Ethics and Sustainability in Accounting and Finance, Volume II 9811519277, 9789811519277

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Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application

Kıymet Tunca Çalıyurt Editor

Ethics and Sustainability in Accounting and Finance, Volume II

Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application Series Editor Kıymet Tunca Çalıyurt, Iktisadi ve Idari Bilimler Fakultes, Trakya University Balkan Yerleskesi, Edirne, Turkey

This Scopus indexed series acts as a forum for book publications on current research arising from debates about key topics that have emerged from global economic crises during the past several years. The importance of governance and the will to deal with corruption, fraud, and bad practice, are themes featured in volumes published in the series. These topics are not only of concern to businesses and their investors, but also to governments and supranational organizations, such as the United Nations and the European Union. Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application takes on a distinctive perspective to explore crucial issues that currently have little or no coverage. Thus the series integrates both theoretical developments and practical experiences to feature themes that are topical, or are deemed to become topical within a short time. The series welcomes interdisciplinary research covering the topics of accounting, auditing, governance, and fraud.

More information about this series at http://www.springer.com/series/13615

Kıymet Tunca Çalıyurt Editor

Ethics and Sustainability in Accounting and Finance, Volume II

Editor Kıymet Tunca Çalıyurt Trakya University Edirne, Turkey

ISSN 2509-7873 ISSN 2509-7881 (electronic) Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application ISBN 978-981-15-1927-7 ISBN 978-981-15-1928-4 (eBook) https://doi.org/10.1007/978-981-15-1928-4 © Springer Nature Singapore Pte Ltd. 2021 This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Singapore Pte Ltd. The registered company address is: 152 Beach Road, #21-01/04 Gateway East, Singapore 189721, Singapore

Acknowledgements

As the founder of the International Group on Governance Fraud Ethics and CSR, I would like to dedicate this book to the distinguished academician, father of informal economy in Turkey, one of the best professors on informal economy in the world, Prof. Dr. Osman Altu˘g. Professor Dr. Osman Altu˘g was my professor in master and doctorate on accounting and finance and also master and Ph.D. advisor in Marmara University. Being a student of Prof. Dr. Osman Altu˘g is a very important privilege in Turkey. I’m so lucky to have that privilege. As a professor of accounting, he supported his students with a deep knowledge and culture of accounting, trade law, economics and social policy. But above all, he teaches his students how to serve the public, people, economy, production and business world fairly.

Prof. Dr. Osman Altu˘g, keynote speaker Conference by Accounting, Finance Student Club, Trakya University

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Acknowledgements

I would like to introduce him with a short biography. Professor Dr. Osman Altu˘g was born in Yozgat, Turkey, in 1946. He completed his primary school in Cankurtaran, ˙ Istanbul. He won one for best elementary school in Turkey, Istanbul Erkek Lisesi (now Istanbul High School). He graduated from Beyo˘glu Commerce High School. His bachelor degree (1968) and Ph.D. degree (1972) are from Istanbul Academy of Economy and Commercial Sciences. He assigned as Associate Professor in 1978

Acknowledgements

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to Istanbul Academy of Economics and Commercial Sciences and professorship in Marmara University (1988). His academic interests are cost accounting and informal economic activity. He has published many books on cost accounting, informal economy, accounting law relations. Turkey’s best-known accounting professor Prof. Dr. Osman Altu˘g advised many politicians, governmental institutions and non-governmental organisations. Professor Altu˘g led to the signing of the first collective agreement between employers and workers in Turkey. He introduced himself “While I was studying in high school, I was also working. While working in the factory, I learned to produce and share. I’ve always graduated schools in the first line”. I m very lucky that I am a student of Prof. Dr. Osman Altu˘g since 1986. I would like to thank to my distinguished professor for his support to his students, academia and economy. Kıymet Tunca Çalıyurt, CFE, CPA Book Series Editor

Contents

1

Introduction Chapter: Why It Is Time to Talk About Fraud Quadrangle: Negative Pressure, Unethical Rationalization, Unsufficient Control-Auditing, and Moral Erosion . . . . . . . . . . . . . . . Kıymet Tunca Çalıyurt

Part I 2

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4

1

Ethics and Sustainability in Finance and Risk Management

Investigation of the Effects of Environment on Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Engin Demirel and ˙Ilknur Eskin

19

An Empirical Investigation of the Determinants of Market Efficiency in Borsa Istanbul . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yusuf Varlı and Ebubekir Sıddık Sahin ¸

39

Impact of Non-financial Disclosure Scores on the Cost of Equity Capital: Evidence from European Data in the Light of the Subprime Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Jocelyn Husser and Elisabeth Paulet

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Profile of the Entrepreneur of Triunfo-Pe Counters . . . . . . . . . . . . . . . Cristina Glória Lima da Silva, Zaidiana Lemos Zaidan, Emanuel Ferreira Leite, and Emmanuelle Leite Cientista

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6

Value Relevance of Intangibles: A Literature Review . . . . . . . . . . . . . 109 Ömer Faruk Güleç

7

Risk Management in the Insurance Company . . . . . . . . . . . . . . . . . . . . 131 Tzvetelina Andreeva

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Contents

Part II

Ethics and Sustainability in Banking

8

Evaluating the Effectiveness of the Coordination Between Internal Control and Internal Audit: A Survey-Based Analysis on Turkish Banking Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Mustafa Tevfik Kartal and Serpil Kılıç Depren

9

Indian Banking Scenario and SBI Mega-Merger . . . . . . . . . . . . . . . . . 161 Renu Jatana and Mehjabeen Barodawala

10 Definition and Classification of Financial Statement Fraud . . . . . . . . 173 Iavor Bachev Part III Ethics and Sustainability in Accounting 11 Islamic Finance and Sustainability Reporting: The Mediator Role of Green Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199 Adel M. Sarea 12 Sustainability Accounting in Turkey . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207 Birsel Sabuncu 13 The Effects of Digital Transformation Process on Accounting Profession and Accounting Education . . . . . . . . . . . . . . . . . . . . . . . . . . . 219 Bilal Zafer Berikol and Mustafa Killi Part IV Ethics and Sustainability in Auditing 14 Evaluation and Rating of Corporate Governance and Internal Auditing in Turkish Public Companies . . . . . . . . . . . . . . . . . . . . . . . . . . 235 Arzu Cevahir and Kıymet Tunca Çalıyurt 15 New Paradigm in Auditing: Continuous Auditing . . . . . . . . . . . . . . . . 253 Hülya Boyda¸s Hazar 16 Enhancing Risk Management Procedures in Audit Firms: Acceptance & Continuance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 Stoyan Deevski Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279

Editor and Contributors

About the Editor Prof. Dr. Kıymet Tunca Çalıyurt, CPA, CFE graduated from the Faculty of Business Administration at Marmara University, Istanbul, Turkey. Her master’s and Ph.D. degrees are in accounting and finance programme from the Social Graduate School, Marmara University. She has worked as auditor in Horwath Auditing Company, Manager in McDonalds and finance staff in Singapore Airlines. After vast experience in private sector, he has started to work in academia. She is holding CFE and CPE titles. Her research interests are in accounting, auditing, fraud, social responsibility, corporate governance, finance and business ethics, with a special interest in aviation management, NGOs, women rights in business. She has been as visiting researcher in Concordia University, Canada, and Amherst Business School, Massachusetts University, USA. She is the founder of the International Group on Governance, Fraud, Ethics and Social Responsibility (IGonGFE&SR) which was founded in 2009. In 2009, she also founded the International Women and Business Group, which organizes a global, annual conference. Kiymet has published papers, chapters and books both nationally and internationally on fraud, social responsibility, ethics in accounting/finance/aviation disciplines in Springer and Routledge. She is book series editor in Springer with the title Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, and book series editor in Routledge with the title Women and Sustainable Business. Some book titles are the following: Emerging Fraud; Corporate Governance: An International Perspective; Women and Sustainability in Business: A Global Perspective; Sustainability and Management: An International Perspective; Globalization and Social Responsibility; Regulations and Applications of Ethics in Business Practice; and Ethics and Sustainability in Accounting and Finance, Volume I. She is acting as Member in Editorial Board, Journal of Financial Crime, International Journal on Law and Management, Journal of Money Laundering Control. She is regular speaker at International Economic Crime Symposium in Jesus College, Cambridge University. She is partner of Herme Consulting in Trakya University Technopark.

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Editor and Contributors

Contributors Tzvetelina Andreeva Finance Account Faculty, Finance Department, University of National and World Economy, Sofia, Bulgaria Iavor Bachev University of National and World Economy, Sofia, Bulgaria Mehjabeen Barodawala Department of Banking & Business Economics, UCCMS, MLS University, Udaipur, Rajasthan, India Bilal Zafer Berikol Business Administration Department, Faculty of Kozan, Çukurova University, Adana, Turkey Kıymet Tunca Çalıyurt Accounting and Finance Division, Business Administration Department, Trakya University, Edirne, Turkey Arzu Cevahir Trakya University, Edirne, Turkey Emmanuelle Leite Cientista Social Mestre em Antropologia, Universidade Federal de Pernambuco, Recife, Brazil Cristina Glória Lima da Silva Faculdade de Integração do Sertão-FIS, Vila Canaã Triunfo-Pernambuco, Brazil Stoyan Deevski University of National and World Economy, Sofia, Bulgaria Engin Demirel Trakya University, Edirne, Turkey Serpil Kılıç Depren Statistics Department, Yildiz Technical University, Istanbul, Turkey ˙ Ilknur Eskin Trakya University, Edirne, Turkey Ömer Faruk Güleç Kırklareli University, Kırklareli, Turkey Hülya Boyda¸s Hazar Department of Business Administration, Istanbul Aydin University, Istanbul, Turkey Jocelyn Husser IAE Aix Marseille Chemin de la Quille, CS Puyricard, France Renu Jatana Department of Banking & Business Economics and Associate Dean UCCMS, MLS University, Udaipur, Rajasthan, India Mustafa Tevfik Kartal Borsa ˙Istanbul Strategic Planning and Investor Relations Directorate, Istanbul, Turkey Mustafa Killi International Trade and Logistic Department, Osmaniye Korkut Ata University (OKÜ), Osmaniye, Turkey Emanuel Ferreira Leite Faculdade de Ciências da Administração de Pernambuco, Universidade de Pernambuco, Pernambuco, Brazil Elisabeth Paulet ICN Business School, CS Nancy, France

Editor and Contributors

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Birsel Sabuncu Pamukkale University, Denizli, Turkey Ebubekir Sıddık Sahin ¸ TOBB Economy and Technology University, Ankara, Turkey Adel M. Sarea Accounting and Economics, Ahlia University, Manama, Kingdom of Bahrain Yusuf Varlı Istanbul Bilgi University and London School of Economics, Istanbul, Turkey Zaidiana Lemos Zaidan Faculdade de Integração do Sertão-FIS, Serra Talhada, Pernambuco, Brazil

List of Figures

Fig. 1.1 Fig. 1.2 Fig. 1.3 Fig. 1.4 Fig. 1.5 Fig. 1.6

Fig. 1.7

Fig. 1.8 Fig. 1.9

Fig. 1.10 Fig. 3.1

Fig. 3.2 Fig. 3.3

Fig. 3.4

Fig. 3.5

The fraud triangle. Source Dorminey et al. (2012) . . . . . . . . . . . . The fraud triangle. Source Dorminey et al. (2012) . . . . . . . . . . . . What anti-fraud controls are most common? Source The 2020 Report to the Nations, p. 31 . . . . . . . . . . . . . . . . . . . . . . . . . How has the use of anti-fraud controls changed over the last decade? (ACFE 2020, 32) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Perpetrator’s department (ACFE 2020, 40) . . . . . . . . . . . . . . . . . . Logo Ashby farmers elevator cooperative. Source https://www.agweek.com/business/agriculture/4515868-ashbyco-op-members-authorize-board-sell . . . . . . . . . . . . . . . . . . . . . . . Logo Theranos. https://www.agweek.com/business/ agriculture/4515868-ashby-co-op-members-authorizeboard-sell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Logo Ted Baker. https://www.tedbaker.com/uk . . . . . . . . . . . . . . The new structure and drafting convention for the code establishes a new emphasize the code’s scalability (IFAC 2018) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fraud quadrangle (The term “Fraud Quadrangle” was used for the first time in literature by Kiymet Prof Caliyurt) . . . . . . . . The performance of Borsa Istanbul regarding the characterization of efficiency between 2008 and 2012. Source Authors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inverse roots of AR characteristics polynomial for individuals (left) and institutions (right) . . . . . . . . . . . . . . . . . Response of efficiency to various shocks on the determinants from the side of individual investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Response of efficiency to various shocks on the determinants from the side of institutional investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variance decomposition to each determinant for individuals . . . .

3 4 5 6 6

7

8 9

12 14

44 51

56

57 58 xv

xvi

Fig. 3.6 Fig. 5.1

Fig. 5.2 Fig. 5.3 Fig. 5.4 Fig. 5.5 Fig. 5.6 Fig. 9.1 Fig. 9.2 Fig. 10.1 Fig. 10.2 Fig. 10.3 Fig. 10.4 Fig. 10.5 Fig. 10.6 Fig. 11.1 Fig. 14.1 Fig. 16.1 Fig. 16.2

List of Figures

Variance decompositions to each determinant for individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Opportunity Entrepreneurship x Necessity [Good oppurtunity x Financial need. Interviewed A, B and C. Identifying a good opportunity. Financial need]. Source Research data 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Motivation for achievement. Source Research data 2015 . . . . . . . Self-control. Source Research data, 2015 . . . . . . . . . . . . . . . . . . . Propensity to take risks. Source Research data 2015 . . . . . . . . . . Problem-solving. Source Research data 2015 . . . . . . . . . . . . . . . . Influencers. Source Research data 2015 . . . . . . . . . . . . . . . . . . . . SBI logo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Key challenges faced by SBI merger . . . . . . . . . . . . . . . . . . . . . . . Categorization of fraud by perpetrator (adapted from classification by ACFE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fraud for and against the company (Jans et al. 2009) . . . . . . . . . . Financial statement fraud in relation to other categories (ACFE 2010) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fraud frequency by category (ACFE 2014) . . . . . . . . . . . . . . . . . Fraud types median loss (ACFE 2016) . . . . . . . . . . . . . . . . . . . . . Profit manipulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Research model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . COSO internal control elements (COSO Cube) . . . . . . . . . . . . . . Summary of client acceptance process. Source Author . . . . . . . . Summary of engagement acceptance process. Source Author . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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99 100 101 101 102 103 164 169 175 178 179 180 181 187 203 238 275 277

List of Tables

Table 2.1 Table 2.2 Table 2.3 Table 3.1 Table 3.2 Table 3.3

Table 3.4 Table 3.5 Table 3.6 Table 4.1 Table 4.2 Table 4.3 Table 4.4 Table 4.5 Table 4.6 Table 4.7 Table 4.8 Table 4.9 Table 4.10 Table 4.11 Table 5.1 Table 5.2 Table 5.3 Table 5.4 Table 6.1

Area of interest in environmental accounting and interested group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Possible classification table of environmental costs . . . . . . . . . . Classification according to functional expenditure of environmental costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data descriptions and Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . Three different regression analysis for individual and institutional investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unit root test results (Augmented Dickey-Fuller—ADF) for individual investors and institutional investors (H0: Non-stationary) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diagnostic test results for individual and institutional investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granger causality test for individual investors . . . . . . . . . . . . . . Granger causality test for institutional investors . . . . . . . . . . . . . Firm characteristics for the period 2006–2008 . . . . . . . . . . . . . . Firm characteristics for the period 2009–2011 . . . . . . . . . . . . . . ESG disclosure scores for the period 2006–2008 . . . . . . . . . . . . ESG disclosure scores for the period 2009–2011 . . . . . . . . . . . . Descriptive statistics—COC . . . . . . . . . . . . . . . . . . . . . . . . . . . . COC and disclosure scores from 2006 through 2008 . . . . . . . . . COC and disclosure scores from 2009 through 2011 . . . . . . . . . Correlation matrix from 2006 through 2008 . . . . . . . . . . . . . . . . Correlation matrix from 2009 through 2011 . . . . . . . . . . . . . . . . The influence of COC compensation on disclosure scores . . . . COC and ESG Scores: dynamic panel data estimates . . . . . . . . Characteristics of the entrepreneur profile . . . . . . . . . . . . . . . . . Skills for the entrepreneur potential . . . . . . . . . . . . . . . . . . . . . . List of skills related to the questions . . . . . . . . . . . . . . . . . . . . . . Average of entrepreneurial skills . . . . . . . . . . . . . . . . . . . . . . . . . Summary of the literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23 27 28 42 47

50 51 53 54 69 69 70 70 72 74 75 76 77 78 78 92 94 97 103 124 xvii

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Table 7.1 Table 8.1 Table 8.2 Table 8.3 Table 8.4 Table 8.5 Table 8.6 Table 9.1 Table 9.2 Table 10.1 Table 10.2 Table 10.3 Table 11.1 Table 11.2 Table 12.1 Table 13.1 Table 13.2 Table 13.3 Table 14.1 Table 14.2 Table 14.3 Table 14.4

List of Tables

Existence of technical reserves is a factor that affects the insurance-technical risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Some selected studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Descriptive statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Distribution of the issues in the context of branch credit audit by department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Distribution of the issues in the context of branch operations audit by department . . . . . . . . . . . . . . . . . . . . . . . . . . Distribution of the issues in the context of other branch audit by department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Coordination of audit works by department . . . . . . . . . . . . . . . . Structure of Indian banking sectors . . . . . . . . . . . . . . . . . . . . . . . List of bank mergers after 1991 . . . . . . . . . . . . . . . . . . . . . . . . . . Features of fraudsters (Ozkul and Pamukcu 2012) . . . . . . . . . . . General fraud schemes related to revenue . . . . . . . . . . . . . . . . . . Inventory manipulation schemes . . . . . . . . . . . . . . . . . . . . . . . . . Validity and reliability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Model results and analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . List of companies included in the index for the period November 2018–October 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . Characteristics of digital economy . . . . . . . . . . . . . . . . . . . . . . . Profession groups that are the most suitable to automation . . . . New curriculum recommendation . . . . . . . . . . . . . . . . . . . . . . . . Mandatory and recommended basic criteria related to internal audit activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic criteria where the level of compliance is low . . . . . . . . . . Levels of compliance with eligibility criteria . . . . . . . . . . . . . . . Compliance levels of companies with eligibility criteria in Tur˘gay’s study (2013) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

134 145 149 151 152 153 154 163 165 177 189 191 203 204 215 221 225 228 244 245 247 248

Chapter 1

Introduction Chapter: Why It Is Time to Talk About Fraud Quadrangle: Negative Pressure, Unethical Rationalization, Unsufficient Control-Auditing, and Moral Erosion Kıymet Tunca Çalıyurt Abstract Changing codes, tightening laws, more disclosures, more control, additional software programs, additional reports….These new legal and initiative requirements against fraud, unfortunately, didn’t stop it in the business world. The solutions we have built on the “fraud triangle” in the business world for years couldn’t help decreasing fraud. Accepted fraud triangle in management and business with the corners; Negative Pressure, Unethical Rationalization, Unsufficient Control-Auditing should be redesign again as Fraud Quadrangle with a new corner named “Moral Erosion”. It’s time to talk about “Behavioral Fraud”, which is new but trending research area in academia. Accountants and auditors usually don’t like to talk about something out numbers, standards, laws like “behavioral”. And it is also completely a different specialization. Accountants, auditors adhere to laws and standards that there are no emotions and initiatives in their world however they have been talking about interdisciplinary issues such as biological risk, climate change, artificial intelligence recently. “Behavioral Fraud” is a new area that needs to be focused on and discussed by researchers in the specialization of accounting, auditing, computer science, auditing law, human resources and statistics. Behavioral Fraud will also lead new discussions on a static and dynamic approaches to leveraging biometrics for fraud detection. New Fraud Quadrangle will help us why some people like and succeed to cheat while others don’t or can’t in the same conditions. Keywords Fraud quadrangle · Business ethics · Behavioral fraud · Behavioral biometric technology

K. T. Çalıyurt (B) Accounting and Finance Division, Business Administration Department, Trakya University, Edirne, Turkey e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_1

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K. T. Çalıyurt

Abbreviations ACFE CEO CFE CMA FTSE GE IESBA IFAC IRS NOCLAR PA PAIBs PAPPs SEC SOX

Association of Certified Fraud Examiners Chief Executive Officer Certified Fraud Examiner Certified Management Accountant Financial Times Stock Exchange General Electric International Ethics Standards Board for Accountants International Federation of Accountants Internal Revenue Service Non-Compliance with Law and Regulations Public Accountant Public Accountant in Business Public Accountant in Public Practice Securities and Exchange Commission Sarbanes Oxley Act

1.1 Introduction If you ask a room full of midcareer professionals whether they have committed a crime in the past week, almost no one will respond (and perhaps understandably so). Some will be offended by the very nature of the question. But if you then ask them whether they drove just one mile over the speed limit in the past week, they will become sheepish. “Of course,” they will reply, “but it was only a couple of miles an hour. The cops don’t care.” That may be true, but legally speaking, it is a violation of well-understood traffic laws—and therefore a crime. In most cases, it may be unintentional (speedometers tend to be subject to margins of error), but in cases of reckless driving, intentional violation of traffic laws unambiguously makes it a crime. (Ramamoorti et al. 2013)

It shows that despite the SOX which was promulgated to stop fraud in business which was peaked in the 2000s, unethical behaviors in business continue without slowing down. Even if auditing standards1 direct auditors to consider consulting with forensic specialists on certain audit engagements to enhance the detection of material fraudulent financial reporting (Asare and Wright 2018), this regulation is only applicable in the USA. In the rest of the world where there are no similar regulations; announcing fraud case by exposed companies is not an easy decision

1 e.g.,

AICPA 2002, 50; AICPA 2012a, 29a; AICPA 2012b; IAASB 2009; PCAOB 2010a, 2010b, 2010c American Institute of Certified Public Accountants (AICPA). 2002. Consideration of Fraud in a Financial Statement Audit. Statement on Auditing Standards No. 99 (Supersedes SAS No. 82). New York, NY: AICPA.

1 Introduction Chapter: Why It Is Time to Talk About Fraud …

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because of its destructive results, furthermore consulting with forensic specialists by an auditor is extremely unrealistic because of its costs to auditing budget. In normal times, companies lose 6% of their revenues to fraud. In the Covid times, as CFEs, we all know that fraud will be increased and new branches will be added to fraud tree related to covid-fraud. The behavioral side of fraud should be discussed by academia and practitioners.In this chapter, our research questions are here: • Is the fraud triangle sufficient to prevent fraud? • Why do some workers behave ethically in all situations while others cheat their companies? Cressey’s (1950, 1953) work on trust violation was seminal in nature, yet represented only the first of many steps toward developing our understanding of whitecollar crime. work on trust violation was seminal in nature, yet represented only the first of many steps toward developing our understanding of white-collar crime (Fig. 1.1). A corollary to the Fraud Triangle is the lesser-known Triangle of Fraud Action, sometimes referred to as the Elements of Fraud (Albrecht et al. 2006; Kranacher et al. 2011). While the Fraud Triangle identifies the conditions under which fraud may occur, the Triangle of Fraud Action describes the actions an individual must perform to perpetuate the fraud (Fig. 1.2). Theoretical models surrounding behavioral aspects of the fraud perpetrator originated in the 1940s and 1950s, and are grounded in the early works of Edwin Sutherland and Donald Cressey Later insights, such as the Fraud Scale (Albrecht et al. 1984) and the Fraud Diamond (Wolfe and Hermanson 2004), incrementally add to our understanding of fraud. Ramamoorti (2008) makes a strong case for the integration of additional behavioral sciences content, including psychology, sociology, criminology, and anthropology, into accounting and anti-fraud curricula. Incidents such as trust violation, motivation, deception, and rationalization are part of human Fig. 1.1 The fraud triangle. Source Dorminey et al. (2012)

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Fig. 1.2 The fraud triangle. Source Dorminey et al. (2012)

behavior that must be incorporated into the study of fraud. A similar argument can be made for further examination of technology in anti-fraud efforts. Among the 18 proactive activities for fraud prevention announced by ACFE 2020 report, two activities are; • to teach auditors, accountants the importance of ethics in daily business, • to train human resources department staff to recruit ethical staff for the companies should be focused on by researchers and practitioners. We see that IFAC, IESBA renews its code of ethics to prevent unethical behavior in the accounting world. The reason for the renewal of the code of ethics for accountants is to prevent unethical erosion among the accounting and auditing practitioners. When we take a quick look at the accounting scandals between 2018 and 2020, we see how ethical code renewal is important, but not enough. Laws, regulations, and other written papers are not enough against fraud caused total losses of more than $3.6 billion annually. So we need to discuss on new approaches and dimensions like Behavioral Biometrics in fraud. According to the survey results of ACFE Report to the Nations, 18 common antifraud controls in the victim organization were listed in report. Figure 1.1 shows that independent external audits of the organization’s financial statements are the most common of the controls examined in the survey; 83% of the victim organizations had their financial statements audited by an outside auditor. While ACFE classifies such audits as an anti-fraud control for purposes of our study, it is important to note that this mechanism is not primarily designed to detect or prevent all frauds. Other common anti-fraud controls include a code of conduct (present in 81% of victim organizations), an internal audit department (74%), and management’s certification of the financial statements (73%) (ACFE 2020) (Fig. 1.3). In the same report, it is mentioned that (page 19), external auditing is not successful to detect fraud. Only 4% of frauds were detected by external auditors. While implementing controls to prevent and detect fraud is a necessary part of managing fraud risk, not all anti-fraud controls are created equally. To help organizations understand

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Fig. 1.3 What anti-fraud controls are most common? Source The 2020 Report to the Nations, p. 31

the potential impact of various controls, ACFE compared the median losses and median durations of the frauds in their report based on whether each specific control was present at the victim organization during the fraud’s occurrence. Over the last ten years of the studies, four of the controls—have seen a consistent and notable increase in implementation rates. These controls are among those most commonly associated with a robust anti-fraud program, which indicates that increasing numbers of organizations are taking the threat of fraud seriously and implementing measures specifically designed to help them mitigate these risks (Fig. 1.4). In ACFE Report 2020, a heat map is showing the frequency and median loss of fraud schemes based on the perpetrator’s department (Fig. 1.5).

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Fig. 1.4 How has the use of anti-fraud controls changed over the last decade? (ACFE 2020, 32)

Fig. 1.5 Perpetrator’s department (ACFE 2020, 40)

1.2 Recent Accounting Frauds in Business World CASE 1 Hennessey, who had managed the 307,000-bushel capacity grain facility since 1989, is accused of stealing more than $5 million from the elevator. As early as 2003, he began writing checks to himself coded as soybean, wheat, and corn purchases to disguise their true nature. The deception escalated from there. Unauthorized checks signed by Hennessey included at least $1.4 million to his personal credit cards with the majority paid to his Cabela’s account, over $500,000 for taxidermy services, and more than $2 million toward hunting trips to Alaska, South Africa, New Zealand, and Australia. Federal prosecutors believe the checks written from the co-op’s account added up to approximately $5.3 million, which Hennessey did not dispute (Bedord 2019). Erik Ahlgren, lawyer for Ashby Farmers Elevator Cooperative, on Oct. 15, 2018, tells members that he has filed a civil suit against former general manager Jerry

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Fig. 1.6 Logo Ashby farmers elevator cooperative. Source https://www.agweek. com/business/agriculture/ 4515868-ashby-co-op-mem bers-authorize-board-sell

Hennessey and his wife, Rebecca, and has urged a Federal Department of Justice to investigate possible criminal bank fraud. Seated second from left is Russell Dewey, the co-op’s board chairman (Ferguson 2019). His sentencing is scheduled for June 21, 2019, at the federal courthouse in Fergus Falls, Minnesota. Hennessey could serve 6½ to 8 years in federal prison, according to court documents. In addition, he would have to pay up to $250,000 in fines and restitution of $6.5 million to victims and the IRS (Bedord 2019) (Fig. 1.6). What are the reasons for this fraud? – The elevator failed to supply financial audits to CoBank, who had been doing business with the elevator since 1985. – The board of directors put too much trust in Hennessey. – A financial audit or review was never done under Hennessey’s leadership. The requirement for all grain buying license holders to submit financial statements on a regular basis was removed from Minnesota statutes in 2012. – Because no one was really watching what he was doing, Hennessey was able to take advantage of a broken system for at least 15 years. – The elevator’s bank account only required one signature on checks (Bedord 2019). What Should We Learn from this case? According to Little, we, as fraud examiners, know there are at least five keys to deterring a fraud like this. They are: • Build a strong “tone at the top” in the organization. Management must be vigilant and broadcast to employees that fraud and abuse will not be tolerated. • Perform a risk assessment. Try to understand where the risk of fraud exists in your organization, and build controls and systems that anticipate that risk. • Create strong internal controls and procedures. There must be checks and balances built into the prescribed policies and procedures. Document, document, document—everything must be set forth in writing, so that there is no uncertainty as to the proper procedure.

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Fig. 1.7 Logo Theranos. https://www.agweek.com/business/agriculture/4515868-ashby-co-opmembers-authorize-board-sell

• There must be periodic monitoring. Regardless of strong procedures, monitoring assures that the procedures are being followed as prescribed. • When fraud and/or abuse is found, it must be thoroughly investigated and prosecuted to the fullest extent. This will drive home that fraud will not be tolerated within the entity. Subsequent to any investigation of abuse, systems may need to be updated with what is learned (Little 2019). CASE 2 Elizabeth Holmes dropped out of Stanford University at 19 to start blood-testing startup Theranos, and grew the company to a valuation of $9 billion. But it all came crashing down when the shortcomings and inaccuracies of the company’s technology were exposed, and Theranos and Holmes were charged with “massive fraud” (Hartmans and Leskin 2020) (Fig. 1.7). The Securities and Exchange Commission (SEC) charged Theranos, a Silicon Valley company founded on supposedly revolutionary, portable blood-testing technology, its founder and CEO Elizabeth Holmes, and its former President Ramesh Balwani with fraud this week related to false statements and representations made while raising more than $700 million from investors (Wilder 2018). If convicted, Holmes could face up to 20 years in prison. A California judge initially set an August 2020 start date for the federal trial, but the case has been delayed until March 2021 due to the corona virus pandemic (Hartmans and Leskin 2020). There are new developments in the court case involving Elizabeth Holmes, the founder of the failed blood-testing startup Theranos. A judge is dismissing several criminal charges against the former Stanford dropout, saying the government needs to narrow its fraud case against her. Holmes is accused of falsely claiming Theranos technology could run dozens of blood tests with a single drop of blood. She will face trial in federal court this August with penalties of up to 20 years in prison and millions of dollars in fines. Holmes and former Theranos COO Ramesh “Sunny” Balwani have pleaded not guilty (7news 2020). CASE 3 Company Ted Baker (Fig. 1.8). Ray Kelvin opened his first Ted Baker in Glasgow in March 1988, and the company expanded to become an FTSE 250-listed luxury clothing range with 490

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Fig. 1.8 Logo Ted Baker. https://www.tedbaker. com/uk

stores and concessions worldwide. In August 2018, KPMG was fined £2.1 million by the Financial Reporting Council following an admission of misconduct on the company’s financial statements in 2013 and 2014, while KPMG partner Michael Francis Barradell was personally reprimanded by the regulator and fined an additional £46,800. The misconduct arose from KPMG providing expert witness services to Ted Baker in a London lawsuit, according to the FRC. As well as heralding an annus horribilis for KPMG, which was singled out for the “unacceptable” decline in the quality of its auditing, it also served to illustrate CMA concerns about the Big Four dominating the market, strengthening the case for a second, smaller firm to be brought in for FTSE 350 members, as well as illustrating the potential clash of interest between separate departments of the same firm (Blackburn 2018). The FRC gave KPMG a severe reprimand and a fine of £3 m, discounted for settlement to £2.1 m, over misconduct relating to the provision of expert witness services. The audit committee noted the FRC’s clarification that this matter did not allege that KPMG was without integrity and objectivity. The annual report went on to state: ‘As such, the audit committee took the view that KPMG could continue to act as an independent and effective auditor’ (Sweet 2019). CASE 4 At the beginning of 2018, it was announced that the Securities and Exchange Commission (SEC) was investigating its “aggressive accounting” practices, a probe that widened throughout the course of the year when in October 2018, its $22 billion non-cash charges related to acquisitions came under scrutiny, with the Department of Justice also launching an investigation. In June, it was removed from the Dow Jones Industrial Average, the only member left of the original 1896 index and in John L Flannery stepped down as Chairman and CEO. GE’s market value fell by more than $200 billion over two years (Blackburn 2018). The company dropped as much as 14% Thursday after accounting expert and Madoff whistleblower Harry Markopolos published a report alleging fraud. The team led by Markopolos claims to have already found $38 billion in fraud, and called the sum “merely the tip of the iceberg.” GE’s CEO Lawrence Culp responded in turn, calling the report “market manipulation” and claiming Markopolos released the document for personal gain. The accounting expert stands to make millions if his claims are true, both from an undisclosed hedge fund partner that is betting against GE and with cash rewards from a government whistleblower program (MarketsInsider 2019).

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1.3 New Revised Ethical Codes for Accountants Regardless of whether your organization is legally mandated to have a code of conduct (as public companies are), every organization should have one. A code has value as both an internal guideline and an external statement of corporate values and commitments. A well-written code of conduct clarifies an organization’s mission, values, and principles, linking them with standards of professional conduct. The code articulates the values that the organization wishes to foster in leaders and employees and, in doing so, defines desired behavior. As a result, written codes of conduct or ethics can become benchmarks against which individual and organizational performance can be measured (Ethics and Compliance Initiative 2020). The International Ethics Standards Board for Accountants is an independent standard-setting body that develops an internationally appropriate International Code of Ethics for Professional Accountants (including International Independence Standards). The Code requires professional accountants to comply with the fundamental principles of ethics. The Code also requires them to apply the conceptual framework to identify, evaluate, and address threats to compliance with the fundamental principles. Applying the conceptual framework requires exercising professional judgment, remaining alert for new information and to changes in facts and circumstances, and using the reasonable and informed third-party test (IESBA 2018). The new International Code of Ethics for professional accountants that were unveiled last month has been ‘long in making’ according to Kim Gibson, CPA, a member of the International Ethics Standards Board of Accountants (IESBA) and chair of the board’s Rollout and Implementation Working Group. Gibson has mentioned that new standards are designed to: – be easier to use, navigate, and enforce. – be more relevant for professional accountants in business. – be distinguished more clearly between requirements and application material (Tysiac 2018). In early April 2018, the IESBA released a completely rewritten and revamped Code of Ethics for professional accountants (PAs). Renamed “International Code of Ethics for Professional Accountants (including International Independence Standards) (“the Code” or “the revised and restructured Code”), the Code will become effective in June 2019. It packages all substantive advancements in ethics and independence over the last four years into a single document and includes the new provisions relating to non-compliance with law and regulations (“NOCLAR”), which are already effective since July 2017, and the revised independence provisions relating to long association which comes into effect in December 2018. The fundamental principles within the Code—integrity, objectivity, professional competence and due care, confidentiality, and professional behavior—establish the standard of behavior expected of a professional accountant (PA), and it reflects the profession’s recognition of its public interest responsibility. Those fundamental principles as well as the categories of threats to them,

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self-review, self-interest, advocacy, familiarity, intimidation threats.

are unchanged. Also, unchanged are the overarching requirements to apply the conceptual framework to comply with the fundamental principles and where applicable, be independent. In addition to the structural revisions made to the entire Code, the substantive revisions include: • An enhanced conceptual framework, which includes extensive revisions to “safeguards” throughout the Code that are better aligned to threats; • Strengthened independence provisions regarding the long association of personnel with audit clients; • Strengthened provisions relating to offering and accepting of inducements, including gifts and hospitality that apply to both PAs in business (“PAIBs”) and PAs in public practice (“PAPPs”); • Strengthened provisions dedicated to PAIBs, including: – A new section relating to pressure to breach the fundamental principles; and – Revised provisions relating to the preparation and presentation of information. • Clarifications about the applicability of PAIB provisions to PAPPs; • New material to emphasis the importance of understanding facts and circumstances when exercising professional judgment; and • New material to explain how compliance with the fundamental principles supports the exercise of professional skepticism in an audit or other assurance engagements (Fig. 1.9).

1.4 Conclusion In recent years, unethical behavior has increased due to many changing situations. The current fraud prevention measures are not very effective. Following reasons which may help increasing fraud in business should be examined by researchers: • We need lecturers on accounting ethics that few lecturers can teach on accounting ethics course within the scope of theoric and pratic, • most of the graduates from business schools do not know anything about accounting ethics because they cannot find any course in the curriculum, • the ethics course is not compulsory in most faculties of business or public administration, • accounting and auditors focus on earning much more profit than quality, • the lack of legal knowledge of accounting and auditors, • different and continuously changing accounting systems for micro, small, medium, and public companies,

Fig. 1.9 The new structure and drafting convention for the code establishes a new emphasize the code’s scalability (IFAC 2018)

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• continuously changing of accounting standards, • increase in e-trade even there is no enough knowledge on how to audit by accountants and auditors, • increase in the number of companies with high intangible assets that these kind of assets are available underestimating or overestimating, • insufficient knowledge of accounting standards, • rise of women in the business world, • non-financial issues related to fraud issues (Brazel et al. 2009).2 When discussing fraud in the business world, it is important to focus in much more specific sub-areas and train educators in this regard. • Behavioral Fraud,3 • gender fraud, and • biological cheating is some of them when talking about evolving cheating. The most important issue is to talk about how ethics should be taught to accountants and how we are going to use new code especially in underdeveloped and developing countries? Armstrong has stated (1993) that ethics should be taught both in existing accounting courses and in a separate course in accounting ethics and professionalism. The author further advocates that a sandwich approach be used, consisting of a general course in ethics taught heath. However, could “moral erosion” cause of accounting fraud that cannot be solved by code and education? Which brings us back to behavioral cheating? We see that the “pressure, rationalization, lack of control triangle that has been taught for years is not enough. Now, the fraud in business needs to be examined as a quadrangle, – – – –

Negative pressure, Unethical rationalization, Unsufficient control-auditing, and Moral erosion” (Fig. 1.10).

2 This

paper investigates whether publicly available non-financial measures (NFMs), such as the number of retail outlets, warehouse space, or employee head counts, can be used to assess the likelihood of fraud. During the trial of former HealthSouth CEO Richard Scrushy, federal prosecutors argued that Scrushy must have known something that was amiss with HealthSouth’s financial statements since there was a discrepancy between the company’s financial and nonfinancial performance. The prosecution noted that, twice during the seven-year fraud, revenues and assets increased even though the number of HealthSouth facilities decreased. “And that is not a red flag to you?” asked prosecutor Colleen Conry during the trial (Florida Times-Union [2005]). Conry’s question implied that HealthSouth’s financial information was inconsistent with its nonfinancial information, and thus, the risk of financial statement fraud (hereafter, fraud) at HealthSouth should has been a concern. The defense witness responded that the inconsistency was not apparent at the time and that HealthSouth’s external auditors also failed to note the inconsistency. 3 The term “Behavioral Fraud” used for the first time in literature.

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Fig. 1.10 Fraud quadrangle (The term “Fraud Quadrangle” was used for the first time in literature by Kiymet Prof Caliyurt)

References 7news, Theranos founder Elizabeth Holmes has several charges partially dismissed. https://abc 7news.com/elizabeth-holmes-theranos-trial-charges-dropped/5927915/ (Accessed on 16 Sept 2020) Albrecht WS, Howe KR, Romney MB (1984) Deterring fraud: the internal auditor’s perspective. The Institute of Internal Auditors’ Research Foundation, Altomonte Springs, FL Albrecht WS, Albrecht CC, Albrecht CO (2006) Fraud examination. Thomson South-Western, New York, NY Armstrong MB (1993) Ethics and professionalism in accounting education, vol 11, pp 77–92 Printed in USA Asare SK, Wright AM (2018) Field evidence about auditors’ experiences in consulting with forensic specialists. Behav Res Account 30(1):1–25 Association of Certified Fraud Examiner (ACFE) The 2020 Report to the Nations, p 31. https:// acfepublic.s3-us-west-2.amazonaws.com/2020-Report-to-the-Nations.pdf (Accessed on 6 May 2020) Bedord L (2019) Minnesote cooperative falls prey to its general manager. https://www.agriculture. com/news/business/sf-special-hunted-by-one-of-their-own (Accessed on 18 Mar 2020) Blackburn V (2018) Top accounting scandals in 2018. https://www.accountancyage.com/2019/03/ 20/a-summary-of-the-cases-of-financial-scandals-of-2018/ (Accessed on 6 May 2020) Brazel JF, Jones KL, Zımbelman MF (2009) Using nonfinancial measures to assess fraud risk. J Acc Res 47(5):1135–1166 Cressey DR (1950) The criminal violation of financial trust. Am Sociol Rev 15(6):738–743 Cressey DR (1953) Other people’s money: the social psychology of embezzlement. The Free Press, New York, NY Dorminey J, Fleming AS, Kranacher M-J, Riley RA (2012) The evolution of fraud theory. Issues Account Educ 27(2):555–579

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Ethics and Compliance Initiative (2020) Developing an organizational code of conduct. https:// www.ethics.org/resources/free-toolkit/code-of-conduct/ (Accessed on 18 Apr 2020) Ferguson A (2019) Elevator embezzling scheme prompts call for farmer protections. https://www. grandforksherald.com/business/agriculture/957266-Ashby-Elevator-embezzling-scheme-pro mpts-call-for-farmer-protections (Accessed on 5 May 2020) Hartmans A, Leskin P (2020) The rise and fall of Elizabeth Holmes, the Theranos founder whose federal fraud trial is delayed until 2021. https://www.businessinsider.com/theranos-founder-ceoelizabeth-holmes-life-story-bio-2018-4 (Accessed on 20 Apr 2020) International Ethics Standards Board for Accountants’ (2018) International code of ethics for professional accountants. https://www.ifac.org/system/files/publications/files/IESBA-Han dbook-Code-of-Ethics-2018.pdf (Accessed on 18 May 2020) Investopedia. What is accounting fraud? https://www.investopedia.com/ask/answers/032715/whataccounting-fraud.asp (Accessed on 18 May 2020) Kranacher MJ, Riley RA Jr, Wells JT (2011) Forensic accounting and fraud examination. Wiley, New York, NY Little J (2019) What we can learn from a five millon dollar agricultural cooperative fraud. https://www.acfeinsights.com/acfe-insights/what-we-can-learn-from-5-million-agricultu ral-fraud (Accessed on 5 Aug 2020) MarketInsider (2019) The bombshell report accusing GE of ‘Enronesque’ fraud is just the latest in the company’s long history of accounting controversies. https://markets.businessinsider.com/ news/stocks/ge-fraud-report-accounting-controversy-history-sec-investigations-markopolos2019-8-1028453418# (Accessed on 5 Aug 2020) Ramamoorti S, Morrison EM, Koletar JW, Pope KR (2013) The A.B.C.’s of behavioral forensics: applying psychology to financial fraud prevention and detection. Wiley Sweet (2019) Ted Baker to investigate £20m inventory overstatement. https://www.accountancyd aily.co/ted-baker-investigate-ps20m-inventory-overstatement (Accessed on 4 June 2020) The International Code of Ethics for Professional Accountants: Key Areas of Focus for SMEs and SMPs. https://www.ifac.org/knowledge-gateway/building-trust-ethics/discussion/int ernational-code-ethics-professional (Accessed on 7 Aug 2020) Tysiac K (2018) 5 things you need to know about the new international ethics code. J Account (May) Wilder M (2018) Theranos appeal not enough to cover up massive alleged fraud. https://www.acfein sights.com/acfe-insights/theranos-elizabeth-holmes-massive-alleged-fraud (Accessed on 6 Apr 2020) Wolfe DT, Hermanson D (2004) The fraud diamond: considering the four elements of fraud. CPA J (December)

Kıymet Tunca Çalıyurt, CPA, CFE graduated from the Faculty of Business Administration at Marmara University, Istanbul, Turkey. Her Masters and Ph.D degrees are in Accounting and Finance Programme from the Social Graduate School, Marmara University. She has worked as auditor in Horwath Auditing Company, manager in McDonalds and finance staff in Singapore Airlines. After vast experience in private sector, he has started to work in academia. She is holding CFE and CPE titles. Her research interests are in accounting, auditing, fraud, social responsibility, corporate governance, finance and business ethics, with a special interest in aviation management, NGOs, women rights in business. She has been as visiting researcher in Massachussetts University Amherst Business School. She is the founder of the International Group on Governance, Fraud, Ethics and Social Responsibility (IGonGFE&SR) which was founded in 2009. In 2009, she also founded the International Women and Business Group, which organizes a global, annual conferences. Kiymet has published papers, book chapters and books both nationally and internationally on fraud, social responsibility, ethics in accounting/finance/aviation disciplines in Springer and Routledge. She is book series editor in Springer with the title Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, and book series editor in Routledge with the title

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Women and Sustainable Business. Some book titles: Emerging Fraud (with Sam Idowu), Corporate Governance: An International Perspective (with Sam Idowu), Women and Sustainability in Business: A Global Perspective, Sustainability and Management: An International Perspective (with Ulku Yuksel), Globalization and Social Responsibility (with David Crowther), Regulations and Applications of Ethics in Business Practice (with Dr Jiang Bian), Ethics and Sustainability in Accounting and Finance, Volume I. She is acting as member in editorial board Journal of Financial Crime, Social Reponsibility Journal, International Journal on Law and Management, Journal of Money Laundering Control. She is regular speaker at International Economic Crime Symposium in Jesus College, Cambridge University. She is member in editorial board Social Responsibility Journal, Journal of Financial Crime, International Journal of Law and Management. She is partner of Herme Consulting in Trakya University Technopark.

Part I

Ethics and Sustainability in Finance and Risk Management

Chapter 2

Investigation of the Effects of Environment on Financial Reporting ˙ Engin Demirel and Ilknur Eskin

Abstract Environmental accounting is a subdivision of social accountancy, which emphasizes accountability not only to shareholders but also to all stakeholders. Until the 1980s, environmental issues were investigated under the heading of social accounting concept. The examination of social and environmental problems in the same title comes from the fact that all living things are affected by environmental events. Accounting as an open system has tried to explain the interaction between people and the environment due to the increase in environmental problems, economic and technological developments, and legal and administrative regulations. In this context, one of the steps at the global level to solve environmental problems and protect the environment is to show the processes related to environmental values in the accounting system. Environmental accounting is defined as the reporting of the business activities of the environment in the accounting records. Accordingly, it is possible to examine environmental accounting from different perspectives concerning business. Financial accounting and cost accounting are discussed to account for the environmental effects of companies. In the research, financial accounting, cost accounting and management accounting relationship with the environment is discussed. Besides, the environmental reports on which the financial account obtained as a result of the “forwarding” function examined. This research also examines the content of these reports by providing information on the emergence and development of sustainability reporting and integrated reporting which provides an internationally accepted standard framework. Keywords Environmental accounting · Environmental reporting · Sustainability reporting · Integrated reporting

E. Demirel (B) · ˙I. Eskin Trakya University, Edirne, Turkey e-mail: [email protected] ˙I. Eskin e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_2

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Key Terms and Definitions ˙ BIST EIRIS GRI IIRC UNEP

Istanbul Stock Exchange Ethical Investment Research Services Limited Global Reporting Initiative International Integrated Reporting United Nations Environment Programme

2.1 Introduction It is necessary from the basic concepts of accounting to reveal the damages that the enterprises have given to nature according to the concept of social responsibility and to determine their effects. It has begun to calculate, classify, monitor and report the costs that may arise for this purpose. As a result of these studies, the concept of “environmental accounting” emerged. Today, businesses voluntarily or necessarily integrate environmental activities into accounting. It is necessary to disclose the public transparently by determining what will be the physical, economic and social influences on the environment in the operations and investment processes of the enterprises. In this study, the concept of environmental accounting emphasized in order to ensure that the physical, economic and social dimension assesses the damage to the environment. Operations of the enterprises related to environmental activities are discussed in terms of financial accounting, cost accounting and management accounting. This research investigated the company’s social responsibility related to accounting reporting function. The environmental activities in the financial statements or financial reporting functions and disclosures in the non-financial data which described in the presentation of an integrated report are analyzed.

2.2 Literature Review When the studies in the literature examined, while some of the researches explained how environmental elements included in the accounting system, the other studies described the reporting of environmental elements (financial and non-financial). These studies are summarized below. Güvemli and Gökdeniz (1996) stated that environmental factors should be planned and applied especially in cost and profit analysis in the accounting system. Özkol (1998) study revealed the necessity of environmental accounting thinking in order to evaluate the harm to the natural environment in micro-, macro-level social, cultural and economic structure.

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Altınbay (2007) study emphasized the need to establish a reporting system that will present environmental costs to information users as a subsystem of the accounting information system of enterprises. Yıldıztekin (2009) stated that the environmental costs recorded according to their expenditure types should be reflected in costs and period costs according to their functions, that price indexes supporting environmental accounting should be created and that environmental costs should be calculated when environmental investment decisions are taken. In the study of Ulusan (2009), the information required to be disclosed in the business environmental reports was examined according to the environmental reporting guidelines published by various organizations. Results stated that Turkish businesses should understand the importance of social responsibilities related to the environment and disclose their environmental information to the public and it should be a compulsory application, not an option. Koruko˘glu (2011) examined the way in which different sectors’ enterprises apply environmental accounting in the province of Izmir. The study results stated that environmental accounting application provides the economic benefits such as resource saving and waste reduction, more efficient use of raw materials and productivity increase. It also emphasized the necessity of establishing environmental cost centers to monitor the environmental costs of the enterprises in more detail, to include environmental information in the annual reports and to prepare an environmental report. In the study of Yanık and Türker (2012), they clarified the terms related to environmental reporting. The developments in the application and theory of environmental reports expressed in different names explained. Gönen and Güven (2014) have examined the environmental costs incurred in an enterprise operating in the ceramic sector in accordance with the uniform accounting system and the accounting plan. In the study, related environmental costs classified in line with the information received from the business, and then they were accounted for under the legal regulations. In the study Akbas (2016), the relationship between the characteristics of the board of directors of companies and the environmental disclosures included in the annual reports investigated by examining the annual reports of 62 companies in different sectors in 2011 which included in B˙IST 100 index. In this research, regression analysis method is used to explain the environmental information of the company, the size of the board, independence of the board, the gender difference in the board and independence of the audit committee. According to the result of the research, only the relation between the size of the management board and the disclosure of the company’s environmental information is positive. It has been emphasized that the increase in the number of board members will have a positive effect on the level of environmental explanations as for the persons with various branches of expertise such as finance and accounting, and will take place in the management board of the company and the management board will increase the monitoring efficiency.

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Saban and Küçüker (2017) describe the role and importance of accounting function in sustainability reporting by addressing some reporting frameworks on corporate sustainability reporting.

2.3 Environmental Accounting Different definitions of environmental accounting, called “green accounting,” “ecological accounting” or “natural resource accounting,” are covered in the literature. These definitions are based on consideration of environmentally related resource use in the accounting process. Environmental accounting includes environmental aspects in which businesses are responsible to society. At the same time, it is the recognition of the financial transactions that they have made in matters such as environmental protection, investment for the environment and environmental pollution prevention studies (Kürklü 2015). According to another definition, environmental accounting is the monitoring of the physical and financial values in the accounting records by determining the qualitative and quantitative adversities that occur in the environment as a result of the interaction between the environment and the economy (Aydın and Gözütok 2015). The concept of environmental accounting has become increasingly important in the 1970s, especially in the Western countries, and nowadays this concept is part of the industrial decision-making process in developed countries (Lazol et al. 2008). Environmental accounting aims to ensure that investments are carried out in compatible with the environment by taking into account the interests of the society and that sustainable development can be ensured through effective and efficient environmental protection activities (Terzi 2013). The general aim of environmental accounting is to produce information at the macro- and micro-level and to try to explain the interaction between the environment and the economy. Macroeconomic objective; to express the value of environmental resources in monetary terms and to show them in national income accounts so that environmental data and economic data collected under the same account. The microeconomic point of view is to give financial qualification to environmental issues and thus to include environmental activities in the accounting system of the economy by showing them on the financial statements (Kırlıo˘glu and Can 2006; A˘g and Vural 2017). Environmental accounting provides benefits to businesses depending on their environmental activities. The following examples illustrate the benefits companies receive from environmental accounting (Beer and Friend 2006): • General Motors Corporation set up a recycling system with its suppliers to reduce waste disposal costs by $12 million. • Edison Electric generated more than $25 million in revenue by using its resources more effectively.

