In our opinion, such consolidated financial
  statements present fairly, in all material
  respects, the financial position of General
  Motors Corporation and subsidiaries at
  December 31, 2005 and 2004, and the results of
  their operations and their cash flows for each of
  the three years in the period ended December 31,
  2005, in conformity with accounting principles
  generally accepted in the United States of
  America. Also, in our opinion, such financial
  statement schedules, when considered in relation
  to the basic consolidated financial statements
  taken as a whole, present fairly, in all material
  respects, the information set forth therein.
• As discussed in Note 1 to the consolidated
  financial statements, the Corporation
  (1) effective December 31, 2005, began to account
  for the estimated fair value of conditional asset
  retirement obligations to conform to FASB
  Interpretation No. 47, Accounting for Conditional
  Asset Retirement Obligations, (2) effective
  July 1, 2003, began consolidating certain
  variable interest entities to conform to FASB
  Interpretation No. 46(R), Consolidation of
  Variable Interest Entities, and (3) effective
  January 1, 2003, began expensing the fair market
  value of newly granted stock options and other
  stock-based compensation awards issued to
  employees to conform to Statement of Financial
  Accounting Standards No. 123, Accounting for
  Stock-Based Compensation.
• We have also audited, in accordance with the
  standards of the Public Company Accounting
  Oversight Board (United States), the
  effectiveness of the Corporations internal
  control over financial reporting as of
  December 31, 2005, based on the criteria
  established in Internal Control  Integrated
  Framework issued by the Committee of Sponsoring
  Organizations of the Treadway Commission and our
  report dated March 28, 2006 expressed an
  unqualified opinion on managements assessment of
  the effectiveness of the Corporations internal
  control over financial reporting and an adverse
  opinion on the effectiveness of the Corporations
  internal control over financial reporting.
• /s/ Deloitte Touche llp
•  
• Deloitte Touche llp
• Detroit, Michigan
• March 28, 2006
• II-52

9
GM SOX

• CERTIFICATION
• I, G. Richard Wagoner, Jr., certify that
• 1. I have reviewed this annual report on Form
  10-K of General Motors Corporation  2. Based on
  my knowledge, this report does not contain any
  untrue statement of a material fact or omit to
  state a material fact necessary to make the
  statements made, in light of the circumstances
  under which such statements were made, not
  misleading with respect to the period covered by
  this report  3. Based on my knowledge, the
  financial statements, and other financial
  information included in this report, fairly
  present in all material respects the financial
  condition, results of operations and cash flows
  of the registrant as of, and for, the periods
  presented in this report  4. The registrants
  other certifying officer and I are responsible
  for establishing and maintaining disclosure
  controls and procedures (as defined in Exchange
  Act Rules 13a-15(e) and 15d-15(e)) and internal
  control over financial reporting (as defined in
  Exchange Act Rules 13a-15(f) and 15d-15(f)) for
  the registrant and have
•  a) Designed such disclosure controls and
  procedures, or caused such disclosure controls
  and procedures to be designed under our
  supervision, to ensure that material information
  relating to the registrant, including its
  consolidated subsidiaries, is made known to us by
  others within those entities, particularly during
  the period in which this report is being
  prepared   b) Designed such internal control
  over financial reporting, or caused such internal
  control over financial reporting to be designed
  under our supervision, to provide reasonable
  assurance regarding the reliability of financial
  reporting and the preparation of financial
  statements for external purposes in accordance
  with generally accepted accounting
  principles   c) Evaluated the effectiveness of
  the registrants disclosure controls and
  procedures and presented in this report our
  conclusions about the effectiveness of the
  disclosure controls and procedures, as of the end
  of the period covered by this report based on
  such evaluation and   d) Disclosed in this
  report any change in the registrants internal
  control over financial reporting that occurred
  during the registrants most recent fiscal
  quarter (the registrants fourth fiscal quarter
  in the case of an annual report) that has
  materially affected, or is reasonably likely to
  materially affect, the registrants internal
  control over financial reporting and
• 5. The registrants other certifying officer and
  I have disclosed, based on our most recent
  evaluation of internal control over financial
  reporting, to the registrants auditors and the
  audit committee of the registrants board of
  directors (or persons performing the equivalent
  function)
•  a) All significant deficiencies and material
  weaknesses in the design or operation of internal
  control over financial reporting which are
  reasonably likely to adversely affect the
  registrants ability to record, process,
  summarize and report financial information
  and   b) Any fraud, whether or not material, that
  involves management or other employees who have a
  significant role in the registrants internal
  control over financial reporting.Date March 28,
  2006
•           /s/ G. RICHARD WAGONER, JR.    G.
  Richard Wagoner, Jr.   Chairman and Chief
  Executive Officer   

