Volume 12, Number 1, 2003
Such names as Enron, Worldcom and Adelphia suggest more than just last year's financial scandals. They have entered the popular culture as metaphors for the disastrous combination of corporate greed and financial mismanagement that continues to haunt financial markets.
One of the outcomes of these corporate failures, financial analysts say, has been an increased awareness of the need to examine the quality of a corporation's reported earnings and the audits used to certify them.
But, even without the lesson of the recent financial and accounting scandals, such issues should always be of primary importance, according to Uma Velury, assistant professor of accounting in the Alfred Lerner College of Business and Economics.
"Earnings quality must be examined constantly, irrespective of what kind of period we are
in," she says. "In a bullish market, people tend to ignore the quality of earnings--with unfortunate consequences, as we've seen. In a bearish market like today's, people are much more critically focused on the fundamentals."
Since joining the College faculty in 1999, Velury has researched audit quality and corporate governance issues to provide a better understanding of the relationships that exist among corporations, their financial auditors and the groups that oversee the audits.
She has looked at corporations with high institutional ownership, such as those with large investments by mutual funds or pension funds, for example. Velury's research examines whether those corporations' reported earnings are of a better quality than those of corporations with low institutional ownership.
In most cases, she says, the answer is yes. She has found that sophisticated shareholders are indeed more likely to demand a high-quality audit that will withstand public scrutiny.
Another issue Velury has addressed is the question of what constitutes a high-quality audit. "As you know, it's not always easy to determine whether audit quality is high or low," she says. "To find a measure, I look at the quality of the earnings numbers. One of my projects involves examining the quality of earnings to assess the performance of a certain type of auditor, in this case the industry specialist."
Quality of earnings has a specific meaning that relates to the usefulness of the information presented in a financial statement. Components recognized by the Financial Accounting Standards Board include predictive value, feedback value, timeliness, verifiability, neutrality and representational faithfulness. Based on this definition, Velury says, her findings show that having a specialist auditor does not automatically guarantee a higher quality of reported earnings.
Particularly in the case of highly leveraged corporations, clients of specialist auditors are just as likely as those of non-specialists to "manage earnings," Velury says. That "managing" process, she explains, occurs when an auditor makes changes in financial structuring and earnings reporting that, while in accord with generally accepted accounting principles, present an enhanced picture of the company's income. The resulting picture might--and might even be intended to--mislead shareholders about actual financial performance.
Although using specialist auditors produces superior results in many cases, Velury says, "Audit quality is not obvious or visible." Therefore, additional monitoring by independent boards and audit committees is needed, she says.
"There are still many unanswered questions regarding auditors and audit quality that need further research," she adds, "but shareholders, especially large shareholders, can play a crucial part in ensuring that firms have adequate checks in place."
Consistent with her interest in current issues, Velury also is investigating the topic of financial distress.
"A lot of work has been done in this area, but the models used have not always been well developed," she says. "I am working with a colleague on new research that employs a heuristic model based on a firm's ability to raise capital or, at least, have access to it. We are trying to develop a simple method of predicting financial distress and the likelihood of a firm emerging from distress intact."
Velury says she emphasizes the importance of all these issues in the courses she teaches, notably advanced accounting and financial statement analysis.
"Every student needs to be aware of the practice of earnings management and how to extract the information that is contained in financial reports," she says. "If we learn how to recognize and use the information provided, we can 'undo' many aspects of earnings management and avert the kinds of accounting problems that we've seen in the past few years."
--Mary Jane Pahls