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Table 2.1 Area of interest in environmental accounting and interested group Types of environmental accounting

Area of interest

Interested groups

National income accounting

Government

External environment, government

Natural resource accounting

Detection and use of underground and aboveground natural resources

External environment, government

Financial accounting

Business

Internal and external environment

Cost accounting

Production, planning

Within the company

Management accounting

Company decision authority

Within the company

Environmental auditing

Environmental accounting records and reports

Internal and external environment

Source Güney and Can (2015)

• Andersen Company’s internal profitability ratio exceeded 50%, implementing various programs to reduce waste. • Public utility electricity and gas company established a gas flow system in 1997, earning more than 2 million dollars. Environmental accounting is the reporting of the environmental costs incurred by each company consuming environmental resource on the financial statements and the disclosure to the public (Aydın 2015). Interest groups related to the areas of business according to the types of environmental accounting are given in Table 2.1 (Güney and Can 2015). As shown in Table 2.1, the information provided by interest groups is utilized differently by the environmental accounting. Environmental accounting is a broad-based concept involving accounting and performance tools (Qian et al. 2018). In environmental accounting, showing the environmental impact of accounting records is the financial accounting. Environmental performance, control costs, production processes and finished products in terms of pricing are the cost accounting. Regarding the knowledge transfer to the managerial decision-making process is the management accounting. Also, the environmental activities and reporting of performance are considered as financial reporting. Furthermore, the environment report is evaluated as an audit tool concerning monitoring environmental performance and presenting to the public (Sentürk ¸ and Fındık 2015). In this context, the relationship between the environment and the accounting will be examined. First of all, financial accounting, cost accounting and management will be addressed from the perspective of accounting, and then environmental reporting will be explained.

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2.4 Environmental Accounting in Terms of Financial Accounting Accounting records classify, summarize and analyze the financial events that arise in an enterprise. Financial accounting within the meaning of the use of environmental accounting, preparation of information relating to the company’s environmental resource use and environmental obligations refers to the transferring to related interest groups (Çelik 2007). When transferring environmental information to the accounting system, the “concept of documentation” of accounting is the first condition to be considered. Two types of documents are used to transfer environmental information to accounting (Ta¸sdemir 2011). These documents are: • Financial Documents: In order to protect environmental values, to minimize or eliminate losses, businesses are made up of financial documents showing their activities (e.g., invoice and receipt). • Non-financial Documents: It is made up of legal documents and technical documents issued for the protection of environmental resources such as laws, regulations, statutes and technical reports. Financial accounting and environmental accounting intersect at two points as “registration” and “reporting” (Ta¸sdemir 2011). Environment-related activities at the point of registration are recorded in the balance sheet accounts or the final accounts. Firstly, in the balance sheet accounts of environmental activities, it is necessary to determine which accounts will be used or which names will be given if a new account will be opened. It should then be registered according to the nature of the process. For example, assets such as raw materials and treatment plants purchased by business within the scope of environmental activities and the provisions allocated for rehabilitating the environment are shown in the balance sheet accounts. Some of the environmental activities are shown in the final accounts, not in the balance sheet accounts. For example, emission control and pollution reduction costs are included in the environmental activities of the operator, new scientific exploration and development costs, depreciation of environmentally related investments and increased sales of environmentally sensitive sales. At this point, financial accounting and environmental accounting will enter into an information exchange (Gönen and Güven 2014). As a result, financial accounting only processes quantitative data that can be measured in money, while environmental accounting processes and relates both quantitative and qualitative data (Ta¸sdemir 2011). The period of environmental accounting is generally the period covered by the environmental report of the business. This period is selected at the same time as financial accounting, as it facilitates comparison opportunity. During this period, financial calculations, the environmental activities of the business and environmental accounting are considered together (TUSIAD 2005). The “reporting” part, which is the second point where financial accounting and environmental accounting intersect, will be explained in detail in “Environmental Reporting” section.

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2.5 Environmental Accounting in Terms of Cost Accounting Cost accounting is an accounting department that allows the calculation of the costs of goods and services produced to be presented to the managers for use in making decisions by the relevant units for use in financial accounting (Gürdal 2007). Environmental costs consist of the costs incurred by enterprises to sustain their natural life by protecting the environment in the production and sale of any goods or services (Alagöz and ˙Irdiren 2013). In a broader sense, environmental costs can be regarded as the cost of labor and capital spent in collecting and destroying wastes, or the costs of purchasing raw materials and inputs that become waste, the storage costs of specific materials and the cost of licensing in the environment. Costs for environmental protection include all expenditures for measures taken by the company to protect the environment (Atlı and Demir 2017). Environmental costs are important for businesses for the following reasons (Çetin et al. 2018): (a) Cost environmental expenses can be significantly reduced, or eliminated, by changes in the redesign of the product or processes. (b) Environmental costs can be overlooked in the calculation of overheads. (c) Most companies can offset their environmental costs by earning revenue through the sale of wastes or a clean technology license. (d) Better management of environmental costs provides significant benefits to human health as well as business success, and environmental performance improves. (e) Understanding the performance and environmental costs of products and processes can help to make products more cost-effective and pricing. (f) For customers, environmentally preferable products, processes and services can provide a competitive advantage for the firm. (g) Recognizing environmental costs and environmental performance can support the process of the entire environmental management system and the development of a company. The importance of detecting the environmental costs is shown as described above. Also, it is important to classify and record these costs correctly because environmental costs are 20% of the total costs (TÜS˙IAD 2005: 12). Environmental activities need to be separated from other activities in order to be able to display and monitor environmental expenditures. For example, a business has covered the cost of water used by the city water network, as well as the cost of polluting the water, thus paying the wastewater cost. Wastewater and environmental cleaning taxes should be separated from water bill and recorded in environmental costs (Haftacı and Soylu 2008). Environmental costs include all activities related to environmental activities. Environmental costs that are classified differently in the literature will be explained in this study as classified as specific (internal) costs and social (external) costs.

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Specific (internal) costs: It is the monetary amount of any price that the entity has a direct financial influence on the business, which is the amount that the businesses pay for not damaging the environment or minimizing the loss given (Aydın and Gözütok 2015). Social (External) Costs: It is the costs that businesses are not financially responsible and whose effects on the environment, the individual and society are not immediately accountable but whose long-term effects are seen (Aydın and Gözütok 2015). Examples of external costs include the damage caused by the release of wastewater, the destruction of solid wastes in the ecosystem and asthma caused by polluted air. Although it is difficult to determine their cost for an enterprise, some enterprises consider these costs under environmental accounting (Beer and Friend 2006). In external costs, there are three groups: prevention costs, usage costs and damage costs (Aydın and Gözütok 2015). Prevention costs are the costs that enterprises are charged to prevent and mitigate environmental problems (Ergin and Okutmu¸s 2007). This cost covers environmental planning, prevention, environmental education, process control, emission measurement devices, environmentally friendly product design, recycling designs, environmentally friendly packaging development, biologist, chemist and environmental engineering services, environmental reports, environmental labels, environmental management system and environmental audit costs (Co¸skun and Karaca 2008). Usage costs cover the costs that a business has to bear against the use of environmental resources, while the costs of damages consist of the costs that environmental damages incurred as a result of the operations will occur on the enterprises (Alagöz and Yılmaz 2001). Usage costs consist of air, water, soil, natural gas, petroleum, coal, energy costs and noise and visual cost. Damage costs consist of air, water and visual pollution costs, penalties and indemnities, bail and guarantee costs, environmental cleaning costs, complaint investigations and other damage costs (Co¸skun and Karaca 2008). Table 2.2 lists the levels of documentation difficulty in terms of classification of environmental costs and availability at the enterprise level. Easy to document environmental costs can be recorded in the accounting system at the enterprise level, but those difficult ones cannot be recorded (Ergin and Okutmu¸s 2007). Total Environmental Costs of a Company equals “Environmental Protection Costs + Waste Materials (Including Water and Energy) Costs + Excess Capital and Labor Cost” (Atlı and Demir 2017). When environmental costs are recorded, those that will not be useful in the future are written as an expense. The environmental costs that will benefit in the future are capitalized. These are environmental assets. Examples of these environmental assets in the form of tangible and intangible assets include waste treatment equipment, waste garbage incinerators, water treatment plants, air pollution filters, waste storage facilities and capitalized research and development costs (Ulusan 2010). In the calculation of unit product costs, the relationship between cost accounting and environmental accounting is more evident. Where environmental expenditure is not recorded in a separate account and shown in general production cost, the

2 Investigation of the Effects of Environment … Table 2.2 Possible classification table of environmental costs

Prevention costs

27 Documentary difficulty

Environmental planning

Easy

Emission measuring devices

Easy

Harmless product design and development

Easy

Develop harmless packaging for the Easy environment Environmental education

Easy

Environmental engineering services Easy Environmental safety

Easy

Preparation of environmental handbook

Easy

Waste control

Easy

Treatment of wastes

Easy

Environmentally friendly first material

Easy

Other prevention costs

Easy

Operational costs

Documentary difficulty

Cost of using air

Hard

Cost of using natural gas

Easy

Cost of using oil

Easy

Cost of using water

Easy

Cost of energy use

Easy

Cost of using land

Easy

Damage costs

Documentary difficulty

Air pollution cost

Hard

Water pollution cost

Hard

Cost of soil pollution

Hard

Penalty and compensation costs

Easy

Environmental cleaning

Easy

Sales reductions

Hard

Other damage costs

Hard/easy

Source Kürklü (2015)

entity will not be able to calculate product costs accurately. However, it is evident that accurate costing can be done with the participation of internal or environmental costs (Esmeray and Tanç 2009). The environmental costs incurred in the production process must directly link to production. Costs incurred as a result of non-compliance and errors in general management, marketing, sales and distribution, research and development, finance policies and activities should also be recorded in operating expenses. Therefore, the

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Table 2.3 Classification according to functional expenditure of environmental costs Environmental costs

Functional distribution of environmental costs Production costs

Activity (term) expenses

General production expenses

R&D expenses

Marketing, sales and distribution expenses

General and administrative expenses

Financing expenses

Prevention costs Operating costs Damage costs Total costs Source Altınbay (2007)

costs of environmental costs can be handled in two parts: production and period (activity). Table 2.3 shows that the environmental costs are classified according to the functional expense principle (Altınbay 2007). Determination and distribution of environmental costs are complicated. However, management accounting techniques are developed that are useful in identifying and distributing environmental costs such as input–output analysis, current cost accounting, activity-based costing and life-cycle costing (Ulusan 2010). Environmental Accounting in terms of Management Accounting Management accounting is defined as the process of identifying, accumulating, measuring, analyzing, preparing, interpreting and communicating financial information in order to ensure proper use and traceability of resources for use by management in planning, evaluation and control (Kaygusuz and Dokur 2015). The production of financial and quantitative information and reports from financial accounting and cost accounting, the interpretation of this information and reports, the making of plans and the organization of business budgets constitute the subject of management accounting (Gökçen et al. 2014). Moreover, environmental management accounting is defined as the collection, analysis and use of financial and non-financial information in order to integrate the economic and environmental policies of the enterprise by integrating environmental and physical and monetary information into the management accounting system (Özçelik 2017). This definition is quite extensive and covers aspects such as environmental performance, control costs, investment in cleaner technologies, greener products and process development (Aslanertik and Özgen 2007). Management accounting is the accounting where the environmental accounting is used the most and the most information about the subject is produced (Ta¸sdemir 2011) because management accounting and environmental accounting are merging at some points which are summarized as follows (˙Içöz and Kılınç 2016):

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• Management accounting is for the future-oriented, and this feature is parallel to the businesses that are trying to be sensitive to the environment. • It is not compulsory for the management account to be expressed in terms of money in order to be subject to a transaction, and this situation, which is the biggest obstacle to environmental accounting, is overcome by management accounting. • The acceptance of the reporting form by the management accountant for the information to be reported in addition to the existing standard reports ensures that the reporting form of the environmental accounting accepted in the management accounting.

2.6 Environmental Reporting Reporting is the latest phase of the accounting system. At this stage, the financial transactions that recorded, classified and summarized by the entity during an accounting period conclude financial statements. Business interest groups make new decisions by making use of financial statements. At this point, the environmental information is included in the reports prepared by the accounting department as it harmonized in the accounting system in the financial transactions for the environmental activities of the business (˙Içöz and Kılınç 2016). Environmental reporting is defined as an audited or un-audited non-financial environmental information of the entity included in addition to or together with financial reports (Yanık and Türker 2012). Environmental reports are prepared for cost control, cost reduction, social responsibility, profitability enhancement and environmental performance (Ergin and Okutmu¸s 2007). Experience with environmental reporting has shown that environmental reporting is not the only way. The reporting of environmental information in the financial statements can also be in the content part of the financial statements, in the footnotes only, or both in the content and footnotes of the financial statements and in a separate part of the financial statements (Ulusan 2009). If companies want their environmental information to be seen more clearly, they publish non-financial reports or include the following information in their annual reports (Yetkin 2013): • • • • • • • • • • •

The business environmental policy, Environmental laws and regulations, Environmental logs, Environmental effects, Internal environmental audit plans and reports, Environmental management records, Review of the environmental management system applied to the business, Environmental control, reports of measurements and tests, Corrective activity reports, Environmental situation analysis reports, Environmental training reports.

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Businesses that are sensitive to the environment and will prepare an environmental report due to legal regulations feel the need to prepare an independent report with the aim of developing a comprehensive report if they cannot provide detailed information on financial statements or annual reports. There are internationally recognized guidelines prepared by various organizations for the creation of environmental information by preparing independent reports (Ta¸sdemir 2011). These reporting guidelines address a number of issues related to environmental reporting, including the structure and content of environmental reports. In addition, these guides contain both quantitative and qualitative information (Ulusan 2009). Sustainability reporting and integrated reporting, the most widely accepted international reporting framework in the world, are examined in the study.

2.7 Sustainability Reporting While sustainability initially seems to be a concept that requires companies to be sensitive to the environment and to reduce negative impacts on the environment, this approach has gradually left the approach of advocating a balanced approach to the economic, environmental and social objectives of companies defined as “three dimensions of sustainability” over time (TÜS˙IAD 2015). At this point, the standards published by the Global Reporting Initiative (GRI) on the reporting of economic, environmental and social performance are globally accepted. GRI was established in 1997 by the United Nations Environment Programme (UNEP) and CERES as a multistakeholder NGO in the USA. GRI has a global network of 30,000 people (www. tisk.org.tr). The organization published the first standards in 2000 and the secondgeneration standards in 2002. The third-generation standards (G3) were developed in 2006, and the fourth-generation (G4) standards were published in the guidance in May 2013 (Güvemli et al. 2016). Sustainability reporting helps organizations determine their goals, measure their performance and manage change to make their activities more sustainable. The sustainability report communicates notifications of a company’s (positive or negative) impacts on the environment, society and economy. The G4 Sustainability Reporting Guide consists of two parts. The first part is “Reporting Principles and Standards Reporting.” This section contains the criteria to be applied by an organization to prepare its reporting principles, standard declarations and sustainability report “in line” with the guidelines. The second part consists of “Application Handbook.” This section contains explanations of how to apply the reporting principles, how to prepare the information to be explained and how to interpret the various concepts in the guidelines (GRI G4 2013). The following sections of the GRI G4 Sustainability Reporting Guide will be announced separately (GRI G4 2013).

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General Standards: These standards apply to all businesses that prepare sustainability reporting. General Standard consists of seven sections. These include Strategy and Analysis, Corporate Profile, Defined Priorities and Frames, Stakeholder Attendance, Report Profile, Governance, and Ethical Values and Integrity. • Strategy and Analysis: In this section, the highest level decision-making body of the business has a statement about sustainability’s relevance to the organization and its strategy on sustainability. This statement should reflect, in particular, the short-, medium- and long-term general vision and strategy of governance of the effects that may be associated with the activities that result from the significant economic, environmental and social impacts that the organization has caused or contributed to, or those associated with others (such as suppliers, local people or organizations). It should also explain the critical sustainability impacts, the impacts on stakeholders and the sustainability trends, risks and opportunities for long-term expectations of the organization and its impact on financial performance. • Corporate Profile: This section contains general information about the company. In this section, the names, products and services of the company, the place where the head office is located, the number of countries where the business operates, the ownership and legal structure, the markets served, the scale of the business (total number of employees, total number of transactions, net sales and net income, total operating capital, the amount of products and services produced), the demographic distribution of the total number of employees, the number of workers covered by the collective labor agreement, the chain of supply, any changes in the operation of the reporting process, and the national and international associations in which the enterprise deals with the “prudence” principle must be disclosed. • Defined Priority Elements and Frames: In this section, the report discloses the report content, the identified priority elements, and their frames and reorganized declarations. • Stakeholder Attendance: This section contains critical issues that are addressed by the business or contacted stakeholders, contact frequency, stakeholder attendance. • Report Profile: This section contains the reporting period, the date of the most recent report presented, the frequency of reporting, contact information for reports related to the report and the GRI content index. • Governance: In this section, the governance structure and composition of the entity are required to be disclosed. This information covers the topics on the aim of establishment of the highest governance body of the enterprise, values, strategy, competence and performance appraisal, risk management, sustainability reporting, economic information of the highest governance body, the environmental and social performance and identification on fees and incentives. • Ethical Values and Integrity: This section contains the company’s values, principles, standards and norms, internal and external mechanisms for proposing ethical and legal behavior, concerns about unethical or illegal behavior, and notification mechanisms for reporting issues related to corporate honesty (Valeri 2019).

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Corporate sustainability consists of three dimensions: economic, environmental and social. The first dimension, economic sustainability, emphasizes the effective management of the asset capital. The second dimension is social sustainability. Socially sustainable businesses are businesses that support social goals by keeping the human capital of stakeholders strong and contribute to the development of social capital. The environmental sustainability listed as the final dimension represents the activities that will ensure the sustainability of the natural resources of the enterprises (Özdemir and Pamukçu 2016). The Global Reporting Initiative (GRI) is the most widely accepted initiative worldwide on integrated reporting. By 2015, 7547 organizations around the world have published a total of 24,405 sustainability reports. About 70% (18,743) of these reports are the Global Reporting Initiative (GRI) reports. The situation is similar to Turkey. Between 2005 and 2014, 181 reports were published by 72 institutions and 130 were prepared in line with the GRI reporting guidelines (Saban and Küçüker 2017). KPMG in 2017 “Corporate Social Responsibility Reporting” search published. In the research, corporate responsibility and sustainability reports of 5150 companies were analyzed. In the research, it was determined that GRI reporting standard is the most preferred report in corporate social responsibility reporting and two-thirds of the companies examined use GRI G4 guidelines and standards (KPMG 2017). Another significant development related to sustainability reporting in Turkey in 2013 is an agreement between Borsa Istanbul and the Ethical Investment Research Services Limited (EIRIS). This agreement was made to calculate the “BIST Sustainability Index” based on the performance of companies in environmental, social and corporate governance issues. According to the agreement, EIRIS evaluates companies considering international sustainability criteria, and companies that exceed the thresholds in the “Index Selection Criteria” determined within the scope of studies conducted with EIRIS are included in the index by Istanbul Stock Exchange. The criteria EIRIS is considered in the valuation process: environment, biodiversity, climate change, human rights, supply chain, corporate governance structure, bribery, health and safety (Gücenme Genço˘glu and Aytaç 2016). This index enables companies to compare their sustainability performance locally and globally (Sahin ¸ et al. 2017). The BIS Sustainability Index includes forty-four businesses from November 2017 to October 2018 (www.borsaistanbul.com).

2.8 Integrated Reporting The fact that the information presented in the sustainability reports is not adequately positioned within the company’s business model and strategy makes it hard to understand how investors are related to the sustainability performance and financial performance of companies and how sustainability creates value for the company. This disconnects between the information that presented prevents investors from seeing the full picture and making the right decisions about the company’s current and

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future performance (TÜSIAD 2015). For this reason, in theory, and practice, environmental accounting, social responsibility accounting, corporate governance and strategic management have been reported for sustainable purposes (Aydın 2015). As a result of these application differences, integrated reporting concept has emerged in order to include sustainable reporting with environmental accounting, social responsibility accounting, corporate governance and strategic management (Yanık and Türker 2012). Beyond consolidating financial and sustainability reports, integrated reporting aims to establish the links between financial and non-financial information and to demonstrate the impact of the information presented on the company’s value creation capacity. Thus, the integrated report aims to help all stakeholders of an organization, especially investors, to make better decisions by providing a complete view of the organization (Altınay 2016). The IIRC was set up in 2010 in order to direct all institutions seeking to prepare integrated reporting and prepare an internationally recognized framework for integrated reporting (Aydın 2015). With the establishment of the IIRC, work on the global scale of integrated reporting has gained an institutional structure. IIRC debuted its first document in 2011 on this framework and then published it in December 2013, the last of which is the International IR Framework, which has been finalized in line with the opinions of the private sector, public, civil society representatives and academics in many countries. Nowadays, companies in developed countries such as Australia, New Zealand, South Africa and European countries have adopted integrated reporting as their preferred manner of reporting their performance using a single report (Suttipun and Bomlai 2019). But integrated reporting is a fairly new reporting framework in Turkey. The International Integrated Reporting Framework adopts a “principled” approach, aiming at a balance between flexibility and order to create an adequate level of comparability between organizations to meet relevant information needs, taking into account the significant differences between the specific conditions of different organizations (IIRC 2013). In Turkey, Garanti Bank and Cimsa in 2018 became the first company participating in the pilot program in order to prepare integrated IIRC report (Isgüden Kılıç 2018). The International Integrated Reporting Framework can be written primarily for private-sector companies and can be used by the public sector or by nonprofit-making private organizations, with the required adaptations (IIRC 2013). The International Integrated Reporting Framework consists of three main components: “capital elements,” “value creation” and “value creation process.” The capital items consist of six items, namely financial capital, capital produced, intellectual capital, human resources capital, social capital and natural capital, which ensure the success of an organization. Capital items are stocks of values that are increased, decreased or converted by the activities and results of the establishment. For example, when an organization provides profit, its financial capital grows, and in this case, it has the opportunity to provide better training to its employees. In this case, this capital items will help improve human capital (IIRC 2013). Value creation emerges by increases, decreases or transformations created on the capital items by the activities

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and output of the value establishment built over time by an organization. Organizational value can be formed in two ways. In its first place, the organization creates value for itself (allowing a financial return to provide financial backers). The other is the value created for stakeholders and the broader community (IIRC 2013). The value creation process is a process that shows how a company creates value through the business models of capital elements (IIRC 2013). IIRC (2013) describes the principles to be taken as a basis in the preparation of the integrated report which is the output of the integrated reporting process as “Guidelines,” and the items proposed to have an integrated report as “Content Items” in the International Integrated Reporting Framework. Businesses are encouraged to report in accordance with the Guiding Principles and Content Documents published in the International Integrated Reporting Framework issued by IIRC during the integrated reporting process. In the event of reporting in accordance with the Guiding Principles and Content Documents, the correct information about the value created on all capital elements will be transferred by the enterprise in a certain period. Applying the complete and future-oriented vision to corporate reporting through the Integrated Reporting Framework provides market stability by shifting capital investor behavior from short-term investment strategy to long term (Yüksel and Aracı 2017).

2.9 Solutions and Recommendations In recent years, businesses have begun to pay more consideration to social responsibility, and as a result, the amount of environmental reports has increased. However, there are differences in the environmental reports published by the companies in Turkey. When the environmental reports of companies in the same sector examined, it is possible to see environmental information in the financial statements and footnotes. Furthermore, some companies publish on the corporate Web site, and some others report on sustainability or integrated reporting, which is an advanced reporting method. One reason for this is that companies report on their legal obligation or social responsibility. The other reason is that the preparation of environmental reports other than financial statements is to be considered as an additional cost to the company. Public and non-public companies in the framework of the laws and regulations in Turkey authorized an independent audit to ensure the reliability of financial statements. Nevertheless, there is no reasonable assurance that the environmental reports are reliable. This situation affects the quality of environmental reports. It will be possible for Turkish companies to comprehend their social responsibilities related to the environment and to be able to make environmental reports become a legal obligation rather than voluntary.

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Future Research Directions This study describes the environmental reporting that created within the framework of information related to the accounting of environmental elements regarding financial, cost and management accounting. In addition to this work, it can be compared practically how the company’s environmental activities are recorded and reported within the framework of information in a company’s accounting information system.

2.10 Conclusion The ability of businesses to account for their activities with the environment depends on the fact that the information is presented in detail in the accounts during the period. In the Uniform Chart of Accounts used in the recording of financial transactions in the Turkish accounting system, there is no separate account for the use of environment-related activities. However, businesses can register their environmental activities through the sub-accounts in the Uniform Chart of Accounts. It is important to note here that it is to distinguish which of the financial transactions are related to the environment. Another critical issue is the necessity of establishing information systems that ensure that these data are obtained correctly so that non-financial data associated with the environment can be present. The activities that businesses have done to protect the environment have attracted more interest groups in recent years. Interest groups consider non-financial information as well as financial information when making business decisions. This point has been provided by the footnotes of the financial statements or environmental reports concerning the business environment-related activities. Subsequently, sustainability reports show the effects of the businesses on the environment, society and economy. Today, the emphasis is on mixed reports that provide links between businesses, both financial and non-financial, and provide a complete perspective to stakeholders. Depending on international developments, there are also companies in Turkey that make sustainability and integrated reporting. However, this reporting is below the desired number due to voluntary structure.

References A˘g A, Vural S (2017) Çevresel Sorunların Önlenmesinde Önemli Bir Yönetim Aracı Olarak Çevre Muhasebesi. J Soc Humanit Sci Res 3:92 Akbas EA (2016) The relationship between board characteristics environmental disclosure: evidence from Turkish listed companies. South East J Econ Bus 11:7–19 Alagöz A, ˙Irdiren D (2013) Maliyet Muhasebesi Bakı¸s Açısı ˙Ile ˙I¸sletmelerde Çevre Maliyetleri ve Yönetimi. Selçuk Üniversitesi ˙Iktisadi ve ˙Idari Bilimler Dergisi 26:433 Alagöz A, Yılmaz B (2001) Çevre Muhasebesi ve Çevresel Maliyetler. Selçuk Üniversitesi ˙Iktisadi ve ˙Idari Bilimler Fakültesi Sosyal ve Ekonomik Ara¸stırmalar Dergisi, p 1,152 Altınbay A (2007) Çevresel Maliyetlerin Raporlanması. Akademik Bakı¸s Dergisi 11:1–11

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Altınay A (2016) Entegre Raporlama ve Sürdürülebilirlik Muhasebesi. Süleyman Demirel Üniversitesi Sosyal Bilimler Enstitüsü Dergisi 25:57 Aslanertik E, Özgen I (2007) Otel ˙I¸sletmelerinde Çevresel Muhasebe. ˙I¸sletme Fakültesi Dergisi 2:171 Atlı Y, Demir Ö (2017) Çevresel Maliyetler ve Bu Döngüde Elazı˘g Altınova Çimento Fabrikasının ˙Incelenmesi. Fırat Üniversitesi Harput Ara¸stırma Dergisi 2:38 Aydın S (2015) Entegre Raporlama. Türkmen Kitabevi, ˙Istanbul Aydın Y, Gözütok E (2015) Sivas ˙Ilindeki Muhasebe Meslek Mensuplarının Çevresel Muhasebeye Yönelik Algılarının Ölçülmesi. Cumhuriyet Üniversitesi. ˙Iktisadi ve ˙Idari Bilimler Dergisi 16:243–246 Beer P, Friend F (2006) Environmental accounting: a management tool for enhancing corporate environmental and economic performance. Ecol Econ 58:549–550 Çelik M (2007) Çevreye Duyarlı Muhasebe. Muhasebe ve Finansman Dergisi 33:153 Çetin A, Özcan M, Yücel R (2018) Çevre Muhasebesine Genel Bakı¸s. Selçuk Üniversitesi ˙I˙IBF Dergisi 7:72 Co¸skun A, Karaca N (2008) KOB˙I’lerde Çevresel Maliyetlerin Sınıflandırılmasına Yönelik Bir Öneri: Metal ˙I¸sleme Sektöründe Bir Uygulama. Ekoloji Dergisi 18:61 Ergin H, Okutmu¸s E (2007) Çevre Muhasebesi: Çevre Maliyetleri ve Çevre Raporlaması. Yönetim Bilimleri Dergisi 5:150–158 Esmeray M, Tanç S¸ (2009) Çevresel Maliyetlerin Mamullere Yüklenmesinde Kullanılan Da˘gıtım Anahtarlarının Seçiminde Analitik Hiyerar¸si Yöntemi ve Bir Uygulama. Süleyman Demirel Üniversitesi ˙Iktisadi ve ˙Idari Bilimler Fakültesi Dergisi, pp 14, 245 Global Reporting Initiative (GRI) (2013) GRI G4 sustainability reporting guidelines. https://www. globalreporting.org/resourcelibrary/GRIG4-Part1-Reporting-Principles-and-Standard-Disclo sures.pdf (01.06.2018) Gökçen G, Çelenk H, Horasan E (2014). Yönetim Muhasebesi ve Uygulamaları. Beta Yayınevi, Istanbul Gönen S, Güven Z (2014) Çevresel Maliyetlerin Muhasebele¸stirilmesine Yönelik Bir Seramik Fabrikasında Uygulama. Muhasebe ve Finansman Dergisi, Temmuz, p 44 Gücenme Genço˘glu Ü, Aytaç A (2016) Kurumsal Sürdürülebilirlik Açısından Entegre Raporlamanın Önemi ve BIST Uygulamaları. Muhasebe ve Finansman Dergisi 72:59 Güney C, Can AV (2015) Çevre Muhasebesi ve Bilgi Teknolojileri. Akademik Sosyal Ara¸stırmalar Dergisi 16:326 Gürdal K (2007) Maliyet Yönetiminde Güncel Yakla¸sımlar. Siyasal Kitabevi, Ankara Güvemli O, Gökdeniz Ü (1996) Çevre Muhasebesindeki Geli¸smeler. Muhasebe Bilim Dünyası Dergisi 1:24–30 Güvemli B, Yaz A, Aydın S (2016) Mali Tabloların Ça˘gda¸sla¸sması ve Sürdürülebilirlik Raporlamaları Kar¸sısında Türk Muhasebe Dü¸süncesindeki Geli¸smeler. Muhasebe ve Finansman Tarihi Ara¸stırmaları Dergisi, p 11,175 Haftacı V, Soylu K (2008) Çevresel Bilgilerin Muhasebesi ve Raporlanması. Kocaeli Üniversitesi Sosyal Bilimler Enstitüsü Dergisi 15:95 http://www.borsaistanbul.com/endeksler/bist-pay-endeksleri/surdurulebilirlik-endeksi (17.06.2018) https://tisk.org.tr/wp-content/uploads/2016/04/CSR.pdf (15.06.2018) ˙Içöz A, Kılınç Y (2016) Çevre Maliyetleri Muhasebesi ve Raporlanması. Uluslararası Sosyal Ara¸stırmalar Dergisi 42:1523–1528 IIRC (2013) “International Integrated Reporting Council” Uluslararası ER Çerçevesi, 2013, 1–37. http://integratedreporting.org/wp-content/uploads/2015/03/13-12-08-THE-INTERNATI ONAL-IR-FRAMEWORK-Turkish.pdf (E.T:11.06.2018) ˙I¸sgüden Kılıç B (2018) Entegre Raporlama ve Türkiye’deki Geli¸smeler: Entegre Rapor Hazırlayan ˙I¸sletmeler ve BIST Kurumsal Sürdürülebilirlik Endeksinde Yer Alan ˙I¸sletmeler Açısından Bir ˙Inceleme. Muhasebe Bilim Dünyası Dergisi 20(1):34 Kaygusuz S, Dokur S¸ (2015) Yönetim Muhasebesi. Dora Kitabevi, Bursa

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Kırlıo˘glu H, Can AV (2006) Çevresel Muhasebede Kavramsal Tartı¸smaların Geli¸simi ve Analizi. Muhasebe ve Finansman Dergisi 31:92 Koruko˘glu A (2011) ˙I¸sletmelerde Çevre Muhasebesi: ˙Izmir ˙Ili Uygulaması. Ege Akademik Bakı¸s Dergisi 11:81–89 Kürklü E (2015) Ye¸sil Muhasebe Açısından Çevreye Duyarlı Olan ve Olmayan Üretim ˙I¸sletmelerinin Kar¸sıla¸stırılması. Akademik Sosyal Ara¸stırmalar Dergisi 3:420–423 Lazol ˙I, Mu˘gal E, Yücel Y (2008) Sürdürülebilir Bir Çevre ˙Için Çevre Muhasebesi ve KOB˙I’lere Yönelik Bir Ara¸stırma. Muhasebe ve Finansman Dergisi 38:62 Özçelik F (2017) Çevre Yönetim Muhasebesi Uygulamaları ˙Için Yeni Bir Yakla¸sım: Malzeme Akı¸s Maliyet Muhasebesi. Uluslararası Yönetim ˙Iktisat ve ˙I¸sletme Dergisi 4:931 Özdemir Z, Pamukçu F (2016) Kurumsal Sürdürülebilir Raporlama Sisteminin Borsa ˙Istanbul Sürdürülebilirlik Endeksi Kapsamındaki ˙I¸sletmelerde Analizi. Mali Çözüm Dergisi 26:16 Özkol AE (1998) Çevre Muhasebesi. Dokuz Eylül Üniversitesi ˙Iktisadi ve ˙Idari Bilimler Fakültesi Dergisi 13:15–26 Qian W, Hörisch J, Schaltegger S (2018) Environmental management accounting and its effects on carbon management and disclosure quality. J Clean Prod 174:1609 Saban M, Küçüker H (2017) Kurumsal Sürdürülebilirlik ˙Ile ˙Ilgili Raporlama Çerçeveleri ve Sürdürülebilir Raporlamada Muhasebenin Rolü, ˙I¸sletme Bilimi Dergisi 5,109 Sahin ¸ Z, Yılmaz Z, Çankaya F (2017) Sustainability reporting and performances of the companies in the Istanbul stock exchange sustainability index. Int J Econ Manage Eng 11(7):1877 Sentürk ¸ F, Fındık H (2015) Türkiye’deki Akademik Dergilerde Çevre Muhasebesi Alanında 2006– 2014 Yılları Arasında Yayınlanmı¸s Bilimsel Makalelerin ˙Içerik Analizi. J Account Finance Audit Stud 3:177 Suttipun M, Bomlai A (2019) The relationship between corporate governance and integrated reporting: Thai evidence. Int J Bus Soc 20(1):349 Ta¸sdemir V (2011) ˙I¸sletme- Çevre ˙Ili¸skilerinin Muhasebe Açısından Raporlanması (Yayınlanmamı¸s Yüksek Lisans Tezi), Ankara Üniversitesi Sosyal Bilimler Enstitüsü Terzi A (2013) Sosyal Sorumluluk Açısından Çevre Muhasebesi ve Çevre Muhasebesine Homo Ekonomikus Bir Bakı¸s. Ordu Üniversitesi Sosyal Bilimler Ara¸stırmaları Dergisi 1:88 The KPMG Survey of Corporate Responsibility Reporting (2017) https://assets.kpmg/content/dam/ kpmg/xx/pdf/2017/10/kpmg-survey-of-corporate-responsibility-reporting-2017.pdf (12 Jaune 2019) TÜS˙IAD (2005) Sirketlerin ¸ Yeni Yönetim Aracı: Çevresel Muhasebe, Yayın No: TÜSAD-T/200506/404, ISBN: 975-8458-88-4 TÜS˙IAD (2015) Kurumsal Raporlamada Yeni Dönem: Entegre Raporlama, Yayın No: T/2015, 10-567, ISBN 978-605-165-012-8 Ulusan H (2009) Çevresel Raporlama Rehberleri ve ˙I¸sletme Çevresel Raporlarında Açıklanması Gereken Bilgiler. Süleyman Demirel Üniversitesi ˙Iktisadi ve ˙Idari Bilimler Fakültesi Dergisi 14:182–206 Ulusan H (2010) Türkiye Muhasebe-Finansal Raporlama Standartları’nın Çevresel Maliyet ve Borçların Muhasebele¸stirilmesi ve Raporlanması Açısından ˙Incelenmesi. Selçuk Üniversitesi ˙Iktisadi ve ˙Idari Bilimler Fakültesi Sosyal ve Ekonomik Ara¸stırmalar Dergisi 9:85 Valeri M (2019) The reporting tools of corporate social responsibility. In: Chapter III, Corporate social responsibility and reporting in sports organizations, Springer Science and Business Yanık S, Türker ˙I (2012) Sürdürülebilirlik ve Sosyal Sorumluluk Raporlamasındaki Geli¸smeler ˙ Sosyal Bilgiler Fakültesi Dergisi 47:291–308 (Tümle¸sik Raporlama), I.Ü. Yetkin N (2013) Çevresel Bilgilerin Muhasebesi ve Raporlanmasına Yönelik Bir Uygulama (Yayınlanmamı¸s Yüksek Lisans Tezi). Dokuz Eylül Üniversitesi Sosyal Bilimler Enstitüsü Yıldıztekin ˙I (2009) Sürdürülebilirlik Kalkınmada Çevre Muhasebesinin Etkileri. Atatürk Üniversitesi Sosyal Bilimler Enstitüsü Dergisi 13:367–390 Yüksel F, Aracı H (2017) Hizmet ˙I¸sletmelerine Ait Raporların Entegre Raporlama ˙Ilkeleri Açısından ˙Incelenmesi. Uluslararası ˙Iktisadi ve ˙Idari ˙Incelemeler Dergisi 18:733

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Engin Demirel is a Professor of Finance in the Faculty of Economics and Administrative Sciences at Trakya University. He received his master’s degree (M.A.) in the field of Finance (Options Pricing) in 2005 from Trakya University and Doctorate (Ph.D.) (Fixed Income Securities Portfolio Optimization) in Accounting and Finance in 2009 from Marmara University. He teaches finance courses at graduate and undergraduate levels. His research interests include financial markets and institutions, portfolio optimizations, and international finance. Demirel has published six books, book chapters, and articles in national and international journals. ˙ Ilknur Eskin currently works as an Assistant Professor at Trakya University, Edirne, Turkey. She holds a B.Sc. in Business Management from Mu˘gla University, Mu˘gla, Turkey (2000), a M.A. in Business Management from Çanakkale 18 Mart University, Çanakkale, Turkey (2003). She received her Ph.D. Degree in Business Management from the Trakya University, Turkey, in 2013. She worked as an accountand in a company about four years. Her teaching focus is in the areas of tax accounting, hotel cost control, IFRS and CSR.

Chapter 3

An Empirical Investigation of the Determinants of Market Efficiency in Borsa Istanbul Yusuf Varlı and Ebubekir Sıddık Sahin ¸

Abstract Following the last global financial crisis, efficiencies of stock markets have come to sight as a novel area of research. The question of what factors shape the efficiency of the stock market is naturally always of curiosity in theory and practice. In line with the framework of this curiosity, this study examines the determinants that play a crucial role in the efficiency of a certain stock market, Borsa Istanbul. Our study contributes to the literature by using five years and daily data for both individual and institutional investors. We here aim to specify the ten determinants of efficiency which are categorized under investor-based, market-based and countrybased determinants. According to the three different regressions and VAR analysis, the model indicates the strong relationship between the efficiency and the specified determinants such as turnover, market volatility, the share of foreign investors, and interest rate. Keywords Market efficiency · Stock exchange · Borsa Istanbul · Individual investors · Institutional investors JEL Classification G1 · G11 · G14 · G23

3.1 Introduction Market efficiency has always been one of the most appealing and curious topics in finance theory. Answer for the question of what determines the market efficiency is sought by not only academics but also people from the industry. For screening and evaluating the quality of financial markets, the efficient market hypothesis (EMH) has recently become a broad approach (Malkiel and Fama 1970). The role of efficiency Y. Varlı (B) Istanbul Bilgi University and London School of Economics, Istanbul, Turkey e-mail: [email protected] E. S. Sahin ¸ TOBB Economy and Technology University, Ankara, Turkey © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_3

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Y. Varlı and E. S. Sahin ¸

for stock markets and what factors determine the efficiency is widely questioned in the literature. Numerous studies (Basu 1977; Fama 1991) aim to investigate the relevance of the EMH hypothesis. With the introduction of EMH in 1970 (Malkiel and Fama 1970), the weak form efficiency and semi-strong form efficiency are described. Afterward, Fama (1991) mounts the stronger form of efficiency, which is the main form that we take into account for this article, to his model. In strong form, all private information is assumed to be reflected by the price. This form explores if the investors’ profits can climb up to exceptional levels by trading with private information. Strong form is tested by examining the group of insiders if any abnormal returns can be generated by utilizing any private information. (Chaudhuri 1991; Del Brio et al. 2002; Tahaoglu and Guner 2010). There are many studies that link efficiency with the market-beating1 , i.e. getting abnormal returns higher than the market. In the simplest terms, if any given market is able to provide smooth return rates for investors and not be beaten consistently, it can be considered as efficient. Damodaran (2003) defines market-beaters as that the investors who are able to have ‘higher’ returns than others by doing better valuation, thanks to their capability to detect under-valued and over-valued firms. Especially, emerging and developing markets are investigated to reveal the factors having an impact on efficiency or the historical progression of the efficiency. Rizvi et al. (2014) examines the status of the efficiency of the stock markets in Islamic countries and compared them with the developed countries by using the EMH approach. In another study, Jamaani and Roca (2015) investigates whether the stock markets of Gulf countries are weak-form efficient and demonstrated that those markets are not weak-form efficient, hence inefficient. In another study using EMH, Rizvi and Arshad (2014) studies the progress of the efficiency in East Asian stock markets and illustrated that the overall efficiency has improved the past two decades. As well as stock markets of developing countries, stock markets of developed countries have become an area of study by the researchers. Urquhart and McGroarty (2016) question the common belief about the efficiency of stock markets in the developed world by examining stock markets in the US, Japan, England, and EU and resulted that the predictability for return in stock markets indeed varies over time and each market adjust itself separately to specific market conditions. Anagnostidis et al. (2016) studies the impact of the 2008 crises on the Eurozone stock market efficiency and concluded that the efficiency is adversely affected by the 2008 crisis. From the view of the variables affecting the efficiency, there is a great lack of researches in literature. Numerous researchers study the link between stock market prices and other variables while little attention is given to determinants of market efficiency. In their work, Muradoglu et al. (2000) investigate the causality between stock market prices and macro-level variables; stock turnover, interest rate, exchange rates, inflation in nineteen emerging markets with twenty years of data. Gay (2008) investigates the time-series relationship between the market and macroeconomics 1 “Market

beating” is defined as being able to attain higher returns than sadjusted return adjusted return while the definition of “market beaten” is vice versa, as attaining lower returns than adjusted returs.

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41

variables such as interest rate and for emerging countries, BRIC. Studies on market efficiency is densified in recent years. Beltratti et al. (2016) figure out the impacts of stock returns and trading volumes on the stock market efficiency in China. Ito et al. (2016) aim to find whether the market efficiency in the US evolve over time by employing a time-varying autoregressive (TV-AR) model. As observed in the literature, the variables of efficiency are barely studied. As it can be seen the examples from the recent literature, although some studies contribute to the revealing the development of the efficiency in specific markets or try to find the relationship between efficiency and a specific factor, best to our knowledge, there is a significant gap in literature aiming to specify the most of the determinants behind the efficiency. The existing studies mostly use common approaches or regressed the price predictability over time to measure the efficiency. In this study, we aim to cast light upon this area by determining the factors affecting the efficiency of stock markets. Revealing the variables which have a significant effect on the efficiency would help policymakers to enhance the market efficiency which is also related to the economic outlook of the country. In order to find the factors behind the market efficiency, we add various determinants obtained from literature review along with efficiency itself by using 5-year daily based investor data from Borsa Istanbul. Firstly, the variables are regressed by various types of estimators to overcome any statistical complications. Then, multiple tests are employed to increase robustness. Tests specifically related to time-series VAR models such as unit root or Jarque-Bera are run to detect or eliminate statistical issues, unique to that kind of model. Lastly, causality, impulse response and variance decomposition analyses are made. According to the results, there is a significance relationship between efficiency and other variables such as turnover, market volatility, the share of foreigners, interest rate. Furthermore, it is found that, during the study time, 2008–2012, the efficiency is increasing in Borsa Istanbul. This paper is organized as follows; Sect. 3.2 provides the data descriptions and data-sets as the methodology of the study is provided in Sect. 3.3. Empirical results are illustrated in Sect. 3.4 and some concluding remarks are highlighted in Sect. 3.5.

3.2 Data Central Securities Depositaries (MKK) where all the stocks listed on Borsa Istanbul are available online for the account of investors are used for data collection of this study. We categorized the total stock investors (#1,091,950) into two groups as individuals (#1,086,400) and institutions (#5,550) and build the regression analysis for both groups in order to provide better insight. First, investors are sorted by their portfolio size, and then the data of investors who have portfolios valued below USD 500 are eliminated. Thereafter, the data of all institutional investors and 25,000 individuals who are selected among the individual investors by using the method of stratified random sampling are employed.

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Y. Varlı and E. S. Sahin ¸

Table 3.1 Data descriptions and Sources Investor based

Market-based

Country based

Abbreviation

Data

Description

Frequency

Eff

Efficiency

Market efficiency based on market beating conditions

Daily

Source ˙ BIST

Divers

Portfolio diversification

Number of stocks Daily in a given portfolio

B˙IST

Turnover

Turnover

Average turnover rate

Daily

B˙IST

Size

Portfolio size

Average value of Daily portfolio holdings of investors (USD)

B˙IST

Mcap

Market cap

Market cap value (USD)

Daily

B˙IST

Volume

Trade volume

Total amount of trade volume (USD)

Daily

B˙IST

Volatility

Market volatility

Historical volatility of the market

Daily

Bloomberg

Foreigners

Share of foreigners

Share of foreign investors in the market

Daily

CRA

Ticksize

Tick size change

Dummy variable for the change of price ticks

Daily

B˙IST

Interest

Interest rate

2-year generic government bond interest rate of Turkey

Daily

Bloomberg

The data has 1259 days since it is daily and is consisted of non-holiday regular weekdays between the years 2008–2012. We have the advantage of high frequency to have a better view of the performance of the investors thanks to our daily data that is uncommon in literature in which annual data is mostly used. The efficiency is defined by the situation of market-beating. Then, we determine nine different variables linked with efficiency [Table 3.1]. The variables are categorized under three group as an investor-based, market-based, and country-based. The data is evaluated separately for individual and institutional investors.

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3.3 Methodology Definitions of Basics We define efficiency as a function of adjusted return which is a calculation dependent on daily raw returns of portfolios of the investors. Defining the basics, we benefit from the study of Varli (2018). Adjusted Return For the definition of daily raw returns of portfolios, we use the equations follows: r raw jt

=

s jt 

pi jt rit

(3.1)

i=1

where for the stock i in day t, r it represents daily return, pijt is the weight computed by dividing the market value for stock i at the end-of-day (t); to the end-of-day (t) market value of portfolio of investor j. Finally, the number of stocks held by investor j at day t is represented by sjt . To calculate the daily market-adjusted returns of individual j: m r jt = r raw jt − r t

(3.2)

Here, r tm is the corresponding daily rate of return of the market. After having the market adjusted daily returns in Eq. (3.2) for each day t which is ∈ [1, 2, …, 1259], the daily average return r¯t for investors is calculated as: r¯t =

J 1 r jt J j=1

(3.3)

where J denotes the total number of investors. It can be observed from Eq. (3.2), the “average return” is market adjusted. Turnover From Barber and Odean (2000), the turnover is defined as follows:   1 TradedValue jt Turnover jt = 2 PSize j

(3.4)

where in regard to market value for each investor j, TradedValue jt is the total trade at day t. and, PSize j is the monthly average of end-of-day portfolio holdings. Having computed market-adjusted daily turnover in Eq. (3.4) for each day t ∈ [1, 2, …, 1259], the daily average turnover Turnovert over investors is calculated as follows:

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Y. Varlı and E. S. Sahin ¸

⎞ ⎛ J   Turnovert = ⎝ Turnover jt J ⎠

(3.5)

j=1

Characterization of Efficiency One of the most common and accurate inferences of Efficient Market Hypothesis is that both the daily returns of market beaters and daily returns of market beaten are near zero (Damodaran 2003). When the group of investors over-perform (underperform) the market, which can also be translated as investors with positive (negative) adjusted return they are called market beaters (market beaten). Here, we want to test whether the difference between the returns of market beaters and returns of market beaten is zero or not. The purpose of this test is to see the evaluation of the market efficiency. Therefore, we use a standard t test for each day. The null hypothesis of the test is that the average of adjusted returns of market beaters equal to the average of adjusted returns of market beatens. The direction of the daily t test values indicates the evaluation of efficiency in the market (Fig. 3.1). −1

Efficiencyt = (Average Adjusted Return of Beaters)t − (Average Adjusted Return of Beatens)t

There are also some alternative definitions for market efficiency (Varli 2018): Due to the randomness in stock prices, the Efficient Market Hypothesis remarks that half of all investors should beat the market in a given period (Damodaran 2003). According to the results of (Barber and Odean 2000), 49.3% of investors beat the market. Moreover, the other half of investors is expected to underperform the market. In order to observe whether the market is efficient or not as a robustness check, we prefer to conduct a test for the null hypothesis of “Number of Market Beaters” equals to “Number of Market Beatens”. In other words, we want to examine that the

Fig. 3.1 The performance of Borsa Istanbul regarding the characterization of efficiency between 2008 and 2012. Source Authors

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45

proportion of the number of market beaters and beatens is 1 or not. As a result, we cannot reject H0 hypothesis. Descriptions and Casual Identification of Variables We classify the variables as potential variables of market efficiency into three categories; investor-based variables which are shaped based on the investors’ decisions as the diversification and size of their portfolios, and average turnover rates; marketbased variables which differ based on the market conditions as the maximum cap value and volatility of the market, total trading volume, the share of foreigners and the change in the tick sizes of prices (dummy); and additional one country-based variable which is completely exogenous, interest rate. Investor-Based • Portfolio diversification: Since the efficiency is defined as the difference between market beaters and market beatens, how the investors diversify their portfolios likely to have a significant impact on efficiency. This data denotes the number of stocks in the investor’s portfolio, which is computed daily. • Portfolio size: The size of the given portfolio for each investor is calculated as the portfolio holdings at the end of the day. It is a variable that should be considered in the same path as diversification since it is a crucial indicator of investor behaviors. • Turnover: Finally, the last variable for the investor-based side is turnover which is widely used in the literature to describe the efficiency. The calculation is provided with detailed explanations in the previous section. Market-Based • Market cap: We also adds the market capitalization that we believe that it might an impact on efficiency based on market-beating. It basically means what the company priced at the given time in the market. It is calculated for each stock with the multiplication of the number of shares of the company and the price of a stock, and all calculations summed up to find the whole market cap. • Trade volume: The impact of trade volume over efficiency is almost as old as the introduction of market efficiency(Easley and O’Hara 1992). It is demonstrated as the volume gets larger, the efficiency increases. • Market volatility: Volatility is translated as the fluctuations of the asset prices over time, which is one of the important indicators that demonstrates the performance and foreseeability of the market. Since the foreseeability of the market is closely linked with the efficiency, we put into the model as efficiency determinants. The researchers have also studied which way the volatility have an impact on market efficiency (Hameed et al. 2006). For the study, the historical volatility data for BIST is obtained from Bloomberg, which is calculated by using close-close volatility method. • Share of foreigners: We also insert the variable of share of foreigners to the model in order to see whether it has an impact on market efficiency. Since the presence of the foreign stocks occupies 65% of all stocks in Borsa Istanbul, which is our

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Y. Varlı and E. S. Sahin ¸

case study, the efficiency of Borsa Istanbul likely to have close connection with the variable. • Tick size change: Since the model is based on daily data, minimum price variations of instrument likely to have an impact on efficiency. We insert the variable because BIST recently changed this minimum value. Country-Based • Interest rate: The country conditions have also a crucial role over stock markets, naturally. Many variables related to the country are considered such as FX Rate or the prices of precious metals, but the only interest rate is taken amongst them due to high correlation between the considered variables. The change in interest rates is expected to have some impact on the efficiency.