10
GM SOX

• Exhibit 31.2
• CERTIFICATION
• I, Frederick A. Henderson, certify that
• 1. I have reviewed this annual report on Form
  10-K of General Motors Corporation  2. Based on
  my knowledge, this report does not contain any
  untrue statement of a material fact or omit to
  state a material fact necessary to make the
  statements made, in light of the circumstances
  under which such statements were made, not
  misleading with respect to the period covered by
  this report  3. Based on my knowledge, the
  financial statements, and other financial
  information included in this report, fairly
  present in all material respects the financial
  condition, results of operations and cash flows
  of the registrant as of, and for, the periods
  presented in this report  4. The registrants
  other certifying officer and I are responsible
  for establishing and maintaining disclosure
  controls and procedures (as defined in Exchange
  Act Rules 13a-15(e) and 15d-15(e)) and internal
  control over financial reporting (as defined in
  Exchange Act Rules 13a-15(f) and 15d-15(f)) for
  the registrant and have
•  a) Designed such disclosure controls and
  procedures, or caused such disclosure controls
  and procedures to be designed under our
  supervision, to ensure that material information
  relating to the registrant, including its
  consolidated subsidiaries, is made known to us by
  others within those entities, particularly during
  the period in which this report is being
  prepared   b) Designed such internal control
  over financial reporting, or caused such internal
  control over financial reporting to be designed
  under our supervision, to provide reasonable
  assurance regarding the reliability of financial
  reporting and the preparation of financial
  statements for external purposes in accordance
  with generally accepted accounting
  principles   c) Evaluated the effectiveness of
  the registrants disclosure controls and
  procedures and presented in this report our
  conclusions about the effectiveness of the
  disclosure controls and procedures, as of the end
  of the period covered by this report based on
  such evaluation and   d) Disclosed in this
  report any change in the registrants internal
  control over financial reporting that occurred
  during the registrants most recent fiscal
  quarter (the registrants fourth fiscal quarter
  in the case of an annual report) that has
  materially affected, or is reasonably likely to
  materially affect, the registrants internal
  control over financial reporting and
• 5. The registrants other certifying officer and
  I have disclosed, based on our most recent
  evaluation of internal control over financial
  reporting, to the registrants auditors and the
  audit committee of the registrants board of the
  directors (or persons performing the equivalent
  function)
•  a) All significant deficiencies and material
  weaknesses in the design or operation of internal
  control over financial reporting which are
  reasonably likely to adversely affect the
  registrants ability to record, process,
  summarize and report financial information
  and   b) Any fraud, whether or not material, that
  involves management or other employees who have a
  significant role in the registrants internal
  control over financial reporting.Date March 28,
  2006
•           /s/ FREDERICK A. HENDERSON    Frederick
  A. Henderson   Vice Chairman and Chief Financial
  Officer   