3.4 Results In order to see the evaluation of market efficiency, we analyze how the market is efficient by using several tests and statistics. First, traditional OLS estimation method is employed along with Newey-West and Prais-Winston estimators to test and eliminate potential statistical issues with the model. Secondly, stationary status, auto-correlation, and heteroscedasticity of our time-series VAR model are tested through unit root test and others. Thirdly, granger causality is applied to the model in order to deeply analyze the relationship between each variable with themselves. Lastly, impulse response and variance decomposition analyses is made to see the responses of each variable during a shock rise in other variables and the amount of information each variable contributes to the other variables, respectively. Regression Analysis In order to see the evaluation of market efficiency, we analyze parameters of market efficiency by employing several tests and statistics. Firstly, we use Regression Analysis (OLS) to test whether there are significant impacts of selected variables on the efficiency. The results generated using Stata software for both individual and institutional investors are illustrated in Table 3.2. As can be seen from the OLS section in Table 3.2, turnover rate, market cap, trade value, market volatility, and interest rate are statistically significant for both agents; individual and institutional investors. In addition, portfolio diversification is statistically significant for only individual investors whereas share of foreigners and tick size change are statistically significant for only institutional investors. Portfolio size, on the other hand, fails to have a significant effect on efficiency for both investor types. With 0.57 R2 for the model of individual investors and 0.60 R2 for the model of institutional investors show that both models have sufficiently specified what variables have affected the efficiency while. However, Durbin–Watson d-statistic value which falls outside of the secure area (1.93–2.06) for both investor types demonstrates that the disturbances are serially correlated as we initially suspected. Thus, we use

R2

_cons

Interest

Ticksize

Foreigners

Volatility

Volume

Mcapa

Sizea

Turnover

Diversa −25.5372** (−2.06)

(−6.99)

−60.5644***

(−4.68)

−0.3954*** (−18.59)

(−9.84)

−0.2576***

(−14.13)

0.57

0.60

(5.83)

(−18.44)

(−18.49)

(15.28)

−1.2142***

−1.0444*** 40.0011***

(2.68)

(1.51)

137.0719***

1.5807***

0.9118

(5.47)

(−10.78)

−1.6500***

–

−1.8400***

(−2.31)

58.0487***

(−3.49)

−17.0449**

–

(0.92) −29.5013***

(0.09)

9.7280

(1.03)

−14.7527***

0.8547

29.1849

Individuals

0.57

(11.83)

137.0719***

(−14.22)

−1.0444***

(1.08)

0.9118

–

–

(−12.32)

−0.2576***

(−7.61)

−1.6500***

(−2.34)

−17.0449**

(0.10)

0.8547

(−3.61)

−60.5644***

(−5.61)

−14.7527***

Newey-West Est. Individuals

Institutions

OLS

Table 3.2 Three different regression analysis for individual and institutional investors

0.60

(4.75)

40.0011***

(−13.85)

−1.2142***

(2.01)

1.5807**

(4.50)

58.0487***

(−14.60)

−0.3954***

(−8.28)

−1.8400***

(−3.23)

−29.5013***

(0.92)

9.7280

(−1.73)

−25.5372*

(0.83)

29.1849

Institutions

Prais-Winsten Est.

0.48

(12.06)

133.7695***

(−15.72)

−1.0773***

(1.49)

1.1558

–

–

(−11.93)

−0.2269***

(−8.79)

−1.7700***

(−2.52)

−17.6263**

(0.51)

4.8188

(−3.26)

−49.4254***

(−5.50)

−14.5551***

Individuals

0.50

(4.20) (continued)

37.5785***

(−14.84)

−1.2595***

(2.42)

1.8360**

(4.32)

59.7812***

(−15.02)

−0.3488***

(−9.51)

−2.0108***

(−3.05)

−26.2016***

(1.23)

13.6168

(−0.75)

−9.9412

(0.33)

11.4021

Institutions

3 An Empirical Investigation of the Determinants of Market … 47

1.57

1.59

–

Newey-West Est. Individuals

Individuals

Institutions

OLS

Note Estimation results for different regression analysis. The t statistics are in parentheses ***indicates significance at 1% level **indicates significance at 5% level *indicates significance at 10% level a The change (first difference) is evaluated for some cases (institution etc.)

Durbin-Watson

Table 3.2 (continued)

–

Institutions

Prais-Winsten Est. 1.57–2.06

Individuals 1.50–2.09

Institutions

48 Y. Varlı and E. S. Sahin ¸

3 An Empirical Investigation of the Determinants of Market …

49

different estimations to overcome the serial-correlation problem such as Newey-West and Prais-Winsten. Newey–West Estimation In the time of common statistical complications such as autocorrelation—the situation occurring during the error terms are correlated over time- and heteroscedasticity, common inferences from OLS model could not directly be performed due to the inefficient estimators and inconsistent standard errors. The interpretations would be biased and invalid. In such cases, two alternatives arise: (1) applying different methods rather than OLS, such as GLS (Prais-Winston i.e.) to achieve more efficient estimations; or (2) accepting the inefficiency and correcting the standard errors by mounting specific techniques such as Newey-West estimator (1987). Newey-West is defined as the estimator which is used to tackle some statistical problems such as autocorrelation and heteroscedasticity in the error terms in the models. It is usually applied to time series data specifically when the dependent variable is lagged. The coefficients typically remain the same while the t-values are changed after the estimator is applied. This common technique is employed to correct the standard errors, and in order to that, valid interpretation can be performed. Therefore, robustness of the tests can be enhanced and the inefficient and biased standard errors can be eliminated. One of the special strengths about Newey-West Estimator (aka Robust Standard Errors) is its power to eliminate both problems (autocorrelation and heteroscedasticity) at the same time. In our results, Durbin Watson test value of OLS estimation illustrated the obvious existence of autocorrelation problems. Thus, Newey-West estimators are employed to overcome the existing problem. After the Newey–West estimation is performed, as it can be observed from Table 3.2, the significance of the variables mostly remains the same except for some tiny differences that would not affect the analysis. Therefore, we can say the serial-correlation problem was successfully eliminated. Prais–Winsten Estimation In order to increase the robustness of the model, along with others, we also apply Prais–Winsten estimator which is defined as one of the three feasible and common estimators using the generalized least-squares (GLS) method to estimate the variables in a linear regression model in which the errors are serially correlated. The Prais– Winsten is an updated version of Cochrane–Orcutt estimator (1949). Unlike Newey– West, the coefficients are expected to be different from OLS estimations as well as the standard errors, since Prais-Winsten works fundamentally different from OLS. Even though it is considered as good estimators when there is no lagged which we have in our model, we apply it to increase the robustness. As demonstrated in Table 3.2, after the estimation, the significance of the variables mostly remains the same except for some tiny differences that would not affect the analysis, which illustrates that we manage to tackle serial-correlation problem for the model. As observed from the table, after Prais-Winston Test, specifically t-values which are on the edge of being the significant switch to insignificant such as turnover for institutional investors.

50

Y. Varlı and E. S. Sahin ¸

Vector Auto Regression (VAR) Analysis After demonstrating OLS estimators along with Newey-West estimators and PraisWinsten estimators to eliminate the serial correlation problem and to enhance robustness, we move on to the diagnostics for VAR (vector autoregression) model. VAR (vector autoregression) is a model used to capture the linear interdependencies among time-series. Since our model is a time-series model, several analyses are conducted to check whether the variables are integrated of order one or not. Unit Root Test Results Before moving the deep analyses, we check for possible statistical issues such as that model being stationary and having stability. So, first, we examine the variables if they are stationary. If series’ levels are non-stationary, then estimated regressions involving the levels cannot be trusted. Therefore, we test the null-hypothesis of the existence of a unit root. According to the results of ADF (Augmented Dickey-Fuller) Unit Root Test, which is commonly used for detecting the unit-roots, in Table 3.3 below, for both investor types, almost all of the test values of the variables fall within critical levels for 1% significance level (divers 5%). Therefore, we can conclude that most of the variables are stationary. We select “Domestic Funds” as a representative institutional type due to the restrictions on portfolio data. Furthermore, as it can be observed from Fig. 3.2, no root lies outside the unit circle and no roots modulus are more than 1. Thus, we can conclude that VAR model also satisfies the stability condition. So, long-run relationship between the variables is stable. The results of ADF unit root tests indicate that there is no problem about the stability of the model with individual or institutional investors. As a result, we Table 3.3 Unit root test results (Augmented Dickey-Fuller—ADF) for individual investors and institutional investors (H0: Non-stationary) Variable

Deterministic terms

Lags

Eff

Intercept

5

Test value for individuals

Test value for institutions

−6.42

−6.26

Critical levels 1%

5%

10%

−3.44

−2.86

−2.57

Diversa

Intercept

5

−2.99

−15.98

−3.44

−2.86

−2.57

Turnover

Intercept

5

−4.82

−7.66

−3.44

−2.86

−2.57

Sizea

Intercept

5

−15.33

−13.94

−3.44

−2.86

−2.57

Mcapa

Intercept

5

−15.45

−3.44

−2.86

−2.57

Volume

Intercept

5

−5.66

−3.44

−2.86

−2.57

Volatility

Intercept

5

−8.32

−3.44

−2.86

−2.57

−3.44

−2.86

−2.57

−3.44

−2.86

−2.57

Foreigners

Intercept

5

−2.2b

Interest

Intercept

5

0.92

a The

change (first difference) is evaluated for some cases (institution etc.)

b Since the correlation between divers and foreigners for individual investors is −0.9551, we dropped

out those variables

3 An Empirical Investigation of the Determinants of Market …

51

Fig. 3.2 Inverse roots of AR characteristics polynomial for individuals (left) and institutions (right)

can move on to impulse response and variance decomposition tests which can be considered valid since the unit root test satisfies the validity. Other Tests Additional diagnostic tests are performed to have more robust results from the model. In Table 3.4, the results of the various statistical test are summarized. LM (Langrage Multiplier; H0: no autocorrelation) test, also called “Score Test”, is employed to test if there is possible auto-correlation, while ARCH-LM Autoregressive Conditional Heteroscedasticity concerns the auto-correlation of the heteroscedasticity (H0: there is no ARCH effect present) and Jarque–Bera Test is simply kind of fitness-of-fit which checks the sample have normal distribution regarding its skewness and kurtosis (H0: the sample data are from normal distribution). As it can be observed from the summary table, all p values for the tests are below critical percentage except Jarque–Bera Test result for institutional investors, which is plausible since the number of samples is low comparing to the individual investors and their stock decisions are less normally distributed. Table 3.4 Diagnostic test results for individual and institutional investors

Type of test

Individual investors

Institutional investors

LM test for autocorrelation

88.08

103.02

(0.02)

(0.05)

ARCH-LM test (eff)

16.50

10.59

(0.01)

(0.06)

Jarque-Bera test (eff)

5.92

3.21

(0.05)

(0.20)

Note The p values are in parentheses

52

Y. Varlı and E. S. Sahin ¸

Granger Causality Granger causality is a statistical concept used to determine whether future outcomes of a variable can be predicted or forecasted based upon its own history and in addition, considering the history of another variable. Contrary to its name, granger causality does not contain causality as in the philosophical sense. Thus, when there is granger causality, the term ‘granger cause’ is often used. Our variables are also tested with the Granger causality in order to reveal the granger causality among the variables. The test is run for all possible combinations and three significance levels. The results for individual and institutional investors are summarized in Tables 3.5 and 3.6, respectively. As observed from the Table 3.5, for individual investors, portfolio diversification, turnover rate, portfolio size, and interest rate granger cause efficiency for various significance level, which means the past values of those variables contribute to the forecasting of the present and future values of efficiency. When the reverse causality is explored for efficiency, it is seen that the portfolio diversification and turnover rate have also causality with efficiency which creates mutual granger causality. Apart from those implications, past values of efficiency have strength in predicting the current and future outcomes of trade volume and volatility in 1% significance level. From the table, with 1% significance level, interest rate is the most successful variable to predict efficiency which is expectable because interest rate has vital importance of economic outlook just like market efficiency. Turnover rate, portfolio diversification and size follow as variables strongly granger-causing efficiency which can be interpreted that components of the market naturally has power to forecast efficiency as they also are partly in the definition of efficiency illustrated in the previous section. Almost all variables except interest rate which is certainly exogenous would help to forecast the future outcomes of portfolio diversification while the future values of the only turnover rate and market value can be predicted by the past values of portfolio diversification. Turnover rate’s future values can be forecasted by the help of past values of efficiency, market cap, portfolio diversification, portfolio size and market volatility which is not a surprise since the definition of turnover rate directly or indirectly contains those variables. As expected, future or current outcome of interest rate can be predicted by past values of market cap and portfolio size which both are the variables having some indicators on the overall economy. Future values of volume and volatility can be forecasted with the help of past values of efficiency and portfolio size. Lastly, from 72 causality combination, for individual investors, the ones whose granger causality is mutual are follows as: efficiency-portfolio diversification, efficiency-turnover rate, portfolio diversification-turnover rate, portfolio diversification-market cap, market cap-portfolio size, market cap-interest rate and portfolio size-interest rate. When it comes to institutional investors, surprisingly, the picture dramatically changed. Different from the table of granger causality table for individual investors, there is additional variable which is share of foreigners. As observed from the Table 3.6, for institutional investors, along with trade volume and share of foreigners; portfolio diversification, portfolio size and interest rate granger cause the efficiency

2.23

(0.816)

(0.000)

(0.281)

(0.000)

27.17‘***

6.27

28.2***

(0.251)

(0.605)

(0.476)

6.61

(0.570)

3.62

4.53

(0.091)

(0.699)

3.86

9.49*

3.01

(0.024)

(0.003)

–

12.97**

(0.003)

17.75**

–

(0.021)

–

17.64***

13.21**

–

Divers

(0.979)

0.77

(0.146)

8.18

(0.098)

9.29*

(0.284)

6.23

(0.632)

3.45

–

–

(0.000)

21.35***

(0.096)

9.35*

Turnover

(0.171)

7.75

(0.311)

5.95

(0.025)

12.88**

(0.048)

11.19**

–

–

(0.000)

27.18***

(0.000)

45.31***

(0.338)

5.69

Mcap

(0.000)

105.8***

(0.006)

16.49***

(0.000)

172.53***

–

–

(0.000)

1273.83***

(0.000)

73.24***

(0.000)

98.47***

(0.018)

13.63**

Size

Note Test statistics values for granger causality. The probabilities are in parentheses ***indicates significance at 1% level **indicates significance at 5% level *indicates significance at 10% level

Volatility

Volume

Interest

Size

Mcap

Turnover

Divers

Efficiency

Efficiency

Table 3.5 Granger causality test for individual investors

(0.0208)

13.29**

(0.415)

5

–

–

(0.022)

13.10**

(0.000)

21.68***

(0.418)

4.98

(0.971)

0.89

(0.000)

32.83***

Interest

(0.213)

7.11

–

–

(0.795)

2.37

(0.637)

3.41

(0.076)

9.97*

(0.119)

8.75

(0.000)

51.62***

(0.174)

7.69

Volume

–

–

(0.017)

13.75**

(0.118)

8.79

(0.356)

5.51

(0.106)

9.06

(0.020)

13.31**

(0.077)

9.94*

(0.716)

2.89

Volatility

(0.000)

248.64***

(0.000)

86.41***

(0.000)

227.32***

(0.000)

70.42***

(0.000)

1380.55***

(0.000)

220.16***

(0.000)

320.37***

(0.000)

93.41***

Overall

3 An Empirical Investigation of the Determinants of Market … 53

5.18

(0.394)

(0.107)

(0.087)

(0.000)

9.05

9.63*

22.82***

(0.698)

(0.000)

(0.007)

3.01

(0.946)

22.57***

15.8***

(0.011)

(0.117)

1.18

14.93**

8.81

(0.000)

(0.02)

(0.402)

105.24***

(0.0008)

13.44**

5.11

–

21.1***

–

(0.901)

(0.046)

–

1.6

11.28**

–

Divers

(0.034)

12.07**

(0.068)

10.27*

(0.000)

22.77***

(0.905)

1.57

(0.235)

6.82

(0.122)

8.69

–

–

(0.208)

7.17

(0.175)

7.68

Turnover

(0.727)

2.82

(0.126)

8.6

(0.126)

8.6

(0.004)

17.31***

(0.043)

11.46**

–

–

(0.013)

14.38**

(0.314)

5.92

(0.640)

3.39

Mcap

(0.000)

60***

(0.000)

73.68***

(0.000)

24.05***

(0.000)

168.07***

–

–

(0.000)

1281.62***

(0.000)

31.25***

(0.000)

25.31***

(0.006)

16.24***

Size

Note Test statistics values for granger causality. The probabilities are in parentheses ***indicates significance at 1% level **indicates significance at 5% level *indicates significance at 10% level a the gap is tested for certain cases (institution etc.)

Foreigners

Volatility

Volume

Interest

Size

Mcap

Turnover

Divers

Efficiency

Efficiency

Table 3.6 Granger causality test for institutional investors

(0.146)

8.18

(0.011)

14.81**

(0.434)

4.85

–

–

(0.055)

10.82*

(0.000)

26.59***

(0.031)

12.29**

(0.569)

3.87

(0.000)

38.61***

Interest

(0.839)

2.08

(0.234)

6.83

–

–

(0.643)

3.37

(0.343)

5.64

(0.003)

17.97***

(0.122)

8.7

(0.153)

8.06

(0.047)

11.23**

Volume

(0.952)

1.12

–

–

(0.004)

17.36***

(0.066)

10.33*

(0.449)

4.73

(0.164)

7.86

(0.153)

8.07

(0.946)

1.19

(0.744)

2.71

Volatility

–

–

(0.536)

4.1

(0.899)

1.62

(0.144)

8.23

(0.021)

13.33**

(0.994)

0.45

(0.548)

4.01

(0.030)

12.41**

(0.085)

9.66*

Foreigners

(0.000)

169.08***

(0.000)

221.2***

(0.000)

105.42***

(0.000)

214.19***

(0.000)

80.78***

(0.000)

1382.37***

(0.000)

106.96***

(0.001)

76.19***

(0.000)

113.45***

Overall

54 Y. Varlı and E. S. Sahin ¸

3 An Empirical Investigation of the Determinants of Market …

55

as they do for the individual investors for various significance level, which means the past values of those variables contribute to the forecasting of the present and future values of efficiency. If the reverse causality is explored for efficiency, it is seen that only trade volume has also causality with efficiency which creates mutual granger causality. From the table, with a 1% significance level, interest rate and market size are the most relevant variables to predict efficiency which is expectable because those variables have vital importance of economic outlook just like market efficiency. On the contrary for individual investors, for institutional investors, almost none of the variables except market size and share of foreigners would help to forecast the future outcomes of portfolio diversification. It can be portrayed because institutional investors are expected to be much better at diversifying their stocks than individual investors which would make the predicting diversification free of other variables unlike for the individual investors. Turnover rate’s future values can be forecasted by the help of past values of efficiency, market cap, portfolio size, and interest rate. Future or current outcome of interest rate can be predicted not only by past values of market cap and portfolio size which is totally expected, but also portfolio diversification and market volatility. This surprising result can be justified as that the institutional investors’ decisions on their portfolio diversification has an impact on the interest rate and market volatility due to the large magnitude of their stocks. Lastly, from 72 causality combination, for the institutional investors, the ones whose granger causality is mutual are follows as efficiency-trade volume, portfolio diversificationportfolio size, market cap-interest rate, market cap-portfolio size, portfolio sizeinterest rate, portfolio size-share of foreigners and interest rate-volatility. When looking at overall which all indicates granger causality for 1% significance level, both for individual and institutional investors, it can be claimed that the model granger causes the variables separately. Past values of the model would contribute to forecasting the future/current outcomes of the variables. Impulse Responses An impulse response analysis is typically a tool to analyze the interactions between the variables in the model. The magnitude and the period of that a certain variable responds to one standard deviation shock on each variable is illustrated in Fig. 3.3 in detail. In our analysis, we concentrate on the responses of efficiency to the impulses on all variables from two different perspectives, individual and institutional investors. The responses of the efficiency to shocks on the determinants; change in the variables can be seen in Figs. 3.3 and 3.4 for individual investors and institutional investors, respectively. It is demonstrated that the change in the Number of Stocks in the Portfolio shock affects the efficiency positively both in the short run and the long run. In the short-run, the response is sharply positive which means that the market efficiency responses rapidly increase towards the shock of portfolio diversification. Despite a relatively fluctuant decline for a very short time, it is approaching to zero by continuing to increase in the medium run. It converges its permanent level after twenty periods (almost two years). Intuitively, as the number of stocks increases, which can be translated as the size of the market increases, the adjusted return of beaters and beaten would converge to each other which increases efficiency in

56

Y. Varlı and E. S. Sahin ¸

Fig. 3.3 Response of efficiency to various shocks on the determinants from the side of individual investors

both short and long term. The same interpretation can be observed for the Turnover Rate, Total Trade Volume as well as the Market Volatility as well with a little more fluctuation in the medium-run. The shock on any of those determinants will lead to a raise in the size of the market which in turn makes it difficult to upsurge for market beaters. Similarly, the shock of the change in the market cap value affected efficiency positively in the short-run, and after reduction for a short period, it even surpasses zero. However, in the long-run it loses its velocity and is reduced by approaching to zero again which will be its permanent level after eight days. The response of the efficiency on the shock of the other variables; specifically, to the change in Portfolio Size and the country interest rate is also illustrated in the figure. In the very short-run, the shock of the change in the portfolio size affects efficiency negatively which swiftly turns positive in medium-run and protects its level. After 6 days -the period for the maximum level the efficiency has ever get- it started to decline and approaches zero. Surprisingly, efficiency responses first positively to the shock in the country interest rate which can be interpreted that the individual investors use the market as escape point while interest rate makes difficult to invest

3 An Empirical Investigation of the Determinants of Market …

57

Fig. 3.4 Response of efficiency to various shocks on the determinants from the side of institutional investors

goods of properties, which increases the number of investors, therefore the efficiency. However, after 5 days, efficiency responses with a sharp decline as expected. Even though it stabilizes by little for a short period, its continuous diminishing period starts and it reaches below zero. It means that the shock in interest rate has permanently a negative impact on efficiency as the adverse relationship was observed in previous sections. From the institutional side, the responses become more fluctuated in the medium and more stable in the long-run. Efficiency responses with two sharp rise and fall on the shock the change in the number of stocks before it approaches the zero which is its permanent level in the long-run. In the case of shock of Turnover rate, on the other hand, efficiency follows a similar path as in the individual investors with sharp rise in the short-run, a little fluctuated decline in the medium-run and continues diminishing increase by approaching to the zero in the long-run. The response of the efficiency for the institutions on the Total Trade Volume, Market Volatility, and the interest rate is almost the same for the individuals. For the case of the shocks on the change in Portfolio Size and change in Market Cap Value for the institutions, the response of efficiency follows a similar path with the individuals with a small difference: the permanent levels those two variables get stays little bit up from the zero for the institutions while it almost reaches zero for the individuals. Lastly, for the shock of foreigners’ share which is exclusively for the institutions, efficiency responses surpass zero by positively and rapidly increasing

58

Y. Varlı and E. S. Sahin ¸

in the short-run, and it reaches its permanent level which is little above zero in the long-run after very small fluctuations in medium-run. Variance Decomposition One of the implications of the structural vector error correction model is variance decompositions. It indicates the amount of information each variable contributes to the other variables in the autoregression. In other words, it determines how much of the forecast error variance of each of the variables can be explained by exogenous shocks to the other variables. The forecast variance decompositions are summarized in Fig. 3.5 for individual investors and in Fig. 3.6 for institutional investors. As it can be observed from Fig. 3.5, for individual investors, for instance, over 50% of the forecast error variance of turnover rates can be explained by exogenous shocks to the efficiency, portfolio diversification and portfolio size while almost 100% of the forecast error variance of efficiency can be explained by exogenous shocks to only the

Fig. 3.5 Variance decomposition to each determinant for individuals

3 An Empirical Investigation of the Determinants of Market …

59

Fig. 3.6 Variance decompositions to each determinant for individuals

efficiency. The forecast error variance of market cap can be explained by exogenous shocks to portfolio size and market cap itself. One of the most variety is present in the forecast error variance of volume, %40 of which can be explained by exogenous shocks to volume itself while 30% of which can be explained by exogenous shocks to efficiency and 20% of which can be explained by exogenous shocks to portfolio diversification. Lastly, exogenous shocks to efficiency plays a great role to explain the forecast error variance of volatility with 20%. For institutional investors, on the other hand, the story goes a little bit differently from individual investors. For example, only 20% of the forecast error variance of turnover rates can be explained by exogenous shocks to the efficiency while 40% of the forecast error variance of volume size can be explained by exogenous shocks to the efficiency and turnover rates. In terms of the forecast error variance of market change, the story is the same with individual investors; half of which can be explained by the exogenous shocks to portfolio size. Unlike in individual investors, only 20%

60

Y. Varlı and E. S. Sahin ¸

exogenous shocks to volume can be explained by exogenous shocks to efficiency. Lastly, exogenous shocks to portfolio size play a great role to explain the forecast error variance of interest rate with 20%, which is also quite similar to individual investors.

3.5 Concluding Remarks In this study, we try to contribute to the discussions over market efficiency which is one of the most interesting subjects in finance theory not only in the world but also in the academic literature. Though there are some studies related to the efficiency of certain markets exist in literature, questions like what is behind the efficiency concept and what is the current situation of efficiency in emerging markets, as a case study Borsa Istanbul-Turkey, remain unanswered. Hence, we aim to illuminate this void by determining the variables having an impact on the efficiency of stock markets. We take Borsa Istanbul as a case and examine its efficiency with the selected variables and definitions of efficiency between 2008 and 2012. In data collection and methodology, in Borsa Istanbul, five years of daily data of 30,550 investors of which 5550 are institutional and 25,000 are individual are collected between 2008 and 2012. Along with provided alternative definitions of the market efficiency, for this study, we take the ‘Adjusted Return of Market BeatersBeatens’ definition which defines the efficiency based on the investors who beat the market and who are beaten by the market. The performance of Borsa Istanbul regarding those three definitions is provided with detailed graphics for five years. Right after we provided ten factors that we believe in behind market efficiency, additional variables -turnover rate and adjusted return—and hot to obtain them mathematically are introduced. Then, those 10 variables for individual investors and 11 variables for institutional investors are regressed by using various types of statistical estimators (OLS, Newey-West, and Prais-Winston) in order to eliminate statistical complications (autocorrelation, heteroscedasticity) and increase the robustness of the model, separately. Since the model is a time series model, additional tests and analysis are conducted to check if the model is appropriate time-series (stationary, etc.). Lastly, multiple deep analyses are followed to have better insight into how the determinants have an impact on efficiency. As a result, we find that the efficiency is significantly affected by turnover rate, market volatility, share of foreign investors, and interest rate. We also find that the efficiency of Borsa Istanbul is increasing in the time of the study, 2008–2012. For future works, a more detailed study can be conducted in panel structure to have a better analysis of the market.

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References Anagnostidis P, Varsakelis C, Emmanouilides CJ (2016) Has the 2008 financial crisis affected stock market efficiency? The case of Eurozone. Phys A Stat Mech Its Appl 447:116–128. https://doi. org/10.1016/J.PHYSA.2015.12.017 Barber BM, Odean T (2000) Trading is hazardous to your wealth: the common stock investment performance of individual investors. J Finance 55:773–806. https://doi.org/10.1111/0022-1082. 00226 Basu S (1977) Investment performance of common stocks in relation to their price-earnings ratios: a test of the efficient market hypothesis. J Finance 32:663–682. https://doi.org/10.1111/j.15406261.1977.tb01979.x Beltratti A, Bortolotti B, Caccavaio M (2016) Stock market efficiency in China: evidence from the split-share reform. Q Rev Econ Financ 60:125–137. https://doi.org/10.1016/J.QREF.2015.11.002 Chaudhuri SK (1991) Short-run share price behaviour: new evidence on weak form of market efficiency. Vikalpa 16:17–21. https://doi.org/10.1177/0256090919910402 Damodaran A (2003) Investment philosophies: successful strategies and the investors who made them work. Wiley, Hoboken, NJ Del Brio EB, Miguel A, Perote J (2002) An investigation of insider trading profits in the Spanish stock market. Q Rev Econ Financ 42:73–94. https://doi.org/10.1016/S1062-9769(01)00103-X Easley D, O’Hara M (1992) Adverse selection and large trade volume: the implications for market efficiency. J Financ Quant Anal 27:185. https://doi.org/10.2307/2331367 Fama EF (1991) Efficient capital markets: II. J Finance 46:1575–1617. https://doi.org/10.1111/j. 1540-6261.1991.tb04636.x Gay RD Jr (2008) Effect of macroeconomic variables on stock market returns for four emerging economies: Brazil, Russia, India, and China. Int Bus Econ Res J 7:3–10. https://doi.org/10.1080/ 00036840600820663 Hameed A, Ashraf H, Siddiqui R (2006) Stock market volatility and weak-form efficiency: evidence from an emerging market [with Comments]. Pak Dev Rev 45:1029–1040 Ito M, Noda A, Wada T (2016) The evolution of stock market efficiency in the US: a non-Bayesian time-varying model approach. Appl Econ 48:621–635. https://doi.org/10.1080/00036846.2015. 1083532 Jamaani F, Roca E (2015) Are the regional Gulf stock markets weak-form efficient as single stock markets and as a regional stock market? Res Int Bus Financ 33:221–246. https://doi.org/10.1016/ J.RIBAF.2014.09.001 Malkiel BG, Fama EF (1970) Efficient capital markets: a review of theory and empirical work*. J Finance 25:383–417. https://doi.org/10.1111/j.1540-6261.1970.tb00518.x Muradoglu G, Taskin F, Bigan I, Taylor P (2000) Causality between stock returns and macroeconomic variables in emerging markets. Russ East Eur Financ Trade 36:33–53 Rizvi SAR, Arshad S (2014) Investigating the efficiency of East Asian stock markets through booms and busts. Pacific Sci Rev 16:275–279. https://doi.org/10.1016/J.PSCR.2015.03.003 Rizvi SAR, Dewandaru G, Bacha OI, Masih M (2014) An analysis of stock market efficiency: developed vs Islamic stock markets using MF-DFA. Phys A Stat Mech Appl 407:86–99. https:// doi.org/10.1016/J.PHYSA.2014.03.091 Solomon S (2005) What is the role of the internal audit function in establishing and ensuring effective coordination among the audit committee of the board of directors, executive management, the internal auditors, and the external auditors? The IIA Research Foundation Tahaoglu C, Guner N (2010) An investigation of returns to insider transactions: evidence from the istanbul stock exchange. SSRN Electron J. https://doi.org/10.2139/ssrn.1734981 Urquhart A, McGroarty F (2016) Are stock markets really efficient? Evidence of the adaptive market hypothesis. Int Rev Financ Anal 47:39–49. https://doi.org/10.1016/J.IRFA.2016.06.011 Varli Y (2018) Evaluation of market efficiency and trading behavior of investors: evidence from Borsa Istanbul. Finans Ara¸stırmalar ve Çalı¸smalar Derg 10:153–165. https://doi.org/10.14784/ marufacd.460679

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Yusuf Varlı graduated from Istanbul Bilgi University and London School of Economics with honor degree B.Sc. in Mathematics-Economics. He worked as Teaching Assistant in the Department of Economics at the University of Iowa and got M.A. Degree from the same department. After finishing his doctoral studies, he earned Ph.D. Degree in Economics from Istanbul Bilgi University. Also, he has been at Syracuse University as Visiting Research Scholar. In addition to his academic studies, Yusuf Varli has worked in the positions of Researcher and Advisor to Chairman in Borsa ˙Istanbul and has given lectures in various certificate programs organized for sector partners. Currently he has been working at Ibn Haldun University as Assistant Professor and has several academic publications in the areas of his research interests, which mainly are Financial Economics, Applied Econometrics, Behavioral Finance and Real Estate Finance. Ebubekir Sıddık Sahin ¸ obtained his Bachelor Degree in Economics from TOBB Economy and Technology University, Ankara. He pursued Master degree in Sustainable Energy from Hamad bin Khalifa University, Doha. After his graduation, he became a Ph.D. candidate in Economics in Ibn Haldun University, Istanbul. In addition to his academic background, he has experiences on various positions in private sector such as chairman assistant in Polatturk and auditor in Kuveyt Turk Participation Bank. He currently is Ph.D. candidate in Economics in Ibn Haldun University, Istanbul. Stock Market Efficiency, Behavioral Economics, Demand Side Management and Renewable Energy are among his research interests and fields.

Chapter 4

Impact of Non-financial Disclosure Scores on the Cost of Equity Capital: Evidence from European Data in the Light of the Subprime Crisis Jocelyn Husser and Elisabeth Paulet Abstract This chapter explores the relationship between social, governance and environmental disclosure scores, on one hand, and the cost of capital, on the other. Its originality is the focus on the quality of corporate social responsibility (CSR) disclosure by studying global CSR at the same time as its three constituent dimensions. The empirical data it uses comes from Euronext SBF 120 companies over the period 2006 through 2011. The longitudinal study covers two separate periods (2006–2008 and 2009–2011). The corporate social responsibility disclosure scores (global, environment, social or governance) have an influence on the cost of capital. Moreover, financial analyst recommendations did, on the other hand, help lower the cost of capital. Lastly, the study shows that since 2009, financial analysts have increasingly taken the quality of CSR information disclosure into account in their Euronext SBF 120 stock recommendations. Keywords Corporate social responsibility · Cost of capital · Social disclosure · Financial analysts · Subprime crisis

4.1 Introduction The past 25 years have witnessed an increasing emphasis worldwide on socially responsible corporate activities. Whereas securities market regulators often argue that equity markets require comprehensive and transparent information (Botosan 1997; Richardson and Welker 2001), investors tend to assess a firm’s financials based on its financial data and disclosure (Cormier and Magnan 2003). Third-party advisors like KLD Research and Analytics, Inc. (KLD) and Bloomberg, Inc. monitor J. Husser (B) IAE Aix Marseille Chemin de la Quille, 13089 Aix en Provence Cedex 2, 30063, CS Puyricard, France e-mail: [email protected] E. Paulet (B) ICN Business School, 86 rue du Sergent Blandan, 70148–54003, CS Nancy, France e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_4

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and assess the quality of CSR disclosure, and on some occasions, CSR performance. With a growing number of countries increasingly legislating and regulating CSR disclosure, firms have also started to display a greater willingness to issue voluntary standalone CSR reports. In turn, sustainability reports are becoming increasingly important to stakeholders (Husser et al. 2012). The growing disclosure of environmental, social and governance information also attests to widespread business interest in improving communications management. Lastly, it raises a number of ancillary questions, including what companies’ ultimate aims are in this area, what advantages (including financial gains) they hope to gain from publishing non-financial information and what effect combining social, environmental and governance information has on the cost of equity capital. The present study falls within an information cost theory framework since it hopes to help companies to make decisions about information disclosure while considering the cost advantages thereof (Verrechia 1983). In this study, we shed light on the relationship between disclosure and the cost of capital for European firms. Contrary to the preceding studies, we intend to give an insight into the implications of integrating social and environmental issues into a company’s strategy and business model through the adoption of corporate policies in a crisis period. Clinch and Verrechia (2013) posit that firms that disclose more than analysts expect ex-ante will benefit from the lower cost of capital. Companies realise then that investors use regulated and unregulated disclosures to assess a firm’s financial performance (Al-Tuwaijri et al. 2004). Gietzman and Ostaszwski (2014) underline that firms for which estimating future earnings are more difficult will disclose more. Hence, as in Cormier and Magnan (2003, 2007), the compromise among the economic benefits of disclosure, risks arising from stakeholder pressure and regulatory constraints is conducive to a new communications strategy. The value relevance of this kind of non-financial disclosure is consistent with companies starting to reveal much more about their social and environmental activities than they are required to under national legislation (Botosan and Plumlee 2002; Plumlee et al. 2010). The overarching thesis of our work is to analyse how voluntary environmental and social disclosure in a crisis period could benefit the business model of European firms by decreasing their cost of capital. The chapter seeks then to ascertain whether CSR reporting has the effect of lowering firms’ cost of equity capital. By shedding further light on environmental, social and governance disclosures, it hopes to show the possibility that CSR reports might be used by investors to reduce uncertainty, thereby improving their corporate earnings forecasts. The chapter compares the pre- and the post- subprime crisis periods. The findings contribute to the current literature in several different ways. The literature review extends previous research into voluntary disclosure’s impact on the cost of firms’ equity capital by breaking results down into environmental, social and governance reporting. Instead of amalgamating all aspects of CSR, the chapter divides global CSR reporting into its key components, enabling a more detailed analysis of the relevant value of each. This follows the same line of argument of Eccles et al. (2014) without introducing any degree of sustainability for firms. We

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will try to identify whether our results manage to stress differences among CSR reporting while facing a crisis period and exhibit differences without any particular distinction among companies. Secondly, it assesses the moderating influence of financial analysts’ recommendations to see how they affect the relationship between each kind of disclosure score and the cost of equity capital. This is because such recommendations can undermine—or, to the contrary, amplify—companies’ communications effort, as expressed through their sustainability reports. Thirdly, it studies the relationship between the quality of each type of disclosure and financial analyst recommendation. It does this by scrutinising the CSR information that analysts highlight in their recommendation decisions. Fourth, we provide robust results that add to prior research on the links between voluntary disclosure and the cost of capital in the particular context of the recent crisis. Some studies document a negative relationship between the cost of capital and aggregate disclosure (e.g., Hail 2002; Botosan and Plumlee 2002; Francis et al. 2005), while others show a positive relationship (e.g., Botosan and Plumlee 2002). We intend to clarify the debate on the positive or negative relationship between the cost of capital and financial disclosure for firms by focusing on a crisis period. Otherwise, on a methodological level, it differs from research done by Plumlee et al. (2008) and Richardson and Welker (2001) through its use of a lead-lag approach. Lagged coverage shocks could be a suitable instrument for voluntary disclosure. Investors appear to react immediately and coverage shocks have no obvious direct effect on liquidity one quarter later. Our chapter tends to examine the validity of this assertion in a context of crisis. Moreover, our analysis differs from Dhaliwal et al. (2011) who examined U.S. firms, where the present chapter focuses on European companies. It also tries to see if and how financial analyst decisions link to CSR disclosure. In sum, the present chapter contributes to the current literature by complementing and extending Plumlee et al. (2008), Richardson and Welker (2001), Dejean and Martinez (2009) and Dhaliwal et al. (2011), El Ghoul et al. (2011). The organisation is as follows. Section 4.2 presents the theoretical framework and research hypotheses. Section 4.3 describes the research design. Section 4.3.2 provides the empirical results. Section 4.3.6 discusses the results and offers a conclusion.

4.2 Theoretical Framework and Hypotheses Any study of voluntary disclosures’ influence on the cost of equity necessarily applies an information cost approach, according to which firms willingly publish non-financial information in the hope of receiving economic benefits in return. Two theoretical orientations have been proposed to explain why this might lower the cost of capital. Firstly, there is the presumption that greater transparency stimulates market demand for a stock. The consequence would be lower transaction costs, leading to

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a lower cost of equity. Furthermore, heightened emphasis on financial communications can reduce shareholders’ risk (by reducing the risk of adverse selection), thereby lowering the cost of equity. Hence the conclusion may logically be made that a negative correlation exists between the cost of equity capital and the quantity of non-financial information being released (Botosan 1997; Botosan and Plumlee 2000). Different authors have investigated this question applying their empirical analysis of diverse geographical areas for firms (Khan et al. 2013) for emerging countries (Cheng et al. (2014) for 49 countries, Noronha et al. (2013) on China). We contribute to the literature by undertaking new research on European firms. Besides the location, institutional variation in Europe and the US justify a different perception and understanding of CSR. This infuses the attitudes of corporate executives. For example, mays CEOs of European firms refer to voluntary corporate responsibility reports and participate in international codes and standards such as UN Global Compact (Doh and Guay 2004). We intend to analyse if these attitudes could influence the cost of capital in the crisis period. Managers choose to voluntarily disclose information because it affects their liquidity directly. Chen and Alii (2011) support the argument that lower earnings uncertainty reduce information asymmetry and so increase liquidity independently of the disclosure. Our work intends to assert this assumption in a context where uncertainty is increasing and where information quality is difficult to identify. Firms engage in CSR activities to acknowledge societal concerns and maintain a positive relationship with stakeholders in order to improve the sustainability of the business. Since the credit crunch of 2007–2008, stakeholders’ perceptions of firms’ risk and performance have become particularly important to satisfy their financing policy. This chapter fills the gap in the literature by investigating whether corporate governance characteristics impact CSR disclosure for European firms before and after the credit crunch of 2007–2008. All the previous arguments raise a question about the voluntary dissemination of environmental information and whether this action—like the release of financial information—culminates in a lower cost of equity capital for the company involved. Richardson et al. (1999) have tried to model both how a firm’s social performance affects the financial markets and how communications activities influence social performance. The expectation is that three effects can exist at this level. Firstly, social disclosures, including environmental and governance information, might have the same effect as financial information in terms of reducing transaction costs (first effect) and/or the risk premium that shareholders will require (second effect). These steps towards disclosure might then influence the choice of investment strategy by steering investors towards socially responsible corporations—even if financial decisions of this kind undermine profitability (third effect). All three effects tend to lower the cost of equity (El Ghoul et al. 2011). Hence, if firms disclose CSR information, it is because they have an economic interest: the benefits (the reduction of the cost capital) are greater than the costs (of information disclosure). To address the potential endogeneity between CSR disclosure and cost of capital, we use a lead-lag approach and posit the first hypothesis below.

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H1 Corporate social responsibility disclosure is associated with a lower cost of capital Prior research has focused on aggregate disclosure (André et al. 2011; Francis et al. 2005; Espinosa and Trombetta 2007) to analyse financial disclosure for firms. This means that the impact of different disclosure types on the cost of capital is not well understood. Our main hypothesis is broken down into the three dimensions (social, environmental and governance) that are traditionally associated with CSR disclosure scores. Firms that disclose information about their governance practices are signalling their willingness to satisfy stakeholders’ expectations in terms of financial transparency, the protection of shareholder and creditor rights, an effective board of directors and equity structure. Recent research has demonstrated the possibility of linking corporate governance to CSR through the shareholder structure and the presence of external directors on the board of directors (Barnea and Rubin 2010). This kind of disclosure helps stakeholders to improve their understanding of the governance methods that are being used (plus the controls being placed on the company’s executives) even as they compile information about the firm’s management methods and commitment to society (Capron 2011). Detailed information gleaned from this kind of score is more useful—once it has been shared with all interested parties— than isolated measures scoring, for instance, one single governance mechanism, like the size of the board, its composition, CEO pay, etc. (Hermalin et Weisbach 2012). Governance, along with the disclosure of information in this area, is an important element for investors. Transparent governance enables equity providers to assess the risks associated with their investment. In this way, reducing uncertainty enables a lower cost of capital. Hence the following hypothesis. H2 The level of disclosure of corporate governance information correlates negatively with the cost of capital Regarding the societal aspects, many researchers (Guthrie and Parker 1989; Orlitzky et al. 2003; Dejean and Oxibar 2007; Cormier et al 2011; Author 1 and Bardinet 2014) have demonstrated a connection between society’s expectations, the disclosure of social information, social reputation and financial performance. Richardson et al. (1999) also proposed a model of the influence that a firm’s social performance exerts on the financial markets, and also how communications activities influence CSR performance, including social information. The first meta-analyses of the relationship between social and financial performance (Margolis and Walsh 2003; Margolis et al. 2007) concluded there exists a probable and moderate influence based on size and sector effects. A second series of studies (Botosan and Plumlee 2002; Richardson and Welker 2001; Dhaliwal et al. 2011) focused on the positive relationships between social performance, the disclosure of information about social activities and cost of capital. The idea here is that a positive relationship exists between social and financial performance over the long run. That being the case, it is in senior managers’ interest to disclose this kind of social data to reduce informational asymmetries (Cormier et al. 2011) and lower the cost

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of capital. Theoretical explanations about spending on social activities would then be based on the idea that CSR should improve a firm’s productivity by getting staff to work better and harder, outcomes that are meant to ensure financial performance and lower the cost of capital. Hence the following hypothesis. H3 The level of social information disclosure correlates negatively with the cost of capital The impact of environmental reporting on the relationship between a firm’s earnings and its stock market value—hence on its cost of capital—can be considered from two perspectives (Cormier and Magnan 2007). The actual substance of the environmental information being disclosed can impact the financial markets negatively. This is because, after the announcement of environmental risks, financial markets tend to expect lower future cash flows, raising companies’ cost of accessing capital. One example is high emission numbers that are not explicitly incorporated into borrowings itemised in a firm’s financials (Clarkson et al. 2001). At the same time, being transparent about environmental risks over the long term can create a climate where stakeholders and shareholders feel trust (Cormier and Magnan 2007). Reducing some of the uncertainty about potential future gains reduces specific risk and leads to a lower cost of capital. This gives rise to the following research hypothesis. H4 The level of environmental information disclosure correlates negatively to the cost of capital Financial analysts also influence the extent to which consideration will be given to CSR information (Dejean and Martinez 2009). There are three main reasons for this. The number of financial analysts scrutinising a particular share might impact the quality and, hence, the CSR disclosure score. Companies are said to be very attentive to the question of whether experts are willing to spend more time following and analysing them. This is because well-explained and argued opinions expressed by experts give investors reliable information that they are then more willing to use. Lastly, financial opaqueness remains a very real problem for investors. Analysis, along with financial analysts’ integration of CSR information into their recommendations, should then reduce informational asymmetries between managers and shareholders, leading in turn to a lower cost of capital. As a growing number of analysts issue recommendations about a firm’s stock (i.e. as the degree of informational asymmetry declines) a fall in equity costs has also been observed, albeit to a lesser extent (Botosan 1997). A recent study by Dhaliwal et al. (2012) showed that the precision and reliability of financial analysts’ predictions and buy recommendations improved whenever they could rely on information from CSR reports. This helps investors by reducing the specific risk for each stock, leading in turn to a lower cost of capital. H5 The number of financial analysts recommending a share correlates negatively to the cost of capital

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4.3 Research Design 4.3.1 Sample Description The data used here come from companies listed on the Euronext SBF 120 index from 2006 through 2011. All data (financial or relating to the disclosure of CSR and sustainability information) was extracted from the Bloomberg database. We have eliminated SBF 120 companies whose post-extraction profile was incomplete. The sample is made up of 90 companies. Firm characteristics Tables 4.1 and 4.2 present the statistics describing the companies chosen for this study. For the period 2006 through 2008 the companies in question were very diverse in terms of size and performance, with total average assets of e106.53 million and an average total shareholders return (TSR) of 12.99%. The same applies to the equity float, averaging 66.06%, with a standard deviation of 23.56%. For the period 2009 through 2011 the companies in question exhibit similar characteristics with an increased Beta (1.03 versus 0.95, p = 0.006) due to the financial shock. Table 4.1 Firm characteristics for the period 2006–2008 Total

assets*

Obs

Mean

Stand. dev.

Min

Max

270

106.53

315.665

8.15

2057.69

Beta (%)

270

0.95

0.23

0.49

1.61

Equity float (%)

270

66.06

23.56

7.1

100

Total shareholders return (%) including transaction costs

270

12.99

40.95

* Assets

−87.94

183.76

are in millions of euros

Table 4.2 Firm characteristics for the period 2009–2011 Obs

Mean

Stand. dev.

Total assets

270

107.49

318.115

6.14

Beta (%)

270

1.03

0.42

0.53

1.71

Equity float (%)

270

67.12

24.42

8.4

104

Total shareholders return (%) including transaction costs

270

10.11

42.85

*Assets are in millions of euros

Min

Max

−101.12

2148.71

225.67

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CSR disclosure measures Bloomberg researchers provide compiled ESG data on companies from published disclosures and news items and turned it into one number: a disclosure score. This score helps investors assess firms’ transparency, risks, and opportunities. As described in Appendix, Bloomberg ESG captures many qualitative and quantitative indicators that investors and analysts can use in evaluating how well your company is involved in the commitment to transparency and accountability. The more information disclosed, the higher the disclosure score. Our study follows the same line of argument as in Cheng et al. (2014): highly sustainable firms High Sustainability firms not only measure but also disclose more non-financial (e.g., environmental, social, and governance) data. This communication to their stakeholders increases their credibility as regards auditing procedures. Tables 4.3 and 4.4 indicate that the governance disclosure score was, on average, higher than the social disclosure score. For the first period, the environmental disclosure score was the lowest (33.94%). Euronext SBF 120 companies tended to disclose less environmental than social or governance information. The average ESG score was 40.13 versus a maximum of 73.96. The standard deviation was high for the environmental and social disclosure scores, and lower for the governance scores. As regards the period following the subprime crisis, the environmental disclosure score was the lowest (37.96%) but increased more than the other factors of ESG score. Euronext SBF 120 companies also tended to disclose less environmental than social or governance information. Clearly, the financial shock seems to have had an impact on the firm disclosure, which will be the core argument of our empirical analysis. The average ESG score was 44.25 versus a maximum of 74.69. The standard deviation was high for the environmental and social disclosure scores, and lower Table 4.3 ESG disclosure scores for the period 2006–2008 0bs.

Mean

Stand. dev

ESG_Score

270

40.13

13.39

Min 9.09

73.96

Max

Env_Score

270

33.94

15.83

2.32

75.19

Soc_Score

270

43.84

16.16

3.50

81.66

Gove_Score

270

55.64

10.21

17.85

76.78

Table 4.4 ESG disclosure scores for the period 2009–2011 0bs.

Mean

Stand. dev

Min

Max

ESG_Score

270

44.25

15.34

10.10

74.69

Env_Score

270

37.96

16.84

9.44

76.30

Soc_Score

270

44.18

17.26

4.60

83.68

Gove_Score

270

56.70

10.43

19.70

78.88

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for the governance scores. The research in hand underlines a notable increase of all disclosure scores for the period that followed the subprime crisis.

4.3.2 Empirical Model We tested H1 by estimating the following regression model over six years: COCi,t = αi + β1 Equityfloati,t + β2 ESG_Scorei,t−1 + β3 Betai,t + β4 Det/Capi,t + β5 Assetsi,t + β6 AnalReci,t + β7 Year + εi,t

(4.1)

To test the influence of each CSR or sustainability component’s disclosure on the cost of capital (H2–H4), the following regressions were used: COCi,t = αi + β1 Equityfloati,t + β2 GOV_Scorei,t−1 + β3 Betai,t + β4 Det/Capi,t + β5 LogAssetsi,t + β6 AnalReci,t + β7 Year + εi,t (4.2) COCi,t = αi + β1 Equityfloati,t + β2 SOC_Scorei,t−1 + β3 Betai,t + β4 Det/Capi,t + β5 LogAssetsi,t + β6 AnalReci,t + β7 Year + εi,t (4.3) COCi,t = αi + β1 Equityfloati,t + β2 ENV_Scorei,t−1 + β3 Betai,t + β4 Det/Capi,t + β5 LogAssetsi,t + β6 AnalReci,t + β7 Year + εi,t

(4.4)

All in all, four models were tested twice over the six years (from 2006 through 2008 and from 2009 through 2011). Since the present study mobilises panel data analysis, it runs a risk of heteroscedasticity and autocorrelation problems. A Breusch-Pagan test has revealed the presence of heteroscedasticity in the models used here. Hence the estimates of our empirical analysis have applied a feasible generalised least squares method applying the random method. A Hausman test enabled a choice between a method with fixed or random effects. As the test was not significant here, a random method was adopted. What the present study has mobilised is a feasible GLS method with random effects (i.e. a GLS regression with correlated error terms), because this made it possible to estimate parameters in the presence of autocorrelation. This explains in part the small magnitude of our coefficients.

4.3.3 Definition of the Variables Our main variable—the cost of capital (COC) the year following a disclosure score— was the implied cost of equity capital. One method for estimating the cost of equity,

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Table 4.5 Descriptive statistics—COC COC

2007

2008

2009

2010

2011

N

90

90

90

90

90

Min

3.40

3.69

3.64

3.42

3.52

Max

6.07

6.17

6.40

6.70

6.86

Median

4.78

4.60

4.68

4.68

4.74

Mean

4.79

4.74

4.80

4.81

4.87

Std

2.55

2.54

2.63

2.76

2.72

based on both Ohlson’s (1995) model and the Feltham and Ohlson model (1995), was proposed by Botosan (1997), who specified that CAPM is not in fact the most appropriate model for testing financial communications’ impact on the cost of equity, insofar as the information being disseminated is not a determinant factor in the expected return. Our main variable of interest, the cost of equity capital in the year prior to first-time CSR disclosure, COC, is the ex-ante or implied cost of equity capital, calculated using three different models, namely, those of Gebhardt et al. (2001), Claus and Thomas (2001), and Easton (2004). The mean of the three measures (COC) serves as our proxy for the cost of equity capital. Table 4.5 offers descriptive statistics for the explained variable, COC. Analysis of these initial findings reveals increased dispersion following the subprime crisis (increase in magnitude and in the dispersion around the mean). To test hypothesis H1, Bloomberg data was used to ascertain the number of global publications amalgamating social, environmental, and governance information (ESG_DISCLOSURE_SCORE). CSR information disclosure scores are published by Bloomberg as per Global Reporting Initiative (GRI) guidelines. Scores were obtained using companies’ voluntary responses to a survey administered by Bloomberg. To test hypotheses H2, H3 and H4, each level of publication (social, environmental governance) was expressed by an index of the same order of magnitude derived from the Bloomberg database (respectively called Social _Disclosure_Score, Environ_Disclosure_Score and Govnce_Disclosure_Score) for the years N − 1. This is because the disclosure scores from N − 1 would be published in N and it is therefore only then that they could affect the cost of capital. The number of criteria selected to create these dimensions was respectively 11, 16 and 11. The global score and the three constituent dimensions were all scored between 0 and 100 points. The scoring accounted for each sector’s specificities to avoid bias. Appendix shows Bloomberg’s CSR scoring grid. The initial sample was established using listed companies on the Euronext SBF 120 index from 2007 through 2011. The sample was reduced to 90 companies because that is the number of Euronext SBF 120 members who agreed to answer the questionnaire. In line with Dhaliwal et al. (2011) and Dejean and Martinez (2009), analysis incorporated the variables that literature traditionally associates with cost of capital. Thus, Equity_Float represents the ratio of the number of shares that are publicly

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owned and available for trading, compared to the total number of shares outstanding at year-end. The study estimated the size of the company as the natural logarithm of the assets at the end of each year (LN_Assets). It controlled for firm size because this captures some of the different factors that induced firms to issue CSR reports, such as public pressure or financial resources (Lang and Lundholm 1993). Otherwise, Total_Anal_Rec represents the number of financial analysts issuing a buy recommendation. Stakeholder theory suggests that engaging in comprehensive corporate risk disclosure is an effective strategy to gain the support of investors (Elzahar and Hussainey 2012), who are crucial for a corporation’s ability to conduct viable operations. From a financial point of view, increased commitment to disclosure facilitates access to resources by minimising capital costs through improved corporate image and reputation (Branco and Rodriguez 2006; Dardour and Author 1 2016). Hence analysts could be willing to have better information as regards firms. Last but not least, the model includes the debt ratio (DET/CAP) because debt servicing plays a monitoring role, and because debt holders demand greater disclosure (Leftwich et al. 1981). The debt ratio was defined as the ratio of total debt divided by total equity.

4.3.4 Empirical Findings Table 4.6 looks at the model of the connection between the cost of equity and CSR disclosure scores, whether total (model 1), governance (model 2), social (model 3) or environmental (model 4). It presents the regression findings using the feasible least squares method based on panel data from 2006 to 2008. Because of the sign of the coefficient, model 1 and 3 are rejected, while all other research hypotheses have been confirmed. Hence, corporate social responsibility disclosure and social information disclosure have a significant influence on the cost of capital. To illustrate our argument, the coefficient of the environmental disclosure score is negative and significant to the threshold of 5% (−0.002; p = 0.007). This finding indicates that incentive compensation is partially explained by the quality of CSR information disclosure. Table 4.7 looks at the model of the connection between the cost of equity and CSR disclosure scores, whether total (model 5), governance (model 6), social (model 7) or environmental (model 8) for the post-subprime crisis period. It presents the regression findings using the feasible least squares method based on panel data from 2009 to 2011. We observe a negative sign for the ESG disclosure in model 5, which indicates a reduction of the cost of capital with CSR disclosure during the post-crisis period 2009–2011 in contrast to the pre-crisis period 2006–2008. A similar reversal in sign is also evident by comparing model 7 to model 3 which shows a reduction in cost of capital for social disclosure during the post-crisis period. Models 6 and 8 confirm the previous result while models 5 and 7 exhibit the importance of disclosure to reduce the cost of capital. In this case hypotheses 1–4 has been confirmed. However, the

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Table 4.6 COC and disclosure scores from 2006 through 2008 Model 1 COC and Model 2 COC and Model 3 COC and Model 4 COC and ESG disclosure Gov Disclosure Soc Disclosure Env disclosure

Discl_Score

Beta

Assets (log)

Equity float

DET/CAP

Coef. Z-value (P > |Z|)

Coef. Z-value (P > |Z|)

Coef. Z-value (P > |Z|)

Coef. Z-value (P > |Z|)

0.002***

−0.001***

0.001***

−0.002***

5.93

−5.07

2.30

2.43

(0.000)

(0.000)

(0.007)

(0.007)

0.096***

0.059*

0.109*

0.108*

2.83

1.64

1.76

1.87

(0.005)

(0.100)

(0.096)

(0.096)

0.019***

0.026***

0.022**

0.022**

−3.65

4.88

−2.38

−2.38

(0.000)

(0.000)

(0.017)

(0.017)

0.002***

0.001***

0.001**

0.001**

12.03

6.24

3.19

1.97

(0.000)

(0.000)

(0.027)

(0.027)

0.001***

0.001***

0.001**

0.001**

11.09

5.34

2.11

2.21

(0.000) ANAL_REC 0.001*** 13.08 D_2006

D_2007

(0.000)

(0.038)

(0.019)

0.001***

0.001**

0.001**

14.74

12.48

2.14

(0.000)

(0.000)

(0.027)

(0.027)

−0.024

−0.027

−0.028

−0.021

−1.16

−1.26

−0.81

−0.79

(0.248)

(0.220)

(0.410)

(0.410)

0.022

0.019

-0.013

−0.012

1.22

1.01

-0.22

−0.23

(0.227)

(0.413)

(0.803)

(0.812)

0.432***

0.018

0.247***

0.217***

11.96

0.068

3.22

3.27

(0.000)

(0.678)

(0.001)

(0.001)

Wald chi2

291.64

103.64

82.59

82.67

Prob > chi2

0.000

0.000

0.000

0.000

N

270

270

270

270

Intercept

***, **, * Significant respectively to a threshold of 1%, 5% and 10%

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Table 4.7 COC and disclosure scores from 2009 through 2011 Model 5 COC and Model 6 COC and Model 7 COC and Model 8 COC and ESG disclosure Gov disclosure Soc disclosure Env disclosure

Discl_Score

Beta

Assets (log)

Equity float

DET/CAP

Coef. Z-value (P > |Z|)

Coef. Z-value (P > |Z|)

Coef. Z-value (P > |Z|)

Coef. Z-value (P > |Z|)

−0.003***

−0.002***

−0.001***

−0.004***

−6.24

−5.08

−2.71

−2.78

(0.000)

(0.000)

(0.007)

(0.007)

0.105***

0.091*

0.119*

0.128*

3.91

2.94

2.98

2.78

(0.005)

(0.100)

(0.096)

(0.096)

0.020***

0.027***

0.021**

0.022**

3.46

4.78

2.47

2.41

(0.000)

(0.000)

(0.017)

(0.017)

0.002***

0.002***

0.001**

0.001**

11.18

5.24

2.11

2.01

(0.000)

(0.000)

(0.027)

(0.027)

0.002***

0.001***

0.001**

0.001**

10.06

4.84

1.91

2.11

(0.000) ANAL_REC 0.002*** 11.09 D_2009

D_2010

(0.000)

(0.027)

(0.027)

0.001***

0.002**

0.001**

5.24

2.21

2.21

(0.000)

(0.000)

(0.027)

(0.027)

−0.026

−0.012

−0.020

−0.020

−1.16

−1.23

−0.82

−0.82

(0.248)

(0.220)

(0.400)

(0.420)

0.017

0.009

−0.004

−0.004

1.22

1.01

−0.24

−0.24

(0.224)

(0.313)

(0.812)

(0.812)

0.542***

0.032

0.365***

0.357***

12.76

0.059

3.12

3.32

(0.000)

(0.678)

(0.001)

(0.001)

Wald chi2

282.62

104.62

80.42

80.42

Prob > chi2

0.000

0.000

0.000

0.000

N

270

270

270

270

Intercept

***, **, * Significant respectively to a threshold of 1%, 5% and 10%

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reduced magnitude of the coefficient is partly explained by the particular financial context: the subprime crisis. With regard to hypothesis 5, the sign of the coefficients for ANAL_REC for all models in both the pre- and post-crisis periods is positive. This suggests that even if disclosures enable financial analysts to better evaluate the quality of CSR information of firms, the financial environment prevents an improvement in the financial cost of equity.

4.3.5 Additional Analyses and Robustness Checks Tables 4.8 and 4.9 present the correlation matrix, which confirms the lack of serious problem correlation between variables for the two periods. Moreover, the results are reported in Tables 4.6 and 4.7 maybe altered by endogeneity, omitted variables, and reverse-causality problems (Abdallah et al. 2015). They are among the main econometric problems encountered in studies on CSR and CEO compensation (Devers et al. 2007; Hermalin and Weisbach 2012). For robustness tests and to address the endogeneity problem, we ran the same regressions using the system generalised method of moments (SGMM) estimators developed by Arellano and Bover (1995) and Blundell and Bond (1998). The lagged levels of explanatory variables are used as instruments. According to Table 4.11, the models Table 4.8 Correlation matrix from 2006 through 2008 [1]

[2]

[3]

[1] COC

1

[2] ESG score

0.34

1

[3] ENV score

0.08

0.11* 1

[4] SOC score

−0.09

−0.03

[5] GOV Score

−0.02

0.06

[4]

0.59

1

0.53*

0.53*

[5]

[6]

[7]

[8]

[9]

[10]

1

[6] Equity float

0.03

0.16* 0.05* −0.00

0.14*

[7] Log assets

0.07*

0.35* 0.04

0.15* −0.22*

[8]

0.03

−0.01

0.07

0.07

−0.03*

0.12* −0.09*

1

[9] Anal Rec

0.03

−0.01

0.07

0.07

−0.03*

0.12*

0.08

0.06

[10] Beta

0.06

0.23* 0.04

0.06

0.05

0.16*

0.21* −0.00 −0.07 1

0.16*

1 1

Det/Cap

* Significant

at less than 5%

1

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77

Table 4.9 Correlation matrix from 2009 through 2011 [1]

[2]

[3]

[1] COC

1

[2] ESG score

0.29

1

[3] ENV score

0.09*

0.12* 1

[4] SOC score

−0.09

−0.04

[5] GOV score

−0.02

0.07

[4]

0.19

1

0.44*

0.43*

[5]

[6]

0.05

0.12* 0.05* −0.00

0.19*

[7] Log assets

0.07*

0.35* 0.04

0.15* −0.22*

[8]

0.03

0.07

0.16* 0.07

[8]

[9]

[10]

1

[6] Equity float

−0.01

[7]

−0.03*

1 1

0.12* −0.09*

1 0.06

Det/Cap [9] Anal rec

0.21*

0.14* 0.06

0.22* −0.03*

0.12*

0.08

[10] Beta

0.07

0.23* 0.04

0.06

0.16*

0.19* −0.04 −0.07 1

* Significant

0.08

1

at less than 5%

seem well fitted with statistically significant test statistics for second-order autocorrelation in the first difference (S1) and statistically insignificant test statistics in the second difference (S2). Likewise, we confirm the validity of the instruments using the Sargan over-identification test, which indicates in all models that instruments are valid in their estimations. The interpretation of the coefficients on environmental scores in Table 4.10 remains qualitatively the same as in Table 4.11 (β = 0.06; p < 0.001; β = 0.004, p < 0.05; β = 0.008; p < 0.05; β = 0.003; p < 0.05).

4.3.6 Discussion and Conclusion The purpose of this study was to assess whether the quality of CSR information disclosure affects the cost of capital in a European context. Prior research reveals that there is an insignificant upward change of disclosures during a period of financial crisis (Mia and Al Mamum 2011; Milton 2002). As an illustration, Giannarakis and Theotokas (2011) stress that, for the period 2009–2010, there is no statistically significant difference between disclosure and CSR performance. Our results contradict these studies as shown in Tables 4.3 and 4.4. During the subprime crisis, European firms increased their disclosure because they estimated it was a relevant tool to obtain funding for their investment. The financial turmoil has revealed severe shortcomings in risk management practices which lead firms to more disclosures.

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Table 4.10 The influence of COC compensation on disclosure scores COC from 2006 to 2008 (1)

COC from 2009 to 2011 (2)

β

Z-stat

β

Z-stat

Intercept

−19.693

−0.91

−3.081

−0.15

ESG scores

2.928***

3.00

Equity float

0.044

0.61

0.043

0.77

Beta

−1.799

−0.37

−4.335

−1.05

Det /Cap

−8.178*

−2.18

−8.010**

−2.18

Anal rec

3.738

−2.17

−5.882**

−2.17

Total assets (log)

1.273

1.45

Industry and year effects

Yes

Yes

Observations

233

239

Chi-squared

84.77***

103.61***

R-squared

0.1710

0.1559

0.469

0.53

Notes Results are based on GLS random effect regressions with controls for heteroskedasticity and autocorrelation. P-values are not reported. ***, **, and * denote statistical significance at the 1%, 5%, and 10% levels, respectively Table 4.11 COC and ESG Scores: dynamic panel data estimates COC from 2006 to 2008 (1)

COC from 2009 to 2011 (2)

β

β

Z-stat

Z-stat

Intercept

0.027*

1.76

0.008

1.16

ESG scores

0.008**

2.22

0.003**

2.12

Equity float

0.068

0.54

0.001

0.45

Beta

0.068

0.54

0.001

0.45

Det/Cap

0.071***

8.10

0.025

1.42

Anal rec

−0.005

−1.02

0.016***

6.51

Total assets (log)

0.042**

2.34

0.160***

8.13

Industry and year effects

Yes

Yes

Observations Sargan test S1 S2

225 221.65 (0.43) −1.816 (0.06)* −0.215 (0.82)

229 330.13 (0.53) −2.165 (0.03)** −1.077 (0.28)

No. of instruments

232

346

Notes The sample consists of an unbalanced panel of corporate governance data from all firms listed between 2006 and 2011. S1 and S2 are t-statistics for first- and second-order serial correlation. Sargan is a test of the over-identifying restrictions under the null that the instruments are valid. The right-hand-side variables are treated as endogenous using lags back from t − 2 as instruments. P-values are not reported. ***, **, and * denote statistical significance at the 1%, 5%, and 10% levels, respectively

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The findings have indicated that the disclosure of social, environmental or governance information had a direct effect on the cost of capital. The small magnitude of the coefficient has to be found in the particular context of the crisis. Whereas the capital market could award a lower cost of capital to companies that correctly disclose information, the unstable context of the crisis prevents analysts to effectively do so. Hence, as stressed in Tables 4.10 and 4.11, disclosure is a necessary condition to decrease the cost of capital, but it could not do so sufficiently in a risky context. Moreover, the small connection between social disclosure and the cost of capital, and the relatively weak link with financial analyst recommendations support the analysis of Margolis and Walsh (2003), who have already underlined the weak connection between the transparency of social information and corporate performance. The financial shock amplifies the phenomenon. Disclosure of material information on foreseeable risk factors is considered as good practice. But in a credit crunch context the impact on cost of capital could be undermined (Kirkpatrick 2009). Disclosures about social valorisation, employee motivation or gender equality were also found to not be determinant in companies’ financial performance or in reducing their cost of capital. Orlitzky et al. (2003) have provided additional explanations at this level with a meta-analysis concluding in a lack of correlation between the quality of the social information being disclosed and financial market performance, leading in turn to a lower cost of capital. Irrespective of the social scoring grid suggested by the researchers surveyed in this meta-analysis, the impact has never been significant for financial performance or the cost of capital. Our results confirm this analysis by adding a new dimension: during the crisis period, the market has difficulty correctly evaluate the quality of the disclosure which prevents analysts from decreasing the cost of capital. This is consistent with the arguments of previous research. For Orlitzky et al. (2003), it was only accounting performance criteria that were positively associated with social performance and disclosure quality. Yet the cost of capital is traditionally calculated using stock market criteria. Our finding has revived a debate that Margolish and Walsh (2003) started regarding social performance, the disclosure thereof and its impact on financial performance and the cost of capital. The social disclosure criteria mobilised in CSR are clearly an insufficient reflection of a company’s social performance. Financial markets are unable to get a sufficient grasp over this to establish a connection with financial performance, thereby influencing the cost of capital. After the subprime crisis investors decided to enlarge their scope of investigation in order to reduce the uncertainty. This finding corresponds to the research made by Author 1 and Bardinet (2014) who revealed that investors were eager to learn more about the impact of CSR disclosure on financial performance and cost of equity. They realised that CSR disclosure reveals pertinent information about social, governance and environmental performance. The study has also revealed that financial analysts played an important role post2008, with findings advancing the idea that investors must now have a much more in-depth analysis of the cost of capital. This is because they feel the need to assess financial risk above and beyond any economic aspects or financial reporting-related issues. Because of these considerations, they tend not to refer to disclosure scores.

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Information confirmation efforts have intensified, with financial analysts becoming a relevant source of information post-2008, helping people to understand a firm’s financial health. Unlike investors, analysts look at the indicators that companies publish and incorporate in their recommendations while assessing the cost of capital, any data published relating to governance, the environment and (to a lesser extent) society. These outcomes can be explained by three main arguments. Firstly, analysts have realised that social information delivered for scoring purposes tends to be relatively weak and uncorrelated with companies’ social hence financial performance. Secondly, they realise that the environmental information being disclosed has a significant effect on future cash flows, hence on a company’s risk. This makes it a key factor in buy recommendations. Lastly, a company’s mode of governance is a concept that can be difficult to apprehend and quantify. Even so, governance performance does affect financial performance, certainly with respect to solvency constraints and funding needs—all of which impacts the cost of capital. Financial analysts require information about the methods and quality of governance. Hence there is a positive relationship between the quality of governance-related disclosures and a buy recommendation. Without corporate disclosures, investors are unable to distinguish between good and bad firms and therefore offer a price that reflects the average value of all firms. So, firms with an above-average value have an incentive to disclose private information about their true value. Once these firms disclose, investors rationally infer that the average value of all non-disclosing firms is lower and adjust the price to reflect this expectation. Globally our analysis has clearly identified the difficulty to identify the quality of disclosure in a crisis context. Before the 2008 crisis, the uncertainty towards disclosure prevented the analysts from diminishing the cost of capital for companies that voluntarily disclose information. After the crisis, the context of credit distribution did not lead to magnifying the voluntary disclosure of firms as regards their liquidity position. Much previous research conveyed the message that CSR reporting—and more specifically, environmental reporting—is an attempt by corporations to manage public impressions and investor perceptions. The present findings suggest that a different perspective is possible, insofar as CSR reporting does give relevant information to at least one key stakeholder group, namely financial analysts. In all probability, what it offers their recommendation decision processes is something much deeper than a mere superficial impression. Uncertainty can nuance this judgement, which constitutes precisely our contribution to the ongoing debate as to whether and how accounting quality decreases the cost of capital. Shocks can prevent practitioners from advising about the missed earnings. In that context, disclosure could not improve market efficiency and thereby not lead to more adequate managerial investment decisions.

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Appendix: Bloomberg Criteria Scoring the Quality of Environmental, Social and Governance Information Disclosure Dimension

Scoring criteria

Disclosure score

Environmental CO2 emissions (thousand metric tons) Greenhouse gas emissions (thousand metric tons) Energy consumption (thousand megawatts/hour) Water consumption (thousand cubic meters) Hazardous waste (thousand metric tons) Total waste (thousand metric tons) Recycled waste (thousand metric tons) Paper consumed (thousand metric tons) Paper recycled (thousand metric tons) Number of ISO 14001 certified sites Investment in sustainability projects (in e million) Social

Number of employees % staff turnover % unionised employees Average employee age % female employees % female managers % employees from ethnic minorities % disabled employees % managers from ethnic minorities Industrial accidents Time lost due to accidents (number of hours) Deaths among contract workers (number) Deaths among full-time staff members (number) Spending on work council activities (in e per employee) Budget for employees’ continuous training (in e per employee) Socially responsible investments (in e million)

Governance

Size of board (number of directors) % independent directors (as share of board total) % women directors (as share of board total) Directors’ average age Age limit for directors Years of service on board (continued)

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(continued) Dimension

Scoring criteria

Disclosure score

Number of annual board meetings Number of annual audit committee meetings Attendance at board meetings Gift and sponsorship policies (in e million) Possibility for CEO to have a dual role (combining Managing Director and Chair of the Board functions)

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Jocelyn Husser is full professor in Corporate Finance and teaches Management, Management Control and Finance at IAE Aix-en-Provence, Aix-Marseille University. He holds a PhD in managerial finance at Bordeaux University. His research concerns 2 fields: Firms’ performance, Corporate Social Responsibility and Sustainable Development, Ethical Decision Making. He wrote two books in Corporate Finance and Management Control. He published in JBE (Journal of Business Ethics) in 2014 and 2019. He works for the Cergam laboratory, IAE Aix-en-Provence. Elisabeth Paulet is professor of Economics and Finance in ICN Business School in Nancy. After a PhD at the European University Institute of Florence, she holds a Jean Monnet Chair. Her main interests are in banking structures and financial policy of firms on historical and contemporary level. She has published several books in this field in editorial house like Pickering Chatto or Cambridge. She has published several scientific articles in Corporate Governance, Journal of Business Strategy, Journal of Business Ethics, Journal of European Economic History. She was in charge of a research project on Banking Regulation and Systemic Risk.

Chapter 5

Profile of the Entrepreneur of Triunfo-Pe Counters Cristina Glória Lima da Silva, Zaidiana Lemos Zaidan, Emanuel Ferreira Leite, and Emmanuelle Leite Cientista

Abstract Entrepreneurship is a term that is gaining its space with the progress made over the years. Thus, the current scenario requests individuals with the capacity to contribute to improvements, but also ready to break paradigms and generate wealth in the environment in which they operate. It is important to note that the participation of women in business and in the labor market is growing day by day. Women are becoming increasingly important, for occupying extremely relevant positions in companies, which before was only the competence of the men. In the matter of undertaking it is not merely opening a business, it also comes to incorporate innovations, offer more employment opportunities, take calculated risks, plan goals, have differentiated views, among other attributes. In this scenario occurs the need to have more professional entrepreneurs who contribute with improvements to the society and have in themselves a competitive advantage, this differential is composed of entrepreneurial skills considered unique in each individual. Accounting has been an important tool combined with management that cares about business success. Therefore, the study of the entrepreneur professional who works in the accounting area is relevant inasmuch as shows the great importance of entrepreneurship to society and to the accounting practices in these professionals daily life. Thus, this study aimed to identify the entrepreneurial profile of accounting professionals located in the city of Triunfo, in the state of Pernambuco. The specific objectives of the research consisted of analyzing entrepreneurship starting from its concept, highlighting the successful entrepreneur, with that came the necessity of pointing out the most frequent C. G. L. da Silva Faculdade de Integração do Sertão-FIS, Vila Canaã, Triunfo-Pernambuco, Brazil Z. L. Zaidan Faculdade de Integração do Sertão-FIS, Serra Talhada, Pernambuco, Brazil E. F. Leite (B) Faculdade de Ciências da Administração de Pernambuco, Universidade de Pernambuco, Pernambuco, Brazil e-mail: [email protected] E. L. Cientista Social Mestre em Antropologia, Universidade Federal de Pernambuco, Recife, Brazil © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_5

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entrepreneurial skills in the interviewed professionals, in view of that, to identify whether there occurred entrepreneurship of necessity or opportunity. To meet the proposed objectives, this work proceeds with a survey alongside three accountants, who are also management, of accounting offices located in the city of Triunfo—PE. The methodology used to obtain the results followed with field research with the professionals of the mentioned city, characterizing it as quantitative and qualitative field research, as well as bibliographic, with the use of questionnaires applied to the managers. It was possible to find in the accountants interviewed that the most present entrepreneurial skills in their profiles were achievement motivation, self-control, and problem-solving. We can verify that those are characteristics that directly or indirectly contribute to improvements in these managers’ enterprises. However, they are lacking the propensity to take risks and influencer skills, it was verified that they presented a very low level in these skills, it is pertinent to say that unfortunately, they do not have completely the entrepreneurial profile. Regarding the business opening, in one of the research objectives it can be ascertained that only an accountant opened the business due to a good opportunity she found in the city, however, the other two counters interviewed said they have opened the offices, which manage, out of the need they were facing at the time. Keywords Women’s entrepreneurship · Accounting professionals · Entrepreneurial profile

5.1 Introduction Entrepreneurship brings together individuals in the execution of ideas into business opportunities, in addition, it can break patterns and, consequently, is able to produce wealth for the social environment. It can be considered as a term that has gained its place in society with the progress made over time. The entrepreneur should not be seen only as an individual who opens his or her own business. Entrepreneurs are people who introduce innovations, increase employment opportunities, take calculated risks, plan theirs goals are optimistic, and have a differentiated view, that is to say, they see opportunities that others do not see. In an increasingly competitive and dynamic scenario, being an entrepreneur professional is to contribute to the economic and social growth, moreover, it is to have a competitive edge. This competitive advantage consists of entrepreneurial characteristics considered unique, which can be internal and may appear in face of external stimuli. Thus, it is possible to see that, with technological advances and fierce competition in the search for success and survival in the economic and social scenario, the women’s role, accounting professional, is becoming increasingly important. It is necessary to monitor the constant changes in this new scenario, meeting the requirements, and adopting appropriate positions. The accountant of any kind stands out, with an important role in generating relevant information on the enterprise, either in the public or private area, assist in decision-making, thereby contributing to the

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survival and progress of the entity. Yet it should not be limited only to these functions, it is interesting to search or awakening itself, other evaluative features to your profession, as for example, having entrepreneurial characteristics that contribute to the professional distinction. Therefore, since its formation and particularly in his or her role as an accounting professional, it is necessary to search continuously, to be always well informed, to know a bit of the whole company, how to work in teams, be motivated, bring innovations, follow all the requirements of today’s economic scenario, etc. Whether in the public or private departments, services sector, trades, industry, tourism, among others, it is of high importance to remain always updated. For this reason, this research favors the accountants located in the city of TriunfoPE. Such a city that not long ago was known as a village linked to other municipalities and today stands out as the tourist town of the hinterland oasis in the Pajeú microregion. The city of Triunfo is located in the hinterland, the countryside of Pernambuco state. Even small, has a differential, as a result of being characterized by a pleasant climate and is renowned for its tourist attractions. The factor that drives its development is the practice of tourism, this contributes to the growth of the economy, thereby creating new entrepreneurial opportunities, new jobs, and space to innovate, among other views to be explored by competent professionals who embrace the emergence of opportunities which contribute to their growth. Then, how to identify the entrepreneurial profile of the accountants in the city of Triunfo-PE, punctuating the main characteristics that compose it? This work aims to identify the entrepreneurial profile of accounting professionals in the city of Triunfo-PE. For this, it is necessary to analyze entrepreneurship from its concept, highlighting the successful entrepreneur professional, by verifying the most outstanding entrepreneurial characteristics and the most relevant in these financial professionals, in the face of that, to identify whether there is the entrepreneurship of necessity or opportunity. To meet these objectives, this work follows with a survey of the accountants located in the city of Triunfo-PE, in a quantitative and qualitative field research methodology, using questionnaires applied to these professionals. The addressed theme is relevant to professional accountants of Triunfo-PE, students, and future professionals and also contributes to the users of financial services, for the investigation of the entrepreneurial profile of these professionals located in the tourist city of Triunfo, analyzing their entrepreneurial characteristics. This work brings collaboration to the extent that identifies their strengths and weaknesses, as participants in the accounting field also proposing their improvement. The theme also contributes to the current students of the Bachelor course in Accounting, as well as future professionals, to form their profile through the data shown and studied here, presented in the research with the accountants located in the city mentioned, also it remains open to new investigations that may contribute to the academic and professional training of these students.

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5.2 Entrepreneurship Entrepreneurship has been recognized in the process of uniting people with ideals of achievement. It is also seen as a wealth generator and an economy booster. These people willing to undertake are individuals with a high capacity to take risks relating to patrimony, time, and even commitment to what they do. They have innovative ideas, break paradigms, among other attributes to pursue the realization of their ideals. The word undertaking comes from the French “entrepreneur”, which means taking risks and start something new, involves people willing to take risks presenting skills and expertise to create, open, and run a business (Dornelas 2014). Entrepreneurship is gaining its important role in the course of time, for monitoring the progress, there is the impression of it being something “new” to society, but one can say that it is an old concept that stood out in different perspectives throughout its trajectory. The origin of entrepreneurship and its contribution to the world are linked since a long time ago. It can be said that its first use took place with Marco Polo’s idea, which was to establish a trade route to the East. To accomplish his ideal, Marco Polo took the entrepreneurial role, found a man to fund his idea, and signed a contract with the same man to sell his goods. Thus, the man, who can be called a capitalist, took risks passively, as for Marco Polo, the enterprising adventurer, took an active role running all possible risks (Dornelas 2014). Therefore, it can be seen that the attitude of Marco Polo shows that entrepreneurship requires much more than a good idea. Being an entrepreneur is to have attitude, boldness, and face all commercial, legal and personal risks of a project. Over the years, emerged more critical views and well-founded about entrepreneurship and the entrepreneur’s role in society. In face of so many ideas about its origin, concepts, and definitions in many angles, both the result of rapid technological advancement, but also by the market through economic competition of who creates more profit and keeps the capitalist scenario, entrepreneurship comes with a new point of view. Entrepreneurship can be seen as a more appropriate method which connects science and market due to the creation of new businesses, consequently carrying new products and service to society. The scenery for the entrepreneur and their important role in society have changed and reflect a new concept of entrepreneurship. Dornelas (2008: 22) states that: “[…] Entrepreneurship is the involvement of people and processes that, together, lead to the transformation of ideas into opportunities. And the perfect implementation of these opportunities leads to the creation of successful businesses.” It can be noticed among so many concepts of other periods related to entrepreneurship that we managed to have this one brought by the mentioned author, showing that entrepreneurship is the combination of people in the goal achievement or the identification of an opportunity to make it happen and offer something different to society. Therefore, it appears that new theories and analyses about the real meaning of the word entrepreneurship were built, several concepts were formed and reformed

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constantly, as well as studies on the ability of people to undertake. With that, a series of questions and answers have been emerging, making this area gain its space and the attention of great scholars on the subject, benefiting people as a whole, as they began to make use of new products and differentiated services.

5.2.1 Women’s Entrepreneurship Entrepreneurship in its entirety does not distinguish between genres because being an entrepreneur and possess entrepreneurial characteristics and skills does not depend on being male or female, even the male public being the most preferred long ago. Women are increasingly participating in the labor market. According to IBGE, in recent decades the female population is more present in several business classes as well as in other market segments. In entrepreneurship, we can see that the participation of women is also growing (IBGE 2015). Researches show that new businesses are being generated by women who are certain of what they want. According to GEM, women open company for various reasons, whether for independence, perception of a market opportunity, need for achievement, among others. For those reasons, there is an increase in female entrepreneurship rate in the country (GEM 2013). Consequently, we can see that women in various positions and professions opt for having their own business with intention of flexibility in their lives, but also as following career options.

5.2.2 Entrepreneurship: Opportunity X Necessity The country’s economic development depends not only on business creation, it is necessary to see the opportunities in the market. This statement unfolds two types of entrepreneurship: opportunity and necessity. It is observed in Brazil, around the 2000s, the intense growth concentrated in the internal market expansion, this led to opening space for the increase in the share of TEA which undertakes by opportunity. By 2006, this segment accounted for approximately 50%, increased from 2007, when it hits 56.1%, reaching 71.3% in 2013. (GEM 2013). It is necessary to understand that the entrepreneurship of opportunity is one in which the entrepreneur even with other career options or source of income, chooses to start a new business, having focus, creates a company based on prior planning having in mind what wants to search for the company, in order to make profits, create jobs and wealth for society, this function can be fully linked to the country economic development (DORNELAS 2014). The entrepreneurship of necessity involves the entrepreneur who starts his business without planning, autonomously, and, for lack of a better occupation and even source of income, ventures in the idea of having their own business (GEM 2013).

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We can see that both are currently taking place, but as for economic and social growth factors, also adding value to the entrepreneur, is more interesting to occur entrepreneurship of opportunity, this, in its turn, is one of the growing options for the country. The entrepreneurship of need as well as being a riskier way to become an entrepreneur, its practice makes the permanence of the enterprise on the market dwindles.

5.2.3 The Accounting Professional and Entrepreneurial Profile The profile of a professional entrepreneur is filled with characteristics that lead to a successful individual. These characteristics can be internal or external in each professional. Innovation, search for new opportunities, vision of future, ability to take risks, among other features, contribute to the formation of an entrepreneur accountant. The accounting professional and its market performance Accounting is part of the Social Sciences since it is based on laws, principles, and other standards due to the social relationships between companies, individuals, and entities in general. Its main object is the property in quantitative and qualitative aspects, focusing on its variations (Fortes, 2001). Connected to this science we have the accounting professional, who in its turn, constitutes a profession that allows multiple possibilities for action. Each day increases the broad areas for accounting, due to market expansion. In addition, there is a more narrowed look, both on the public and the private sector on such importance and influence that the accounting information has to successful management. The accounting profession is regulated by Decree Law 9,295 / 46, which determines two professional categories: accountant and accounting technician. Both are trained professionals, prepared and legally authorized by the Regional Accounting Council—CRC of the place where they will perform the functions which are entitled (Fortes 2001). Thus, one can see that the prospects of action for professional accounting are composed of the analysis of market opportunities, as well as the requirements of this market to the future accounting professional role. However, it is considered as the main function of the accountant the production of information needed for decision-making. The current scenario of accounting does not turn to the owner but to the central figure of the entity. And so, the accounting professional has the important role of managing all the information along with the data that influences decision-making (MARION, 2007). The accountant needs to have in his or her profile characteristics that make him or her ready for boosting up and also being more valued by society, so Koyama (2010:

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60-61) state that: “The professional must have initiative, ethics, vision of future, ability to create and innovate to provide information necessary so there is survival in a globalized world.” These characteristics are very interesting combined with the profile of professional accounting entrepreneur, which are called entrepreneurial characteristics. The current dynamic and competitive market requires accountants with entrepreneurial profiles, filled with features that turn them into a competitive edge. Hence, for the accounting professional is extremely important since his or her formation and especially in their professional practice, to seek constantly to be well informed, to know a little about the entire company, to be motivated and learn how to motivate your employees, to know how to work in teams, to have good ideas as well as to bring innovation to the social and economic environment in which they operate.

5.2.4 Entrepreneur Profile The entrepreneur is an individual with a high capacity to stimulate the creation of the future. With a differentiated view of others, is always looking for new business opportunities. Their talent is the result of perception, direction, dedication, and hard work. But the act of undertaking consists not only in spotting a good opportunity, but also includes choosing the best path to lead the project to success (DORNELAS 2014). The entrepreneur has simplicity while doing the most basic tasks, has a sense of mission, i.e. sets the priorities, has a view toward customers and even the products, it makes they create a company based on this vision, dedicated more to have a lasting development, influenced by the reality in which he or she lives, dominates the field of destination, in addition, its action is always innovative. The literature has been constantly outlining an entrepreneur profile, seen as an individual with high creativity and great fulfillment capacity. Known as a practitioner of contributing ideas to leverage the economy, assumes all calculated risks, and keeps his gaze to the relentless pursuit of growth and achievement of his or her objectives and goals. Therefore, it is noted that the entrepreneur is not something that can be produced, in the sense that the individual is born ready with the perfect profile of an entrepreneur. Any human being can have in them the entrepreneurial spirit, which needs to be stimulated and developed, for only then produce effects on the environment they live in (Dolabela 2006). The person who wants to become an entrepreneur essentially needs to have the entrepreneurial spirit. This spirit is not something drawn on the personality, it can even exist, but it is considered as a behavior that can be adopted according to the environment where the person lives and works. The XXI Century entrepreneur’s profile in relation to the past has some distinctive attributions, these can be said, according to Leite (2012), which are characteristics that build up their current profile based on their behavior. It is shown in Chart 5, some features on the highlighted entrepreneurial behavior (Table 5.1).

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Table 5.1 Characteristics of the entrepreneur profile Features

Entrepreneurs

High need for achievement

Work with the expectation of achieving the highest levels of accomplishment

Taking risk

Do not intimidate with the possibility of taking risks, although opt for calculated and not excessive risk

Know how to solve problems Are innate leaders and usually the first to identify potential problems and find possible solutions Need for status

Find satisfaction in symbols of success external to themselves. Like that the business built by them to be admired, but are embarrassed when the praise is addressed to them directly. Do not allow the needs relating to the status to interfere with the business mission

High achievers energy levels

Are, mostly, dedicated, willing, and ready to work. They can work for long, continuous periods of time as they build their businesses

Have self-confidence

Are extremely self-confident individuals, believing in their skills and abilities. They believe to be able to change the order of events and be masters of their own lives

Emotional detachment

Do not allow their emotional relationship to hinder the success of the enterprise

Need for personal satisfaction Due to the fact that they are motivated by an extreme need for personal satisfaction, have, for the most part, little interest in any form of organizational structure. They see most organizational activities with disdain and have difficulty working in large companies Source LEITE (2012: 135)

These characteristics cited by the mentioned author can be said to form the behavior of an entrepreneur. Known also for their way of dealing with the reality around him, their features make them an individual with a differential over the others, despite being a human being like any other. In this sense, the entrepreneurial spirit can be shaped and fixed, by observing a few missing or less present features in order to be worked for a better entrepreneurial profile.

5.2.5 Entrepreneurial Skills and Professional Accounting The constant changes in the economic scenario entail the necessity to adapt to the dynamics of such changes. As a way to continue inserted and survive in this big picture, it is necessary to adopt the appropriate profile. It is necessary to encourage ideas, seek new opportunities, have a differentiated vision, optimism, innovation, and inherent characteristics of the successful entrepreneur. Currently, the entrepreneur is recognized as a driver of the economy, who transforms ideas into reality and promotes

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changes. The entrepreneur is a dynamic individual, according to Dolabella (2006: 31) “The entrepreneur is dissatisfied that turns their nonconformity into discoveries and positive proposals for themselves and for others.” This is a peculiar and striking feature, having in their cognitive and irrational nonconformity linking their currentness to situations or things that need to be changed. Therefore, it is noted that the entrepreneur is not a settled person, due to which is always changing the environment they live in. A good entrepreneur must know very well the product or service offered, the market in which operates as well as learn to coordinate people and motivate them, being them customers or employees, the consumer choices of products or services, also in carrying out tasks. Based on these ideas, we note that the current social context requires a fully trained individual, who has characteristics focused on absorbing all possible knowledge so that it is consistent with the science of the present and the vision of the future (Drucker 2010). Thus, it is clear that it is not interesting to the accountant to adopt a settled professional posture, limiting their function within the entity. With that, the accounting professionals need to form their profile combined with features that make them successful. It is important to have extensive knowledge of the market in which they operate as well as being a reference in the development of their work. For this professional, it is important to go beyond its role in observing the taxable part of a company, for example. Their potential should be influence participation in decision-making, with a focused vision to identify and correct any difficulties encountered along the way. For this role, it is significant to develop entrepreneurial actions based on the information obtained by accounting. The current competitive market requires immediate and innovative solutions to problems and economic needs as well as social, so the accountant, to be successful, needs to have the entrepreneurial spirit. Concerning the entrepreneurial spirit, Drucker (2009:33) states that “The entrepreneurial spirit is, therefore, a distinctive feature, either of an individual or an institution, is not a personality trait.” Another important factor in a successful entrepreneur is not only having the idea of undertaking but having in themselves the entrepreneurial spirit. The market segment for accounting professional is broad, which makes the requirements to have updated and skilled professionals increasingly all the time so that being these successful ones, ensure the provision of reliable tools that contribute to the continuity of the enterprise. Therefore, for the success of any company, entity, or we can also say organization, whether public or private, it is necessary to have people endowed with features that make them references to the success of the enterprise. Hence, we can see that the environment is a complementary and stimulating factor for the development of the entrepreneur and his peculiar personality. It is clear that some people dominate an inner strength that leads to the act of undertaking in benefit of themselves or other external cause, or some other stimulus inherent to their outside, to know all these characteristics becomes a relevant point to perform the actions for entrepreneurship development around the world.

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Table 5.2 Skills for the entrepreneur potential Skills for the entrepreneur potential Achievement motivation

Um desejo de fazer acontecer, de atingir um alto padrão de realização/atingimento de objetivos

Self-control (of destination)

Sense of influencing the course of events in their lives. The destination is defined more by something internal to the person than due to external factors

Propensity to take risks

Takes calculated risks and seeks information before acting. Desire to be responsible for the actions

Resolução de problemas

Someone who knows how to solve problems realistically and plays an operation/business without needing a lot of help from others

Influenciador

The ones who find people to help them meet their own goals. Knows how to convince people to work for the achievement of a goal set out for them

Fonte: Dornelas 2015

It is noticed that for the accounting professional there is the necessity of selfimprovement to better meet the demands of the current economic and social scenario, generating positive results and contributing to local growth in which they operate as well as standing out as a renowned professional. The current market requires much more from accounting professionals than just technical knowledge. It is important for this professional to develop skills to understand better the business and develop its role in the best possible way. Thus, it is relevant to the accountant to develop a more coherent profile with the current scenario requirements. The accounting professional ability to undertake, according to Vieira (2006) consists of having skills such as self-knowledge, learning from self-experience, dedication, innovative spirit, motivation, planning, and market analysis. The entrepreneur potential can be observed along with the development of some skills, Dornelas stresses them as shown in the Table 5.2. In the face of this, it can be seen that the accounting professional needs, in addition to master the technical knowledge, to assign to other characteristics, which are also skills, which gives a competitive difference. The current market demands and creates expectations about this professional regarding the favorable performance of the entity. Consequently, it is relevant to them to always be qualified to be capable of interacting with people and evaluate growth patterns and strategies. Based on the skills mentioned by the author, Dornelas, the research in question will have them as reference. Will be used the questionnaire prepared by the same author to identify the entrepreneurial profile of the accountant in the city of Triunfo-PE.

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5.3 Methodology Regarding the objectives Method To achieve the objectives of this study it was decided to use the bibliographic method, along with documental, monographic, and descriptive. According to Gil (2009, p. 50), “bibliographical survey is developed based on material already prepared, consisting mainly of books and scientific articles.” The literature survey is more advantageous because it allows the reader to have a wider knowledge, i.e. in this type of research every detail of what is needed to meet the reader’s needs is understood. In Marconi’s vision; Lakatos (2003, p. 108), the monographic method “is the study of certain individuals, professions, conditions, institutions, groups or communities, in order to obtain generalizations.” Concerning the procedures The procedures used were: Descriptive, Bibliographical, Survey. According to Gil (2009, p. 28) “Descriptive research aim to describe the characteristics of a given population or phenomenon.” The Bibliographical one, as stated by Marconi; Lakatos (2003, p. 182) “covers the entire bibliography already published in relation to the subject of study. It has the function to put the researcher in direct contact with all that has been written. The survey also, according to Gil (2009) consists of direct questioning of people, from whom we want to know about the behavior. Comes from the information request to a determinant group of people about the studied problem. Regarding the research techniques Indirect Documentation For data collection was used to document and literature research. Marconi (2003) states that the documentary research feature is that the data collection source is restricted to documents, written or not, constituting what is called primary sources. On March 9, 2015, it was made contact with the Regional Accounting Council— CRC, located in Recife, capital of Pernambuco state. A list of accounting firms in the city of Triunfo was requested. We were informed that Triunfo city had three companies registered in the CRC entity. Direct Documentation Direct documentation was used in the field research with a survey and a quantitative and qualitative approach. For Gil (2009, p. 55), a field survey is characterized by questioning directly people whose behavior you want to acknowledge. Proceeded to the information request to a significant group of people about the problem studied, so then, by quantitative analysis, obtain the corresponding conclusions from the data collected. If on one hand quantitative methods are based on the positivist philosophy,

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qualitative methods have an orientation to the interpretative paradigm. Thus, the reductionist view expands to attempt in-depth understanding of the studied object (Marconi 2003). About quantitative and qualitative research, Silva (2008, p. 28) comments that quantitative approach in research methods is well used to develop descriptive investigations. Qualitative investigation is emphasized, yet, according to Silva (2008, p. 31) as the one that works predominantly with qualitative data, i.e. data collected by the researcher which is not necessarily expressed in numbers. Concerning the approach The universe of this research is the existence of three accounting offices, located in the city of Triunfo-PE. Universe or Population is conceptualized by Marconi (2009, p. 112) as the set of animate or inanimate objects having at least one characteristic in common. The research follows with probabilistic sampling, simple random sampling. According to Marconi (2009, p. 112) the probabilistic sampling is based on the random selection by researchers, meaning that the random selection is made so that each member of the population has the same probability of being chosen. Simple random sampling, according to Gil (2009, p. 91) consists of assigning to each member of the population a unique number and then select some of these elements in a casual way. A questionnaire was applied during the period from 15th to 22nd April 2015, to the three professional accountants from the three accounting offices, located in the city of Triunfo-PE to identify their entrepreneurial profile. Regarding the data collection instrument The instrument was a questionnaire with a total of 41 multiple-choice questions, 35 of those taken from the José Dornelas web page, the other six questions were adapted and inserted by the author of this work. The 35 covered the skills for entrepreneurial potential, the other six, asked about the professional profile characterizing it and how did the opening of the business happen. For Silva (2008, p. 60) questionnaire is an orderly and consistent set of questions regarding variables and situations to be measured or described. The analysis of the questionnaire was done by scores on the answers of respondents. Each question corresponds to an entrepreneurial skill, so, with the sum of the points from the responses, it is possible to verify to what extent the accounting professional has the skills that make an entrepreneurial profile. Concerning the analysis of the data For a better understanding of the information collected, the data were treated using graphics, which provided better clarity of the research and better interpretation.

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5.4 Presentation and Discussion of Results Research Application The survey was conducted in three accounting offices located in the tourist city of Triunfo in the state of Pernambuco, with the aid of a questionnaire answered by the managers of these enterprises. The three managers will be identified as Interviewed A, B, and C, respectively, maintaining the confidentiality of their identities. During the research, it was verified if the opening of the offices was held by entrepreneurial of opportunity or necessity. Also with the results, the entrepreneurial profile of these professionals was analyzed, punctuating their main entrepreneurial skills (Table 5.3). The city of Triunfo—PE Located in the hinterland of Pernambuco, 402 km from the capital Recife, Triunfo is known as “Oasis of the Hinterland” due to its location being at a higher point, having lower temperatures, making the microclimate cold. According to IBGE (2010), Triumph-PE has a territory of 191,518 square kilometers, borders the state of Paraiba, and the cities of Flores, Calumbi, Santa Cruz da Baixa Verde, its population in 2010 was 15,006 inhabitants and estimated for 2014 is approximately 15,264 inhabitants. Its Human Development Index (HDI) in 2010 was 0,670. According to the target plan 2013–2016, the Gross Domestic Product (GDP) in 2005 was 37,746, and the per capita GDP of R $ 2,475.00. In a brief historical approach of the city of Triunfo, it appears that his name “Triunfo” comes from winning a fight that involved the Campos Velhos family of the city of Flores, with the inhabitants of Baixa Verde, eager to follow the progress of the town, created a street market. The Campos Velhos, unsatisfied, tried to stop, but could not, so this fact stimulated the desire of the inhabitants of Baixa Verde to dissociate from the Campos Velhos. It was initiated that the search for the transformation of Baixa Verde into a Village, on June 2, 1870, by Provincial Law No. 930, which created the parish of Nossa Senhora das Dores, dismembered from Flores parish, this law turned the Baixa Verde village to the category of town with the name of Triunfo. On June 13, 1884, Provincial Law No. 1805 created the district of Triunfo and changed the village of the same name into the category of a city. Table 5.3 List of skills related to the questions

Entrepreneurial skills

Related questions

Motivation for achievement

8, 11, 17, 18, 19, 25 and 26

Self-control (of destination)

10, 14, 20, 24, 29, 34 and 37

Propensity to take risks

13, 16, 23, 28, 30, 35 and 41

Problem-solving

9, 12, 15, 21, 27, 31 and 33

Influencers

7, 22, 32, 36, 38, 39 and 40

Source Research data 2015

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Triunfo is now recognized as a quiet country town, where people live peacefully, without violence, its main activities are agriculture and tourism. According to the Municipal Department of Tourism, there have been several major tourist attractions such as the mills, caves, waterfalls, and the highest point in the state of Pernambuco: Pico do Papagaio. Not to mention the folkloric demonstrations in festive seasons, the tradition of “Caretas”, a special kind of masked manifestation which is a trademark of the locality (Tourist Office—Triunfo City Hall). The touristic activity is developed in accordance with principles and practices based on aid to achieving the desired development in order to reduce occurrences of environmental, economic, and even social unsustainable practices. This activity is of great value to the city, it leverages the economy and thereby creates new entrepreneurial opportunities, new jobs, and space to innovate and develop a competitive edge combined with internal and external characteristics applicable to a successful entrepreneur. Therefore, the city of Triunfo was chosen as a field of study for this monograph. The purpose of the research is to contribute in general to the prospects of accounting professionals because they contribute significantly to the society of the city concerned. It is worth mentioning about the entrepreneur’s behavior, this, in turn, may be related to various professions and even spheres of human life, but here focuses on the Triunfo accountant figure.