11
GM SOX

• GENERAL MOTORS CORPORATION AND SUBSIDIARIES
•       Our independent registered public
  accounting firm, Deloitte  Touche LLP, audited
  managements assessment of internal control over
  financial reporting and has issued an attestation
  report on managements assessment, included in
  Part II, Item 8 of this annual report on
  Form 10-K.
•     /s/ G. RICHARD WAGONER, JR.  /s/ FREDERICK A.
  HENDERSON    G. Richard Wagoner, Jr. Chairman and
  Chief Executive Officer March 28, 2006  Frederick
  A. Henderson Chief Financial Officer March 28,
  2006 Limitations on the Effectiveness of Controls
•       Our management, including our CEO and CFO,
  does not expect that our Disclosure Controls or
  our internal controls will prevent or detect all
  errors and all fraud. A control system, no matter
  how well designed and operated, can provide only
  reasonable, not absolute, assurance that the
  control systems objectives will be met. Further,
  the design of a control system must reflect the
  fact that there are resource constraints, and the
  benefits of controls must be considered relative
  to their costs. Because of the inherent
  limitations in all control systems, no evaluation
  of controls can provide absolute assurance that
  all control issues and instances of fraud, if
  any, within General Motors have been detected.
  These inherent limitations include the realities
  that judgments in decision-making can be faulty,
  and that breakdowns can occur because of simple
  error or mistake. Controls can also be
  circumvented by the individual acts of some
  persons, by collusion of two or more people, or
  by management override of the controls. The
  design of any system of controls is based in part
  upon certain assumptions about the likelihood of
  future events, and there can be no assurance that
  any design will succeed in achieving its stated
  goals under all potential future conditions. Over
  time, controls may become inadequate because of
  changes in conditions or deterioration in the
  degree of compliance with associated policies or
  procedures. Because of the inherent limitations
  in a cost-effective control system, misstatements
  due to error or fraud may occur and not be
  detected.
• II-50

12
What is Auditing?

• And who are the consumers?

13
Auditing

• An audit is an evaluation of an organization,
  system, process, project or product.
• performed by a competent, independent, objective,
  and unbiased person or persons, known as
  auditors.
• One purpose is to make an independent assessment
  based on management's representation of their
  financial condition (through their financial
  statements).
• Another purpose of the audit is to ensure the
  operating effectiveness of the internal
  accounting system is in accordance with approved
  and accepted accounting standards, statutes,
  regulations, or practices.
• It also evaluates the internal controls to
  determine if conformance will continue, and
  recommends necessary changes in policies,
  procedures or controls.
• Auditing is a part of quality control
  certifications such as ISO 9000.

14
Financial Audits

• Financial audits are typically performed by firms
  of practicing accountants due to the specialist
  financial reporting knowledge they require.
• The financial audit is an assurance or
  attestation functions provided by accounting
  firms, whereby the firm provides an independent
  opinion on published information.
• Internal auditors, who do not attest to financial
  reports but focus mainly on the internal controls
  of the organization.
• External auditors
• including US's Certified Public Accountant (CPA)
  after which HKs system is patterned, and
• UK's Chartered Certified Accountant (ACCA) and
  Chartered Accountants

15
History

• Independent auditing developed with the expansion
  of the British Empire in the 19th century
• Prior to the 1930s, corporations were required
  neither to submit annual reports to government
  agencies or shareholders nor to have such reports
  audited.
• The 1929 crash initiated to pressure for audit of
  publicly traded companies
• In the UK, the London Association of Accountants
  successfully campaigns for the right to audit
  companies in 1930
• In the US, the Securities Exchange Act of 1934
  required all publicly traded companies to
  disclose certain financial information, and that
  financial information be audited.
• The establishment of the U.S. Securities and
  Exchange Commission (SEC) created a body to
  enforce the audit requirements.

16
History since 1980

• The Pro-business Reagan administration in the US,
  and the Thatcher regime in the UK lifted many of
  the controls over the profession
• Leading to abuses that resulted in the crashes of
  1987 and 2001
• Since then, the Sarbanes-Oxley Act (SOX) has
  forced an expansion of audit responsibility and
  driven up audit revenues (and costs)
• One study estimated the net private cost of SOX
  to amount to 1.4 trillion in the US.
• It is an econometric estimate of the loss in
  total market value around the most significant
  legislative eventsie, the costs minus the
  benefits as perceived by the stockmarket as the
  new rules were enacted.

17
Audit Firms

• The largest accounting firms (the 'Big 4' or
  Final 4) audit nearly all of large
  quoted/listed companies.
• In addition to providing audits, they also
  provide other services including tax advice and
  strategic consultancy
• The 5th largest firm, Grant Thornton, has only
  around 10 of the revenues of KPMG

18
Worldwide Big 4 revenues

• The revenues of the big accounting firms grew by
  a healthy 15 last year.
• They are in effect, the back office of the global
  markets
• They are a private police force hired, fired
  and paid for by company management
• The big four firms employ around half a million
  people

19
Worldwide Big 4 revenues
20
Stages of an auditPlanning and risk assessment

• Timing before year-end
• Purpose
• to understand the business of the company and the
  environment in which it operates.
• to determine the major audit risks (i.e. the
  chance that the auditor will issue the wrong
  opinion).
• For example, if sales representatives stand to
  gain bonuses based on their sales, and they
  account for the sales they generate, they have
  both the incentive and the ability to overstate
  their sales figures, thus leading to overstated
  revenue.
• In response, the auditor would typically plan to
  increase the rigour of their procedures for
  checking the sales figures.

21
Stages of an auditInternal controls testing

• Timing before year-end
• Purpose to assess the internal control
  procedures
• (e.g. by checking computer security, account
  reconciliations, segregation of duties). If
  internal controls are assessed as strong, this
  will reduce (but not entirely eliminate) the
  amount of 'substantive' work the auditor needs to
  do

22
Stages of an auditSubstantive procedures

• Timing after year-end
• Purpose to check that the actual numbers in the
  Income Statement and Balance Sheet (and, where
  applicable, Statement of Changes in Equity and
  Cash Flow Statement) are reliable, by performing
  tests that use the numbers provided.
• Methods
• where internal controls are strong, auditors
  typically rely more on Substantive Analytical
  Procedures (the comparison of sets of financial
  information, and financial with non-financial
  information, to see if the numbers 'make sense'
  and that unexpected movements can be explained)
• where internal controls are weak, auditors
  typically rely more on Substantive Tests of
  Detail (selecting a sample of items from the
  major account balances, and finding hard evidence
  (e.g. invoices, bank statements) for those items

23
Recent Audit Report Card

• In 2005, 174 auditors were inspected by the
  Public Company Accounting Oversight Board (PCAOB)
  
• almost half have been deemed to have some trouble
  doing their job satisfactorily.
• On January 19th 2006, Grant Thornton became the
  latest.
• Fifteen of its audits were found to have
  significant deficiencies and one client had to
  restate at least part of its financial statements
  as a result of the inspection.
• Some audits by the Big Four accounting firms
  have also been found wanting (A few clients of
  each of the four restated their accounts)
• At least 19 of PwC's audits, for instance, were
  found to include deficiencies.
• Most of these failures resulted from accounting
  firms inability to properly audit computer based
  accounting systems

24
New Business Models

• The business of providing high-end temporary
  accounting help is already worth 5 billion a
  year
• Siegfried Group has seen Revenues sextuple in the
  past two years, to 73m.
• In 2003 its core accounting business had just 15
  clients last year it had 100 by the end of May
  it had 155.
• More than 50 of these are among America's largest
  companies.
• Siegfried has even received business from a Big
  Four accounting firm.
• Siegfried's astonishing growth is explained by
  what it does not do consulting and auditing, the
  signature products of the big firms.
• Siegfried is on the other side of the outsourcing
  boom it is an insourcer.

25
Audit Phases

• Planning and risk assessment
• Timing before year-end
• Purpose
• to understand the business of the company and the
  environment in which it operates.
• to determine the major audit risks (i.e. the
  chance that the auditor will issue the wrong
  opinion). For example, if sales representatives
  stand to gain bonuses based on their sales, and
  they account for the sales they generate, they
  have both the incentive and the ability to
  overstate their sales figures, thus leading to
  overstated revenue. In response, the auditor
  would typically plan to increase the rigour of
  their procedures for checking the sales figures.