5.5 Analysis and Results At this point, we have the analysis and discussion of the survey results carried out with accounting offices, prioritizing their managers located in the mentioned city. The questionnaire used in this study has 41 multiple-choice questions. This questionnaire template was taken from the Dornelas webpage (2015) with some adjustments made by the author of this work. Questions 1–5 correspond to identifying the professional and forming their profile, observing attributions such as female, male, age, education degree, among others. Question No. 6 addresses the opening of business, it was asked if was entrepreneurship of necessity or opportunity. Still, about the questionnaire, questions 07–41 relate to the group of five entrepreneurial skills, each skill has seven questions, each question contains three alternatives, only one of which corresponds to a ponctuation score, referring to an entrepreneurial skill. Thus, the sum of the extracted points of the responses of the interviewees is used to verify to what extent the Triunfo accountants have skills that compose their entrepreneurial profile. In Chart 08—List of skills related to the questions, has issues regarding every entrepreneurial skill. The three managers interviewed are listed as, respectively, Interviewed A, B, and C with a description of the data of their profiles soon to follow. The interviewed A is female, would not reveal her age. It has technical training in accounting, resides in Triunfo. It can be seen that the interviewee has extensive experience in accounting

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Boa oportunidade x Necessidade Financeira

0,5 0 Entrevistado A

Entrevistado B

Identificação de uma boa oportunidade

Entrevistado C Necessidade Financeira

Fig. 5.1 Opportunity Entrepreneurship x Necessity [Good oppurtunity x Financial need. Interviewed A, B and C. Identifying a good opportunity. Financial need]. Source Research data 2015

practice, but did not want to go beyond the technical course and much less to recycle her knowledge in extracurricular courses. The interviewed B is female and resides in Triunfo. 51-year-old, her educational background consists of a degree course in mathematics and a bachelor’s degree in accounting. Besides these, she has an extracurricular course that somehow contributes to her professional development, she revealed that the course was called “Accounting for Success”. The interviewed C is female, lives in Triunfo. 54 years and their training is technical in accounting. Did not write about her educational background beyond the technical course and revealed that did no extra course to recycle and keep updated. Based on the responses of interviewees above we can observe if in the opening of business there was entrepreneurship of necessity or opportunity, as shown in Fig. 5.1. Opportunity Entrepreneurship x Necessity. The opportunity entrepreneurs are those who undertake because they have found a good business opportunity, even with other options for employment and income. As for the entrepreneurship of necessity, it occurs due to not finding better employment options and also by the need to generate income for themselves and their families (GEM 2013). At this moment of the survey, it was possible to respond to the third specific objective, which is to identify whether there is the entrepreneurship of necessity or opportunity at the opening of business. According to the data shown in the chart above, note that from the three managers interviewed, two developments were for necessity and the only one took place by opportunity. The entrepreneurship opportunity, according to surveys conducted by GEM (2013), is growing at a significant percentage in Brazil. But based on the chart, it can be said that this fact, unfortunately, does not occur with the searched object. Since the entrepreneurship of opportunity is not done by most managers of the accounting offices of the city concerned. Thereafter, there are the graphics showing entrepreneurial skills, they have a 0–7 range to measure these skills, 0 is considered low and seven considered high. These are divided into motivation for achievement; Self-control (of destination); Propensity to take risks; Problem-solving and Influencers.

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Motivação para realização 7 6 5 4 3 2 1 0 Entrevistado A

Entrevistado B

Entrevistado C

Motivação para realização Fig. 5.2 Motivation for achievement. Source Research data 2015

(a) Motivation for achievement Motivation can be conceptualized, according to Robbins (2005), as a process responsible for the intensity, direction, and persistence of a person’s efforts to the success of a particular goal. Figure 5.2—Motivation for achievement presents itself as an entrepreneurial skill. Motivation for achievement according to Dornelas (2015) is the desire inherent in the human being to achieve total satisfaction on your goals. We see that the Motivation for achievement of an interviewed accountant has an average of 3.34, thus the counters were at an intermediate stage. Then, it becomes possible to see that, in general, the professionals interviewed have in their profile a good incentive to seek their goals, with a desire to be successful. Among the respondents, only A showed considerably lower motivation in relation to others. The entrepreneur is driven by the achievement motivation, according to Leite (2012) this realization is not directed only to the financial side, first of all, the entrepreneurs are motivated in their personal fulfillment. When checking the chart above, which deals with the entrepreneurial of opportunity x of necessity, it is clear that interviewed A and B opened their business due to financial needs, were motivated by the need of having a source of income. As for interviewed C, she was motivated to build the business due to having seen a good opportunity to offer her services to the triunfense society. (b) Self-control Self-control is the individual way of managing their emotions and desires for the future. The following Fig. 5.3 shows the self-control ability. Dornelas (2015) states that in self-control the individual’s destiny is defined by internal influences than external factors. Thus, it is clear in graphic 4.3 that the interviewed have an average of 4.67 points. Still, to said author, the higher the self-control means that there is internal self-discipline. It can be verified that the interviewees are

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Autocontrole 7 6 5 4 3 2 1 0

Entrevistado A

Entrevistado B

Entrevistado C

Autocontrole

Fig. 5.3 Self-control. Source Research data, 2015

more inclined to internal self-control than external what shows that they have greater responsibility for their actions because they have a great attitude to have initiative and be responsible for the success or failure of their attitudes. (c) Propensity to take risks Being an entrepreneur requires taking calculated risks, in this way, we have in Fig. 5.4 the propensity to take risks ability. Propensity to take risks is according Dornelas (2015) related to calculated risks, is to seek information before acting, taking responsibility for the actions. In this ability, interviewed had an average of 2.67. A relatively low level to characterize them as driven to take risks.

7

Propensão a assumir riscos

6 5 4 3 2

1 0 Entrevistado A

Entrevistado B Entrevistado C Propensão a assumir riscos

Fig. 5.4 Propensity to take risks. Source Research data 2015

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Resolução de problemas

7 6 5

4 3 2

1 0

Entrevistado A

Entrevistado B Resolução de problemas

Entrevistado C

Fig. 5.5 Problem-solving. Source Research data 2015

The authentic entrepreneur, according to Leite (2012) has in his or her mind the trend and acceptance to take risks of various types. It appears in the graphic above that only the interviewee B has higher levels of taking risks than the others, it shows that this entrepreneurial skill is more present in the profile of this professional accountant, but this does not justify adopting as her remarkable ability. The profile of an entrepreneur, according to Dornelas (2014) brings the ability to take calculated risks, to know how to manage and evaluate the risks and see the opportunities for success. Taking risks and engaging in challenges, this shows that for the entrepreneur the greater the challenge, the more motivated he or she is. (d) Problem-solving Problem-solving can be considered as the way of reacting in the face of problems that appear in daily life. In Fig. 5.5, we have entrepreneurial problem-solving skill. Dornelas (2015) conceptualizes Problem-solving as someone who knows how to solve problems realistically and can run a business without much help from others. Interviewees had an average of 4.0 on a scale 0–7, this ability presented by the interviewees we can note that they are at an intermediate level. The entrepreneur, according to Leite (2012) can be characterized as a self-confident individual, who believe in their abilities and skills, having the capacity to solve problems before they happen, because they are attentive to every detail. They have the need to seek and propose solutions to problems and use creativity and ability to innovate. In this way, the graphic shows that interviewed A and B have the same scale in this ability and only the interviewed C has a level considered lower compared to the others. This shows us that in all the accountants, there is still a need to rely on others to solve problems encountered in everyday work in the office, so it is not a remarkable skill in these professionals studied here.

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(e) Influencers The ability to influence others, to induce someone to perform a certain action or adopt certain behavior can be seen as a skill. In Fig. 5.6. we have the ability of Influencers. The entrepreneur is characterized as an influencer individual. Being influential is to have the power to persuade people to execute your idea, which can be through material, financial, human resources, etc. An Influencer, according to Dornelas (2015), is someone who finds people to help them meet their own goals. They know to convince people to work toward achieving a goal set out by him or her. This ability is weakly acknowledged by the interviewed who presented an average of 0.67 points. On a scale of 0–7, the score attained by the accounting professionals surveyed is considered very low. The results on the set of entrepreneurial skills of interviewed A, B, and C are summarized in the following Table 5.4. From the results, it can be seen that the three managers interviewed do not present the whole set of entrepreneurial skills. Being a professional endowed with these skills is important inasmuch as having an entrepreneurial profile is relevant to management and business success.

Influenciador 7 6

5 4

3 2

1 0 Entrevistado A

Entrevistado B

Entrevistado C

Influenciador Fig. 5.6 Influencers. Source Research data 2015

Table 5.4 Average of entrepreneurial skills

Entrepreneurial skills

Average of interviewed

Motivation for achievement

3.34 points

Self-control (of destination)

4.67 points

Propensity to take risks

2.67 points

Problem-solving

4.0 points

Influencer

0.67 points

Overall Average

3.07 points

Source Research data 2015

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5.6 Final Considerations In a contemporary scenario that brings the need to follow up the high competitiveness and dynamism, increasingly present in everyone’s daily lives, entrepreneurship is gaining its space, breaking paradigms and bringing innovations that contribute to society improvements. Then, it is necessary to have in this scenario professionals who meet the requirements and excel with a competitive edge, and this is true for all types of professionals. The professional accountant needs, in addition to technical knowledge, to adopt in their profile other features that make them become skilled in their decisions, which can be seen as a differential that contributes to their professional success. Therefore, this study aimed to identify the Triunfo-PE accountant entrepreneurial profile through field research and literature. It was possible to obtain what are the main entrepreneurial skills that form them as an updated professional accountant, punctuating the according to the specific objective, which is to verify the most outstanding and relevant features in the professionals interviewed. Also stood out the response to the third specific objective, which is to identify if the owner of the accounting firm in Triunfo opened their own business due to an opportunity found or was the financial need, checking for entrepreneurship of opportunity or necessity. Thus, it was possible to respond to the general objective of the research in question. Which showed us that the professionals interviewed described as A, B, and C, unfortunately, are not characterized as entrepreneurs professionals in their management methods. From the surveyed entrepreneurial skills, the result was unsatisfactory to be able to say that there is entrepreneurship predominant in their ways of managing the businesses. It was found that, according to the third specific objective of this study, the managers interviewed had an uneven level, regarding the entrepreneurship of necessity versus the one of opportunity. The survey results reveal that interviewed A and B opened the business due to financial need, which is conceptualized as entrepreneurship of necessity, however professional C, opened her business and manages up to the present moment, due to a good opportunity found in Triunfo-PE. The contemporary reveals that both forms of entrepreneurship occur, however, as an adding value to the entrepreneur and also a factor of economic and social growth, it is preferable to occur entrepreneurship of opportunity. In the accountants interviewed it was identified that the most present entrepreneurial skills in their profiles were the motivation for achievement, selfcontrol, and problem-solving. Those are skills that directly or indirectly contribute to improvements in these managers’ enterprise. However, they are lacking the propensity to take risks and influencer skills because showed a very low level in these skills, with that it becomes relevant to assert, through the researched object, that unfortunately, accountant professionals do not have the complete entrepreneur profile. The accountant, woman, or man, either with technical training or bachelor degrees, becomes important insofar as doing their job in the best possible way. Their role must go beyond the tax calculation, as the successful business requires high-quality management, thus their potential must be influenced by entrepreneurial practices.

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The entrepreneur professional is considered one of the most important factors of economic and social development. In view of this, anyone can be an entrepreneur, provided that you have in yourself an entrepreneurial spirit. This spirit is not necessarily something you are born with, it can be stimulated and developed, for only then produce improvements in the environment in which it operates. Therefore, it is impossible not to observe the utmost importance it has to the accountant in their working environment, for obtaining success in managing their business or even as company employees. It was observed through the survey with the three accountants located in Triunfo— PE, described immediately above in this work, the existence of a great need to improve the management of their offices. Quality management leads the business to success in every way and therefore the enterprise remains more “alive” in the market. It is important for these professionals to search for updating their knowledge, or get recycled to keep up with today’s demands. The city of Triunfo known as a tourist attraction in the state of Pernambuco is inserted in today’s competitive market. This requires immediate and innovative solutions to economic as well as social problems. Thus, accountants located in that city should seek practices that wakes up their entrepreneurial spirit. Therefore, this academic work contributes to future research on the subject, due to the fact that the results found were not so satisfactory. A research suggestion is to continue the theme by assessing what is these interviewed accountants need for achievement. The lack of entrepreneurial spirit in the accountants and their management ways itself can be seen as a weak point appropriate for a study related to proposing improvements for these professionals, in order to encourage them to adopt an appropriate profile for the current scenario. This can be in the academic field, or even competent organizations, such as the CRC of Pernambuco.

References Cfc Resolution No. 560/83. Available in www.Cfc.Org.Br/Sisweb/Sre/Docs/Res_560.Doc. Accessed on 26 Mar 2015 Collected Data From The Ibge. Available at http://www.cidades.Ibge.gov.br/painel/painel.php? lang=&Codmun=261570&Search=Pernambuco|Triumph|Infographics:-Data-General-Of-Mun icipality. Accessed on 19 Nov 14 Com.Br/Legislacao/126558/Decreto-Lei-9295–46 . Accessed on 31 Mar 15. Available at Entrepreneurship: The Need To Learn To Undertake: http://www.Novomilenio.br/foco/2/artigo/ artigo_daniele.pdf. Accessed on 01 Nov 14 Data On Entrepreneurship. Available at http://www.Ibge.gov.br/home/estatistica/economy/entrep reneurship/2010/. Accessed on 18 Mk 15 Decree Law 9, 295 / 46. http://Presrepublica.Jusbrasil.Com.Br/Legislacao/126558/Decreto-Lei-929 5–46. Accessed on 31 Mar15 Entrepreneurship: The Need To Learn To Undertake: http://www. Novomilenio.br/foco/2/artigo/artigo_daniele.pdf. Accessed on 01 Nov 14

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Desenvolvimento_Econ%C3%B4mico_Uma_Investiga%C3%A7%C3%A3o_Sobre_Lucros_ Capital_Cr%C3%A9dito_Juro_E_Ciclo_Econ%C3%B4mico.Pdf. Accessed on 21 Mar 15 Dornelas JCA Skills for entrepreneurial potential. Available at http://www.josedornelas.com.br. Accessed on 16 Feb 15 Dolabela F (2006) The louise secret, 30th edn. Editora Culture, São Paulo Dolabela F (2008) Entrepreneur workshop. The teaching methodology that helps transform knowledge into wealth. Rio De Janeiro, Sextante Dornelas JCA (2008) Entrepreneurship in practice. Rio De Janeiro Dornelas JCA (2014) Entrepreneurship: transforming ideas into businesses 5th edn. Rio De Janeiro, Empreende Dornelas JCA (2015) Empreendedorismo: transformando ideias em negócios. Empreende Drucker P (2009) Innovation and entrepreneurship reprint edition, HarperCollins e-books Drucker PF (2010) Innovation and entrepreneur spirit. Cengage Learning, São Paulo Fortes JC (2001) Accountant’s guide. Recife, Regional accounting council of the state of Pernambuco Gem (Global Entrepreneurship Monitor). Entrepreneurship in Brazil. Available at http://www.Ibqp. org.br/upload/tiny_mce/gem_2013_livro_empreendedorismo_no_brasil.Pdf. Accessed on 26 Jan 15 Gil AC (2009) Methods and techniques of social research 6th edn. São Paulo, Atlas Koyama CM, Silva DCD, Oliveira CR (July/Dec 2010) The profile of professional accounting and the guidelines of a new curriculum. J Account Res, Londrina 01(01):57–76. Semester. Available at http://www.uel.br/revistas/uel/index.php/rec/article/download/9400/8149. Accessed on 13 Oct 2014 Leite E (2012) The phenomenon of entrepreneurship. Saraiva, São Paulo Marconi MA, Lakatos EM (2009) Methodology of scientific work, 7th edn. São Paulo, Atlas Marconi MA, Lakatos EM (2003) Scientific methodology fundamentals, 5th edn. São Paulo, Atlas Marion JC (2007) Business accounting. 13th edn. São Paulo: Atlas Robbins SP (2005) Organizational behavior, 11th edn. Pearson Prentice Hall, Sao Paulo Schumpeter JA. Theory of economic development. An investigation into profits, capital, credit, interest and the economic cycle. Maria Silvia Possas Translation . Available in http://www.ufjf. br/oliveira_junior/files/2009/06/s_schumpeter_teoria_do_ Search: Professional profile of the 2012/13 Accounting / Federal Accounting Council. Brasilia: Cfc, 2013. Available in: Portalcfc.Org.Br/Wordpress/Wp-Content/…/Livro_Perfil_2013_Web2.Pdf. Accessed on 26 Mar 15 Silva ACR (2008) Research methodology applied to accounting: study guidelines, projects, articles, monographs, 2nd edn. São Paulo, Atlas Softex. Available in: http://www.softex.br/wp-content/uploads/2013/07/cadernos-tematicos-do-obs ervatorio-economia-da-informacao-e-internet1.pdf. Accessed on 16 Mar 15 Triunfo Tourism Target Plan—2013–2016. Operating plan of consolidation of the tourist destination. City Of Triunfo—Pe Vieira Maria Das Graças (2006) The ethics in the accounting profession. São Paulo, Thomson

Cristina Glória Lima da Silva graduation at Ciências Contábeis from Faculdade de Integração do Sertão (2015). Zaidiana Lemos Zaidan graduate at Comunicação Social - Habilitação Relações Públicas from Universidade Católica de Pernambuco (2003). Has experience in Administration, focusing on Administration.

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Emanuel Ferreira Leite graduate at Administração from Universidade Federal de Pernambuco (1982), master’s at Mestrado em Administração from Universidade Federal da Paraíba (1992) and Ph.D. at Ciencias de Engenharia from Universidade do Porto (1999). Has experience in Administration, focusing on Administration, acting on the following subjects: empreendedorismo, administração, empresa de base tecnológica, inovação and empreendedor.

Chapter 6

Value Relevance of Intangibles: A Literature Review Ömer Faruk Güleç

Abstract Value relevance can be defined as the association between accounting values and market values and it is one of the most important quality attributes of financial reporting. Recognizing, measuring, and reporting the intangible assets properly has become gradually more important due to the increasing importance of intangibles in the statement of financial position and the shift from a tangible-based economy to an intangible-based economy. Value relevance of intangibles examines how well accounting treatments of intangibles are related to stock market values and it is a controversial and heavily debated issue in the literature. Thus, the purpose of this study is to demonstrate how valuable intangibles and to provide useful information about the value relevance of intangibles by reviewing the most cited literature. For this purpose, the study investigates R&D expenditures, goodwill, patents, brands, and advertising expenditures by comparing the results of the studies. According to the results, while IFRS adoption is expected to provide more comparable and highquality information, the overall value relevance of intangibles has generally declined after the IFRS. In addition, capitalizing the R&D expenditures seem to be more value relevant than the expensed portion. These results are also consistent with the other intangibles such as patents and brands. Keywords Value relevance · Intangibles · IFRS JEL Codes M40 · M41 · M49

6.1 Introduction Value relevance is a well-documented and controversial phenomenon that basically “examines the association between accounting amounts and equity market values”. While accounting information provides a historical perspective of a firm’s financial position, stock market valuation gives a forward-looking perspective of a “firm’s Ö. F. Güleç (B) Kırklareli University, Kırklareli, Turkey e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_6

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future” cash flow and the difference between these perspectives is the subject of value relevance (Hirschey et al. 2001). Francis and Schipper (1999) define value relevance as “the ability of accounting numbers to summarize the information underlying the stock prices, thus value relevance is indicated by a statistical association between financial information and prices or returns” (Alali and Foote 2012). Barth et al. (2001) state that “only if an accounting amount is reliable and relevant to the users can make a difference in financial decisions and note that accounting information is relevant to investors in valuing a company only if it is measured reliably enough to be reflected in share prices”. The research on value relevance evaluates “how well accounting figures” reflect information used by equity investors (Gong et al. 2016). Although, Holthausen and Watts (2001) emphasize that the value relevance concept is related to capture the firm value, Barth et al. (2001) note that value relevance is not related to the firm value but to assess valuing firm’s equity. “Value relevance is one” of the main quality attributes of accounting information that is even more important than conservatism or timeliness according to Francis et al. (2004). Value relevance research provides insights not only to academic researchers or financial statement users but also to standard-setters, policymakers, and regulators (Barth et al. 2001). Numerous studies deal with the concept of “value relevance in terms” of book value and market value with the models operationalized and the adoption of accounting standards. However, the value “relevance of intangibles” is still a heavily debated issue and thus, the purpose of this study is to examine the value relevance concept with respect to intangibles to detect the changes in different approaches over the years by reviewing the most cited studies in the literature. The increasing importance of intangibles such as, “research and development (R&D), computer” software, patents, brands, and franchise costs in financial statements in the new and changing economy leads to the proliferation of studies related to the value relevance of intangibles for the last 20 years. Since the proper accounting treatment (recognizing, measurement, expensing or capitalizing and amortization) for intangible assets is heavily debated, this study may contribute to the existing literature by focusing on pioneering studies’ results in different accounting arguments and in different country settings. The remainder “of this study is” organized as follows. “Sect. 6.2 gives” a brief overview of the value relevance concept by reviewing the definitions and the historical background. Section 6.2 also discusses the studies that address the relation between value relevance and accounting standards. Section 6.3 examines the studies that investigate the value relevance of identifiable and unidentifiable intangibles by reviewing the most cited papers in the literature and the study concludes in Sect. 6.4.

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6.2 Value Relevance Concept 6.2.1 Definition of Value Relevance and Historical Background The usefulness and relevance of financial information are provided only if it is comparable, verifiable, “timely and understandable.” Relevance is one of the most essential criteria of financial reporting that the information generated by an accounting system should impact the decision-making process of financial statement users. Hellström (2006) defines the relevant information as, “it influences the economic decisions of users by helping them evaluate the past, present, and future events”. Since the relevance of financial information plays a major role in financial decisions, value relevance literature has proliferated for the last 20 years. Naimah (2012) defines the value relevance as “the empirical operationalization of the relevance and reliability criteria”. Thus, value relevance studies empirically examine the association between a “stock price-based dependent variable” and a “set of accounting variables” (Beaver 2002) and, an accounting amount is “value relevant if it” is significantly related to equity market value (Barth et al. 2000). “The association between stock” price and accounting earnings “(Ball and Brown 1968; Beaver 1968)” or stock price and assets and liabilities (Amir et al. 1993; Francis and Schipper 1999) are proved in many studies. Holthasuen and Watts (2001) also emphasize the usefulness of accounting numbers in determining firm value by investigating whether the accounting number is associated with share prices. Many studies address and summarize the issues related to value relevance as: (1) How well do accounting amounts measure value? (2) What accounting amounts provide information about value? (Barth et al. 2000). Francis and Schipper (1999) conclude that there is a decline in the relation between returns and “earnings and book values” and they claim that “decreased value relevance” of financial reporting is related to the “current reporting model” which does not properly recognize and measure the economic assets. Lev and Zarovin (1999) explain this decline as the failure to follow the current needs and pace of the business environment. Barth et al. (2001) suggest that determining variables or models in value relevance research design is crucial. In addition, they point out that studies use share price focus on what is reflected in firm value while studies use price changes or returns is concentrated on determining “what is reflected” in changes in value over a “specific period” of time. Besides, Chang (1998) and Naimah (2012) mention that findings of value relevance are strictly upon the methods and models operationalized. Reporting environment and country-specific factors also play a greater role in determining the “value relevance of accounting information” as well as the differences in recognition and measurement between IFRS and national GAAPs (Ball 2006). In addition, Beaver (2002) states that value relevance studies need to take into consideration the details about accounting institutions, “accounting standards, and the specific features of the” institutional background. In addition, Hellström

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(2006) embarks that the value relevance of accounting information is affected by “the quality of accounting laws” and regulations since recognition, measurement, and valuation principles are the main determinants of “accounting information in financial statements.” Hellström (2006) evaluates the value relevance studies from two perspectives and these are the signaling and the measurement approaches. While the signaling perspective-based studies focus on the “reaction to the announcement” of accounting information, “the measurement perspective-based” studies are interested in the relation between the market value of the company and accounting information. Anthony and Ramesh (1992), Runsten (1998), and Jenkins et al. (2009) are studies that examine the value relevance concept with the business (life) cycle perspective. Jenkins et al. (2009) conclude that “while current earnings are more value relevant in contractionary economic periods, expected future earnings are more value relevant in expansionary periods.” Yang (2007) highlights that financial and non-financial information is complimentary in evaluating the overall financial performance of a firm and thus, non-financial information “should be included” in value relevance studies. Flöstrand and Ström (2006) use the term “valuation relevance” that differs from value relevance that can be described as the usefulness of information to users of financial reports. They follow an index to measure the non-financial information with 70 items. These 70 items are grouped into two main categories as “forward-looking information and historical information.” The study claims that while value relevance is a statistical definition of information usefulness, valuation relevance is a behavioral definition of information usefulness. According to the results, “forward-looking nonfinancial information” is used more than historical non-financial information by the analysts. Value relevance studies have a long history and date back to the 1960s. Miller and Modigliani (1966) and Ball and Brown (1968) are pioneering studies to examine the relation between accounting figures and equity values. However, “value relevance” term was first used in Amir et al. (1993) study and the literature has proliferated since numerous studies document the empirical relation between particular accounting amounts and stock market returns or values (changes) over the last 20 years (Holthausen and Watts 2001). The underlying theories of value relevance studies are the combination of valuation theory and some contextual accounting arguments and Beaver (2002) explains that there are three major types of valuation models in the literature. These are: – Earnings approach, Miller and Modigliani (1966) – Balance sheet approach, Barth et al. (1996) – Book value and earnings approach, The Feltham-Ohlson model.

6.2.2 Value Relevance and Accounting Standards The harmonization and convergence of financial reporting standards lead to allow financial statement users to compare and understand financial statement outcomes

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easily. Reporting under IAS/IFRS rather than local GAAP will help to reach the widest” access to investment capital since it provides greater disclosure, higher accounting quality and comparability (Agostino et al. 2011). In addition, IFRS adoption might have major changes in stakeholder-based economies than shareholderbased economies since the presentation of financial statements is exposed to great changes (Hung and Subramanyam 2007). Thus, “the European Union (EU) requires” listed companies to prepare their “consolidated financial statements” in compliance with the “International Financial Reporting Standards” (IFRS) since 2005 (Devalle et al. 2010). IASB and FASB also work together to converge the accounting regimes to create high-quality financial reporting. In addition, in an effort to achieve a fair and true view of financial position, FRS 102 and FRS 105 in the UK are fundamental regulations to reinforce the integration and harmonization of small, medium, and micro-sized enterprises. The reasons for mandating IFRS are explained in Capkun et al. (2008) as: (1) The establishment of a single set of internationally accepted high-quality financial reporting standards. (2) To contribute to the efficient and cost-effective functioning of the capital market. (3) Increase the overall global competitiveness of firms within the EC and thereby improve the EU economy. (4) Higher quality standards are expected to lower the cost of capital due to lower information asymmetry. Francis et al. (2004) assess “the value relevance is one of the” main quality attributes of accounting information that is even more important than conservatism or timeliness. Given that value, relevance is one of the generally accepted methods to measure accounting quality, studies that focus on the association between value relevance and the adoption of IFRS address the question of whether accounting standards have led to more disclosure, more comparability, and higher quality in reporting. There are numerous studies that investigate whether the value relevance increased after the adoption of International Accounting and Financial Reporting Standards. While some studies test value relevance in cross-country samples, others examine the value relevance of financial information in a specific region or country. Soderstrom and Sun (2007) remark that the value relevance is a function of countryspecific factors and Holthausen and Watts (2001) also indicate that studies need to take into consideration the standard-setting inferences in value relevance studies. Many studies generally use the model of Ohlson (1995) and subsequent refinements. However, existing studies display “conflicting evidence on the” value relevance of accounting amounts under IAS/IFRS and other domestic standards such as US GAAP, UK GAAP or Australian GAAP, etc. While some studies claim that IFRS adoption enhances the overall value relevance since it provides greater transparency, comparability, and quality information, other studies conclude that value relevance has declined after mandatory IFRS adoption. There are controversial results in the value relevance of intangibles with the adoption of accounting standards as well. Internationally harmonization of accounting standards raises a question of whether the accounting treatment for intangible assets is proper, useful, relevant, and reliable

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(Dahmash et al. 2009). Lack of internationally accepted rules on what types of intangibles should be recognized or expensed makes it difficult to regulate and evaluate the intangibles by accounting standard-setters worldwide (Lev and Zambon 2003). International “Accounting Standards Board (IASB)” and “Financial Accounting Standards Board (FASB)” suggest a more stringent and conservative approach when it comes to intangibles, although intangibles play a greater role in financial statements recently (Ji and Li 2014). On the other hand, the shift from a “tangible-based economy” to an “intangible-intensive economy” raises a question of whether existing local GAAP may have lost its usefulness to investors and (Ciftci et al. 2014). Studies examine the value relevance of intangibles for the pre-IFRS and post-IFRS periods generally conclude that there is a statistically significant decrease in the value relevance after IFRS adoption although it is claimed that IFRS adoption should enhance the quality of accounting information and mitigate the information asymmetries (Morricone et al. 2009). Dahmash et al. (2009) summarize some unanswered questions related to intangibles as: (1) Should intangible assets be recognized and if so, should purchased intangible assets be treated differently to internally generated intangible assets? (2) If intangible assets are recognized, should all intangible assets be systematically amortized or should intangible assets with indefinite lives simply be subjected to impairment testing? (3) Should companies be permitted to revalue (upwards) intangible assets to better reflect their fair values? Given that intangible assets may provide potential asset creation and may generate future revenue and profit, investigating the intangibles in terms of value relevance and accounting standards and answering the questions above may contribute to the existing literature.

6.3 Value Relevance of Intangibles “Value relevance of intangibles” is widely documented and “the proper accounting treatment for” intangible assets “is being heavily debated” subject since it is sensitive to represent the real situation of a firm (Morricone et al. 2009). There is a discrepancy related to the overall value relevance of tangibles and intangibles in the literature. While Amir and Lev (1996) suggest that accounting numbers seem not to be value relevant and accounting procedures do not fully recognize “the economic value of intangible” assets for “intangible-intensive” firms, Collins et al. (1997) argue that “there is an increase” in value relevance of accounting information for intangibleintensive industries. Studies that address the decline in value relevance of intangibles are attributed this to the lack of proper recognition and immediate expensing of intangibles in the financial statements (Lev and Zarowin 1999). Ji and Li (2014) add that although some types of intangibles such as “research and development”

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costs, brands, mastheads, and internally generated goodwill are categorized as one of the most valuable assets, not reporting them on balance sheets “may contribute to the decline” of value relevance. Collins et al. (1997) and “Lev and Zarowin (1999)” emphasize the economic importance of unreported intangible assets that contribute to the value relevance of accounting information. Abdul-Shukor et al. (2008) emphasized that the value relevance of intangibles is associated with the economic condition and accounting environment. They also state that intangibles would be more value relevant in better economic conditions and in a stronger accounting regulatory period. The increasing importance of the balance sheet relative to the profit and loss statement emphasizes the proper recognizing of intangibles since they are the value drivers of a new and changing economy (Dahmash et al. 2009). Technological advancements lead firms to offer products and services that are more characterized as knowledge bases such as research and development, patents, and human resources and this might be interpreted as a shift from physical assets to intellectual assets (Sriram 2008). Sriram (2008) also highlights that increasing place of intangibles in the balance sheet does not necessarily mean that firms’ long-term growth and survival are guaranteed since this is up to generate future revenues and profits from intangible assets. However, generating revenues and profits out of intangibles relatively take more time owing to the uncertainty (unverifiability), recognition, and measurement concerns by nature (Wyatt 2008). Firm value can not only be explained with accounting measures if they omit the capture the value of intangible assets, especially brands, information technology, and research and development expenditures (Aaker and Jacobson 2001). Financial analysts ignore the intangibles as core assets as well as tangibles when evaluating the capital structure or debt level of companies. Wyatt (2008) raises a question to pay attention to the importance of intangibles as “Why intangibles, in the business community, are not considered as core assets even if it is agreed that it is an important category of investment?” in the study. Intangible assets are one of the competitive strengths of the companies and due to the changes in the globalized economy, conventional tangible assets play less role in financial statements (Dainelli and Giunta 2011; Amir and Lev 1996). Lev (2001) states that the competitiveness contribution of intangible assets to a firm depends on some criteria such as: “scalability (non-rivalry), increasing returns, and network effects versus partial excludability (the general lack of full control over the benefits of intangibles), inherent risk, and nontradability (absence of organized markets in intangibles)”. The economic importance of intangibles in financial statements is obvious especially in fast-growing tech industries since their assets heavily depend on the R&D expenses, trademarks, etc. The increasing gap between the book value and the market value of the firm’s share prices is the result of not recognizing intangible assets in financial statements (Chan et al. 2001). Lev and Zambon (2003) remark that in order to reduce the information asymmetries in the decision-making process of investors intangible assets play a major role and therefore regulatory bodies and standard-setters should realize the importance of intangible assets.

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While relevance is one of the key factors in determining the quality of accounting information, reliability is also an essential and complementary determinant of relevance. Ji and Li (2014) state that the reason why IFRSs require more stringent rules for recognizing capitalized intangibles may be explained as the association between reliability and relevance since the reliability of intangibles is the main concern of IASB and other standard-setters. In addition, Wyatt (2008) raises the question of whether the reliability of reported intangibles is of the main concern for analysts. While tangible assets are more standardized and homogeneous, intangible assets are characterized as heterogeneous and uncertain and value relevance studies should take into consideration the reliability concern (Wyatt 2008). Godfrey and Koh (2001) state that providing some discretion to managers in intangibles to mitigate the error and bias or to increase the reliability may be useful in the case of creation some incentives to managers that are aligned with shareholders. Non-financial information has gradually been recognized since it provides useful information to investors, thus, AICPA Special Committee on Financial Reporting or other foundations encourage firms to increase disclosure of such information (Hirschey et al. 2001). The raising question is “are non-financial indicators really useful for the investor’s decisions?”, and studies that address the value relevance of non-financial information try to answer this question (Dainelli and Giunta 2011). Studies address the question of whether non-financial information contributes to value relevance concentrate on the industries with a high amount of intangible assets. Studies that highlight the value relevance of identifiable intangibles such as R&D, patent, brand-name focus on the capitalization and expensing (Godfrey and Koh 2001) while other studies that investigate the unidentifiable intangibles such as intellectual capital mainly concentrate on financial and non-financial disclosures (Iatridis 2006). Amir and Lev (1996) are one of the first studies that examine the question “How should non-financial variables be incorporated with financials in a valuation model?”. According to the study results by using two sets of regression models in the U.S. cellular communications industry, financial measures that include earnings, book values, and cash flows are not relevant for security valuation. However, the model that includes non-financial indicators (growth potential of the licensed operator and penetration rate) contributes to the value relevance. Goodwin and Ahmad (2006) address the issue of whether there is a “decline in the value relevance” of intangibles and they investigate this by using 13,000 firmyear observations (Australian sample) from 1975 to 1999. The study also divides the sample as Expensers and Capitalizers and finds that while the “value relevance of earnings” and book value has increased for capitalizers, it is not valid for noncapitalizers. Ji and Liu (2014) examine the value relevance of intangibles by using 6,650 Australian firm-year observations between the years 2001 and 2009 to determine the effects of pre and post-adoption periods of IFRSs. The study concludes that while the quality of earnings has enhanced with the adoption of IFRS, there is a decline in value relevance of intangibles. The reason for declining value relevance may be explained with the more rigorous capitalization policy on intangibles. Ciftci et al. (2014) investigate “the value relevance of accounting” information in intangible-based and nonintangible-based industries in the USA by using 171,894

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firm-year observations between 1975 and 2007. They conclude that R2 is lower for intangible-intensive industries and while R&D capitalization helps to mitigate the discrepancy between two groups of firms, it still not eliminates the value relevance difference. This study examines “the value relevance of intangibles” by reviewing the most cited studies in the literature. For this purpose, research and development expenditure and other intangibles are investigated separately.

6.3.1 Value Relevance of Research and Development (R&D) Expenses R&D is a sum of activities that companies “undertake to innovate and introduce” new products or services to generate income to be more competitive. This is an increasing investment activity that provides a technological advance for the companies and almost %2,5 of the worldwide GDP constitutes R&D spending. Reporting R&D expenditures has attracted more interest recently from researchers, investors, and standard-setters owing to the increasing significance of intangibles and “intellectual property rights (Zhao 2002).” Gong et al. (2016) focus on the value relevance of R&D for two reasons. First, there are different “accounting treatments of R&D expenditures” under different accounting regimes among countries. Second, R&D expenditures are an essential part of financial statements that provide future economic benefits with a high degree of uncertainty. The national GAAP and IFRS require different accounting treatments on R&D expenditures. IFRS, IAS 38 mandates immediate expensing of research costs while capitalizing the development costs when six criteria are satisfied and it does not give any management discretion to capitalize R&D (Shah et al. 2013). However, “the national GAAP on R&D expenditures in many countries require expensing R&D costs (the mandatory expensing rule), allowed capitalization of R&D costs (the optional capitalization rule), or mandated capitalization of R&D costs under certain conditions (the mandatory capitalization rule)”(Gong et al. 2016). The most common and controversial issue about R&D is whether the managerial discretion to allocate “R&D expenditure between capitalization” and expense or mandatory immediate expense would “increase the value relevance” of R&D reporting (Zhao 2002). The value relevance of R&D expenses also will change due to the switch from national GAAPs to IFRS (Gong et al. 2016). Lev and Zarowin (1999) and Gong et al. (2016) state that accounting for R&D activities is difficult since quantifying the future economic benefits is quite controversial. Studies address the expensing method as superior claim that this practice eliminates the managers’ discretion to capitalize R&D if there is a low probability of success (Cazavan and Jeanjean 2006). Cazavan and Jeanjean (2006) summarize the accounting treatment of R&D expenditure in favor of expensing since it is perfectly

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objective and verifiable whereas capitalization of R&D is less reliable. They criticize the value relevance approach since it is only limited to the relation between accounting numbers and market values. Healy et al. (2002) embark on this trade-off between reliability and relevance. Cazavan et al. (2011) note that managers’ discretion about the capitalization of R&D expenses may lead to earnings management problems since they may feel the pressure to meet or beat the thresholds. Markarian et al. (2008) also examine the motivations for the capitalization of R&D spending and highlight the earnings management problem related to R&D expenditure in Italy context. Ahmed and Falk (2006) mention the drawbacks of the mandatory expensing rule of the R&D expenditure. This accounting procedure may be costly and may prevent management from reducing information asymmetry. In addition, this practice may generate mispricing of stocks and deteriorates the profitability measures such as ROE. Studies suggest that allowing managers to decide about R&D practices may lead to enhance firms’ financial statements relevance. Lev and Sougiannis (1996) and Chambers et al. (1998) report that capitalizing R&D expenditure is superior to expensing when it comes to reflect future benefits and enhance relevance in the US context. Cho and Chung (2001) support the capitalization of R&D expenditures and find that an averagely 1 unit of R&D expenditures generates 1.25 unit of earnings over the following 2–4 years in the Korean sample Han and Manry (2004). state that capitalizing R&D expenditure is strictly up to the future economic benefits otherwise expensing should be preferred. Capitalization of R&D expenses occurs when future economic benefits are expected while evaluating R&D expenditure in the income statement is the result of uncertainty (Tsoligkas and Tsalavoutas 2011). Ahmed and Falk (2006) state that capitalizing R&D is perceived as good news since it suggests that there is an expectation to yield measurable economic benefits in the foreseeable future. In addition, ignoring recognition of R&D expenditure as an asset may decrease the relevance of financial reporting when there is a future benefit. A great number of studies examine the value relevance of R&D expenses in different accounting regimes and results vary according to accounting treatments of R&D expenses, country-specific factors, sample period, and methods employed. Lev and Sougiannis (1996) examine the value relevance of R&D expenses with 825 firms for the periods of 1975–1991 in the USA. The purpose of the study is to address the issues of reliability, objectivity related to R&D capitalization and conclude that capitalizing R&D produces reliable and relevant information in the U.S. context. Zhao (2002) examines France, UK, Germany, and USA samples since the first two countries allow conditional capitalization of R&D while the others require immediate expensing rule. USA is a relatively unique sample as a result of requiring the full and immediate expensing of R&D while many other countries allow for optional accounting practices of R&D. Thus, Zhao (2002) employs 13.029 firm-year observations in 4 countries (5044 for the USA) between the periods of 1990–1999 According to the results, capitalization of R&D enhances the value relevance in France and UK and especially in US software industry because of the management discretion. The study also focuses on the country-specific factors such as law system,

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ownership concentration, financial transparency, and accounting quality and states that value relevance of R&D is a function of these environmental factors. Han and Manry (2004) use the Korean sample between the years of 1988 and 1998 by employing 3.191 firm-year observations to examine the value relevance of R&D. They conclude that capitalizing R&D expenditure provides higher value relevance. Callen and Morel (2005) investigate the value relevance of R&D for 284 firms with a total of 6.819 firm-years of data from 1962 to 1996 by using an earnings-based time series valuation model instead of using cross-sectional regressions or panel data regressions. Unlike many other studies, the results indicate that there is a very weak association between R&D investment and market values. Ahmed and Falk (2006) employ an Australian sample (1.172 firm-year observations, 347 firms) that are categorized into two groups as Expensers and Capitalizers between the years of 1992–1999. The results of the study claim that managerial choice of capitalizing or expensing R&D displays higher value relevance than mandatory R&D expensing. In addition, capitalizing R&D shows greater value relevance than expensing R&D both in managerial discretion. The study also denotes that capitalizing R&D is positively and significantly related to the firm’s future earnings. Cazavan and Jeanjean (2006) research 197 French firms (770 observations) between 1993 and 2002 and the results of the study differ from the previous ones since it offers that capitalized R&D is negatively associated with stock prices and returns. The firms that choose capitalizing R&D are characterized as smaller, highly leveraged, less profitable, and have less growth opportunities. Cazavan and Jeanjean (2006) explain this difference by emphasizing country characteristics. They mention that previous studies resulting in favor of capitalization of R&D have a sample of high legal enforcement countries, unlike the French context. They also add that unexpected relationships between R&D capitalization and stock prices (returns) may be the result of not properly application of standard by French managers. Studies that examine the value relevance of R&D expenses before the IFRS adoption generally follow the procedure of dividing the sample into two categories as “Expensers and Capitalizers”. Oswald (2008) use 3.229 UK firm-year observations (603 firms) for the period of 1990–2004 to examine the value relevance of R&D for expensers and capitalizers. The study concludes that “earnings variability, earnings sign, firm size, R&D intensity, leverage, steady-state status of the firm’s R&D program, and R&D program success have an impact on the decision to capitalize or expense” the R&D. Oswald (2008) also mentions that managers should choose the correct decision in capitalizing or expensing R&D to best reflect the private information to the related parties. Morricone et al. (2009) find that R&D expenditures seem not to be value relevant either in Italy GAAP or in IFRS. Tsoligkas and Tsalavoutas (2011) is the first study in the UK to analyze the changes in value relevance of R&D expenses in pre-IFRS and post-IFRS periods (2005–2007) by using 418 firm-year observations. Results denote that while the capitalized portion of R&D is positively related to market values expensed portion of R&D is negatively related. The reason why there is a positive relationship between the capitalized portion of R&D and market value is explained with the market perception of R&D that might provide future economic benefits.

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Shah et al. (2013) examine “the value relevance of R&D expenses in the UK for the periods of 2001 and 2011 to capture pre-IFRS and post-IFRS effects in 1415 companies (15,565 firm-year observations).” Results indicate that while capitalized R&D has value relevance for the whole sample, there is no increase in value relevance in the post-IFRS period. In addition, while the firm size is an important determinant of value relevance (larger firms display higher value relevance than small firms), sectors (manufacturing-non manufacturing) are not effective on the value relevance of R&D expenses. Gong et al. (2016) investigate the value relevance of R&D expenses for the pre-IFRS and post-IFRS periods during 1997–2012 in 9 countries. The contribution of the study is to demonstrate “how the value relevance of R&D expenses changes after a switch in the accounting treatment of R&D” to IFRS. According to the results, the value relevance of R&D expenses declines in countries where “mandated immediate expensing” or “allowed optional capitalization” of R&D costs was applied after IFRS adoption. Countries that switched from the mandatory capitalization rule to IFRS display no change in value relevance of R&D costs. Gong et al. (2016) also examine the effects of national characteristics and conclude that changes in value relevance are higher in countries with stronger investor protection and smaller in countries with having higher uncertainty avoidance.

6.3.2 Value Relevance of Other Intangibles and Goodwill While Research and Development (R&D) expenditures play a major role in many studies that investigate the value relevance of intangibles, patents, brands, and other intangibles assets are also examined in terms of value relevance in literature. Besides, some of these studies also examine the R&D expenditures with the other intangibles when evaluating the value relevance. Apart from the intangible assets, goodwill is an essential determinant in international mergers and acquisitions since it dominates the underlying economic value of assets acquired (Ji and Lu 2014). Chauvin and Hirschey (1994) investigate the value relevance in the US sample during 1989 to 1991 and conclude that while goodwill, net income, advertising expenses, R&D and “tangible assets are value relevant for non-manufacturing” firms, goodwill, and “intangible assets are not valued relevant for manufacturers under” GAAP. Godfrey and Koh (2001) assess the value relevance of identifiable (R&D, patents, brand names, mastheads, licenses) and unidentifiable intangible assets (goodwill) in Australian companies in 1999 with 172 firms. They conclude that taken as a group, intangible assets are value relevant but not capitalized R&D. Godfrey and Koh (2001) summarize the issues about the intangibles specifically in goodwill as: (1) Should intangibles assets be capitalized or not (2) Should non-purchased assets such as internally generated goodwill be capitalized or not

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(3) If intangibles are capitalized, should all, or only some intangibles be amortized or not (4) If they are amortized, what should be the appropriate period for their amortization Chalmers et al. (2008) use the Australian sample (599 firms) from 2005 to 2006 to examine the value relevance of identifiable intangible assets under AIFRS and AGAAP. The results of the study indicate that goodwill is the only asset that provides incremental information that is valuation-relevant under AIFRS. In addition to these results, when all intangible assets are examined separately, goodwill and software seem to be value relevant under AIFRS and patents, licenses, R&D measures with positive value relevance under AGAAP. Chalmers et al. (2008) state that reporting goodwill has shifted from an amortization regime to an impairment regime. AbdulShukor et al. (2008) investigate the value relevance of intangibles non-current assets (NCA) for Bursa Malaysia from 1990 to 2001. Their results reveal that goodwill and research and development (R&D) expenses are negatively associated with firms’ share prices. Morricone et al. (2009) use the Italian sample (267 non-financial firms) for the periods of 1996–2006 to examine “the value relevance of goodwill, brands and patents, licenses, computer software, and capitalized and expensed R&D.” They find that IFRS application reduces the value relevance of intangibles, specifically in goodwill. In addition, the study indicates that the impairment test causes a significant decrease in the value relevance of goodwill due to the high managerial discretion in goodwill valuation. Researchers claim that the reporting environment of Italy can be characterized as a weak corporate governance system and low financial transparency. Dahmash et al. (2009) use the Australian sample during the period of 1994–2003 to investigate the value relevance and reliability of goodwill and identifiable intangible assets. Unlike the other studies, they conclude that although the accounting information produced under International Accounting Standards seems to be value relevant, it is not reliable. In addition, they find that while other intangible assets are reported aggressively, goodwill is reported conservatively. Oliveira et al. (2010) examine the impact of IFRS adoption on the value relevance of goodwill and other identifiable intangible assets in the firms listed at the Portuguese Stock Exchange for the years of 1998–2008. Overall results indicate that goodwill and other intangible assets are highly related to market value. On the other hand, the accounting information produced under IAS/IFRS shows less value relevance than Portuguese GAAP. Hirschey and Weygandt (1985) and Bublitz and Ettredge (1989) are one of the first studies that examine the value relevance of advertising expenses as well as the R&D expenditure. Hirschey and Weygandt (1985) use “Tobin’s q and conclude that R&D and advertising expenditures are positively associated with market value. On the other hand, Bublitz and Ettredge (1989) use the term “unexpected” for both R&D and advertising expenditures and find that while unexpected R&D should be capitalized as an asset, unexpected advertising expenditures should be recognized as expenses.”Han and Manry (2004) also examine the value relevance of advertising expenditures by using the Korean sample between the years of 1988 and 1998 by

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employing 3.191 firm-year observations. They find that advertising expenditures are negatively associated with the stock price since its benefits are perceived to be expired in the current period by the investors. Value relevance of brands is another aspect of intangible-based value relevance studies. Aaker and Jacobson (2001) examine the value relevance of brand attitude for firms in the computer industries using quarterly data between 1988 and 1996. The results indicate that changes in brand attitude are associated with the stock return and lead to accounting financial performance. They claim that brand-building initiatives may create long-term profits, especially in high-technology companies. Kallapur and Kwan (2004) investigate the value relevance and reliability of brand assets recognized by 33 U.K. firms from 1985 to 1997. They highlight that brands are likely to be more discretionary than other intangibles. The study claims that when contracting incentives are important and there is a managerial subjective valuation, this leads to substantial differences in market capitalization. The results also indicate that in spite of managers’ discretion in overvaluing the brand values, recognized brand values are value relevant in the sample period. Dainelli and Giunta (2011) follow the procedure of Amir and Lev (1996) and examine the non-financial indicator effect on value relevance by using the data of 30 firms in the European fashion industry for the years between 2000 and 2008. They use “change in mono-brand stores” as a non-financial indicator and after the necessary adjustments in the model, the study concludes that non-financial information is a crucial ingredient of valuation. The patent has always become one of the most important parts of the intangible assets and many studies focus on the value relevance of patents in the literature. Deng et al. (1999) analyze the relationship between patent quality “(the number of patents, the impact of patents, and the scientific connection) and corporate stock prices” and market-to-book Ratio for 388 firms from 1985 to 1995. “Their results indicate that three measurements of patent quality are positively related to the market-to-book ratio. Hirschey et al. (2001) also examine the value relevance of non-financial patent information by using 1290 U.S. high-tech company observations during the period of 1989–1995.” They investigate the patent quality with respect to the citation of patents and the closeness of patents to the current scientific research base. They also conclude that the R&D expenditures are more value relevant in the firms that offer higher patent quality. Yang (2007) is another study that investigates the patent information and financial performance by using 292 U.S. biotechnology companies’ data for the periods of 1990–2001. The study measures the patent information with six quantity and quality variables and finds that patent information is related to biotech firm’s subsequent financial performance. Lastly, software development costs are another important feature of intangible assets, and Aboody and Lev (1998) are one of the first studies to investigate the software development costs in 163 firms (US) for the period between 1987 and 1995. The results document that while “changes in capitalized software development costs are positively related to stock returns, the expensed portion is negatively associated with market value.”

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6.4 Concluding Remarks Value relevance is a well-documented and heavily debated phenomenon that basically examines the “association between accounting information” and equity market values. Due to the increasing importance of intangible assets in financial statements and since they are one of the competitive strengths of the companies, studies should also need to examine the value relevance of intangibles. Not properly recognizing “intangible assets in financial statements are one of the main results” of the increasing gap between the book value and the market value of the firm’s share prices and this creates information asymmetries in the decision-making process of investors. Thus, the purpose of this study is to demonstrate how valuable intangibles and to provide useful information about the value relevance of intangibles by reviewing the most cited literature. The study also tries to focus on the accounting treatment of intangibles (either capitalization or expensing) and display the country-specific results related to relevance and reliability. Investigating the value relevance of intangibles will contribute not only to regulatory bodies and standard- setters but also to investors or any stakeholders. Table 6.1 denotes the fundamental studies’ results in terms of the intangibles employed in the papers. The results generally indicate that; – Examining the value relevance of intangibles may contribute to the standardsetters, academics, and investors. – IFRS adoption generally decrease the overall value relevance of intangibles. – Capitalization of research and development expenditures (R&D) generally produces reliable and relevant information. – Managerial choice of capitalizing or expensing R&D displays higher value relevance. – There are controversial results about the value relevance of advertising expenses. – Patent quality is generally positively related to market values. – Recognized brand values are generally value relevant. – While capitalized software development costs are positively related to stock returns, the expensed portion is negatively associated with market value. This study has some limitations. First, it only covers the studies that are related to specific intangibles such as R&D, Patents, or Brands. Future studies are needed to examine different characteristics of intangibles. In addition, since this study is a literature review of most cited papers, future studies may concentrate on cross-country examples by using large sample data and by employing different value relevance models.