26
Audit Phases

• Internal controls testing
• Timing before and/or after year-end
• Purpose
• to assess the internal control procedures (e.g.
  by checking computer security, account
  reconciliations, segregation of duties). If
  internal controls are assessed as strong, this
  will reduce (but not entirely eliminate) the
  amount of 'substantive' work the auditor needs to
  do (see below).
• Notes
• In some cases an auditor may not perform any
  internal controls testing, because he/she does
  not expect internal controls to be reliable. When
  no internal controls testing is performed, the
  audit is said to follow a substantive approach.

27
Audit Phases

• Substantive Tests
• Timing after year-end (see note regarding
  hard/fast close below)
• Purpose
• to collect audit evidence that the actual figures
  and disclosures made in the Financial Statements
  are reliable and in accordance with required
  standards and legislation.
• Methods
• where internal controls are strong, auditors
  typically rely more on Substantive Analytical
  Procedures (the comparison of sets of financial
  information, and financial with non-financial
  information, to see if the numbers 'make sense'
  and that unexpected movements can be explained)
• where internal controls are weak, auditors
  typically rely more on Substantive Tests of
  Detail (selecting a sample of items from the
  major account balances, and finding hard evidence
  (e.g. invoices, bank statements) for those items)
  
• Notes
• Some audits involve a 'hard close' or 'fast
  close' whereby certain substantive procedures can
  be performed before year-end. For example, if the
  year-end is 31st December, the hard close may
  provide the auditors with figures as at 30th
  November. The auditors would audit income/expense
  movements between 1st January and 30th November,
  so that after year end, it is only necessary for
  them to audit the December income/expense
  movements and the 31st December balance sheet. In
  some countries and accountancy firms these are
  known as 'rollforward' procedures.

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Audit Phases

• Finalisation
• Timing at the end of the audit
• Purpose
• to compile a report to management regarding any
  important matters the came to the auditor's
  attention during performance of the audit,
• to evaluate and review the audit evidence
  obtained, ensuring sufficient appropriate
  evidence was obtained for every material
  assertion and
• to consider the type of audit opinion that should
  be reported based on the audit evidence obtained.

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Importance of Financial Statements

• Two schools of stock price analysis
• Technical all stock prices are set by trends
  indicated by prior prices
• Fundamental stock prices track the value of
  the firm, which is reported in the financial
  statements
• Audits assure that Financial Statements are
  correct
• Situation before 1930s
• Financial statements were often not even kept
• Misstatement of financial position was common

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What are financial markets?

• And why are audits important to them?

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Financial Markets
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"Simple" auction markets

• The prior four types of auction markets are
  "simple" in the sense that there is
• (1) one seller and several buyers, or
• (2) one purchaser and several suppliers
• They are auctions in the popular sense

43
Matching Mechanisms

• "Double" auction markets
• A double auction assumes there are several market
  participants on both sides of the market who
  publicly announce their demand and supply prices
• The market price (publicly announced) is the one
  that equates supply and demand (i.e., clears)
• Securities exchanges tend to be double auctions.
• Matching Mechanisms

44
"Double" auction markets

• Though more complex, it is argued that
• ï double auction markets are efficient, i.e.,
  that their prices reflect all available (price
  relevant) information
• ï their current prices transmit the private
  information of the better-informed dealers to the
  less-informed, and
• ï these prices correctly aggregate the possibly
  conflicting information available to the
  individual buyers and sellers.

45
Initial Public Offering (IPO)

• Company gives shares to an underwriter, who is
  responsible for finding buyers
• Or can run its own subscription (Google)

46
Financial Publishing

• The most profitable part of the publishing
  industry
• Is financial publishing
• Run by DowJones, etc.
• Financial statements, and reports using financial
  statements are a major input to the Financial
  Publishing industry
• Much of the rest is opinion

47
Secondary Sales

• Subsequent buyers can resell through brokers,
• who will match selling requirements
• limit, market, stop limit, short sale
• with potent buyers
• Called clearing
• Transfer of physical stock certificate, and of
  money are handled by transfer agent / clearing
  house
• Important there must be one central point for
  setting prices, holding all of the demand and
  supply information

48
Commissions

• Who gets them
• Broker
• Exchange
• Clearing house
• But brokers may make markets
• i.e., buy and sell from their own stock of
  securities
• And thus make additional money on markups and
  markdowns of orders

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Internet Trading

• Firms like eTrade are essentially huge brokers
• They have computers and economies of scale
• They can find buyers and sellers cheaper than
  others
• They have huge inventories for market making and
  short sales
• They also have huge databases of research
  reports, financial statements, etc.
• They are a modern alternative to paper publishing
  of financial information

50
 Market Models

• What market models from existing industries can
  provide guidance in investment in electronic
  markets, pricing of services, and delivery of
  "products"?
• At least three groups have an interest in market
  structure
• The market owner-managers
• The buyers, and
• The sellers

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Desirable Market Characteristics

• Fairness Trading is fair if one trader cannot
  systematically profit from another trader
• Efficiency Price should reflect underlying
  value, supply, and demand for a security. It
  should be quickly influenced by new information
  about the security. The speed and completeness
  with which new information is incorporated in
  price is termed the efficiency of the market 

52
Desirable Market Characteristics

• Transparency Fairness and efficiency require
  that information about the security, as well as
  information about offers, sales and the trading
  environment be available to all traders in the
  market. The amount and timeliness with which this
  information is disseminated to traders and
  potential traders is called the transparency of
  trading

53
Desirable Market Characteristics

• Orderly trading Traders derive considerable
  information from price movements in a securities
  markets. Sometimes changes in price alone can
  impel dramatic increases or decreases in price of
  a security. Specialist trading (75 of which must
  counter price trends in the market) and circuit
  breakers (which stop trading if an excessive drop
  in prices is detected) promote order trading on
  the underlying value of securities

54
Desirable Market Characteristics

• Best price discovery The securities exchanges
  also discard the "price-taking" assumption of
  traditional markets, where goods are given a
  price (e.g., on a sticker attached to the
  product, or in a catalog) and the customer can
  either take or leave it. Instead, they support
  the more involved price search involved in
  matching the varying preferences of buyers and
  sellers (supply and demand)

55
Desirable Market Characteristics

• Liquidity. Even where the "price-taking"
  assumption of traditional markets has been
  supplanted by a price discovery, traders would
  still like some assurance that the last price at
  which a security was traded is close to the price
  at which they can trade, and that there is
  sufficient quantity of the security for trade to
  complete the transaction they want at an
  acceptable price. These properties are termed the
  liquidity of securities trading in the market

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"Continuous Market"

• Four aspects of market operation are necessary
  for continuity
• (1) sales must occur frequently enough that
  buyers and sellers do not become impatient,
• (2) the spread between bid and ask offers must be
  narrow,
• (3) bids and asks orders, as well as sales must
  be executed quickly, and
• (4) price changes between transactions should be
  small and recover quickly
• A market which displays these attributes is said
  to be "liquid"
• Liquidity is desirable, and buyers and sellers
  will presumably pay to have a liquid market
•  
•  

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Financing Market Activities

• Financing of the activities in which purchased
  commodities are used becomes less expensive as
  markets become more liquid
• (1) Deliveries can be more closely tailored to
  planned production, thus lowering inventory
  carrying costs, and providing more of the
  advantages of just-in-time inventory management,
  and
• (2) Liquidity facilitates collateral lending
  because assets which can be readily bought and
  sold are generally considered of higher value by
  lenders
• The amount that these producers should be willing
  to pay for liquidity will approach the savings
  from reduced interest and fees on lending, and
  reduced inventory carrying costs.
•  

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Frequency of sales

• This depends on
• The impatience of buyers and sellers, and
• The number of bids and asks (i.e., the amount of
  negotiation) required for each sale
• In on-line trading through computer software
• ... delays of hundredths of a second are normal
  in trades and negotiation
• In any market price changes between transactions
  should be small and recover quickly
•  

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How frequent must trading occur?

• Depends on the commodity
• Usually is related to the lead time required for
  its use
• For example, concrete and steel contracted for a
  highway which will be constructed over the next
  decade need not be traded more than once every
  few months for buyers to consider the market
  sufficiently liquid
• Of the 2200 listed New York Stock Exchange
  securities, probably 50 issues will not be traded
  during a calendar week.