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Table 6.1 Summary of the literature Study

Sample

Subject

Findings

Chauvin and Hirschey (1994)

1989–1991

All intangibles

While goodwill, net income, advertising, R&D, intangible assets, and tangible assets are value relevant for non-manufacturing firms, goodwill, and intangible assets are not value relevant for manufacturers under GAAP

Godfrey and Koh (2001)

172 firms, in 1999

All intangibles

Taken as a group, intangible assets are value relevant but not capitalized R&D

Chalmers et al. (2008)

599 firms in Australia, All intangibles 2005–2006

Goodwill provides incremental information that is valuation-relevant under AIFRS

Abdul-Shukor et al. 1990–2001, in (2008) Malaysia

All intangibles

Goodwill and research and development (R&D) expenses are negatively associated with firms’ share prices

Morricone et al. (2009)

267 firms in Italy, 1996–2006

All intangibles

IFRS adoption reduces the value relevance of intangibles

Dahmash et al. (2009)

1994–2003, in Australia

All intangibles

Although the accounting information produced under IAS seems to be value relevant, it is not reliable

Oliveira et al. (2010)

1998–2008, in Portugal

All intangibles

Goodwill and other intangible assets are highly related to market value

Lev and Sougiannis 825 firms, USA, (1996) 1975–1991

R&D

Capitalizing R&D produces reliable and relevant information

Zhao (2002)

R&D

Capitalization of R&D enhances the value relevance in France and the UK and especially in the US software industry

13.029 firm-year observations in 4 countries, 1990–1999

(continued)

6 Value Relevance of Intangibles: A Literature Review

125

Table 6.1 (continued) Study

Sample

Han and Manry (2004)

3.191 firm-year R&D observations in Korea, 1988–1998

Subject

Findings Capitalizing R&D expenditure provides higher value relevance

Callen and Morel (2005)

6.819 firm-year observations, 1962 to 1996

R&D

There is a very weak association between R&D investment and market values

Ahmed and Falk (2006)

1172 firm-year observations in Australia, 1992–1999

R&D

Managerial choice of capitalizing or expensing R&D displays higher value relevance

Cazavan and Jeanjean (2006)

770 firm-year observations in France, 1993–2002

R&D

Capitalized R&D is negatively associated with stock prices and returns

Oswald (2008)

3.229 firm-year observations in the UK, 1990–2004

R&D

Managers should choose the correct decision in capitalizing or expensing R&D

Tsoligkas and Tsalavoutas (2011)

418 firm-year observations in UK, 2005–200

R&D

While the capitalized portion of R&D is positively related to market values expensed portion of R&D is negatively related

Shah et al. (2013)

15,565 firm-year observations in UK, 2001–2011

R&D

Capitalized R&D has value relevance for the whole sample

Gong et al. (2016)

7613 firm-year observations in 9 countries, 1997–2012

R&D

The value relevance of R&D expenses declines in countries where mandated immediate expensing or allowed optional capitalization of R&D costs was applied after IFRS adoption

Hirschey and Weygandt (1985)

390 firms in US, 1977

Advertising expense

Advertising expenditures are positively associated with market value

Bublitz and Ettredge (1989)

328 firms in US, 1974–1983

Advertising expense

Unexpected advertising expenditures should be recognized as expenses (continued)

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Table 6.1 (continued) Study

Sample

Han and Manry (2004)

3.191 firm-year Advertising expense observations in Korea, 1988–1998

Advertising expenditures are negatively associated with the stock price

Deng et al. (1999)

388 firms, 1985–1995

Patents

Patent quality is positively related to the market-to-book ratio

Hirschey et al. (2001)

1.290 firms in US, 1989–1995

Patents

R&D expenditures are more value relevant in the firms that offer higher patent quality

Yang (2007)

292 firms in US, 1990–2001

Patents

Patent information is related to biotech firm’s subsequent financial performance

Aaker and Jacobson 1988–1996 (2001)

Brand

Changes in brand attitude are associated with the stock return and lead to accounting financial performance

Kallapur and Kwan (2004)

Brand

Despite the managers’ discretion in overvaluing the brand values, recognized brand values are value relevant in the sample period

Dainelli and Giunta 30 firms in EU, (2011) 2000–2008

Brand

Non-financial indicators (change in mono-brand stores) increase the value relevance

Aboody and Lev (1998)

Software development costs

While changes in capitalized software development costs are positively related to stock returns, the expensed portion is negatively associated with market value

33 firms, in the UK, 1985–1997

163 firms in US, 1987–1995

Subject

Findings

6 Value Relevance of Intangibles: A Literature Review

127

References Aaker DA, Jacobson R (2001) The value relevance of brand attitude in high-technology markets. J Mark Res 38(4):485–493 Aboody D, Lev B (1998) The value relevance of intangibles: the case of software capitalization. J Account Res 36:161–191 Abdul-Shukor Z, Ibrahim MK, Kaur J, Md-Nor H (2008) The value relevance of intangibles noncurrent assets in different economic conditions. Int Rev Bus Res Papers 4(2):316–337 Agostino M, Drago D, Silipo DB (2011) The value relevance of IFRS in the European banking industry. Rev Quant Financ Acc 36(3):437–457 Ahmed K, Falk H (2006) The value relevance of management’s research and development reporting choice: evidence from Australia. J Account Public Policy 25(3):231–264 Alali FA, Foote PS (2012) The value relevance of international financial reporting standards: empirical evidence in an emerging market. Int J Account 47(1):85–108 Amir E, Lev B (1996) Value-relevance of nonfinancial information: the wireless communications industry. J Account Econ 22(1–3):3–30 Amir E, Harris TS, Venuti EK (1993) A comparison of the value-relevance of US versus non-US GAAP accounting measures using form 20-F reconciliations. J Account Res 31:230–264 Anthony JH, Ramesh K (1992) Association between accounting performance measures and stock prices: a test of the life cycle hypothesis. J Account Econ 15(2–3):203–227 Ball R (2006) International financial reporting standards (IFRS): Pros and cons for investors. Account Bus Res 36(sup1):5–27 Ball R, Brown P (1968) An empirical evaluation of accounting income numbers. J Account Res 6(2):159–178 Barth ME, Beaver WH, Landsman WR (1996) Value-relevance of banks’ fair value disclosures under SFAS No. 107. Account Rev 513–537 Barth ME, Beaver W, Landsman W (2000) The relevance of value relevance research. In: Journal of accounting and finance conference at Stanford University in October Barth ME, Beaver WH, Landsman WR (2001) The relevance of the value relevance literature for financial accounting standard setting: another view. J Account Econ 31(1–3):77–104 Beaver WH (1968) The information content of annual earnings announcements. J Account Res 67–92 Beaver WH (2002) Perspectives on recent capital market research. Account Rev 77:453–474 Bublitz B, Ettredge M (1989) The information in discretionary outlays: advertising, research, and development. Account Rev 108–124 Callen JL, Morel M (2005) The valuation relevance of R&D expenditures: time series evidence. Int Rev Financ Anal 14(3):304–325 Capkun V, Jeny A, Jeanjean T, Weiss LA (2008) Earnings management and value relevance during the mandatory transition from local GAAPs to IFRS in Europe. Available at SSRN 1125716 Cazavan-Jeny A, Jeanjean T (2006) The negative impact of R&D capitalization: a value relevance approach. Eur Account Rev 15(1):37–61 Cazavan-Jeny A, Jeanjean T, Joos P (2011) Accounting choice and future performance: the case of R&D accounting in France. J Account Public Policy 30(2):145–165 Chalmers K, Clinch G, Godfrey JM (2008) Adoption of international financial reporting standards: impact on the value relevance of intangible assets. Aust Account Rev 18(3):237–247 Chambers DJ, Jennings R, Thompson RB (1998) Evidence on the usefulness of capitalizing and amortizing research and development costs. Available at SSRN 58661 Chan LK, Lakonishok J, Sougiannis T (2001) The stock market valuation of research and development expenditures. J Financ 56(6):2431–2456 Chang J (1998) The decline in value relevance of earnings and book values. Working Paper, Harvard University Chauvin KW, Hirschey M (1994) Goodwill, profitability, and the market value of the firm. J Account Public Policy 13(2):159–180

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Cho SP, Chung JY (2001) The effect of R&D expenditures on subsequent earnings. Korean Manage Rev 30(1):289–313 Ciftci M, Darrough M, Mashruwala R (2014) Value relevance of accounting information for intangible-intensive industries and the impact of scale: the US evidence. Eur Account Rev 23(2):199–226 Collins DW, Maydew EL, Weiss IS (1997) Changes in the value-relevance of earnings and book values over the past forty years. J Account Econ 24(1):39–67 Dahmash FN, Durand RB, Watson J (2009) The value relevance and reliability of reported goodwill and identifiable intangible assets. Br Account Rev 41(2):120–137 Dainelli F, Giunta F (2011) The value relevance of non-financial performance indicators: new cues from the European fashion industry. Financial Reporting Deng Z, Lev B, Narin F (1999) Science and technology as predictors of stock performance. Financ Anal J 55(3):20–32 Devalle A, Onali E, Magarini R (2010) Assessing the value relevance of accounting data after the introduction of IFRS in Europe. J Int Financ Manage Account 21(2):85–119 Francis J, Schipper K (1999) Have financial statements lost their relevance? J Account Res 37(2):319–352 Francis J, LaFond R, Olsson P, Schipper K (2004) Costs of equity and earnings attributes. Account Rev 79(4):967–1010 Flöstrand P, Ström N (2006) The valuation relevance of non-financial information. Manage Res News 29(9):580–597 Godfrey J, Koh PS (2001) The relevance to firm valuation of capitalising intangible assets in total and by category. Aust Account Rev 11(24):39–48 Gong JJ, Sophia I, Wang L (2016) Changes in the value relevance of research and development expenses after IFRS adoption. Adv Account 35:49–61 Goodwin J, Ahmed K (2006) Longitudinal value relevance of earnings and intangible assets: evidence from Australian firms. J Int Account Audit Taxation 15(1):72–91 Han BH, Manry D (2004) The value-relevance of R&D and advertising expenditures: evidence from Korea. Int J Account 39(2):155–173 Healy PM, Myers SC, Howe CD (2002) R&D accounting and the tradeoff between relevance and objectivity. J Account Res 40(3):677–710 Hellström K (2006) The value relevance of financial accounting information in a transition economy: the case of the Czech Republic. Eur Account Rev 15(3):325–349 Hirschey M, Weygandt JJ (1985) Amortization policy for advertising and research and development expenditures. J Account Res 326–335 Hirschey M, Richardson VJ, Scholz S (2001) Value relevance of nonfinancial information: the case of patent data. Rev Quant Financ Acc 17(3):223–235 Holthausen RW, Watts RL (2001) The relevance of the value-relevance literature for financial accounting standard setting. J Account Econ 31(1–3):3–75 Hung M, Subramanyam KR (2007) Financial statement effects of adopting international accounting standards: the case of Germany. Rev Acc Stud 12(4):623–657 Jenkins DS, Kane GD, Velury U (2009) Earnings conservatism and value relevance across the business cycle. J Bus Financ Account 36(9–10):1041–1058 Ji XD, Lu W (2014) The value relevance and reliability of intangible assets: evidence from Australia before and after adopting IFRS. Asian Rev Account 22(3):182–216 Kallapur S, Kwan SY (2004) The value relevance and reliability of brand assets recognized by UK firms. Account Rev 79(1):151–172 Lev B (2001) Intangibles—management, measurement and reporting. The Brookings Institution, Washington, DC Lev B, Sougiannis T (1996) The capitalization, amortization, and value-relevance of R&D. J Account Econ 21(1):107–138 Lev B, Zambon S (2003) Intangibles and intellectual capital: an introduction to a special issue. Euro Account Rev 12(4):597–603

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Lev B, Zarowin P (1999) The boundaries of financial reporting and how to extend them. J Account Res 37(2):353–385 Markarian G, Pozza L, Prencipe A (2008) Capitalization of R&D costs and earnings management: evidence from Italian listed companies. Int J Account 43(3):246–267 Miller MH, Modigliani F (1966) Some estimates of the cost of capital to the electric utility industry, 1954–57. Am Econ Rev 56(3):333–391 Morricone S, Oriani R, Sobrero M (2009) The value relevance of intangible assets and the mandatory adoption of IFRS. Available at SSRN 1600725 Naimah Z (2012) Bias in accounting and the value relevance of accounting information. Proc Econ Financ 2:145–156 Oliveira L, Rodrigues LL, Craig R (2010) Intangible assets and value relevance: evidence from the Portuguese stock exchange. Br Account Rev 42(4):241–252 Oswald DR (2008) The determinants and value relevance of the choice of accounting for research and development expenditures in the United Kingdom. J Bus Financ Account 35(1–2):1–24 Runsten M (1998) The association between accounting information and stock prices model development and empirical tests based on Swedish data Economic Research Institute Shah SZA, Liang S, Akbar S (2013) International Financial Reporting Standards and the value relevance of R&D expenditures: Pre and post IFRS analysis. Int Rev Fin Anal 30:158–169 Soderstrom NS, Sun KJ (2007) IFRS adoption and accounting quality: a review. Eur Account Rev 16(4):675–702 Sriram RS (2008) Relevance of intangible assets to evaluate financial health. J Intell Capital 9(3):351–366 Tsoligkas F, Tsalavoutas I (2011) Value relevance of R&D in the UK after IFRS mandatory implementation. Appl Fin Econ 21(13):957–967 Wyatt A (2008) What financial and non-financial information on intangibles is value-relevant? A review of the evidence. Account Bus Res 38(3):217–256 Yang YW (2007) The value-relevance of nonfinancial information: the biotechnology industry. Adv Account 23:287–314 Zhao R (2002) Relative value relevance of R&D reporting: An international comparison. J Int Fin Manage Account 13(2):153–174

Ömer Faruk Güleç is Assistant Professor in Business Administration Department at Kırklareli University, Kırklareli, Turkey. He received Bachelor’s degree in Business Administration and Integrated Ph.D. degree in Business Administration—Accounting and Finance from Hacettepe University, Ankara, Turkey in 2010 and 2017 respectively. His areas of interest include Financial Performance, Corporate Governance, Controlling and Audit. He has participated in many national and international conferences and has many publications on various topics.

Chapter 7

Risk Management in the Insurance Company Tzvetelina Andreeva

Abstract Risk is at the heart of any activity. Its diversification and management turn into value. Risk (risks) is also at the core of the business of an insurance company that offers insurance protection against risks under certain conditions. Risk management is seen as a consistent application of management approaches, methods to identify, analyze, assess, eliminate or limit the observed risk. The object of research is the insurance company. The subject of research is risk management. The aim of the article is to study and systematize the insurance company’s risk management concept along with the types of risks inherent in the non-life insurance company. The possible forms (methods, tools) for managing the risk of the insurance company are outlined. For the purposes of risk management, the article highlights the importance of information on risk development, the calculation of insurance premiums—the price of the insurance product, the allocation of reserves, reinsurance, investment and other. Keywords Risk · Risk management · Risk management methods · Insurance premium · Reinsurance JEL Classification G2

7.1 Introduction Risk management is a scientific approach to the problem of risk/risks/that has as its objective the reduction and elimination of risks facing the businesses. It evolved from the field of corporate insurance buying and is now recognized as a distinct and important function of all businesses and organizations.1 Risk management is always an up-to-date topic in business organizations. It is a continuous process for every 1 Vaughan

and Vaughan (2007), p. 12.

T. Andreeva (B) Finance Account Faculty, Finance Department, University of National and World Economy, Sofia, Bulgaria e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_7

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company, including the insurance company. Risk management has its specificity in the insurance company, which is dictated by the fact that along with the risks that are typical of other companies, the insurance activity is related to providing protection against certain risks or the insurance companies manage risks. Its importance also increases due to some trends typical of the insurance market. The insurance industry is developing dynamically. It went through the process of merges and acquisitions, emerging in new markets, markets’ distribution and digitalization. Overall, and given the social and economic development over the last decades, there has been an increase in the magnitude of damages and the frequency of disasters. Change in lifestyle, including increased mobility of people is a prerequisite for searching for new covers, changes in the development of risks, increasing customer requirements in search of new solutions, accessible, fast, quality and modern services at an affordable and adequate price. Last but not least, the burdened by regulatory changes and demanding requirements business environment put the need for additional resources of companies to cover them. These and other reasons justify the efforts of insurance companies to better manage risk. The aim of the article is to study and systematize the risk management concept of the insurance company, the types of risk and possible factors associated with the change of the risk situation, as well as the forms (methods, tools) for risk management of insurers.

7.2 Risk in Insurance The risk in insurance, respectively, in the insurance company, has its specificity. On the one hand, insurance offers protection against many risks, which are covered risks within the insurance contract. Such are the risks against which people’s life and ability to work are insured, their assets—movable and immovable. In non-life insurance, the risks covered are those from natural disasters, such as hail, storm, earthquake, floods, fires and others and third-party liability. On the other hand, there are the types of risks inherent in the insurance company discussed in the upcoming article. The term “risk” means an exposure to accidental loss, damage or liability, death or personal injury. Insurance risk is accidental, and its occurrence can only have negative consequences for the insured. Accidentality in events directs us to probability theory, which is an important source of insurance theory and especially about the theory of risks in insurance.2 The probability theory is the mathematical basis of insurance. “Probability theory deals with accidental events by not investigating the effect and interaction of the cause’s result of which is the single accidental event. It explores the trends that occur by the accidental events when they are mass. It explores the laws that make their way through accidental mass events.” Accidental events with 2 Katsarov

(1966), p. 8.

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a mass character have an absolute frequency, i.e., the number of cases that have occurred of interest for us or the occurrence of things with a certain sign. When this frequency is applied to all cases or the whole, a relative frequency is obtained. By some events, the latter shows persistence, especially as the number of cases (aggregate volume) increases.3 In insurance, based on historical observations and given statistical aggregates, indicators are produced that calculate the premiums and reserves that will apply in the future. With the conclusion of insurance contracts and the payment of insurance premiums, the insurance company assumes responsibility for damages caused by the occurrence of the accepted in responsibility risks and by the conditions stipulated in the insurance contracts. Or, through the conclusion of insurance contracts, the cover of the consequences of the occurrence of unexpected events is transferred from insured to the insurer and the insurance company is a kind of “accumulator” of risks. In order to fulfill the obligations to the policyholders when concluding the contract the insurance company calculates from them an insurance premium, allocates reserves, invests, reinsures, etc. The insurance premium is calculated on the basis of historical data about the risk development, on the basis of the paid indemnities in the past, which form the so-called risk premium to which the so-called safety loading, other loadings, the costs and profit of the insurer are added. It is possible that in a given year, the amount of the paid indemnities is higher than expected. Thus, from the initial risks that the insured transfer to the insurer a risk is formed—called in the insurance literature “the risk of the insurer”, respectively “the risk of the insurance company”. Its essence is that it is not certain whether the insurer will be able to fulfill the assumed responsibility to the insured persons and legal entities, as well as to carry out its activity successfully. Therefore, the risk of the insurer, respectively, the insurance company, differs from the risk that the insurance company covers the insured. The insurer’s risk is if the insurer cannot fulfill his obligations to the insured. In this sense, the risk is also known as “technical risk” of the insurer or “underwriting risk”.

7.3 Type of Risks Common for Insurance Companies The main types of risks of the insurance company are the insurance-technical risk, the investment risk, the operational risk and the administrative–economical risk.

3 Katsarov

(1966), p. 12.

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7.3.1 Insurance–Technical Risk The insurance–technical risk is one of the most important risks inherent in the insurance company. This risk is limited to a deviation (negative deviation) between the expected (calculated) and the actual need of sources of an insurance company to cover the damage caused by the occurrence of risk. It is a risk to which the insurance company is exposed that over a period of time the aggregate loss for an aggregate in relation to the risk development cannot be covered by the relevant net premiums (risk premium and safety loading) and the available reserves, whereby there is a loss for the company from the development of risk (Draganov 2003, 211–213). The term “aggregate” should be understood as the insurance group for a given type of insurance or the whole insurance group of the insurance company. The expenses in connection with the development of risk may include both insurance indemnities on incurred and filled claims or not yet filled claims that have not been paid at the end of the previous period (not filled during past periods but filled during the observed period). These expenses also include the cost of claims management, which also relates to risk development. The costs in relation to risk development are covered by the technical net premiums and technical reserves. Technical reserves are amounts that an insurer has to set aside in order to guarantee to some extent that it will meet its financial obligations to the insured. The existence of technical reserves is a factor that affects the insurance– technical risk (Table 7.1). As can be seen from the table, the amount of technical reserves for Bulgarian non-life insurance companies for the period from 2013 until 2018 increases. The reserve for outstanding payments/outstanding losses has the biggest share, followed Table 7.1 Existence of technical reserves is a factor that affects the insurance-technical risk Year

Premium reserve thousand BGN

Reserve for non-terminated risks thousand BGN

Outstanding Safety losses fund reserve thousand BGN

Reserve Total for thousand bonuses BGN and discounts thousand BGN

Index

2013

472,861

16,627

664,524

5,205

6,069

1,165,286 100,00 100,00

2014

486,158

17,230

726,241

5,636

6,615

1,241,880 106,57 106,57

2015

494,119

13,783

722,044

7,209

7,207

1,244,362 106,79 100,20

2016

458,068

12,036

741,734

4,987

7,032

1,223,857 105,03 98,35

2017

715,367

20,618

1,424,409

4,340

7,361

2,172,095 186,40 177,48

2018

864,452

18,232

1,679,432

3,353

6,206

Total 3,491,025 58,526 annual (36.45%) – average share

5,958,384 (62.2%)

30,730 40,490 (0.32%) (0.42%)

Basic

Chain

2,571,675 220,69 118,40 9,579,155 – (100%)

–

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by the premium reserve and the safety reserve, respectively, by 62.2, 36.45 and 0.32%.4 The existence of insurance–technical risk is due to the influence of various factors, also called elements of the insurance-technical risk. These are factors that are due to accidental risk deviations or “risk of random fluctuations”. In this case, the factual value of the aggregate loss deviates from its expected value, because more in number and/or very large in amount damages occur accidentally. In this regard, there is also a “risk of accumulation”—when an insurance event affects a number of the insured objects and in the case of unusually large losses to the insurance company for “catastrophic risk”. Another group of factors is related to changes in the risk situation after risk assessment (“risk of change”). Other factors may be due to error (“risk of error”). In this case, the deviation of the actual value of the aggregate loss from its expected value may be due to an inappropriate risk development assessment. Reasons may be incomplete, wrong, missing information, the quality of information, incorrect statistical processing methods and the calculated insurance premiums by company employees. The underwriting risk can also be seen as a factor that has an impact on insurance– technical risk. Here attention is paid to the selection of the objects and the risks for which insurance protection is offered and the calculation of the insurance premiums by the employees of the insurance company.

7.3.2 Underwriting Risk In English-language literature, the underwriting risk is identified with insurance– technical risk. This risk is of the insurer when he does not reach the resources— premiums and reserves to cover the incurred insurances losses and the related with them expenses. The underwriting risk is seen as “premium risk”, “reserve risk” and “catastrophe risk” (Doff 2007, 44–45).

7.3.3 Investment Risk Each insurance company has temporary free funds, including parts of the cash from the insurance premiums paid, from the technical reserves, etc. During the period in which these funds are available, the insurance company usually invests part of it in order to realize a corresponding income. In general, the types of investments in which non-life insurance companies invest are in financial assets—stocks, bonds, mainly with fixed income, deposits and real estate investments (land and buildings). 4 Financial

supervision commission, yearly reports 2013–2018, the calculations are done by the author based on data from insurance companies, submitted to the financial supervision commission in the period 2013–2018.

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The loss from an investment can pose a serious threat to the company’s results. At the same time, investment profits favor financial results, can be used to cover losses in bad development of insurance risk and be used to create a competitive advantage over other market participants.

7.3.4 Operational Risk Operational risk is the risk of loss due to inadequate internal processes or weaknesses, errors in internal processes, people and systems or as a result of external events (Doff 2007, 73). Examples of operational risk are losses due to hardware, software and telecommunication issues, information system errors, fraud, unlicensed products sale, regulatory discrepancy, misuse of confidential information, damage to company property as a result of natural disasters and many others.

7.3.5 Administrative–Economical Risk The expenses occupy an important place in the insurance–technical plan of insurance products. Given the competition on the market, insurance companies tend to maintain a low level of costs as they directly affect the price of the products offered. In relation to the expenses, the insurance company is exposed to the so-called administrative– economic risk that arises for the company when, for a given period, the incomes from the provided loadings for administrative costs prove to be insufficient to cover the actual executed administrative costs. It is important to address affective and modern costs management methods to maintain optimal levels of administrative costs (Deevski 2013, 17–21).

7.4 Risk Management in the Insurance Company Risk management plays an important role in the strategic management of the insurance company. This is the process in which the insurance company systematically studies and manages risks through methods, techniques, forms of control and risk financing and their combined application. Risk control includes the methods of risk avoidance, risk mitigation by prevention and diversification and loss control, i.e., taking measures to reduce the frequency and magnitude of the damages. Risk financing insurance companies can realize through co-insurance, reinsurance, risk transfer via insurance pool and alternative financial transfer. Risk avoidance is possible with respect to a type of insurance, the coverage of a risk, risks, the offering of insurance cover for an object or subject, group of subjects,

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given the results, specialization, opportunities and policy of the company. Risk reduction is mainly achieved through preventive measures and diversifications. Diversification can be achieved by expanding the types of the practice insurances, the subjects, the covered risks, the territorial scope and the participation of more active reinsurers in the insurer’s insurance programs. In insurance, it mainly involves risk spreading to reduce, stabilize and balance the risk. The key to loss control is to reveal the causes of the occurrence of damages and to prevent to some extent their recurrence, as well as to reduce their size. This also requires that priority is given to sources of greater losses, i.e., more frequent and heavier risks, and focusing primarily on optimizing the preventative strategy. Risk management is a continuously evolving process with separate stages, part of this process. The first stage aims to outline some basic parameters related to risk management. These are the company’s strategic goals, the company’s goals to be achieved through risk management, specific risk management tasks, the participants in risk management and other. The second stage is the identification of the risks inherent in the insurance company. For this purpose, it is necessary to know the internal and external environment of the company and to collect sufficiently up-to-date information about the risks from different sources. Teamwork is required by the company’s risk manager with specialists from different departments within and outside of the company. Along with the identification of all risks, many of the factors influencing the occurrence of risks must be outlined. In this matter, it is also important to know the appropriate method or combination of methods, given the specifics of the insurance company. Such methods are SWOT analysis and risk–identification matrix (Romeike and Mueller-Reichart 2005, 75). The third stage in the risk management process is to analyze and assess the risks and mainly to determine the possible consequences (losses) of the risks. In the risk analysis, a “top-down” or “bottom-up” approach can be used to highlight correspondingly the consequences (losses) of the occurred risks or the reasons for their occurrence (Romeike and Mueller-Reichart 2005, 76). There are different methods for assessing risks such as value at risk (VaR) or cash flow at risk used to assess market risk in the financial sector. The Monte–Carlo simulation method is used to assess the impact of all types of risk. The fourth stage is the development of a risk management program. The fifth stage is the stage of monitoring and reviewing the risk management program by which it should be determined: Whether the adopted procedures are understood and implemented and what needs to be changed in the program and in the risk management process?

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7.5 Conclusion Risk management is a process that is important for the shareholders of the insurance company and for the insured and society as a whole as insurers run huge funds. Risk management is a continuous and evolving process involving experienced and competent specialists in a variety of fields. It should, along with the risks inherent for other activities, focus on the insurance–technical risk and on monitoring the development of risk of the individual aggregates, the calculation of adequate premiums and the allocation of sufficient reserves. Preventing and limiting losses have an important place in risk management. Optimal reinsurance and investment programs should be applied to them unconditionally. It is essential to address possible operational risks and avoid them, as well as optimize the costs and maintain optimal levels of administrative costs.

References Deevski S (2013) Methods of costs distribution and management in an industrial company, Series Economics and law. Sci J New Univ Russia 9(31) Doff R (2007) Risk management for insurers—risk control, economic capital, solvency. Risk books, London Draganov H (2003) Risk management. Trakia-M, Sofia Katsarov I (1966) Theory of risks. Svishtov Romeike F, Mueller-Reichart M (2005), Risikomanagement in Versicherungsunternehmen— Grundlagen, Methoden, Checklisten und Implementierung. Wiley-VCH Verlag, Weinheim Vaughan JE, Vaughan T (2007) Fundamentals of risk and insurance, 10th edn. Wiley, New York www.fsc.bg

Part II

Ethics and Sustainability in Banking

Chapter 8

Evaluating the Effectiveness of the Coordination Between Internal Control and Internal Audit: A Survey-Based Analysis on Turkish Banking Sector Mustafa Tevfik Kartal

and Serpil Kılıç Depren

Abstract Audit is the process which evaluates the suitability of operations of a company according to the rules. In this process, firstly, the rules related to the operations should be identified. Secondly, necessary information for these operations should be obtained. Thirdly, there is a comparison with this information and the rules to understand whether the company performs effectively or not. In this step, all deficiencies related to the company can be identified. Fourthly, these deficiencies are sent to necessary department managers. Another important point of the audit is that there will be a periodic control to see if these deficiencies are corrected or not. Banks are the companies in which audit works are conducted by different parties. There is an internal audit department that makes a control for the operations of the banks for a period. In other words, it gives independent assurance about the effectiveness of the operations made by personnel of the banks. In addition, internal control department makes also audit works for ongoing process. Similar to the internal auditors, internal control personnel also work in the banks. Also, there are external auditors and state auditors. As it can be seen above, there are many audit works in the banks which are performed by different parties. However, if the similar works are made by these parties, this situation has a decreasing effect on the effectiveness of the works because all parties will consume time for the same works. Therefore, there should be coordination between assurance providers. Within this context, Performance Standard 2050 emphasizes that audit works should be coordinated and hence audit works can be conducted more effectively. It is clear that coordination between assurance providers is very significant. The purpose of this study is to evaluate the effectiveness of the coordination between internal control and internal audit departments in Turkish banking sector. In order to reach the stated aim, a research was made M. T. Kartal (B) Borsa ˙Istanbul Strategic Planning and Investor Relations Directorate, Istanbul, Turkey e-mail: [email protected] S. K. Depren Statistics Department, Yildiz Technical University, Istanbul, Turkey e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_8

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M. T. Kartal and S. K. Depren

with employees who work in internal audit and internal control departments and chisquare test was used to analyze survey responses. According to results, there are some deficiencies regarding coordination of audits. Almost all cases that are questioned in the survey are controlled by both internal control and internal control departments. However, these participants think that audit works are coordinated. This result shows that there is a communication problem between internal control and internal audit departments. To provide full coordinated audit works between internal control and internal audit departments, it is appropriate that banks should take corrective actions. In this context, issues stated in our study will have bank guiding characteristics. Keywords Banking · Chi-square test · Coordination of audit works · Internal audit · Internal control · Survey · Turkey

8.1 Introduction There are two basic financial systems which are bank-based and capital market-based. Banks are one of the most important financial intermediaries in bank-based financial systems. In these financial systems, most of the economic activities are funded by banks. In other words, banks take a substantial role in continuous financing of investment and commerce activities (Yüksel et al. 2015, 2). Beside these, banks match those who has cash surplus with whom need cash. Hence, one party can meet cash need and other party can gain interest by giving loan. Taken into consideration those functions of banks, as financial intermediaries, banks’ critical role for economies of countries’ could be understood well (Dinçer et al. 2016, 33). Due to fact that banks are important for economies, troubles, which could be seen in banking system, could make bad effect on economies of countries. Therefore, efficient and effective auditing of banks is a need (Zengin and Yüksel 2016, 78). Banking sector in most of the countries are followed closely by regulatory authorities. In order for efficient auditing of banks, a lot of regulations were made. Besides regulations, there are also international models, approaches, and best practices. Based on these structures, a variety of audit works is done in banks by internal auditors (including auditors working in internal control and internal audit departments), external auditors (independent auditors), and statutory auditors (working in different governmental institutes). Results of audit works done by internal auditors are reported to board of directors (BoD), audit committee (AC), chief executive officer (CEO), and senior management of audited departments. Results of audit works done by external auditors are reported to BoD and AC of banks and to regulatory authorities. Results of audit works done by statutory auditors are reported to BoD and AC of banks and to management of regulatory authorities (Yurtsever 2009, 20; Yüksel et al. 2016, 102). Banks are audited by internal and external auditors and a lot of audit reports and findings are published. In these audit works, some areas are audited repetitive while

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some areas are out of the audit universe. Because of these separate structure, coordination of audit works is a need. Due to fact that external auditors are independent in the view of legislation, banks can coordinate audit works of internal controllers and internal auditors. By coordinating works of internal control and internal audit, many favors in banks could be gained. Some of these favors could be summarized as (1) standardization of different rating and reporting structure, (2) determination of high risky areas, repetitive audited areas and areas which do not have any audit assurance, (3) sharing of learned information, (4) decreasing auditing costs, (5) efficient resource allocation between audit activities, and (6) minimum intervention to business processes (Huibers 2015, 4). In addition to benefits of coordination of internal control and internal audit works, it is also a requirement according to International Internal Audit Standards. Standard 2050 says that “The chief audit executive should share information and coordinate activities with other internal and external providers of assurance and consulting services to ensure proper coverage and minimize duplication of efforts” (The Institute of Internal Auditors (The IIA) 2003, standard 2050). When internal control and internal audit are coordinated efficiently, senior management of banks can get rid of assurance fatigue (Huibers 2015, 4). Hence, more effective governance, risk, and control oversight are provided to BoD and AC of banks. Unfortunately, it is impossible to coordinate statutory audit with internal audit because of regulatory restrictions in Turkey. So, in this study, coordination of internal control and internal audit is reviewed. This paper was prepared to make a research regarding effectiveness of the coordination between internal controllers and internal auditors. For this purpose, a survey was conducted on Turkish Banking Sector with internal controllers and internal auditors. This study will consist of five parts. After the introduction part, audit works in Turkish banking sector are examined in the second part. In addition to them, within the context of literature review, similar studies about coordination of audit works are detailed in the third part. Moreover, a survey-based analysis regarding branch audit on Turkish banking sector is handled in the fourth part. Finally, an evaluation is made in part V.

8.2 Audit Works in Turkish Banking Sector As it is stated in introduction parts, banking sectors are one of the most important sectors for countries. Therefore, they are regulated and auditor strictly. In Turkey practices, it is seen that banks are audited by a variety of auditors. In other words, banks in Turkey are audited by different assurance providers as internal control, internal audit, external (independent) auditor, and state auditors. According to International Internal Audit Standards, audit works between different assurance providers should be coordinated (The IIA 2003). This means

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that assurance providers should benefit and take others’ audit works into consideration their audit works. In Turkey, according to current regulations, combining all audit works of assurance providers is unfortunately impossible due to fact that external auditors and state auditors are independent. However, this condition does not prevent to coordinate audit works of internal control and internal audit. Coordination of audit can be provided between all assurance providers or some of them such as between internal control and internal audit. This is the point at which this study handles the subject. In other words, this study focuses on audit coordination limited to between internal control and internal audit. Coordination of audit works can provide a lot of benefits to banks. Some of them can be summarized as “exchange of information and discussion, deficiency of internal controls could be made available by internal auditors to the external auditors, to know methodology for understand the audit approach for each other, to enable access to specific working papers, regular meetings between the internal auditors and external auditors to discuss any relevant issues” (Dumitrescu and Bobitan 2016, 89).

8.3 Literature Review There are a variety of studies about coordination of audit works. Within the context of literature review, some of selected studies are included in Table 8.1.

8.4 A Survey-Based Analysis Regarding Effectiveness of the Coordination Between Internal Control and Internal Audit on Turkish Banking Sector Aim and Method The main purpose of this study is to assess effectiveness of the coordination between internal control and internal audit teams on Turkish banking sector. In order to achieve this aim, a Web-based survey is prepared by using SurveyMonkey and survey links are sent to employees from different sectors. Field research is conducted between 12.11.2017 and 01.31.2018. The questionnaire consists of five different sections, which are demographics of participants, issues in the context of branch credit audit, issues in the context of branch operation audit, issues in the context of other branch audit, and statements about audit coordination. In demographics section, information about participants’ educational level, gender, position in the bank of the participants, type and status of the bank at which participants work are questioned. In second, third, and fourth sections, participants are asked to answer “yes” or “no” for the related items in order to understand if they are dealing with the issues that are questioned. Examination of the issues in the context of branch credit audit section consists of seven different items, which are credit documents (application

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Table 8.1 Some selected studies Author

Year

Scope

Results

Felix et al.

1998

United States of America (USA)

Coordination with external audit has potential to increase effectiveness of contribution of internal audit to financial statement audit

Felix et al.

2003

USA

The level of coordination between internal and external audit affects significantly decisions of internal audit reliant

Endaya

2014

Libya

Coordination between internal auditors and external (independent) auditors give lots of benefits and contribute in improving auditors’ works

Wood

2004

USA

Internal auditors can team with external auditors to improve shareholders trust by coordination

Glass

2005

New Zealand

Coordination of audit activities between internal and external audit is important for entity resources and each party keeps other party in order for this

Solomon

2005

United Kingdom (UK)

Effective coordination between external audit and internal audit fosters a culture of transparency and accountability, results in more effective reporting and efficient operational processes, and improves independence

Chambers

2006

UK

It was stated that audit committees provide coordination of audit works

Sarens and De Beelde

2006

Belgium

Internal and external auditors can enhance coordination through information exchange (continued)

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Table 8.1 (continued) Author

Year

Scope

Results

Albrecht

2007

Belgium

Cooperation between external audit and internal audit could be divided into several stages as separation, alignment, cooperation, and partnering

Institute of Directors in Southern Africa (IoD)

2009

South Africa

It was determined that audit committees should enable combined assurance approach between assurance providers and coordinate audit activities

Akyel

2010

Turkey

There are problems and deficiencies in coordination of external audit and internal audit

Fowzia

2010

Bangladesh

Cooperation promoted through audit committee is the most important factor for assessing cooperation between external auditors and internal auditors in banks

Halimah et al.

2010

Malesia

Coordination between internal and external auditors has positive influence of effectiveness of internal audit

Gray and Hunton

2011

USA

External auditors could use internal auditors’ works if internal auditors report the audit committees

European Confederation of Institutes of Internal Auditing (ECIIA)

2013

Belgium

Internal audit and external audit collaborate in order to harmonize the message received by the governing body. The audit committee should define and manage the scope of this cooperation

EY

2013

Gambia

It was concluded that risk management activities in first and second line of third line defense model can be optimized by coordinating audit activities (continued)

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Table 8.1 (continued) Author

Year

Scope

Results

Decaux and Sarens

2014

Belgium

Internal audit function should be the champion of combined assurance due to its placement in organizations, should facilitate and coordinate other assurance providers and processes, should be focal point for reporting

Endaya

2014

Libya

Effective coordination between external and internal auditors provides lots of benefits including quality, audit cost, and contribution in improving auditors’ works

Decaux and Sarens

2015

Belgium

They concluded that coordination of audit activities requires presence of a leader for process, matching daily routine activities and assurance works, and reporting findings

Forte and Barac

2015

South Africa

Internal audit is the most important party in coordination and consolidation of audit works

Gül and Kaban

2015

Turkey

There are a partial coordination between internal audit and internal control in banks in the view of inspectors

Huibers

2015

Netherlands

Common language and common perspective enable audit works to be much more efficient and effective

Lewis

2015

South Africa

Internal audit is one of the most important parties in coordination of audit works. It is also the most convenient party for coordination of audit (continued)

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Table 8.1 (continued) Author

Year

Scope

Results

Schreurs and Marais

2015

South Africa

Absence of a coordinator responsible for enabling coordination of audit works restricts accurate execution of combined assurance

Swellendam Municipality

2015

South Africa

Determination of assurance providers and potential, stating of test scope, focusing on risks and exercising combined assurance approach are the main steps in coordination of audit works

Dumitrescu and Bobitan

2016

Romania

There is a good relationship, good interaction, and an almost good reliance of the external auditors on activities of internal auditors

Zhou et al.

2016

Australia

Coordination of audit works decreases information risk

Dmitrenko

2017

Ukraine

Audit committees should approve the approach to be used for coordination of audit works in the organizations

Huibers and Rittenberg

2017

USA

Coordination of audit takes play an important role in achieving advanced governance, risk, and control maturity

Kartal et al.

2018

Turkey

Internal control, internal audit, and independent audit activities were not coordinated by audit committees in some banks

Source Authors

form, payment plan, signature control, etc.), requests of credit customer, collaterals and insurances, proper use of credit for credit purpose, fictitious sales in mortgage and vehicle credits, customers whose credits on delay, and application documents of credit cards and POS machines (form, identity, contract, signature, income, authorization, etc.). There are 11 items in the examination of the issues in the context of branch operation audit. These issues are customer information files for account opening (identity, contract, signature, etc.), checkbook files and checkbooks, safe deposit

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149

boxes files, examination of anti-money laundering and criminal incomes, teller batches, accepted/returned checks and promissory notes, transactions done with instructional operations (instruction, signature, authorization examination, etc.), derivative instruments (instruction, signature, contract, etc.), reversal transactions of deposits/participation funds, money transfer transactions, and alternative distribution channels transactions (Internet-telephone banking, automatic payment, etc.). Expenses and accounting records, cash counting, cash deficits/surpluses, trap moneys, continuation form, security cameras, existence of customer signed teller batches which are not used yet, existence of cash which are not recorded, compulsory documents required by legislation, systematic controls, and examination regarding personnel fraud are the items that investigated in the fourth section. In the last section, there are four statements that participants are expected to give an answer “agree” or “disagree” with the 5-point Likert scale (from 1-strongly disagree to 5-strongly agree). This scale is converted to the 3-point scale with agree, neither agree nor disagree, and disagree in the analysis. Also, there is 1 question about who should be the responsible for the coordinating internal control and internal audit for audit tasks. Four items are mentioned above are “Audit work carried out by internal and internal auditing is coordinated,” “Coordination of audit activities is very useful for banks and all parties in banks,” “Uncoordinated audit works lose meaning of its work,” and “The approaches of regulatory bodies make coordination of audit work difficult.” All questions in the questionnaire are shown in Appendix. Data obtained from survey participants is analyzed using descriptive statistics and cross-tabulation with chi-square test using SPSS v.20 package program. Descriptive Statistics 88 employees in Turkish banking sector participated to the survey. Descriptive statistics is given in Table 8.2. Table 8.2 Descriptive statistics Education level

n

Bachelor

55

Master or Doctorate 33

%

Bank type

63 Deposit bank

n

%

61

69

38 Participation or Development and Investment bank 27

31

Total

88 100 Total

87 100

Gender

n

Bank status

n

Male

79

90 Private or foreign

72

82

10 Public

16

18

Female

9

%

%

Total

88 100 Total

Position

n

Personnel

61

69 Internal audit

48

55

Manager

27

31 Internal control

40

45

Total

88 100 Total

%

Department

88 100 n

%

88 100

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M. T. Kartal and S. K. Depren

Firstly, demographic characteristics of participants are investigated in order to understand the distribution of the sample. In the sample, 38% of the participants have a master or PhD degree and percentage of male is significantly higher than female participants. In addition to examining of the demographic characteristics of employees, working position of the participant, bank’s type, and status are examined. 69% of the total sample is working as non-manager position at their company. When bank type and status are examined, it can be seen that 69% of the bank’s type is deposit bank and 82% of the bank’s status is private/foreign bank. Furthermore, 55% of the participants have been working at internal audit department and 45% of the participants have been working at internal control.

8.5 Evaluation of Questionnaire Participants’ Responses There are seven items in examining the issues in the context of branch credit audit section and the distribution of the answers given to these items is shown in Table 8.3. According to Table 8.3, more than 80% of participants in total state are examining all the issues about branch credit audit and also the chi-square test results are given in Table 8.3. When the results are examined by internal control and internal audit, it is revealed that ~80% of answers given to the items are not differentiating according to the participant’s department in most of the cases, and the answers given to requests of credit customer and customers whose credits on delay are statistically significantly differentiating by participants’ department. All participants are stated they are dealing with examining credit documents and collaterals and insurances. Parallel to this, more than 90% of participants working in either internal audit or internal control are said they are controlling the proper use of credit for credit purpose and fictitious sales in mortgage and vehicle credits. In some cases, percentage of yes between participants who are working in internal control and internal audit is not close to each other. For example, 100% of participants who are working in internal audit are stated they are controlling the requests of credit customer, while this ratio is 83% for participants who are working in internal control. There is a similar gap in the application documents of credit cards and POS machines issue. Another point that is noteworthy is that 98% of internal auditors are examining the customers whose credits are on delay while this ratio is 63% for internal controllers. As a result of this section, it can be said that coordination between internal control and internal audit is not coordinating effectively in branch credit audit tasks. There are 11 items in examining the issues in the context of branch operation audit section, and the distribution of the answers given to these items is shown in Table 8.4. According to Table 8.4, more than 90% of the participants stated they are controlling customer information files for account opening, checkbook files and checkbooks, examination of anti-money laundering and criminal incomes, teller batches and transactions done with instructional operations during the branch operations audit. Furthermore, more than 70% of the participants stated that they are dealing

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151

Table 8.3 Distribution of the issues in the context of branch credit audit by department Answers

Total

Department Internal audit

Chi-square test Internal control

n

%

n

%

n

%

Credit documents (application form, payment plan, signature control, etc.)

Yes

88

100

48

100

40

100

No

0

0

0

0

0

0

Requests of credit customera

Yes

81

92

48

100

33

83

No

7

8

0

0

7

18

Collaterals and insurances

Yes

88

100

48

100

40

100

No

0

0

0

0

0

0

Proper use of credit for credit purpose

Yes

82

93

45

94

37

93

No

6

7

3

6

3

8

Fictitious sales in mortgage and vehicle credits

Yes

82

95

47

98

35

92

No

4

5

1

2

3

8

Customers whose credits on delaya

Yes

72

82

47

98

25

63

No

16

18

1

2

15

38

Application documents of credit cards and POS machines (form, identity, contract, signature, income, authorization, etc.)

Yes

73

86

37

80

36

92

No

12

14

9

20

3

8

a Statistically

n/a

χ2 : 9.126; sd:1; p < 0.05 n/a χ2 : 0.054; sd:1; p > 0.05 χ2 : 1.165; sd:1; p > 0.05 χ2 : 18.397; sd:1; p < 0.05 χ2 : 2.454; sd:1; p > 0.05

significant gap in terms of 95% of confidence interval

with safe deposit boxes files, accepted/returned checks and promissory notes, derivative instruments, reversal transactions of deposits/participation funds and money transfer transactions during the branch operations audit. Additionally, answers of the participants are examined based on the participants’ departments. More than 80% of the participants who are working in internal audit department are stated that they are controlling all the items given in Table 8.4 except “Alternative distribution channels transactions (Internet-telephone banking, automatic payment, etc.),” “Derivative instruments (instruction, signature, contract, etc.),” and “Reversal transactions of deposits/participation funds.” Additionally, more than 90% of the participants who are working in internal audit department stated that they are controlling all the items given in Table 8.4 except “Accepted/returned checks and promissory notes,” “Derivative instruments (instruction, signature, contract, etc.),” “Reversal transactions of deposits/participation funds,” and “Alternative distribution channels transactions (Internet-telephone banking, automatic payment, etc.).”

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Table 8.4 Distribution of the issues in the context of branch operations audit by department Answers

Total

Department

Chi-square test

Internal audit Internal control n

%

n

%

n

Customer information Yes files for account opening No (identity, contract, signature, etc.)

83

94

44

92

39

% 98

5

6

4

8

1

3

Checkbook files and checkbooksa

Yes

80

92

40

85

40

100

No

7

8

7

15

0

0

Safe deposit boxes files

Yes

74

86

38

81

36

92

No

12

14

9

19

3

8

Examination of anti-money laundering and criminal incomes

Yes

82

94

45

96

37

93

No

5

6

2

4

3

8

Teller batches

Yes

84

97

46

96

38

97

No

3

3

2

4

1

3

Accepted/returned checks and promissory notesa

Yes

63

74

38

83

25

64

No

22

26

8

17

14

36

Transactions done with instructional operations (instruction, signature, authorization examination, etc.)

Yes

83

95

46

96

37

95

No

4

5

2

4

2

5

Derivative instruments (instruction, signature, contract, etc.)

Yes

67

78

36

78

31

78

No

19

22

10

22

9

22

Reversal transactions of deposits/participation funds

Yes

64

74

38

79

26

68

No

22

26

10

21

12

32

Money transfer transactions

Yes

77

89

40

85

37

93

No

10

11

7

15

3

8

Alternative distribution channels transactions (Internet-telephone banking, automatic payment, etc.)b

Yes

58

67

28

60

30

77

No

28

33

19

40

9

23

a Statistically b Statistically

significant gap in terms of 95% of confidence interval significant gap in terms of 90% of confidence interval

χ2 : 1.385; sd:1; p > 0.05

χ2 : 6.479; sd:1; p < 0.05 χ2 : 2.330; sd:1; p > 0.05 χ2 : 0.420; sd:1; p > 0.05 χ2 : 0.166; sd:1; p > 0.05 χ2 : 3.768; sd:1; p < 0.05 χ2 : 0.045; sd:1; p > 0.05

χ2 : 0.007; sd:1; p > 0.05 χ2 : 1.286; sd:1; p > 0.05 χ2 : 1.161; sd:1; p > 0.05 χ2 : 2.921; sd:1; p > 0.05

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There are 11 items in examining the issues in the context of other branch audit section and the distribution of the answers given to these items are shown in Table 8.5. In Table 8.5, other branch audit items are questioned. Similar to Tables 8.3 and 8.4, more than 90% of participants stated that they are controlling cash counting, cash deficits/surpluses, and systematic controls and ~80% of participants stated they are controlling expenses & accounting records, trap moneys, security cameras, existence of customer signed teller batches which are not used yet, existence of cash which are not recorded and compulsory documents required by legislation. Additionally, only 45% of the participants are controlling continuation form. When results are examined by departments, it is shown that participants who are working in internal Table 8.5 Distribution of the issues in the context of other branch audit by department Total

Department Internal audit

Chi-square test Internal control

n

%

n

%

n

%

71

83

36

78

35

88

Expenses and accounting records

Yes No

15

17

10

22

5

13

Cash counting

Yes

85

97

46

96

39

98

No

3

3

2

4

1

3

Cash deficits/surpluses

Yes

81

92

46

96

35

88

No

7

8

2

4

5

13

Trap moneys

Yes

69

80

37

79

32

82

No

17

20

10

21

7

18

Yes

38

45

15

33

23

59

No

46

55

30

67

16

41

Yes

72

83

38

81

34

85

Continuation forma Security cameras

No

15

17

9

19

6

15

Existence of customer signed teller batches which are not used yet

Yes

68

78

39

81

29

74

No

19

22

9

19

10

26

Existence of cash which are not recorded

Yes

67

79

38

83

29

74

No

18

21

8

17

10

26

Compulsory documents required by legislation

Yes

71

81

32

67

39

98

No

17

19

16

33

1

3

Systematic controls

Yes

78

89

42

88

36

90

No

10

11

6

13

4

10

Yes

64

74

40

85

24

62

No

22

26

7

15

15

38

Examination regarding personnel fraud a Statistically

significant gap in terms of 95% of confidence interval

χ2 : 1.268; sd:1; p > 0.05 χ2 : 0.184; sd:1; p > 0.05 χ2 : 2.069; sd:1; p > 0.05 χ2 : 0.149; sd:1; p > 0.05 χ2 : 5,545; sd:1; p < 0.05 χ2 : 0.261; sd:1; p > 0.05 χ2 : 0.599; sd:1; p > 0.05 χ2 : 0.861; sd:1; p > 0.05 χ2 : 13.308; p < 0.05 χ2 : 0.135; p > 0.05 χ2 : 6.219; p < 0.05

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M. T. Kartal and S. K. Depren

control and internal audit departments are giving similar answers to all items except continuation form, compulsory documents required by legislation and examination regarding personnel fraud. 33, 67, and 85% of the participations who are working in internal audit stated that they are controlling continuation form, compulsory documents required by legislation and examination regarding personnel fraud, respectively. These ratios are 59, 98, and 62% for the participants who are working in internal audit, respectively. There are five items in the examining the issues in the context of coordination of audit works section and the distribution of the answers given to these items are shown in Table 8.6. Table 8.6 Coordination of audit works by department Total

Department

n

%

Internal audit

Internal control

n

n

%

Chi-square test

%

Audit work carried out by internal control and internal audit is coordinated

Disagree

11

12.5

3

6.3

8

20.0

Neither agree nor disagree

15

17.0

8

16.7

7

17.5

Agree

62

70.5

37

77.1

25

62.5

Coordination of audit activities is very useful for banks and all parties in banks

Disagree

3

3.4

1

2.1

2

5.0

Neither agree nor disagree

1

1.1

1

2.1

0

0.0

84

95.5

46

95.8

38

95.0

8

9.1

4

8.3

4

10.0

11

12.5

7

14.6

4

10.0

Agree

Uncoordinated Disagree audit works Neither agree nor lose meaning of disagree its work Agree

69

74.8

37

77.1

32

80.0

The approaches of regulatory bodies make coordination of audit work difficult

Disagree

40

45.5

21

43.8

19

47.5

Neither agree nor disagree

22

25.0

13

27.1

9

22.5

Agree

26

29.5

14

29.2

12

30.0

Who should be responsible for coordinating your internal control and internal audit work?

Executive responsible from internal control and internal audit

28

31.8

15

31.3

13

32.5

BoD

12

13.6

8

16.7

4

10.0

Committee/internal systems officer

48

54.5

25

52.1

23

57.5

χ2 : 3.967; sd:2; p > 0.05

χ2 : 1.379; sd:2; p > 0.05

χ2 : 0.457; sd:2; p > 0.05 χ2 : 0.256; sd:2; p > 0.05

χ2 : 0.839; sd:2; p > 0.05

8 Evaluating the Effectiveness of the Coordination …

155

There are five questions, which are about coordination of audit works at the end of the questionnaire. 77% of internal audit staff and 63% of internal control staff said audit works are coordinated. However, 23% of internal audit staff and 37% of internal control staff did not agree with “Audit work carried out by internal control and internal audit is coordinated.” Almost all participants give positive feedback on “Coordination of audit activities is very useful for banks and all parties in banks” and also more than 75% of participants are said that “Uncoordinated audit works lose meaning of its work.” Additionally, almost half of the all participants are not agreed with “The approaches of regulatory bodies make coordination of audit work difficult.” When it is asked who should be responsible for coordinating your internal control and internal audit work, generally “committee/internal systems officer” and “executive responsible from internal control and internal audit” answers are given.

8.6 Conclusion Banks have substantial importance for economies and countries. For this reason, banks are regulated highly due to this importance. Parallel to and as a result of this condition, bank are audited frequently by different parts such as external auditors, state auditors, and auditors who work in internal control and internal audit departments of banks. This structure is also same for Turkey. While bank and bank departments are audited frequently by different parties, there occurs duplicating audit works unfortunately. Thus, banks consume assurance sources inefficiently. In order to prevent this, audit works should be coordinated. In this study, it is aimed at to determine coordination level between internal control and internal audit departments in banks due to fact that external auditors and state auditors are independent and they cannot be included in coordination in Turkey practice. Taken into consideration, combination of audit works is performed by only internal control and internal audit departments, and in this study, it is researched coordination audit works by a survey including total 40 questions in 5 subunits. In this context, the survey is conducted and completed with 88 participants. Most of the participants have bachelor degree (63%), male (90%), are audit personnel (not audit manager) (69%), work in deposit banks (69%), work in private or foreign banks (82%), and work in internal audit department (55%). When examining participants’ responses related to branch credit audit, there are seven tasks that are questioned. Almost 80% of participants, who are working in internal control and internal audit departments, state that they are examining the related tasks. Furthermore, in some cases, all of participants, who are working in internal control and internal audit departments, state that they are examining the related tasks such as credit documents and collaterals and insurances. This case shows us that coordination of branch credit audit is not performed efficiently. When examining participants’ responses related to branch operation audit, it is shown that almost 80% of participants state that they are examining all the tasks which are related to operations in the branch except reversal transactions

156

M. T. Kartal and S. K. Depren

of deposits/participation funds, accepted/returned checks and promissory notes, and alternative distribution channels transactions. 60, 68, and 64% of participants state that they are controlling reversal transactions of deposits/participation funds, accepted/returned checks and promissory notes, and alternative distribution channels transactions, respectively. Similar to branch operation audit, there are probably no coordination between internal control and internal audit departments in branch operation audit tasks. When examining participants’ responses related to other branch operation audit, more than 70% of participants state that they are controlling all tasks that are listed in Table 8.5 except continuation form. When examining participants’ responses are related to coordination of audit works, they stated that audit works are coordinated; coordination of audit works is very useful for banks; uncoordinated audit works lose meaning; audit committee/internal systems officer should be responsible for coordinating audit works. These results may be a clue of lack of communication between internal control and internal audit departments. 70% of participants state they are controlling related tasks although some participants state that they are dealing with almost all tasks. Finding reached as a result of survey shows that precautions should be taken regarding coordination of audit works in Turkish banking sector. So, taken positions of internal control and internal audit departments in banks’ organizations, board of directors, audit committees, internal systems officer, chief executive officer, and senior managers of internal audit and internal control departments should take necessary actions to improve coordination of audit works. Hence, banks will benefit much more from audit works, internal control, and internal audit departments. The points specified for the coordination of audit activities in this study will guide the point of taking action to the board of directors of banks, audit committees, internal systems officers, and senior management of internal control and internal audit departments. It is believed that this study makes an important contribution to the literature by analyzing an important point for the banking sector. As a result, it is recommended that audit works of internal control and internal audit should be coordinated in Turkish banks. Hence, it is possible to report to BoD, AC, and senior management in an accurate, efficient, effective, and timely. Banks will also be benefitted from this structure in many ways such as cost reduction and timely reporting. In future studies, it would be beneficial to include much more participants in survey-based researches and to research audit coordination practices in development and investment banks if it is possible.

Appendix: Survey Form

No

Question

Answer options

Information of participants 1

School

High School; Bachelor; Master; Doctorate (continued)

8 Evaluating the Effectiveness of the Coordination …

157

(continued) No

Question

2

Gender

Answer options Male; Female

3

Bank type that you work in

Deposit; Participation; Investment & Development

4

Bank status that you work in

Public; Private; Foreign

5

Department that you work in

Internal Control; Internal Audit

6

Your status

Manager; Personnel

Do you examine the following issues in the context of branch credit audit? 7

Credit documents

8

Intelligence of credit customers

9

Collaterals and ınsurances

10

Proper use of credit for credit purpose

11

Fictitious sales in mortgage and vehicle credits.

12

Credit customers on delay

13

Application documents of credit cards and point of sales

Yes; No; No Idea

Do you examine the following issues in the context of branch operation audit? 14

Customer information files for account opening

15

Checkbook files and checkbooks

16

Safe deposit boxes files

17

Examination of anti-money laundering and criminal incomes

18

Teller batches

19

Accepted/returned checks and promissory notes

20

Transactions done with instructional operations

21

Derivative instruments

22

Reversal transactions of deposits/participation funds

23

Money transfer transactions

24

Alternative distribution channels

Yes; No; No Idea

Yes; No; No Idea

Do you examine the following issues in the context of other branch audit? 25

Expenses & accounting records

26

Cash counting

27

Cash deficits/surpluses

28

Trap moneys

29

Continuation form

Yes; No; No Idea

(continued)

158

M. T. Kartal and S. K. Depren

(continued) No

Question

30

Security cameras

31

Existence of customer signed teller batches which are not used yet

32

Existence of cash which are not recorded

33

Compulsory documents required by legislation

34

Systematic controls

35

Examination regarding personnel fraud

Answer options

Could you express at which level you agree with following statements? 36

Audit work carried out by internal and internal auditing is coordinated.

Absolutely Agree; Agree; Neither Agree Nor Disagree; Disagree; Absolutely Disagree

37

Coordination of audit activities is very useful for banks and all parties in banks.

38

Uncoordinated audit works lose meaning of its work.

39

The approaches of regulatory bodies make coordination of audit work difficult.

40

Who should be responsible for coordinating BoD; Audit Committee/Internal Systems your internal control and internal audit Officer; CEO; Executive Responsible from work? Internal Control and Internal Audit (Coordinator)

References Akyel R (2010) Yönetimde ˙Iç Kontrol ˙Iç Denetim ve Dı¸s Denetim Fonksiyonlarının Birbirleri ile ˙Ili¸skileri ve Türk Kamu Yönetiminde Uygulanmalarının De˘gerlendirilmesi. Çukurova Üniversitesi Sosyal Bilimler Enstitüsü Dergisi 19(3):1–22 Albrecht T (2007) What assurance to expect from internal audit? An External Audit View. IAS Conference, Brussels Chambers A (2006) Assurance of performance. Meas Bus Excell 10(3):41–55 Decaux L, Sarens G (2014) The champion role of the internal audit function in combined assurance. Unpublished Working Paper, Louvain School of Management Research Institute Decaux L, Sarens G (2015) Implementing combined assurance: insights from multiple case studies. Manag Audit J 30(1):56–79 Dinçer H, Hacıo˘glu Ü, Yüksel S (2016) Performance assessment of deposit banks with CAMELS analysis using fuzzy ANP-MOORA approaches and an application on Turkish banking sector. Asian J Rese Bus Econ Manag 6(2):32–56 Dmitrenko M (2017) Combined assurance as an element of effective corporate governance. Sci J Pol Univ 21(2):84–90 Dumitrescu D, Bobi¸tan N (2016) Cooperation and coordination between internal and external auditing. Ann Constantin Brancusi Univ Targu-Jiu 1:87–92 ECIIA (2013) Improving cooperation between internal and external audit. Position Paper

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159

Endaya KA (2014) Coordination and cooperation between internal and external auditors. Res J Financ Account 5(9):76–80 EY (2013) Maximizing value from your lines of defense. A pragmatic approach to establishing and optimizing your LOD model. http://www.ey.com/Publication/vwLUAssets/EY-Maximizingvalue-from-your-lines-of-defense/$FILE/EY-Maximizing-value-from-your-lines-of-defense. pdf. 03 Dec 2017 Felix WL, Gramling AA, Maletta MJ (1998) Coordinating total audit coverage: the relationship between internal and external auditors. The Institute of Internal Auditors, Altamonte Springs, FL Felix WL, Gramling AA, Maletta MJ (2003) The influence of non-audit service revenues and client pressure on external auditors’ decisions, pp 1–33 Forte J, Barac K (2015) Combined assurance: a systematic process. South Afr J Account Audit Res 17(2):71–83 Fowzia R (2010) Co-operation between internal and external auditors: a comparative study on nationalized and foreign banks in Bangladesh. World J Manag 2(2):22–35 Glass R (2005) The relationship between internal and external audit in the public sector. In: IIA New Zealand Conference, pp 21–23 Gray J, Hunton JE (2011) External auditors’ reliance on the internal audit function: the role of second-order belief attribution. Unpublished working paper discussed at Bentley University, pp 1–49 Gül M, Kaban ˙I (2015) Bankalarda ˙Iç Kontrol-˙Iç Denetim ˙Ili¸skisi ve Bir Uygulama. Muhasebe ve Denetime Bakı¸s 15(45):89–112 Halimah NA, Othman R, Othman R (2010) Internal and external factors influencing effectiveness of Internal Audit Department (IAD) in Malaysian local authorities. http://www.anzam.org/wpcontent/uploads/pdf-manager/649_ANZAM2010-131.PDF. 03 Dec 2017 Huibers SCJ (2015) Combined assurance: one language, one voice, one view. The IIA CBOK Report Huibers SCJ, Rittenberg L (2017) Improve GRC maturity through combined assurance. http://info. metricstream.com/rs/404-BGD-511/images/Improve-GRC-Maturity-Combined-Assurance.pdf? aliId=329680907. 03 Dec 2017 IoD (2009) King code of governance principles for South Africa 2009. http://c.ymcdn.com/sites/ www.iodsa.co.za/resource/collection/94445006-4F18-4335-B7FB-7F5A8B23FB3F/King_III_ Code_for_Governance_Principles_.pdf. 03 Dec 2017 Kartal MT, ˙Ibi¸s C, Çatıkka¸s Ö (2018) Adequacy of audit committees: a study of deposit banks in Turkey. Borsa ˙Istanbul Rev. https://doi.org/10.1016/j.bir.2018.01.002 Lewis I (2015) The role of internal auditing in providing combined assurance: assessing internal financial controls. Master Thesis, Faculty of Economic and Management Sciences, University of Pretoria Sarens G, De Beelde I (2006) The relationship between internal audit and senior management: a qualitative analysis of expectations and perceptions. Int J Audit 10(3):219–241 Schreurs HK, Marais M (2015) Perspectives of chief audit executives on the implementation of combined assurance. South Afr J Account Audit Res 17(1):73–86 Solomon, S. (2005). What is the role of the internal audit function in establishing and ensuring effective coordination among the audit committee of the board of directors, executive management, the internal auditors, and the external auditors? The IIA Research Foundation Swellendam Municipality (2015) Combined assurance policy framework. https://www.swellenmun. co.za/download_document/564. 03 Dec 2017 The IIA (2003) 2050 no.lu Uluslararası ˙Iç Denetim Standardı, Uluslararası Mesleki Uygulama Çerçevesi, ABD Wood DA (2004) Increasing value through internal and external auditor coordination. The Institute of Internal Auditors Research Foundation, pp 1–14 Yüksel S, Dinçer H, Hacıo˘glu Ü (2015) CAMELS-based determinants for the credit rating of Turkish deposit banks. Int J Financ Bank Stud 4(4):1–17 Yüksel S, Zengin S, Kartal MT (2016) Banka Personelinin Tefti¸s Kuruluna Bakı¸s Açısının De˘gerlendirilmesi. Finans Polit Ekon Yorumlar 53(622):101–115

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Yurtsever G (2009) Tefti¸sten ˙Iç Denetime Banka Müfetti¸sli˘gi. TBB Yayını, ˙Istanbul Zengin S, Yüksel S (2016) Likidite Riskini Etkileyen Faktörler: Türk Bankacılık Sektörü Üzerine Bir ˙Inceleme. ˙Istanbul Ticaret Üniversitesi Sosyal Bilimler Dergisi 15(29):77–95 Zhou S, Simnett R, Hoang H (2016) Combined assurance as a new assurance approach: is it beneficial to analysts? https://www.researchgate.net/publication/315029098_Combined_Assura nce_as_a_New_Assurance_Approach_Is_It_Beneficial_to_Analysts. 03 Dec 2017

Mustafa Tevfik Kartal is a currently capital markets professional. He received the MBA degree in business administration from Sakarya University, Sakarya, Turkey in 2009, and PhD degree in banking from Marmara University, ˙Istanbul, Turkey in 2017. His research interests focus on accounting, audit, banking, capital markets, economics, finance, Islamic finance, laws, and legislations. He has authored 1 book, 19 book chapters, 32 articles, and 7 proceedings in Turkish and English. Also his 2 article has been in publishing process and his 5 articles have been in reviewing process. He continues to work on book chapters and articles. He has also been taking role as referee in 18 national and international journals. Serpil Kılıç Depren is Associate Professor in Statistics at Yıldız Technical University (YTU), ˙Istanbul, Turkey. She received M.S. degree in Statistics from YTU in 2008 and Ph.D. degree in Statistics from the Marmara University in 2012. Her areas of interest include Hierarchical Linear Models, Generalized Estimation Equations, Mixed Models, Machine Learning Techniques, Entropy, Data Analysis and Multivariate Statistical Methods. She has 20 international publications, 7 national publications in different journals. She has participated in 17 proceedings in international conferences and 4 proceedings in national conferences. She won 7 academic awards from TUBITAK and YTU.

Chapter 9

Indian Banking Scenario and SBI Mega-Merger Renu Jatana and Mehjabeen Barodawala

Abstract Banking system remains focal point in the financial setup of any developing country. They play a dynamic role in the economic development of a country. The growth story of an economy depends on the robustness of its banking industry. Today, Indian banking industry is a lifeline of the economy which has converted the hopes and aspirations of millions of people into reality. SBI, the oldest bank of India, has now also become the largest bank after the merger with its associates and Bhartiya Mahila Bank in April 2017. With this merger, SBI entered into the league of top 50 global bank with the total asset book of Rs. 37 lakh crores. This merger is a test case for a bigger consolidation to follow in the public sector bank planned by the government. In this paper, emphasize on how the Indian banking scenario has changed and what all challenges banking industry will face after the mega-merger of SBI with its associate banks. Keywords Banking system · Merger and acquisition · SBI · SBI associates

9.1 Introduction to Banking System Banking system remains focal point in the financial setup of any developing country. They play an increasingly important role in a nation’s economy. Economists have expressed a wide variety of opinions on the effectiveness of banking systems in promoting or facilitating economic development. Schumpeter, the first modern economist to study the relationship, regarded banking system as one of the two R. Jatana (B) Department of Banking & Business Economics and Associate Dean UCCMS, MLS University, Udaipur, Rajasthan, India e-mail: [email protected] M. Barodawala Department of Banking & Business Economics, UCCMS, MLS University, Udaipur, Rajasthan, India e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_9

161

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R. Jatana and M. Barodawala

key agents (the other being entrepreneurship) in the whole process of development (Schumpeter 1923). Alexander Gerschenkron looks at banks as a substitute for deficiencies in the original accumulation of liquid wealth in moderately backward economics (Shah 1974). Banks are considered to be the most important of all the financial intermediaries in the financial system of a country due to the following reasons: • Banks are the only institutions with the ability of creating money in the form of demand deposits. • Banks are the primary financial institutions responsible for administering the payment mechanism. • Banks represent the focal point, as monetary policy is implemented by the central bank. • Banks affect all sectors of the economy and have a relatively pervasive impact on the economic growth. • Banks are generally more heavily regulated than any other financial institution. The banking industry plays a dynamic role in the economic development of a country. The growth story of an economy depends on the robustness of its banking industry. Today, the Indian banking system is known the world over for its robustness. Indian banking is the lifeline of the nation and its people. It has helped in developing the vital sectors of the economy and usher in a new dawn of progress. The sector has converted the hopes and aspirations of millions of people into reality. The Indian banking sector can be categorized into two eras, viz., pre-liberalization era and post-liberalization era. In the pre-liberalization era, Government of India initially nationalized 14 banks on July 19, 1965 and later on six more commercial banks on 15 April 1980. In the year 1993, government merged the New Banks of India and Punjab National banks reducing the number of nationalized banks from 20 to 19. In the post-liberalization regime, where LPG policy was adopted by the government, licenses were issued to the private banks which in turn lead to the growth of Indian banking sector. The Indian banking industry has shown a sign of improvement in performance and efficiency after the global crises in 2008–2009. The Indian banking industry having far better position now than it was at the time of the crises. Government has taken various initiatives to strengthen the financial system (Tamragundi and Devarajappa 2016). In India banking system has a wide mix—comprising of public sector banks, private sector banks, foreign banks, exchange banks, post-office saving banks, etc. Table 9.1 provides a brief detail of the structure of Indian commercial banks in 2017–2018. For the past three decades, India’s banking system has several outstanding achievements to its credit. It is no longer confined to only metropolitans or cosmopolitans in India. In fact, Indian banking system has reached even to the remote corners of

9 Indian Banking Scenario and SBI Mega-Merger Table 9.1 Structure of Indian banking sectors

Type of banks

163 No. of banks

No. of branches

Public sector banks

21

94142

Private sector banks

21

24423

Foreign banks

45

286

RRBs

56

21358

Total

143

140209

Source Calculated from the statistical tables relating to banks in India, RBI, 2017–20181 , 2

the country. This is one of the main reasons of India’s growth process. With total deposits of Rs. 107300294.9 million in March 2017,3 the Indian commercial banking sector is one of the largest in the world. Over the decades, the Indian banking sector has grown steadily in size, measured in terms of total deposits, at a fairly uniform average annual growth rate of 22%.

9.2 State Bank of India (SBI) State Bank of India (SBI) is a multinational banking and financial services company based in India. It is a government-owned corporation with its headquarters in Mumbai, Maharashtra. SBI has 20% market share in deposits and loans among Indian commercial banks. As of 2016–2017, it had assets of 30.72 trillion (US$460 billion) and more than 14,000 branches, including 191 foreign offices spread across 36 countries, making it the largest banking and financial services company in India by assets. SBI traces its heritage to the 1806 formation of the Bank of Calcutta. The bank was renamed to the Bank of Bengal in 1809 and operated as one of the presidency banks. In 1921, the government consolidated the three presidency banks, viz., Bank of Bengal, Bank of Bombay and Bank of Madras, into the Imperial Bank of India. The Imperial Bank of India continued until 1955, when India’s central bank, RBI, acquired the majority interest in the bank and changed its name to the State Bank of India (SBI). After 1960, SBI had seven associate banks; all use the State Bank of India logo, which is a blue keyhole, and all use the “State Bank of” name, followed by the regional headquarters’ name: • • • • • • •

State Bank of Saurashtra (1902) State Bank of Mysore (1913) State Bank of Patiala (1917) State Bank of Hyderabad (1941) State Bank of Travancore (1945) State Bank of Indore (1960) State Bank of Bikaner and Jaipur (1963) (Fig. 9.1).

164

R. Jatana and M. Barodawala

Fig. 9.1 SBI logo

9.3 Mergers and Acquisitions of Indian Banks Mergers and acquisitions have become the crucial means of bank expansion, especially for banking firms seeking commanding heights in global financial markets. Bank mergers produced a sea change in the banking industry structure. Merger can be defined as a mean of unification of two players into single entity. It is a process of combining two business entities under common ownership. According to Oxford Dictionary the expression “merger means combing two commercial companies into one.” Bank merger is an event of when previously distinct banks are consolidated into one institution (Pilloff and Santomerro 1996). A merger occurs when an independent bank loses its charter and becomes a part of an existing bank with one headquarter and unified branch network (Fabio and Salleo 2002). Merger occurs by adding the active (bidder) bank assets and liabilities to the target (passive) banks’ balance sheet and acquiring the bidder’s bank name through a series of legal and administrative measures. Merger and acquisition in Indian banking sectors have been initiated through the recommendations of Narasimham committee II. The committee recommended that “merger between strong bank/financial institutions would make for greater economic and commercial sense and would be case where the whole is greater than the sum of its parts and have “force multiplier effect” (Devarajappa 2012). Table 9.2 shows the list of important bank mergers that took place in India after economic reform of 1991.

9 Indian Banking Scenario and SBI Mega-Merger

165

Table 9.2 List of bank mergers after 1991 S. No

Year of merger

Bidder bank

Target bank

1

1993

Punjab National Bank

New Bank of India

2

1994

Bank of India

Bank of Karad Ltd.

3

1995

State Bank of India

Kashinath Seth Bank

4

1996

Oriental Bank of Commerce

Punjab Co-op Bank Ltd.

5

1997

Oriental Bank of Commerce

Bari Doab Bank Ltd.

6

1999

Bank of Baroda

Bareilly Corp Bank Ltd

7

1999

Union Bank of India

Sikkim Bank Ltd

8

2000

HDFC Bank Ltd

Times Bank Ltd

9

2001

ICICI Bank

Bank of Madura

10

2002

ICICI Bank

ICICI Limited

11

2002

Bank of Baroda

Benaras State Bank Ltd

12

2003

Punjab National Bank

Nedungadi Bank Ltd

13

2004

Industrial Development Bank of India

IDBI Bank Limited

14

2004

Bank of Baroda

South Gujarat Local Area Bank

15

2004

Oriental Bank of Commerce

Global Trust Bank Ltd

16

2005

Bank of Punjab

Centurion Bank

17

2006

Federal Bank

Ganesh Bank of Kurundwad

18

2006

Industrial Development Bank of India

United Western Bank

19

2006

Centurion Bank of Punjab

Lord Krishna Bank

20

2006

ICICI Bank

Sangli bank

21

2007

Indian Overseas Bank

Bharat Overseas Bank

22

2008

State Bank of India

State Bank of Saurashtra

23

2008

HDFC Bank

Centurion Bank of Punjab

24

2010

State Bank of India

State Bank of Indore

25

2010

ICICI Bank

Bank of Rajasthan

26

2014

Kotak Mahindra Bank

ING Vysya Bank

27

2017

State Bank of India

SBI’s 5 Associate Banks and Bhartiya Mahila Bank

Source Compiled from various publications of RBI

9.4 SBI Mergers In 1959, the government passed the State Bank of India (Subsidiary Banks) Act, which made eight state banks associates of SBI. Earlier SBI had eight associate banks, viz.; State Bank of Bikaner, State Bank of Jaipur, State Bank of Hyderabad, State Bank of Mysore, State Bank of Patiala, State Bank of Travancore, State Bank

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of Saurashtra and State Bank of Indore; all of which had belonged to princely states until the government nationalized them between October 1959 and May 1960. In tune with the first Five Year Plan, which prioritized the development of rural India, the government integrated these banks into State Bank of India system to expand its rural outreach. There has been a proposal to merge all the associate banks into SBI to create a “mega bank” and streamline the group’s operations. The first step toward unification occurred in 1963 when State Bank of Bikaner and State Bank of Jaipur were merged to form State Bank of Bikaner and Jaipur. Later on, on August 13, 2008 State Bank of Saurashtra was merged with SBI, reducing the number of associate state banks from seven to six. Then, on June 19, 2009, the SBI board approved the absorption of State Bank of Indore. The process of merging of State Bank of Indore was completed by April 2010, and the SBI Indore branches started functioning as SBI branches on August 26, 2010. Thereafter, SBI had the following five associate banks: • • • • •

State Bank of Bikaner and Jaipur (1963) State Bank of Hyderabad (1941) State Bank of Mysore (1913) State Bank of Patiala (1917) State Bank of Travancore (1945).

9.5 SBI’s Mega-Merger The most recent and largest merger in the history of banking industry is of State Bank of India with its five associate banks, namely State Bank of Bikaner and Jaipur (SBBJ), State Bank of Hyderabad (SBH), State Bank of Mysore(SBM), State Bank of Patiala(SBP), State Bank of Travancore(SBT) and Bhartiya Mahila Bank which took place on April 1, 2017. Founded in 1806, Bank of Calcutta was the first bank established in India which over a period of time, evolved into State Bank of India (SBI). SBI represents a sterling legacy of over 200 years. It is the oldest commercial bank in the Indian subcontinent, strengthening the nation’s trillion-dollar economy and serving the aspirations of its vast population. The Bank is India’s largest commercial bank in terms of assets, deposits, branches, number of customers and employees, enjoying the continuing faith of millions of customers across the social spectrum. SBI provides a wide range of products and services to individuals, commercial enterprises, large corporates, public bodies and institutional customers through its various branches and outlets, joint ventures, subsidiaries and associate companies.

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9.6 Reasons of Merger Mergers and acquisitions are no new concept for Indian banking industry. In past years, a number of mergers have taken place where some M&A are done voluntarily for expansion, diversification and overall growth of bank, while some are being undertaken for restructuring of weak banks. The reasons behind the mega-merger of SBI with its associate banks and Bhartiya Mahila Bank can be short-listed as follows4 : • Government of India provides subsidy and contribution for bad debt recovery and share capital to SBI and its associate banks. It will become easy for government to provide aid to this single amalgamated bank instead of giving it separately to SBI and its associate banks. • For last few years, the profitability of SBI was going down and this merger will be able to show better position of profitability in books of SBI. Net profit of the group fell from Rs. 12,225 crores in Financial Year 2016 to Rs. 241 crores in Financial Year 2017 and the losses were mainly due to associate banks (Devangi 2019). • To recover loans which have turned bad and to reduce NPA of SBI and associate banks in the future, merger of SBI with associate banks was important. • For reconstruction of SBI and associate banks in face of financial crises, so that it can meet its liabilities. • With the merger, SBI has become bigger than before. Now it has a larger asset base and ranks 45th among top banks of the world. • Management of bank will become easier as earlier all the branches were managed by separate management though the holding was same and it used to make the whole process cumbersome. • Cost of managing large number of branches will reduce which will increase profitability of bank.

9.7 Effects of Merger The merger has placed SBI at 45th position among top banks of the world. SBI merged with its associate banks in order to have more benefits of increased balance sheet and economies of scale. With this merger: • • • •

SBI entered into the league of top 50 global banks. SBI now has 24,017 branches and 59,263 ATMs serving over 42 crore customers. SBI has become a banking behemoth with an asset book of Rs. 37 lakh crores. A merged entity has one-fourth of the deposit and loan market, as the SBI’s market share has increased from 17 to 22.5–23%. • SBI’s asset base is now five times larger than ICICI bank, the second-largest Indian bank.

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Apart from these facts, there are many perceived gains as well. The government, as shareholder, feels that now it will have six less capital-hungry banks to worry about. It was expected that a larger institution will be better equipped to deal with sticky loans, thereby enabling fresh credit outflows to productive sectors. Thus, productivity and efficiency are also among the expected benefits (Kaur 2019). Out of the total asset base of SBI, 28 shares of SBI are given to SBBJ shareholders holding 10 shares, 22 SBI shares to SBM, and SBT shareholders having 10 shares each as only these associate banks are listed with stock exchange. Rest two banks, i.e., SBP and SBH are not listed with the stock exchange. Effects of merger on customers shall have a dual effect. Most of the continuing branches are working in the manner they used to work. Even the rate of interest they are offering on deposits is still same till the end of that contract. However, NEFT/RTGS charges which are applicable to SBI are being charged. Online transactions of associate banks can now be done from Web site of SBI using previous username and password (Khurana 2017).

9.8 Key Challenges of Merger SBI—associates merger is a test case for a bigger consolidation planned by the government to follow in the public sector bank. The merger is not going to be a smooth sailing. There will be plenty of challenges for the merged entity and there is also a fear that management bandwidth would go on resolving these issues. Following are some key challenges which bank may face during its working5 : • Branch Overlapping SBI today runs the largest bank in the country in terms of assets as well as branch network. They have branches in every nook and corner of the country. The associate banks are regional with good branch network in the place they are headquartered. There is a huge overlap of branches in the five states of Rajasthan, Bengaluru, Andhra Pradesh, Punjab and Kerala. • Management Complexity The merger of SBI with its associate banks is the biggest merger in the Indian banking history. With this merger, SBI has combined assets of over Rs 6 lakh crore, which is almost equal to the size of the two largest private banks HDFC Bank and ICICI Bank Ltd. The merged SBI has 24,000 plus branches, 58,000 ATMs and 2.7 lakh employees. The management and regulation of such a huge entity will be a great challenge for the organizations (Fig. 9.2). • Cautious and Far-sighted Vision In the post-2008 scenario, the world saw the government bailing out large banks from taxpayers’ money. SBI though is identified by the RBI as a systemically important bank requires additional capital in its book for absorbing any future shock. But SBI’s size is not comparable with other banks. SBI, with close to Rs. 30 lakh crore assets, is way ahead of the two largest private banks—HDFC Bank

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Fig. 9.2 Key challenges faced by SBI merger

and ICICI Bank, which are in the region of Rs. 7–8 lakh crore. Managing a bank of SBI’s size will require more cautious and far-sighted vision by the regulator. • A bad bank within a bank This huge portfolio of bad loan makes it a bad bank within a bank. The five associate banks for instance have stressed loans (gross NPAs and restructured loans) at a staggering Rs 35,396 crore level. This amount is almost half of SBI’s Rs 66,117 crore stressed loans in 2015–2016. It would be a huge task to resolve the bad loans given the challenging operating environment.

9.9 Conclusion The banking industry is one of the rapidly growing industries in India. The growth rate of this sector is remarkable and it has become the most preferred banking destinations for international investors. After economic reforms, 1991, there has been paradigm shift in Indian banking sectors. A relatively new dimension in Indian banking industry has accelerated through mergers and acquisitions. As SBI needed reconstruction, this step of merger seems to be a smart step. Long-term benefits of the merger will significantly outweigh the near-term challenges. The resulting cost advantage; enhanced reach; and economies of scale from this merger, will help SBI sustain its

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mission of being an enduring value creator. But at the same time, the enthusiasm to create massive banks through mergers needs to be tempered with skepticism. Notes 1 Foreign banks in India as on September 30, 2019—branch/WOS form of presence. https://www.rbi.org.in/commonman/upload/english/content/pdfs/ 71207.pdf. Accessed 15 June 2019. 2 Reserve Banks in India, Banks in India. https://www.rbi.org.in/commonman/eng lish/scripts/banksinindia.aspx. Accessed 15 June 2019. 3 https://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications#!9. Accessed 15 June 2019. State and Bank Group-Wise Deposits of Scheduled Commercial Banks According To Type of Deposits March 2017. 4 IANS, SBI merger impact: 47% of associate banks’ offices to shut down. http://www.businessstandard.com/article/finance/sbi-merger-impact-47of-associate-banks-offices-to-shut-down117032100246_1.html. Accessed 15 June 2019. 5 Five key challenges ahead for SBI post merger. https://www.businesstoday.in/ sectors/banks/sbi-associate-banks-merger-five-key-challenges-ahead/story/246 939.html. Accessed 15 June 2019.

References Devangi G (2019) ET Bureau, SBI’s Merger with associates to hurt its numbers. http://economict imes.indiatimes.com/markets/stocks/news/sbis-merger-with-associates-to-hurtits-numbers/art icleshow/58834608.cms. Accessed 15 June 2019 Devarajappa S (2012) Mergers in Indian Banks: a study on mergers of HDFC Bank Ltd and Centurion Bank of Punjab Ltd. Intern J Market Financ Serv Manag Res 1(9) Focarelli D, Panetta F, Salleo C (2002) Why do banks merge? J Money Credit Bank 34(4):1047–1066 Kaur J (2019) A case study on mega merger of SBI with its associate banks and Bhartiya Mahila Bank. http://www.tips.edu.in/download_pdf/186.pdf. Accessed 15 June 2019 Khurana B (2017) Analysis of mergers of SBI & its associates. Intern J Res Granthaalayah 5(5) Pilloff SJ, Santomero AM (1996) The value effects of bank mergers and acquisitions. In: Center for financial institutions. Working papers 97-07, Wharton School Center for Financial Institutions, University of Pennsylvania Schumpeter JA (1923) The theory of economic development. Cambridge Shah AC (1974) Banking for economic growth. J Indian Inst Bank 45(1):33 Tamragundi AN, Devarajappa S (2016) Impact of mergers on Indian banking sector: a comparative study of public and private sector merged banks. Acme Intell Intern J Res Manag Soc Sci Technol 13(13)

Prof. Renu Jatana was born in Jaipur, India in 1960. She obtained her M.Com and M.Phil. degree from University of Rajasthan, Jaipur. She obtained Ph.D. in commerce from Mohan Lal Sukhadia University, Udaipur (Rajasthan). Presently, she is the Dean and Faculty Chairman at Faculty of Commerce, ML Sukhadia University, Udaipur. She has attended and participated two times in

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International Conference held at London Metropolitan University, London. She has edited four volumes of ‘Social Corporate Responsibility’ along with Prof. David Crowther. She has successfully guided 32 PhD. Scholars and has over 34 years of teaching experience in commerce. She has also completed major research project of ICSSR New Delhi. Recently she has visited Thailand for research work on ‘Leadership Qualities of Women executives in India and Thailand’. Her area for teaching interest includes Business Economics, Banking and Finance, International Trade and Finance. She has published a number of research papers and articles in reputed Indian and International Journals. At present she is Course director of Master of International Business. Prof. Jatana is married, a girl and a boy’s mother. Dr. Mehjabeen Barodawala was born in Udaipur, India in 1988. She is a Post-Doctoral Fellowship scholar from Indian Council Social Science Research in the Department of Banking and Business Economics at Faculty of Commerce, Mohan Lal Sukhadia University, Udaipur. She has completed her Ph.D. under the able guidance of Prof. Renu Jatana on the topic ‘A Study on Impact of Various Promotional Techniques towards Demand Generation among Children’ in 2016. She received Master’s Degree in Commerce in 2013 and Master’ Degree in International Business in 2011 from MLS University, Udaipur. She is NET qualified in Commerce in July 2012. She has seven years teaching experience as a Lecturer in the Department of Banking and Business Economics. She also has interest in the field of International Business Studies and do take lectures on India’s Foreign Trade, International Business Environment and Export-Import Procedure and Documentation. She has a textbook on Indian Banking System published in her name. She has number of research papers being published in National and International Journals. Currently, she is also the Director of The Udaipur Urban Co-operative Bank Ltd., Udaipur. Dr. Barodawala is married, a boy and a girl’s mother.

Chapter 10

Definition and Classification of Financial Statement Fraud Iavor Bachev

Abstract The literature review represents an organization of existing information published on a certain topic, which is used to provide a summary of existing knowledge and ideas. It is based on the relevant information and theories that apply to the understanding of the nature, occurrence, and control of financial statement fraud. The research has reviewed the needed definitions and concepts in order to establish the relevant context. The following chapter consists of the literature review. Keyword Financial statement fraud

10.1 Introduction: What Is Fraud? Fraud has been present in the human environment since the ancient of times. In the broadest sense, it is defined as a “wrongful or criminal deception which results in some form of personal gain” (Oxford Dictionary 2016) or an “intentional perversion of truth” in order to induce another to part with something of value or to surrender a legal right (Merriam Webster Dictionary 2016). Generally a number of conditions have to be met in order to classify a case to be fraudulent. Davia (2000) outlines several items that constitute a fraudulent act: There must be a victim (could be one person or many) which are led to a loss via a deceptive act by someone (also called the perpetrator). Moreover, evidence about the intent and profit of the perpetrator must be present. Putting it in another way—a fraud could involve one or more individuals which act in secret for their own enrichment by depriving another of something of value. Fraud is more comprehensively defined as a combination of means, result of man’s ingenuity, for obtaining advantage of one individual over another through deceitful proposals or concealment of truth. Dinev (2006) including: Fraud abuse—The difference is sought in the deliberateness and intention in the actions Ph.D, CIA, CFE I. Bachev (B) University of National and World Economy, Sofia, Bulgaria e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_10

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of an individual who is aware in advance that these actions would be prejudicial for the entity. Fraud error: The difference consists of the presence of intentional acts aiming to gain an advantage over others through fraudulent manipulation. Fraud elements include pressure/motive; opportunity; justification/rationalization; concealment t; and encashment. There is a certain motivation or pressure when speaking of fraud. Dinev (2006) states that fraud is always perpetrated in favor of someone and in favor of an enterprise or for both cases. It could be generated by greed, substantial financial liabilities, unexpected financial needs, unsatisfactory recognition of the work performed, desire for better life, etc. Opportunities arise where certain weaknesses exist within the system such as: no controls or overcoming the controls; inability to evaluate the quality of business activity implementation; failure to discipline fraud perpetrators; no access to information; neglect, apathy, lack of capacity, and lack of audit trails (Dinev 2006). Moreover, Dinev (2006) argues that there are various methods of fraud concealment—from documents falsification and destruction to disclosing only half of the truth. This research is concerned with organizational fraud where fraud as an act could be classified by a variety of criteria depending on the questions posed. Like any classification not all fraud can be fit in any one category; the purpose is to give a general distinction between the different ways of looking at categorization of fraud.

10.2 Classification of Fraud When we look at fraud and ask who the perpetrator is two types are prevalent in the literature. First and most prevalent one statistically (ACFE 2018) is the white color fraud (also known as employee fraud) usually associated with theft, embezzlement of cash by individuals, breach of fiduciary duty, and other illegal acts. Second classification is fraud made by high level of management (management fraud) where the negative consequences are much more severe and in most cases many individuals are involved due to the inherent complexity of the fraud. On the other hand, when fraud is looked at in relation to the organization/entity classification is made of internal or occupational—committed by managers, board of directors, internal auditors, ordinary employees and external—committed by suppliers, external auditors, investors (Fig. 10.1). Other general classifications of fraud are available. So is the one by type are proposed by Albrecht and Albrecht (2003). They distinguish and explain the different types of fraud and connect them to the most common victim and perpetrator, those include: • Employee embezzlement or occupational fraud: Here the victim are the employees and the fraud is perpetrated by their coworkers who try to steal directly or indirectly from the organization.

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Fig. 10.1 Categorization of fraud by perpetrator (adapted from classification by ACFE)

• Management fraud: Here the victims are the owners, lenders, and other parties that rely on the financial performance of the organization. The fraud is perpetrated by management which falsifies and misrepresents the financial information. • Investment scams: Here the victims are investors and the fraud is perpetrated by individuals that try to lure the investors to invest in fraudulent investments as a pretext as an opportunity for making money. • Vendor fraud: The victims of vendor fraud are typically organizations that buy goods or services from different entities (vendors) which try to overcharge for the services or merchandise provided. In many cases, no shipment or rendering of services is done even though the organization has paid the vendor. • Customer fraud: Here the fraud is on the opposite side of the spectrum of the vendor fraud. The victims are organizations that provide services or sell goods. The perpetrators are customers that deceive the sellers by paying less or receiving something of value that they should not have. Dinev (2006) argues that the correct classification of fraud contributes to the better examination, recognition, detection, and prevention of fraud. Dinev (2006) indicates the following criteria for the classification of fraud: penal code; place of fraud being committed; public domain; type of legal registration of the perpetrator; orientation (direction); and technology of business activities performed. More specifically, according to Dinev (2006) fraud classification looks as follows: 1. According to the regulatory framework (penal code), fraud has the following forms: ordinary; document fraud (misrepresentation); insurance fraud; computer fraud, accounting fraud; business assessment fraud; and fraud committed by certified public accountants;

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2. According to the place where fraud has been committed, fraud can be internal and external; 3. According to the public domain in which committed, it can be political, economic, and social; 4. According to the type of business registration of the perpetrator, fraud could be individual and corporate; 5. According to the ownership and the status in the management hierarchy, fraud can be committed by proprietors; directors; managers; employees; and non-employees; 6. According to its target, fraud could be directed against the entity; on behalf of the entity against third parties; through the entity in favor of third parties; and in favor of the entity directed against third parties; 7. According to the technology of the activities performed, fraud can be perpetrated in the process of bidding, negotiation, and implementation of agreements; financing and providing loans to business; investing and reporting of capital expenditure and investments; insurance and payment of defaults; health care and social security; purchase and supply of goods; Internet trade; taxation; money and securities counterfeiting; learning and research process; donation and religious activities. As can be seen there is a multitude of types of fraud that an organization can face in terms of both victim and perpetrator. The correlation between the type of fraud and the position of the fraudster can be clearly inferred. The more and higher the responsibilities of the perpetrator the higher the complexity of the fraud that can be accomplished and the more detrimental the negative effects for the organization, investors stakeholders, and society.

10.3 Who Commits Fraud? Another aspect of fraud concerns the perpetrators of such acts. The question of “what are the features of people that commit fraud” is answered by Ozkul and Pamukcu (2012) who bring us a comprehensive list of features of fraudsters summarized in Table 10.1. There are a few features that can be used to describe a fraudster—gender, educational level, age, etc. All of which play an important role to the type and severity of fraud he/she is able to commit. Individuals that commit fraud in many cases have common personality traits that are accompanied with the fraudulent act such as controlling behavior or sudden change in behavior. A study conducted by KPMG (2011) says a typical fraudster is between 36 and 55 years (in more than 70% of the cases reviewed, male, undertaking fraudulent behavior against the organization and has been working in the company between 2 and 10 years on average 66% of cases). Only in 1% of the cases the fraudster has worked for the company for less than a year and in 33% more than 10 years. This characteristic leads us to individuals that are on senior position that

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Table 10.1 Features of fraudsters (Ozkul and Pamukcu 2012) Feature

Characteristics

Gender

75% of fraudsters appear to be male; this difference is explicit in the monetary value of the fraud as well

Marital status

Bigger percentage of the people who attempt to commit fraud are married, many of them have children and a happy marriage

Education level

Good education is correlated with the amount and magnitude of fraud

IQ level

Individuals with higher IQ levels who are willing to commit fraud are more likely to find a way to circumvent any controls and systems designed to prevent fraud

Age level

Individuals at any age can resort to fraud but generally the number and amount of the fraud increases with age. The number of fraud older people commit is twenty-eight times higher than younger ones. Explanation is that the older a person gets the more knowledge and skill he possesses that allows him to pull higher level of fraud

Working conditions

Generally individuals that spend most of their time at work alone have tendency to commit fraud. Furthermore, it is estimated that managers that refuse to take time off have higher chance of being a fraudsters because of the possibly that someone could discover their actions in their absence

Position at the entity

Although any person can resort to fraud, studies indicate that position in the entity matters in respect to amount and consequences of the fraud. When the individuals are at positions of trust, the monitoring over them weakens. Moreover, because of the position they hold they might better understand the internal control structures which makes the execution of the fraud easier. Many people who committed fraud were not suspected by anyone before the fact

Relations outside the entity Last but not least is the level of relations between the fraudster and parties in other entities such as regulators, suppliers, and external auditors. Close personal relations breed good conditions for collusion and fraud

tend to know the structure of the organization very well (with all control strengths and weaknesses) and engaging in fraudulent activity over a long period of time. A point has to be made that this fraudulent activity in the majority of cases involves the overriding controls that are established in the organization. The most common method is exploiting weak internal controls—74% of the cases (KPMG 2011) followed by collusion in order to circumvent good controls (11%) and just acting fraudulently regardless of controls (15%). Of course the methods vary with the specifics of each type of fraud perpetrated. However, fraud is not always used only for the benefit of the perpetrator (like embezzlement, theft, etc.) but and against the organization as well. Fraud, especially management one, is often used for the benefit of the entity—examples include tax

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Fig. 10.2 Fraud for and against the company (Jans et al. 2009)

evasion, inflated revenues, and violations of laws. All of those, however might indirectly reflect the perpetrator in a form of higher bonuses, keeping the management position or increased stock price-related benefits. In Fig. 10.2, Jans et al. (2009) present us with a visual depiction. However, it has to be mentioned that not all types of fraud (e.g., forced bankruptcy, arson for profit) can be placed exactly in this representation. Moreover, although there could be a short-term positive effect, all fraud is damaging to the organization in the long term. Not all fraudulent cases are investigated and resolved—it all depends on the potential losses (current and potential future) and the results of the cost–benefit analysis done after initial detection. In case of fraud related to the financial statements, almost all cases of fraud are investigated due to the severity and impact of this type.

10.4 Financial Statement Fraud: Definitions What Is Financial Statement Fraud? Financial statement fraud is a type of fraud perpetrated by high level of management. The official definition by the American Association of the Certified Fraud Examiners is “the intentional, misstatement (or omission) of material facts or other type of data which when considered with other publicly available information would make the user of the information change or alter his/her’s judgment.” It is one of the three branches of occupational frauds used by the ACFE (Fig. 10.3) together with corruption and asset misappropriation. The National Commission on Fraudulent Financial reporting (1987) states that fraud in the financial statements is a reckless conduct by act or omission that is likely to result in materially misleading financials. Other definitions vary but the common thread is that it involves a deliberate misleading or omitting of information in the

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Fig. 10.3 Financial statement fraud in relation to other categories (ACFE 2010)

financial statement in order to misinform misdirect and “injure” the users of this information (investors, creditors, auditors, and other stakeholders). Gravitt (2006) presents several schemes that are involved in financial statement fraud: (1) manipulation or falsification of the financial information and any supporting documents; intentional misuse of procedures, policies, and relevant accounting principles used in the preparation of the financials and deliberate omissions or alteration of events and transactions that have relation to the reporting of the financial position of the company. Razaee (2010) expands on the schemes of financial statement fraud by including: the use of aggressive accounting techniques via illegal earning management and using loopholes in the accounting standards that allows the entities to conceal the real situation of the entity. Financial statement fraud has been defined as a financial crime. According to the Financial Services and Market Act of 2000 passed in the UK, it includes three aspects: (1) a fraud or dishonest action, (2) that includes misconduct or misuse of

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information that related to the financial markets, or (3) handling the proceeds of such crime. The UK Fraud Act of 2006 further reinforces the notion and definition of such crime acknowledging that such fraud incorporates (1) false numbers and/or representation; (2) inaccurate information that might lead to failure to disclose the correct information; and (3) involvement on the side of the organizations management or directors. Losses from Financial Statement Fraud According to the ACFE (2012), the average organization worldwide has an estimated 5% of revenue lost due to fraud which translates into trillion of dollars lost worldwide. Although the frequency of financial statement fraud is low compared to other types of fraud, the median loss associated with such fraud a million dollars is ten times more compared to other types of fraud. Moreover, there is an increase of fraud related to the financials in the past few years which increases the seriousness of the problem. The Center for Audit quality (2010) states that the aftermath following a financial statement fraud does not only include financial losses but loss of shareholder value and bankruptcies. There are consequences for those individuals that have conspired in committing the fraud. They are not only fired but could be jailed or fined. In many cases, their reputation prevents them from being hired in other organizations. It has to be mentioned that fraud in organization is not limited to only one form but it can incorporate a combination of different schemes in conjunction with fraud in the financials (Figs. 10.4 and 10.5).

Fig. 10.4 Fraud frequency by category (ACFE 2014)

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Fig. 10.5 Fraud types median loss (ACFE 2016)

However, not all discrepancies in records or information could be a direct result of fraud. The other reason is an error which is unintentional and caused by a computational or human fault. Such errors in the financials are not considered fraud but rather mistakes. They could be due to a mistake in the gathering and processing of financial statement data, inaccurate accounting estimates or by simple mistake in the application of the accounting principles (Kwok 2005). Those are the opposite to irregularities that in lead to fraud including: the intentional omission of events and transactions or misapplication of accounting principles with specific intent. Dinev (2015) points out that “unlike errors, fraud results from mercenary motives intentionally and predominantly committed in an organized way. Moreover, a fundamental characteristic of fraud is that an advantage is obtained through the use of fraud, it is always the advantage that is sought.

10.5 Importance of Financial Statement Information But why the financial statement information is so important and any fraud pertaining relating to it has such an aftermath? The simplest and most straightforward answer comes from its importance to the economy as a whole. It helps users of such information make rational decisions by providing an accurate picture of the economic reality (financial information should be reliable and relevant (FASB 1980). Prior research shows that the decision-makers rely on the source of information the more they are concerned with the its credibility (Coleman and Irving 1997). If this information is false or manipulated, the users are going to make investments that could be irrational and lead to an unprofitable outcome (wrong pricing of debt and other securities is an example). If the user confidence in the provided information disappears, it could

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lead to no decisions made in the market place and an exodus to areas where the financial information is reliable. Existing literature supports this rationale by arguing that accounting fraud leads in many cases to unrealistic expectations leading to inefficiency in the market system (Miller 2003; Erickson et al. 2004). However, the effect from such fraud is not limited only to the financial market—Sadka (2004) argues that the product markets suffer as well as a consequence and from there making the effect spread in the whole industry leading to adverse consequences on the social welfare as well. As the capitals market grow, the type of investors change as well. Many non-professional investors have started to represent a large portion of the markets. The judgments and investment decisions on such investors are much more dependent on the financial information produced including its presentation and format (Warne 2009) with main points on information sources, fair-market valuation, comprehensive income, and operational forecasts (Elliot 2006). The investors need to be able to rely on the financial information provided if they begin to question its validity and reliability because of previous cases of misrepresentation this is surely going to be one of the biggest challenges to business worldwide. According to Petrova (2007), the consequences of fraudulent financial statements come down to: undermining the quality and credibility of the financial reporting process; the confidence of capital markets in the reliability of financial information goes down; decline in the reputation of auditor’s profession in the society and arousal of suspicion to the efficacy of financial statements audit; destruction of the career of the individuals involved in fraud; entities engaged in fraud could sustain substantial economic losses; enormous court expenses; strengthening of regulatory intervention; decrease in dependability of capital markets and unfavorable effects on the national economic development and prosperity. Cunningham (2005) argues that there are two possible solutions that can address the problems associated with this forward-looking financial information. The first one is legal—focusing on re-examining the disclosure standards applicable to managers. The other is business-related—focusing on how the financial figures are disclosed. They both try to address the inherent unreliability connected to produce financial information. The former emphases the identification and disclosure of material risks that can occur in future rather than requiring organizations to provide earning and other forecasts. The investors would use this information as a guide to the future performance of the organization. This would be better than publishing inherently unreliably estimates by the organization which are in many cases encouraged to bolster the firm’s inherent value. The latter, on the other hand, focuses on changing the accounting framework based in the reporting due to the inability of correctly estimating some of the items in the financials such as the amounts of reserves or the exact cost of inventory sold. One way of solving this would be to report the amounts in ranges rather than trying to determine a single amount which is subject to change anytime.