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Fully Electronic Securities Markets

• Fully electronic matching in securities markets
  have operated for years
• ... e.g., Instinet Institutional Networks and
  Crossing Networks provided by Reuters
•  
• These operationalize features of electronic
  commerce
• ... but electronic commerce is having more impact
  on securities markets than the reverse
•  
• Eliminating the privileged positions of market
  makers in stock markets
• ...such as the London Stock Exchange and NASDAQ

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Market Fairness

• Buyers and sellers must be convinced that a
  market is "fair"
• ... i.e., that no one group of buyers or sellers
  can extract wealth at the expense of other buyers
  and sellers
•  
•  

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Liquidity, Fairness and Trading Rules

• In order to attract buyers and sellers to a
  market, market transactions must be liquid on
  four dimensions
• Width is the cost per share, including
  transaction costs and seller profit, of
  liquidity
• Depth is the number of transactions possible at a
  given profit level
• Immediacy refers to the speed at which
  transactions can be completed and
• Resiliency refers to how quickly market prices
  return to equilibrium after a transaction.
• These are all attractive to buyers and sellers
• ...who should be willing to pay the market owners
  to attain them.
• These are all terms from securities markets
• ... but they are important design parameters in
  any electronic market

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Price Setting

• The stated price in a retail market is set to be
  competitive
• The stated price that an auction market sells or
  buys a particular commodity is typically the
  price at which the last trade took place.
• Market prices may be set through two classes of
  mechanisms
• (1) dealer quotes (quote driven), and
• (2) price matching of bid and ask offers (order
  driven)
• Each approach has particular strengths and
  weaknesses

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Quote Driven Price Setting

• Dealers may place their own interests ahead of
  traders
• ... or may "Rat Trade" ó i.e., trade on inside
  information about the actual demand price, at the
  expense of traders
• But every good traded has a price and inventory
  amount posted
• ... which is useful where markets are thinly
  traded

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Two automated securities markets

• National Association of Securities Dealers
  Automated Quotation (NASDAQ) system
• system of electronically linked competing market
  makers
• The New York Stock Exchange (NYSE)
• floor trading system with monopoly market makers
  (specialists) who are obligated to provide
  liquidity
• NASDAQ has no trading floor where market makers
  meet.
• NASDAQ automated a previously sluggish market
• Individual dealers, who kept inventories of
  particular securities, quoted and compared bid
  and asked prices for securities over the
  telephone
• Both systems handle comparable trading volumes
  (around 50 billion shares annually)
• NASDAQ share value averages only about one-third
  of NYSE share value

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Prices are not enough

• There would still be conflicting claims to a
  particular stock of a commodity
• ...if price was the only basis for order
  completion
• To prevent over-commitments and imbalances,
  orders are also completed based on
• Time (first bid at a particular price wins the
  trade)
• Size of order
• Type of trader placing the order
• Etc.

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Types of Traders

• Buyers and sellers (or traders) may participate
  in an electronic market for various reasons
• If the market is to profit from fees based on
  market use (the most commonly suggested way of
  funding electronic commerce)
• then it must cater to traders who, as a group,
  provide the greatest potential dollar and
  transaction volumes of trades
• Traders fall into two broad groups
• (1) those who participate in order to buy the
  product ó call them value motivated, and
• (2) those who participate in order to speculate
  on future price ó call them speculators

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Electronic Wholesaling

• Despite current focus on electronic retailing
• ... the greatest volume of trading occurs in the
  market for raw materials and intermediate
  production factors
• ... i.e., electronic wholesaling
• Both will probably be important in the future
• Electronic retailing provides retailers greater
  reach, pervasiveness and access to customers than
  a retail store
• Electronic wholesaling provides producers with an
  efficient market for factors

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Types of Orders in Order Driven Securities Markets

• Limit Buyer specifies the highest price that can
  be paid, or seller specifies the lowest price
  that can be accepted
• Market Filled immediately at the best possible
  price
• Stop Becomes a market order stock reaches a
  certain (stop) price (sell order stop price
  buy order stop price)
• Time Limited An order which expires after a
  specified period (e.g., one day, one week)
• All-or-None Fill the entire order or none

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Brokers

• Because of restrictions on membership, traders
  wishing to buy or sell a specific security must
  contract with a member (for a commission) to
  represent them as an agent, or broker, on the
  trading floor.
• Membership itself is a commodity which may be
  used, sold, or leased by the member.
• The high cost of membership (membership, or a
  seat, has recently sold in the range of 300
  thousand to 500 thousand) means that members are
  typically corporations or partnerships, and may
  serve several functions on the floor. Three of
  these functions are particularly important

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Commission Brokers

• The largest number of members are commission
  brokers
• These members represent securities firms (e.g.,
  firms such as Merrill Lynch and Shearson, Lehman)
  that deal with the public at large, gathering
  orders off the NYSE floor
• The main job of commissioned brokers is to get
  the best possible price for the customer

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Specialists

• The second largest number of members are
  specialists a special group of brokers designated
  to maintain a fair and orderly market
• The specialist is a dealer (i.e., deals from his
  own inventory of securities)
• ...and is obligated, on 75 of transactions for
  his own account, to trade counter to the market
  trend
• This typically results in losses to the
  specialist (which must be made up in the
  remaining 25 of trades) but keeps the market
  "continuous."

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Floor Brokers

• The third largest number of members are floor
  brokers.
• Floor brokers work only for other members, taking
  transactions which they are incapable of handling
  at the moment.
• Automation of order acquisition through SuperDOT
  has also decreased the importance of actually
  being present on the floor to trade

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Automation Reporting of Market Information

• Automation began with the invention of the stock
  ticker in 1867
• The stock ticker allowed rapid circulation of
  securities price quotations
• ...but the first stock tickers were slow and
  unreliable, and made few inroads against the Wall
  Street messenger boys.
• Thomas Edison (recently fired from his railroad
  job for operating an unauthorized chemical
  laboratory in the baggage car)
• ... was making a temporary home in the Exchange's
  boiler room

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Thomas Edison

• He was able to repair the ailing stock ticker and
  was promptly hired at 300 a month by the owner
  of the ticker service to manage the shop that
  made the machines
• Edison subsequently made improvements in the
  efficiency and reliability of the stock ticker
  which made it a viable option for information
  dissemination
• Ticker tape is no longer used for market
  information dissemination
• Market history is maintained on the consolidated
  tape

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Importance of the Ticker

• In order to attract order flow, a market must
  provide real-time information on orders to buy or
  sell shares which have been placed
• Some information, such as the identity of
  traders, probably should not be displayed
• If trader identity were displayed, then sellers
  might take advantage of a large buy order by
  raising the price
•  

77
Potential for Manipulation

• Certain types of manipulation are likely to be
  both prevalent and damaging to electronic
  commerce
• Wash sales A sale in which the owner sells a
  quantity of product to a buyer who sells it back
  at a contrived (usually higher) price. A wash
  sale involves no real change of ownership, but
  attempts to manipulate price, and misinform other
  traders. As other traders offer a higher price
  for the product, the owner can sell at a profit.
• Artificial market activity This is similar to a
  wash sale, with the same intent, but involving
  more than two traders. Groups of traders (often
  including management from the firms of traded
  securities) "churn" stocks to artificially set
  price, and profit by that artificial price
•  

78
Potential for Manipulation

• Matched orders Matched orders exist when two or
  more traders collaborate by placing offsetting
  orders with two different brokers (to hide the
  activity), for example to buy 1000 shares at 35,
  and to sell 1000 shares at 35. If the price
  without this trade is 30, then the effect is to
  misinform the market about the value of the
  security
• Circulation of manipulative information for a
  remuneration Certain individuals, e.g.,
  newscasters and columnists, are held in trust by
  the public, and thus have the ability to
  manipulate the perceived value of a product. If
  they do this for remuneration, to the advantage
  of specific traders, then they abuse that trust,
  and misinform the trading public at large