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10.5.1 Costs Associated with Financial Statement Fraud The literature discusses the so-called measurable costs of financial statement fraud. The two main categories that summarize the effects of financial statement fraud— realized costs (the real measurable costs associated with the fraud); speculative costs—not measurable but showing an alternative scenario had the fraud not occurred and other that have effect on the decision making of other individuals and entities. (1) Real measurable costs: Real measurable costs include the loss of investor and stakeholder confidence— the confidence of the public is easily lost but hard to gain. If the entity recovers from the aftermath of a financial statement fraud, it would be very difficult to regain the trust and rebuild the relationships it once had. (2) Opportunity costs: Opportunity costs represent the alternative of what would have been if there were no financial statement fraud. The parties involved on the stakeholder side would have probably made different decisions if they had known for the existence of the fraud. (3) Costs for keeping the fraud believable: Those costs were first discussed by Kedia and Philippon (2005) who argue that entities engaging in financial statement fraud need to act the part, thus making decisions from a different operational perspective leading to overinvesting and over hiring to keep up the deception going. (4) Decision-making distortion: Since the financial statement is the vehicle thought in which the performance of the organization is shown to the public, any unrealistic performance indicators might motivate competitors on the industry to resort to fraud as well in order to show similar results to remain competitive and keep their compensation packages. The costs of financial statement fraud are potentially enormous but the negative consequences associated with it could be devastating both on micro- and macrolevels. Rezaee (2002) makes a good generalization of the harmful effects of such fraud which include: – Undermining of the quality and integrity of the financial reporting as a whole; – Jeopardizes the objectivity and integrity of the accounting profession; – Diminishing the overall confidence of the capital market participants, including providers of capital, in the reliability of the financial information produced; – Making capital markets less efficient which has negative effects on the economy as a whole; – Affecting adversely the nation’s growth and prosperity; – Having losses resulting from litigation and other actions of law; – Destroying the careers of the individuals that were involved in the fraud; – Causing bankruptcy or economic losses of the company engaged in the fraud;

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– Encouraging a higher level of regulatory intervention by governments and other bodies; – Causing destruction to the normal operation and performance of the alleged companies an their conspirators. The firms that have been associated with financial statement fraud and not gone bankrupt have faced significant financial penalties or changes in ownership in order to continue operating. However, a specific price cannot be put on the bad reputation acquired which will have negative effects on the business of the entity in future. The costs of financial statement fraud are not limited only to the organization where the fraud occurs. Many researchers agree that such fraud undermines the integrity and efficiency of the economy as a whole (Alexander 1996; Booth 2005).

10.6 Range of Financial Statement Information Even though the financial information is primary produced for business purposes, the main idea behind creating such information is that it could be used by anyone. The financial statements represent the vehicle through which an entity shows its performance and financial position. The financial statements are the end product of accounting. They are the results of application of unique techniques and methods innate to accounting. Those methods include a system of elements and techniques which ensure constant objective reflection of the processes and transactions of the entities in course of daily operations (Stoyanov 2008). The accounting rules and regulations for preparing the financial statements in each country have differences when compared to one another but the there are three main conditions that must be met for the produced financial information: First, it should be able to fulfill its purpose; Second, It should be accurate, complete, and objective; Third, It should be timely—provided at a particular time. Only by following those conditions the information is suitable for reaching economic and rational decisions by achieving a predictive quality for the entity’s position in future periods. The financial statement’s objectives to provide information about the company’s performance and changes in the financial position since past periods cannot be incorporated in only one statement thus the need of several each focusing on different aspect on the reporting process. Typical range of financial statements produced are the following: a balance sheet, an income statement, and statement of cash flow and any notes accompanying them. Their building blocks play an important role in financial statement fraud. Hogget et al. (2008) state that the balance sheet represents an extension of the basic accounting equation (shown below) by representing the company’s assets liabilities and capital at a specific point in time. Assets = Liabilities + Capital (owners’ equity) The assets are the items owned by the entity;

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Liabilities are the items that are owed by the entity; And equity is the difference between the assets and the liabilities. The income statement shows the total profit/loss of the organization has been made during an accounting period. The main two parts that constitute the income statement are the revenues and expenses: Profits = Revenues − Expenses The income statement and the balance sheet are related by the retained profits in the organization. The reason behind this is that the capital in the organization can be accumulated in two ways: from the retained profits and owners contributions, which is the amount of assets (cash or other) that the shareholders have introduced into the entity in exchange for stock. At the end of each financial cycle, the accounts on the income statement are reduced to zero and the difference is added (in case of profits) or deducted (in case of losses) from the retained profits on the balance sheet. Assets = Liabilities + Share Capital + Retained Profits (Profits−Dividends) Cash flows—the amount and way that cash has been transferred in and out of the entity, usually includes cash flows from investing, operating, and financing activities. The organization needs to keep detailed and sufficient records which can be used to substantiate the financial statements and demonstrate the result of the operation of the entity. A general rule is to include all material information in the financial or in the accompanying notes in order to provide the best representation of the financial position of the organization. Financial statement fraud can be caused by anyone having the access and capability of doing it. Taylor (2003) points out two parties that have high likelihood of involvement is such fraud: (i) Lower-level employees which are in charge of divisions, subsidiaries; in charge of daily operations of the organization; and other company parts—they commit fraud in order to conceal any slowdowns in performance indicators or to get awarded bonuses and other benefits. (ii) Top-level management—Those are responsible for the general governance of the company and in the majority of cases the chief executive officer and/or chief financial officer have been found to be involved. Financial statement fraud is generally committed with the knowledge of the management in an organization that is the reason why some authors consider it synonymous with management fraud (Elliott and Willingham 1980).

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10.7 Types of Fraud in the Financial Statements The Institute of Certified Public Accountants (AICPA) and the Statement on Auditing Standards 99 defines two main possible misstatements in relation to the financial statements that constitute fraudulent activity: The first one is fraud due to fraudulent financial reporting and the second is fraud due to misappropriation of assets. Each of the two categories is constituted of variety of ways for their perpetration. Generally the consequences from fraudulent financial reporting are considered of much bigger magnitude due to their effect on the organization and even society. Misstatements that Are Caused by Fraudulent Financial Reporting Fraudulent financial reporting incorporates actions designed to deceive the users of such information, usually with the purpose of an indirect benefits for the individual committing the fraud. The primary objective of such reporting is usually to show a better financial position of the entity and one way is overstate the revenue and/or income. The same effect can be achieved by understating the expenses and cash outflows of the entity. A representation can be found in Fig. 3. The Securities and Exchange Commission (SEC) (1999) sees fraudulent financial reporting as the use of tricks in order to achieve a specific results by manipulating the financial information (performance) of an organization. The literature discusses two types of fraudulent financial reporting that result in direct or indirect manipulation of the profits and losses of organization (Dooley 2002). The first one is inclusive meaning that misstatements in the financials arise from overstatements of revenues assets and or understatement of liabilities. The second one is exclusive and it involves an intentional omission of liabilities and/or other obligation from the company’s financials. According to statement on auditing standards No. 82. of the AICPA financial statement misrepresentation arising from fraudulent financial reporting may involve: • Intentional misapplication of the relevant accounting principles and policies in regard to amount estimation, classification, and disclosure. • Intentional omission of material information from the financials • Alteration of accounting records and the respective supportive documents in order to conceal the fraudulent action (Fig. 10.6). In many cases, financial statement manipulation is done in order to report a constant, steadily increasing income which creates an impression of minimization of the unpredictability of the operations of the company and influencing the value of the organization. Reliable financial reporting on the other hands characterizes itself as one that has met the financial reporting objectives, has used the applicable financial reporting framework, and has complied with relevant laws and other regulatory requirements. The schemes that can result in financial statement fraud can reach hundreds thus a summary of the most popular and general categories as described by the AICPA is provided in this section.

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Fig. 10.6 Profit manipulation

10.7.1 Revenue Manipulation The most popular way of manipulating the financial statements is via the revenues (the largest item on the financial that was involved in 38% of fraud schemes associated with the financial statements (Deloitte Report 2008)) and/or accounts receivable. Hunt (2000) argues that the number associated with fraud associated with revenue recognition is over 50%. By increasing the accounts receivables, the income and assets are inflated and higher revenue is reported. Since the accounts receivable are viewed as the second best thing to cash this creates the illusion that the activity and capacity of the organization have increased. It is estimated that the bulk of the revenue recognition schemes is comprised of fictitious and premature revenue schemes. Such schemes include timing differences manipulation where revenues and their corresponding expenses are recorded in different accounting periods. The Financial Accounting Standards Board has set explicit rules that try to fight this by outlining four criteria for recognizing revenue: 1. Persuasive evidence of an arrangement exists; In many cases companies engage in fraud by trying to circumvent this and acknowledging the revenue even thought.

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– The company has no written or verbal arrangement for the business dealing. – The order is conditional on some other factors such as right of return or on consignment. – There exists a side latter that alters the terms of the arrangement. 2. Delivery has occurred or services have been rendered Here, the organizations try to acknowledge revenue without delivering or providing the service to completion. Situations include cases when: – Shipment delivery is not considered complete until installation, customer testing, and customer acceptance have passed. – Some of the components that are required for the operation of the shipment are not delivered or with wrong specification. – Not meeting other appropriate criteria or applying principles in situations where they should not be applied such as “bill and hold” transactions. – Services in the contract have not been provided yet or are provided over an extended period are recognized in the current period. 3. The seller’s price to the buyer is fixed (or can be determined); Example of situations where the price cannot meet the requirement but applied by organizations include: – Situation where the price of the sale is contingent on future events; – Fees or other commissions are subject to cancelation at any time during the contract period; – There is option in the contract that allows the exchange of the good for other goods; – Payment terms that include and extension of the period and additional discounts (upgrades) which might be required for the buyer to continue his payment and usage of the products. 4. Collectability of the payment is reasonable assured. Organizations are in violation of this principle when they assume that the payment is reasonable but in reality: – The sale payment is contingent of some future events beyond the control of the organization such as resale or litigation from the buyer. – The buyer has no means to pay for the sale (Table 10.2). Some authors consider revenue manipulation as a subclass of the so-called earnings management which includes a purposeful intervention in the financial reporting and disclosure process with a specific intend (Schipper 1989). Moreover earnings management can be defines as making decisions that might lead to the achievement of specific accounting goals but be accompanied by destruction of economic value

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Table 10.2 General fraud schemes related to revenue Type of fraud scheme(s)

Accounts used in the fraud Type of procedure involved

(1) Understate the allowance for doubtful accounts (indirectly overstating receivables)

Bad debt expense and allowance for doubtful accounts

(2) Record fictitious Accounts receivable, (non-existing, illigitimate) revenue accounts (sales sales—including related party revenue) transactions, sales with conditions, etc.); recording sales with fictitious customers

Estimating the uncollectible receivables Selling goods/services to customers and other parties

(3) Recognizing revenue too early (improper cutoff, % of completion, etc.); (4) Overstate real sales (inflate amounts, change contracts, disguised consignment sales, etc.) (5) Not recording returned goods from customers

Sales returns, accounts receivable

Accepting returned goods

Allowance for doubtful accounts, accounts receivable

Writing off receivables from the financials

Accounts receivable and cash accounts

Collecting wrong transactions

Sales discounts, accounts receivable, cash

Collecting cash in discount period

(6) Recording returned goods in next periods, keeping the books open beyond the period (7) Not writing of uncollectible receivables (8) Writing uncollectible receivables in wrong period (9) Recording bank transfers as cash (10) Manipulating cash received from related partiers (11) Not recognizing discounts given to customers, manipulation of customer incentives

in the process (Graham et al. 2004). The Committee on Sponsoring Organizations (1999) further lists some schemes that are considered part of the illegitimate ways of recognizing revenue and manipulating the earnings of the organization. Bill and Hold Transactions Bill and Hold transactions refer to a situation where the organization keeps the sold inventory in order to meet the needs of the buyer. Fraudulent behavior occurs when the entity recognizes the revenue generated from the goods before the goods are delivered as the revenue is commonly recognized. Rezaee (2002) gives this way of

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revenue manipulation as an example of substance over form and emphasis the ability to distinguish how the revenue is recognized in different transactions. Other timing of revenue schemes The most common timing of revenue schemes involve keeping the accounting records open more than the corresponding period thus inflating the earnings for the current period. A special situation occurs when leasing transaction is in place where the organization misstates its upfront revenue from different type of leases such as sales type lease. Side arrangements Side arrangements exists in order to add to or alter the terms and conditions of different sales transactions with goal of motivating the consumer to engage in the transaction. Usually they are in a form of special contingencies such as a right for refund, prolonged financing or some sort of customization. Some sectors such as the services or technology ones provide ample opportunities for side arrangements which might not be clear and result in revenue misstatement. Improper Related party Transactions Improper related transactions are commonly used revenue manipulation due to their ability to remain out of sight and difficult to identify without a provision of a proper disclosure. Pesaru (2002) sees them as a relationship or other link (financial) between an organization and a customer. An example of how such relationship can result in earnings management is the trading and/or reselling of the same inventory over and over again between the entity and a customer which could be immaterial in the beginning but add to a material misstatement of the financials overtime. Channel stuffing (also known as trade loading) Channel stuffing involves selling more goods to distributors that they are able to resell in the current period. The usual way of motivating distributors to buy bigger quantifies is via the offer of deep discounts or warning of losing business with the entity. This practice makes related revenue recognition more unclear by delaying the exact pricing of the merchandise until the end of the period resulting in fluctuating volume of sales. Channel stuffing usually results in returns due to the surplus of goods that the distributors are unable to resell. Without proper disclosure and estimation channel stuffing results in overestimation of earning in the period because of the extra revenue has been recognized without taking into account the possibility of sales returns afterwards.

10.7.2 Inventory Manipulation The second most common method for committing fraud in the financials is by manipulating the inventory. With inventory manipulation higher ending inventory can be

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Table 10.3 Inventory manipulation schemes Fraud scheme

Accounts involved

Type of procedure

(1) Under-recording purchases

Accounts payable, inventory

Purchasing of inventory

Accounts payable, inventory

Returning goods to suppliers

(6) Overstating purchases

Accounts payable, cash

Paying vendors

(7) Overstating discounts

Accounts payable, cash, inventory

Paying vendors

Cost of goods sold, inventory

Selling inventory, recognizing cost of goods sold

Inventory write down, inventory

Estimating inventory quantities, estimating obsolete inventory

(13) Over-counting Inventory

Inventory shrinkage, inventory

Counting of inventory quantities

(14) Using incorrect costs

Inventory, cost of goods sold

Determining inventory costs

(2) Recording purchases in wrong period (3) Not recording purchases at all (4) Overstating returns (5) Recording returns in wrong period

(8) Not reducing inventory’s cost (9) Recording at lower amount of cost (10) Not recording cost of goods sold or inventory (11) Not writing off/down obsolete inventory (12) Over-estimating inventory

(15) Recording fictitious inventory

produced as well as higher income for the period. Typical schemes are found in Table 10.3.

10.7.3 Liability Manipulation Financial Statement Fraud Liabilities are the third most often used method to commit financial statement fraud. They are schemes in which the financial statements are misstated by improperly recording the liabilities and/or other obligations. Moreover, the liabilities could be understated by improperly classifying liabilities as equity or recording shot term debt as long term. Missing transaction can be harder to detect than misclassification because of the lack of audit trail. Here, the characteristic schemes are grouped into three main categories: liability/expense omissions; capitalized expenses, and failure to disclose warranty costs and liabilities. Examples are:

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Not recording accounts payable; Not recording accrued liabilities; Understatement of expenses; Recording unearned revenues as earned; Not recording warranty/service liabilities; Not recording loans; Keeping liabilities off the books; Not recording contingent liabilities; Ignoring monetary legal judgmental against the organization.

10.7.4 Asset Manipulation in Financial Statement Fraud Assets are the fourth most common method in fraud in the financials. They could be increased artificially by not booking the accounts receivable or not acknowledging the expense for impairment. Assets manipulation schemes include falsifying the value of the organization’s assets with intended goal in mind typical schemes include: • • • • • • • • •

Overstatement of current assets—cash, securities, etc. Including assets that are not under reporting control and ownership of the entity Overstating pension assets Capitalizing instead of expensing assets Not recording depreciation or amortization expenses Extending the useful lives of assets Overstating assets via creation of complex entities, mergers and acquisitions Overstating inventory counts and receivables Failure to record impairment losses (book value of assets is greater than its fair value or net realizable value) • Recording fake unrealized gains • Keeping insufficient reserves for uncollectible receivables. Inclusive/Exclusive fraud categorization If a categorization is made via the inclusive and exclusive categories the inclusive fraud can involve either the creation of fictitious assets, omission of present liabilities or in some cases inappropriate timing of transactions: In the fictitious assets case, the most common techniques are: recording of fictitious revenues and their corresponding receivables and recording of fictitious inventory thus influencing the cost of goods sold item. Both of this techniques require the creation of a debit account which has to be matched with a credit to either revenues or an expense account making the earnings misstated as well. Inappropriate timing of transactions can include a variety of scenarios ranging from: – Premature recognition of receivables and other revenue (before they can be considered realizable or realized).

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– Accruals not recognized in a timely manner skewering the recognition of any related expenses. – Allowances (account, sales returns) and reserves (liability, litigation) and other contingencies not recognized when probable or estimable delaying the related expenses. – Deferring cost of goods sold associated costs instead of accruing them either by overstating the value of the current inventories or deferring the recognition of any purchases and other costs (labor, materials, etc.). On the other hand, the category of excusive fraud focuses on the omission of liabilities and other expenses and obligations (guarantees, commitments) from the financials. The effects involve: Underestimation of items that influence the financials like: – – – – –

Clean up and other related expenses Failure to properly account for litigation reserves and estimation of liabilities due Losses with debt and other liabilities Reserves associated with impairments and investment losses Interest expense

Moreover, exclusive fraud typically results in an overstatement of financial rations relating to liquid of the company due to their understating effect of liabilities.

10.8 Disclosure Fraud Disclosure fraud is another type of fraud that can be connected with tampering with the disclosure mechanisms of the financial statements. Characteristics of such schemes is the failure of management to disclose material information in the financial documents in attempt to mislead the users of the information. Three types of disclosure frauds exist that aim at deceiving parties about the real situation of the organization’s financials: I.

Overall misrepresentation about the nature of the organization triggered by unreal reports, interviews and rumors; II. Tampering with the management discussions and other non-financial sections of the annual/biannual reports; III. Falsifying or misrepresenting footnotes in the financial statements. The footnotes contain information to assumptions that were made in preparation of the financials and could be used to conceal any unrealistic expectations or assumptions made by executives.

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Gray Zone The so-called gray zone exists in which the distinction line between fraudulent behavior and aggressive but appropriate accounting methods is blurred. International accounting standards such as the Generally Accepted Accounting Principles (GAAP) allow for a variety of ways for representing the operations and current financial situation of a company which include legitimate accounting choices. This in many cases can blur the real financial position of the organization which inclines to the fraudulent spectrum of managing the entity. Other name for this process is “aggressive accounting” which is comprised of earnings management techniques that allow the organization’s management to meet the desired performance indicators and make the company’s financials look better. Griffiths (1986) states that those manipulation techniques are the biggest trick invented after the Trojan horse. Most common examples of such are: – The choice of changing the methods of depreciation from accelerated to straight line (a more conservative approach to allocating depreciation) or vice versa. – Determining/estimating the exact useful lives and the salvage values of company’s assets. – Classifying the decline of the value of an investment or other asset as temporary or permanent loss. – Classifying assets as impaired or writing them off. – Estimating the allowance for accounts receivable that are uncollectable. – Use of accounting estimates for the presentation of information in the financial statements generates possibilities for their manipulation, as long as these values are determined based on an approximation in the absence of a precise means of measurement and evaluation (ISA 540 Auditting Accounting Estimates). Usually, they are applied when determining the collectability of receivables and their impairment; upon revenue accrual; upon recognition of deferred taxes; recognition of warranty maintenance; recognition of provisions for losses of court litigations; when determining the useful life of assets and depreciation charges. The accounting standards allow for the accounting estimates to be changed when obtaining new information and new experience. (IAS 8). It is difficult to judge when the application of accounting estimates results in misrepresentation of financial statements. There are three characteristics, which, if available, can be considered to constitute a misrepresentation in this case: There should be a certain degree of intention; recurrence of an incorrect estimate made; creating and usage of documents substantiating this estimate (Petrova 2007). The management’s intent is important. If applying such principles is done with clear intend to conceal a fraud or make one, the actions of the perpetrators should be treated as misconduct. On the other hand, any misrepresentation of the financial situation of the organization could be due to error or misapplication of the relevant principles. This does not mean that there are not earnings management schemes that are considered as a clear violation and indication of fraud. Such schemes include but are not limited to: acknowledging fictitious sales, illegitimate recognition of revenue, and use of reserves (Rezaee 2002).

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Kwok B (2005) Accounting irregularities in financial statements: a definitive guide for litigators, auditors and fraud investigators. Gower. ISBN-13:978-0566086212 Merriam Webster Dictionary (2016) http://www.merriam-webster.com/. Accesed on 5 May 2016 Miller S (2003) The press as a watchdog for accounting fraud. Working paper, Harvard University National Commission on Fraudulent Financial Reporting (1987) Report of the national commission on fraudulent financial reporting. http://www.coso.org/FraudReport.htm. Accessed 5 May 2016 Oxford Dictionary (2016) Oxford dictionary.com Ozkul FU, Pamukcu A (2012) Fraud detection and forensic accounting. In: Caliyurt K, Idowu S (eds) Emerging fraud: fraud cases and emerging economies. Springer, Berlin, pp 19–41 Pesaru S (2002) Tech-professors expose fuzzy accounting. Contributing writer Petrova D (2007) Use of accounting estimates and fraudulent financial reporting—a paper read at the conference. Theory and Practice of Financial Crimes Rezaee Z (2002) Financial statement fraud. Prevention and detection. Wiley, New York Rezaee Z (2010) The importance of internal audit opinions: as their role expands, many auditors are providing opinions on governance, risk management, and internal control, internal auditor 67(2):47–51 Sadka G (2004) Financial reporting and product markets: learning from competitors. Working-paper, University of Chicago Schipper (1989) Earnings management. Account Horiz Securities and Exchange Commission (1999) Annual Report. https://www.sec.gov/ Stoyanov S (2008) Accounting principles. Textbook Taylor N (2003) Reporting of crime against small retail businesses. In: Trends and issues in crome and criminal justice no 242. Australian Institute of Criminology, Canberra Warne RC (2009) The effects of fair-market valuations of non-current assets on the judgments of nonprofessional investors. Working Paper. George Mason University

Iavor Bachev is an assistant professor in financial control at the University of National and World Economy (UNWE), Sofia, Bulgaria. He received Bachelor’s degree in Finance from Richmond University, London, United Kingdom in 2011. He also received Master’s degree in International Management from King’s College London in 2013. He obtained Ph.D. in 2017 from the Higher School of Insurance and Finance, Sofia, Bulgaria. He has the Certified Internal Auditor and Certified Fraud Examiner certifications. His interests revolve but are not limited to fraud, corruption and their control in organizations and across society.

Part III

Ethics and Sustainability in Accounting

Chapter 11

Islamic Finance and Sustainability Reporting: The Mediator Role of Green Accounting Adel M. Sarea

Abstract The paper is to explore the relationship between (Islamic Finance) and (Sustainability Reporting), The Mediator Role of (Green Accounting). A quantitative survey was developed and validated. A total of 87 responses were collected from Accounting, Finance, and Banking Department at Ahlia University (Bahrain) and used for the analysis. The results show that (Islamic Finance) in terms of Murabahah financing (sale by cost mark-up plus), Mudaraba financing (silent partnership), and Musharakah financing (joint venture partnership) has a significant association with attitudes to lead toward the need of (Sustainability Reporting). The results also indicate that (Green Accounting) strengthen the positive association between (Islamic Finance) and (Sustainability Reporting). The paper adds value to the literature on Islamic Finance, sustainable reporting by looking at role of Green Accounting in promoting friendly environment. Keywords Islamic finance · Sustainability reporting · Green accounting · Bahrain

11.1 Introduction The Islamic financial system is a manifestation of the Islamic worldview. It comprises rules and regulations, which are mainly in compliance with the principles of Islamic law or the Shariah, which govern human activities (Al-Roubaie and Sarea 2019). Islamic financial institutions must take into consideration those principles in their funding to ensure that investment activities will be in compliance with the Islamic legal system. Islam is very specific as far as making use of natural resources. Its use must not only protect the environment, but must also support human survival, i.e., it is against Islamic law to cause damage to the environment by polluting the air, the water, and cutting trees. In this regard, the Islamic banking system must ensure that lending to investors will not cause damage to the environment (Al-Roubaie and Sarea 2019). In other words, lending should be based on a complete understanding A. M. Sarea (B) Accounting and Economics, Ahlia University, Manama, Kingdom of Bahrain e-mail: [email protected]; [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_11

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of what the investment is going to be used for to ensure that the environment is protected (Al-Roubaie and Sarea 2019). The message of the Shariah constitutes “the core element of faith” that must be practiced in everything we do. In conventional finance, such a request may not be required simply because of the nature of profit and the non-compliance of banks with principles which limit lending. All investments must abide by Islamic principles, so that money will only be allocated for investment in products or activities, which are lawful. In Islam, man is given the privilege by God to be vicegerent. As such, this requires man to act responsibly fulfilling all the principles of the Shariah and the practices shown to him by the Prophet (Al-Roubaie and Sarea 2019). Not only should man not invest in harmful businesses, he must also work hard to protect the environment and all its resources. Resources are considered a gift or bounty from God provided for man to satisfy his basic needs. In Islam, nature is a trust that should not be harmed or excessively consumed. Resources, according to Islamic principles, must serve the entire population and not be controlled by the few rich and influential individuals (Fung et al. 2010). The Prophet is quoted as saying “the earth is a mosque” which makes all resources including those above and below ground to be scared. The Quran in several places reflects on the damage to the environment caused by human hands. “Corruption has appeared on the land and in the sea because of what the hands of humans have wrought. This is in order that [Allah] give them a taste of the consequences of their misdeeds that perhaps they will return to the path of right guidance.” (Qur’an, 30:41). Such corruption will damage the environment and reduce the prospects that resources will enable humanity to sustain development and ensure human survival (Al-Roubaie and Sarea, 2019). In this regard, Islamic Finance becomes an important factor in sustainable development and reporting.

11.2 Sustainability of Islamic Financial System Companies traditionally been interested in a single de facto bottom line—profit—but business leaders are no longer satisfied solely with financial performance—sustainable transparency and progress on environmental, social, and governance issues are now just as important. According to the Governance and Accountability Institute, ESG reporting has increased by more than four times since 2011 among S&P 500 companies, and as global interest grows, there have been calls for more uniform metrics. ESG reporting provides more accountability, enhances legitimacy, increases profitability, and improves governance, and as climate change affects all markets and presents risks that shareholders can no longer ignore, investors are demanding answers about fundamentals in the investment process. The principles of Islamic Finance offer a just and fair socioeconomic system where there is a strong commitment toward the well-being of society. One of the most important objectives of Islam is to realize and promote greater justice in human society.

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According to the Qur’an, a society where there is no justice will ultimately head toward decline and destruction (Qur’an, 57:25). One of the fundamental elements for ensuring justice is a set of rules and moral values, which are faithfully accepted and adhered to by members of the society. However, the behavior of financial actors that led to the recent financial crisis represented, in many ways, deviations from some universally accepted ethical principles, including justice, fairness, and honesty, causing (a) too much debt, (b) overleveraging of assets, (c) excessive securitization, and creation of new assets that were neither transparent nor understood and (d) diversification of risk, based on unreal models (Mathews and Tlemsani 2010). In conventional markets, the Islamic principle of prohibition of riba was clearly violated in cases of excessive lending and borrowings. Although there are arguments among scholars as to what precisely constitutes riba, the high rates of interest charged in credit card lending, certain subprime mortgages, and the fraudulent manipulation of debt could be qualified as riba or usury from most perspectives (Rahman 2009). Islamic markets thus can provide a model for socially responsible, sustainable changes in the financial system. There are many emerging avenues on global development of Islamic Finance; • The prospect for harmonization of Islamic financial principles: A response to the increasing need for globally accepted Islamic financial principles. • Innovation in Islamic Finance (e.g. liquidity management and commodity financing), information, and other technology advancement; • Islamic funds and exploring sources of Sharia-compliant liquidity for investment in least-developed nations. • An appraisal of Sukuk issuance in the Middle East and North Africa. • Opportunities and challenges of expansion of Islamic banking in the U.S. financial markets.

11.3 Literature Review Islamic financial institutions must play a leading role in the development of a Shariah compliant green investment system to support the environment (Sarea 2020). Islamic banks should encourage to finance any project with free environmental risk and the use of green technologies to fund projects. However, investments in costeffective energy sources will support building capacity for sustainable development by reducing pollution and improving productivity. Technology could also help in increasing productivity by putting less pressure on natural resources. Therefore, the employment of appropriate technologies will minimize the damage to the environment because it can reduce the emissions of carbon dioxide and cut back on waste. However, priority in the Islamic economy must be given to the production of necessities instead of luxury products which only the rich can afford. Production of necessities will reduce pressure on the excessive exploitation of natural resources and also improve management of these resources. In the capitalist system, free competition among individuals could lead to a concentrated and excessive accumulation of

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wealth by few. Individuals will compete to enrich themselves at the expense of the common good. In other words, capitalism provides incentives for a few capitalists to own the entire means of production. Those few then maximize their personal wealth, while little attention is paid to community welfare. The Islamic economic system, on the other hand, strengthens the Islamic fundamentals of individual liberty, right to ownership, social justice, social security, and a greater circulation of wealth. Compliance with these fundamentals reduces the risk of environmental degradation because it prohibits investment in environmentally detrimental projects. Green investment should be incorporated into national economic policies to ensure that adequate environmental protection is provided in order to sustain development (Al-Roubaie and Sarea 2019). According to the principles of the Shariah, investment must adhere to all legal aspects endorsed by the Shariah in both public and private business activities. Any violation of these measures breaches the code of ethics in business activities. To overcome any violations, Islamic banks should insist on funding green projects not only to protect the environment from irresponsible investment but also to improve the lives of people by promoting socially responsible investment. Similarly, corporations and business enterprises in the Islamic economy must enforce the guidelines of the Shariah by developing high governance standards to ensure that business activities are not only for the purpose of maximizing profits, but also for advancing objectives of society. Those activities must implement equity, justice, accountability, and transparency. Islamic Finance reduces the risk of uncertainty and speculation which will subsequently contribute to both financial stability and long-term sustainability. The survival of living species, both human and animals, depends on the environment to provide the basic essentials, and therefore, any failure to preserve and protect those natural resources will jeopardize human survival (Al-Roubaie and Sarea 2019). Furthermore, as an integral part of the Islamic economic system, the Islamic financial system promotes ethical development that ensures green economic growth and provides mechanisms to protect the environment. For instance, Malaysia published ‘The National Green Technology Policy’ in 2009 to support the green investment drive and protect the environment. The policy comprises several components including energy consumption, the environmental, economic, and social elements. The objective of the policy was to improve the quality of life by promoting the efficient utilization of energy, enhancing development through the use of technology and minimizing the impact on the environment. To endorse those objectives, the government must develop guidelines and introduce regulatory measures that involve Islamic Finance in the development of green technology.

11.3.1 Research Methodology This study is based on (Sarea 2020). We formulated the study hypotheses based on the literature review according to (Sarea 2020). We used 5-point Likert scale; we designed the survey based on previous studies conducted in different countries.

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Fig. 11.1 Research model

Fifteen items were developed and used for the analysis of the data. The contribution of this study is using structural equation modeling (SEM) through SmartPLS software. According to Hair et al. (2017), PLS-SEM is the best technique as the data in this study were non-normal distributed. (Fig. 11.1).

11.4 Results and Analysis The results show that most of the items used had loadings above the recommended value of 60%. In terms of internal consistency, the CR values for all items exceeded the value of 70%. As for the AVE, the results in Table 11.1 indicate that the AVE for all the latent variables under study was above the recommended value of 50%. To check the multicollinearity issue, we analyzed the variance inflation factors (VIF) and its result, as presented in Table 11.1. No multicollinearity was in this analysis. Table 11.1 Validity and reliability Constructs

Items

Mean

SD

CR

AVE

VIF

SustR

4

4.4

0.416

0.80

0.58

–

MoIF

6

4.5

0.335

0.83

0.62

1.16

GeenA

5

4.4

0.401

0.84

0.53

1.04

Notes SustR = Sustainability Reporting; MoIF = Mode of Islamic Finance; GeenA = Green Accounting; SD = standard deviation; CR = composite reliability; AVE = average variance extracted; VIF = variance inflation factors

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Table 11.2 Model results and analysis Hypothesis and path

β

CI—Min. CI—Max. t-value p-value Decision

f2

H1

MoIF → SustR

0.176 0.064

0.28

2.64

0.004

Supported 0.045

H3

GeenA → SustR 0.336 0.240

0.42

6.12

0.000

Supported 0.177

H5

MoIF × GeenA → SustR

0.17

1.85

0.031

Supported 0.020

0.092 0.010

R2 = 0.422 Q2 = 0.228 Notes SustR = Sustainability Reporting; MoIF = Mode of Islamic Finance; GeenA = Green Accounting; CI = confidence interval

The structural model assessment is presented in Table 11.2. This table displays the path coefficients (β), t-values, and p-values of all hypothesized relationships. Overall, the results show that all proposed relationships from exogenous variables to the endogenous variable can be statistically accepted as long as a bootstrap critical tvalue is ± 1.65 (one-tailed). Specifically, the relationship between MoIF and SustR attitudes found to be significant and positive (β = 0.176; t = 2.64; p = 0.004). Similarly, GeenA (β = 0.336; t = 6.12; p = 0.000) and SustR (β = 0.337; t = 6.123; p = 0.000) were significantly and positively related to SustR’ attitudes toward monetary donation. Thus, all hypotheses were supported. Furthermore, the results as displayed in Table 11.2 illustrate that R2 value of 0.422, indicating that predictors can collectively explain 42% of the attitudes toward Sustainability Reporting. Using the blindfolding method, the value of predictive relevance (Q2 ) of the endogenous variable (attitude) was above zero (see Table 11.2). The bootstrapping analysis shows a significant moderating effect of Green Accounting on the association between Mode of Islamic Finance and attitude to Sustainability Reporting (see Table 11.2).

11.5 Conclusion The Islamic financial system promotes human capital development to build capacity for innovation in Muslim societies. Investment in education increases productivity and strengthens a society’s ability to sustain development. Knowledge in Islam is crucial to promote social and economic development (Sarea 2020). Islamic financial institutions can contribute to the development of Muslim societies through investment in research and development in such areas as poverty reduction, science and technology, environmental protection, and sustainable development. Project financing could be restricted to meet certain conditions considered friendly to the environment. The paper summarizes the relationship between (Islamic Finance) and (Sustainability Reporting), The Mediator Role of (Green Accounting). The method used in this study was questionnaire that consists of (15 items). The results also indicate that

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(Green Accounting) strengthen the positive association between (Islamic Finance) and (Sustainability Reporting). The paper adds value to the literature on Islamic Finance, sustainable reporting by looking at role of Green Accounting in promoting friendly environment.

References Al-Roubaie A, Sarea A (2019) Building capacity for green economy: the role of islamic finance. TAFHIM: IKIM J Islam Contemp World 12(2) Fung H, Law S, Yau J (2010) Socially responsible investment in a global environment. Edward Elgar, Cheltenham, p 5 Hair JFJ, Hult GTM, Ringle CM, Sarstedt M (2017) A primer on partial least squares structural equation modeling (PLS-SEM), 2nd edn. Sage, Thousand Oaks, CA. Available at: https://www.amazon.de/Partial-Squares-Structural-Equation-Modeling/dp/148337744X/ref= sr_1_1?ie=UTF8&qid=1462617386&sr=8-1&keywords=PLSsem#reader_148337744X Matthews R, Tlemsani I (2010) The financial tower of Babel: roots of crisis. Int J Islamic Middle Eastern Finan Manage 3(4):334–350 Rahman A (2009 March) The relevance of Islamic finance principles to the global financial crisis, [discussion paper], Harvard Law School Sarea AM (2020) The impact of islamic finance on sustainability reporting. In: Global approaches to sustainability through learning and education. IGI Global, pp 262–269

Chapter 12

Sustainability Accounting in Turkey Birsel Sabuncu

Abstract Sustainability accounting, which arises as a result of the failure of the traditional accounting system to meet the information needs for corporate sustainability, has been examined in this study. Through sustainability accounting, which may be useful for companies by transferring useful information, in addition to collecting, classifying and recording documents, sustainability information has also been included in its contents. As a new concept, sustainability accounting has come to the fore because traditional accounting is not sufficient enough to convey information for corporate sustainability. Sustainability accounting in Turkey is subject to a voluntary basis. Developing a sustainability accounting system which increases the reliability and transparency of the enterprises on social and environmental issues enables more accurate determination of product costs and efficiency in resource utilisation. In the traditional approach to accounting, the use of natural resources is neglected and economic development will accelerate with the inclusion of sustainability accounting as it is not enough for companies to use this method alone. Keywords Sustainability corporate sustainability · Sustainability accounting

12.1 Introduction Sustainability is a set of methods that provide stakeholders with information about the position of a company in the marketplace, informing their stakeholders and what kind of changes in the company’s position in the future. The global financial crises and global risks have made the need for new strategy models more visible. Ethical concerns in the conduct of business activities, social and environmental impact and responsibilities to the stakeholders have also increased the importance of sustainability in the business world. The main purpose in the emergence of sustainability practices is to continuously transfer human needs to future generations and not to deprive anyone of these needs. B. Sabuncu (B) Pamukkale University, Denizli, Turkey e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_12

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This issue covers not only human life but also chaining the entire ecosystem. Enterprises are institutions that carry out their activities in various fields as living organisms. All managers wish to be able to offer and receive the best service in line with employee and shareholder interests. Due to this, the concept of sustainability develops day by day. Today, due to the decrease in resources, the necessity to take measures in this regard is indicated by global agreements. Companies from various sectors that undertake a large portion of resource usage are expected to adhere to these global agreements. When using economic, environmental and social resources, companies are expected to use their resources not only for production but also for the benefit of society and to continue their activities in this direction. Sustainability accounting, which takes into account social and environmental factors, has emerged under these conditions. In this study, what sustainability accounting is, which need made it necessary to emerge, different from traditional accounting, impact and sustainability accounting in Turkey in the field of corporate sustainability accounting are examined. Sustainability accounting is subject to a voluntary basis in Turkey. Certain companies found in Borsa Istanbul publish sustainability reports. While the number of these companies is only 70 for this year, 50 companies will be included in the sustainability index for the next year. As the prevalence of sustainability, accounting becomes more widespread in both small and large companies, increasing the competitiveness of companies and ensuring the ecological life of the next generations will also be ensured.

12.2 Sustainability and Corporate Sustainability Sustainability emphasises that not only the efficient distribution of resources over time but also the economic activities of resources and opportunities in a dimension proportional to the present generation and future generations, as well as its ecological life support system. Sustainability has made cooperation with many disciplines mandatory, with a global need for a much more common decision-making mechanism. (Yanık ve Türker 2012: 295). Sustainability can be called the environment, making nature sustainable and fulfilling its responsibilities towards nature. Even if humans advance technologically nature shall always be a part of life. Besides, the sources provided by nature are observed as the most preferred concepts of life. Since these resources are not renewable resources, attention must be paid during use. The riches obtained from nature are known as special concepts that cannot be recovered. The concept of sustainability, which is to be considered as a kind of progress, favours development in every sense. Since the concept of sustainability is a concept that includes both economic, environmental and social objectives, it can be expressed as three different dimensions in which each of these three elements is subordinate to each other and are connected to other elements (Giddings et al. 2002: 192).

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The concept of sustainable development was first defined in the Brundtland Report, prepared by the World Environment and Development Commission in 1987, as the development that meets today’s needs without compromising its ability to meet the needs of future generations. (https://betanir.wordpress.com). Corporate sustainability can be defined as the adoption of business strategies and activities that enable the protection of humans and natural resources that the business will require in the future (Roca and Searcy 2012: 104). In addition to economic sustainability, enterprises that take into account the principles of corporate sustainability have to increase and expand their social and environmental sustainability. In this sense, corporate sustainability has three dimensions: economic, social and environmental. The first dimension of corporate sustainability is economic sustainability. Economic sustainability is related to the financial, tangible and intangible capital of the enterprise and emphasises the effective management of these types of capital. The second dimension of corporate sustainability is social sustainability. Social sustainability requires the development of human and social capital. (Dyllick and Hockerts 2002: 131–134). The last dimension of corporate sustainability is environmental sustainability. Environmental sustainability means ensuring the continuity of natural resources. The level of utilisation of resources is the rate of self-renewal of these resources; the rate of pollutants released should not exceed the rate at which natural sources process these pollutants. Bio-diversity; human health; quality of air, water and soil; protection of animal and plant life is also included in environmental sustainability (Kaypak 2011: 26).

12.3 Sustainability Accounting The role of accounting in a sustainable organisation, developing and implementing organisational policies in line with sustainability, managing the operational risk, developing the supply chain associated with the management system, creating purchasing policies and standards. Supporting the creation of an effective process that can easily reach and rely on partners, creating voluntary environmental and social regulations and rules, establishing an organisational structure that will provide the timely submission of information on environmental and social results. The failure of traditional accounting structure to provide information to corporate sustainability has led to the emergence of new accounting approaches that take social and environmental factors into account. Sustainability accounting, interactions between social, environmental and economic issues that constitute a defined economic system (enterprise, production facility, etc.), firstly the financial effects caused by environmental and social factors; and the sub-branch of accounting that deals with the activities, methods and systems of the enterprise in order to record, analyse and report their relationship (Schaltegger and Burritt, 2010: 377).

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A company that wishes to use sustainability accounting should first define environmental and social factors and interpret the relationship between environmental, social and economic concepts, which are the tripartite dimension of sustainability. It is in the interest of businesses to include the concept of sustainable accounting in the reporting process while creating accounting records. By making sustainability reporting, the company can transfer the data related to its financial structure to the stakeholders and also provides information to people outside the company. Sustainability accounting: unlike general accounting types, the economic, social and environmental sustainability of the company can be expressed as a combination of accounting methods that ensure the simultaneous harmony. Sustainability accounting involves assessing risks and opportunities, linking sustainability initiatives to company strategy, and providing accounting and performance management skills embedded in the company’s daily operations (Altınay 2016: 59). The information generated by the accounting process plays an important role in the acquisition and development of information on the social and environmental activities of enterprises. For corporate sustainability, the most important information that constitutes the foundation of the company’s sustainability strategy can be obtained from sustainability accounting (Hernadi 2012: 27). When sustainability accounting is examined, the fact that most of the data is based on environmental factors can be examined. With sustainability accounting, it is possible to reduce risks and increase opportunities. Sustainability accounting makes it easy for the company to perform its business on a regular basis. Informs stakeholders transparently during the periods the reports are published. The contents of sustainability reporting are the works to keep the environment clean, the efforts to provide social order that values people, the practices that do not harm nature during development and production of added value in doing so. With sustainability accounting, the role of accounting, which is defined as accounting method and new information management that can sustain the sustainability of enterprises, can carry quality information to enterprises. Beyond document collection, classification, recording, sustainability and sustainability development have been transformed and reported. The audit and accounting of sustainability play a key role in both creating strategies and in relations with stakeholders. Accounting, auditing and reporting have an important role in the implementation of sustainability, in the formation and execution of social responsibility strategies, and in the development of trust relationship with stakeholders.

12.4 Sustainability Accounting Standards Board (SASB) Sustainability accounting, in which the performance of the entity is evaluated in all aspects, financially and non-financially, was given a new dimension with the establishment of the Sustainability Accounting Standards Board. In addition to financial knowledge, the importance of non-financial information has been understood in the international arena and the applicability of non-financial

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information on sector basis has started to be investigated. Sustainability Accounting Standards Board was established in 2011 in order to establish and test a scope in which relevant performance indicators are examined by determining the issues of sector-specific importance. SASB establishes sustainability accounting standards to be used by US-listed companies in explaining significant sustainability issues to investors and public interest. The SASB provides an overview of sustainability accounting by identifying basic concepts, principles, definitions and objectives that guide the approach to setting standards for sustainability accounting. The SASB is an independent standards body that is responsible for processing, results and ratification of its standards, including changes to standards. It operates in a sectoral committee structure that appoints at least three board members to review, debate and communicate with each sector. The members of the Standards Board are appointed by the Board of Directors of the SASB Foundation. 77 standards have been published specifically for sectors such as consumer goods, financial, food and beverage, healthcare, infrastructure, renewable resources and alternative energy, resource transformation, services, technology and communication and transportation (https://www.sasb.org). It can be viewed that all the standards that SASB makes can be implemented by all investors, to deal with the overall sector, to create added value, to be transparent and to be easy to understand, to assist in impartial decision-making, to reflect the opinions of all stakeholders and to include a structure of thought compatible with International Accounting Standards. SASB ensures that companies comply with relevant, useful, feasible, cost-effective, benchmarking, auditing and impartiality concepts. The SASB focuses on financially important issues and helps companies around the world report on sustainability issues that give utmost importance to investors. The SASB standards developed with comprehensive market input are used by companies and investors to apply principles-based frameworks, including recommendations for integrated reporting and climate-related financial statements. Whether used alone or as part of an integrated report as well as other reporting frameworks, the SASB standards and metrics enable companies to communicate with investors in detail and strength. SASB has developed standards for disclosure of material sustainability knowledge to investors in mandatory filing. The SASB standards set out the key sustainability factors that are likely to affect financial performance. Investors have their own unique needs, unlike suppliers, customers, communities, interest groups and other stakeholders. They demand reliable and comparable sustainability information that includes open links to financial performance. Focusing on this need, the SASB standards define a subset of sustainability issues that are likely to be material for investors. SASB standards are industry-specific to continue to focus on financial priority and provide comparability among colleagues.

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12.5 Sustainability Reports As a new concept, sustainability accounting has come to the fore because traditional accounting is not sufficient in conveying information for corporate sustainability. The use of finance and the concept of accounting have a great influence on economic development. In the traditional accounting approach, the use of natural resources is ignored and it is inadequate to use this method. Environmental accounting and sustainability are included in the reporting issues of the concept. In order to obtain a competitive advantage, enterprises have to follow the economic, social and environmental impacts of their activities in line with the wishes and needs of their stakeholders and to report them to the related parties with various information. These reports, which include information on environmental, economic and social responsibilities of enterprises, are called sustainability reports. Sustainability reports are considered as a key indicator of social, environmental performance and corporate transparency for investments and shareholders today. In the literature, these reports come up with many names such as triple responsibility reporting, social and environmental reporting, corporate social responsibility reporting, non-financial reporting (Özsözgün Çalı¸skan 2012: 41). In sustainability accounting and reporting, it is not possible to mention a single sustainability reporting globally. There is no compulsion on which standard, what format and in which range the companies choose to publish, the enterprise is at liberty to decide on their own method. There are different sustainability reporting frameworks published by different organisations. One of the reasons behind the popularity of sustainability reporting is that transparency not only helps companies to tell their own stories but also brings about improvements in performance. Therefore, more than one sustainability reporting framework has emerged. SASB works with a number of organisations that want to promote reporting and sustainability in sustainability issues. They complement global initiatives, including the Global Reporting Initiative (GRI), the International Integrated Reporting Committee (IIRC), the Climate Disclosure Task Force, CDP and others. GRI Sustainability Reporting Standards (GRI Standards) are the first and most widely accepted global standards for sustainability reporting. Since the establishment of GRI in 1997, it has been recognised by a growing number of organisations. 93% of the world’s 250 largest companies report on their sustainability performance. The practice of disclosing sustainability information encourages accountability, helps identify and manage risks, and enables organisations to capture new opportunities. With GRI Standards, reporting companies support public and private, large and small companies, protect the environment and improve society, but also grow economically by improving governance and stakeholder relations, increasing credibility and building trust. GRI helps businesses and governments around the world understand and communicate their impact on critical sustainability issues such as climate change, human rights, governance and social welfare (www.globalreporting.org).

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Today, the most preferred and globally accepted reporting standard, GRI has developed the first corporate sustainability reporting framework. GRI standards are used by the majority of companies providing sustainability information. The standards are designed to provide information to a wide range of global stakeholders, from civil society to investors. GRI standards include a very broad description scope. In general, companies use them to develop and design sustainability or corporate responsibility reports. GRI standards are designed to provide information to a wide range of stakeholders, and consequently, include a wide range of topics. The SASB is designed to provide information to investors and ultimately focus on a subset of financially important sustainability issues. Transparency is important to build trust between investors and other stakeholders. Investors need standard, high-quality information about the material factors that can affect the price or value. The International Integrated Reporting Committee (IIRC) has established its reporting framework. The integrated report will be a type of reporting that can explain integrated reporting, environmental, social and corporate management information. It is planned to serve the purpose of generating understandable, comparable and clear information by investors (www.ey.com).

12.6 Sustainability Accounting and Sustainability in Turkey Turkey, which wants to achieve its global goals within the framework of the EU adaptation strategy, is implementing the necessary policies for sustainable development through the state. In the framework of the rules laid down by the state, the business world adopts the concept of corporate sustainability in its own practices and cooperates with civil society and contributes to sustainable development (Altunta¸s and Türker 2012: 48). In Turkey, the concepts of ecological and environmental sensitivity began gaining widespread approval in the 1970s. In 1978, the Prime Ministry Undersecretariat of Environment was established to represent us on the environment, nation and international platforms. Environmental protection was added to the Constitution for the first time with the 1982 Constitution. The Environmental Working Group established under Turkish Industrialists’ and Businessmen’s Association in 1995 and under the Industrial Affairs Commission can be given as an example. The aim of the Group is to carry out its activities in a way to cover both environmental and social responsibility subjects. This target to perform with the business community in the vanguard with six non-governmental organisations the (Environmental Protection and Packaging Waste Utilisation Foundation, Istanbul Chamber of Industry, Turkey Quality Association, Turkish Foundation for Combating Soil Erosion, for Reforestation and the Protection of Natural Habitats,

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Turkish Chemical Industrialists Association, Turmepa) brought together and established the Environmental Platform for Sustainable Development in 2002 (Altunta¸s and Türker 2012: 49). Since 2003, Turkey has gained complete membership to the European Environment Agency and has contributed to one of the fundamental sustainable development activities between 2003 and 2007 and has influenced the business world to focus on these topics. In 2004, concepts specific to Turkey were taken into account and the National Sustainability Development Commission was established. In 2005, the parties to the Kyoto Protocol officially came into force as of 2009, Turkey was among the countries that began to take part in studies related to environmental sustainability. In this respect, many public and private institutions, including the Energy and Environmental Management Department, under the Ministry of Energy and Natural Resources, are actively involved in environmental and climate change issues. The studies carried out by the Turkish Ministry of Energy and Natural Resources on climate change are summarised as follows (www.enerji.gov.tr): Preparation of technical opinions on international climate change The Climate Change and Air Management Coordination Board have been appointed as the responsible institution for greenhouse gas emission reduction in the energy sector. Emissions from calculated electricity generation are sent to Turkish Statistical Institute for processing in Common Reporting Format (CRF) tables.

Borsa Istanbul in 2013 in Turkey, The Ethical Investment Research Services Limited (EIRIS) and the business of ecological, based on their performance on issues related to social and corporate governance has signed a cooperation agreement in order to measure the BIST Sustainability Index. BIST Sustainability Index; global warming, destruction of natural resources, reduction of water resources, health, security, employment, etc. Turkey and to show what they see as the crucial problem of sustainability for the entire world so that the approval be evaluated by an independent look at the decisions and activities of the company will be provided. In short, this index will allow enterprises to compare their corporate sustainability performance in the national and global arena. The scope of sustainability in Turkey has been calculated using the BIST Sustainability Index as of November 4, 2014. The purpose of the BIST Sustainability Index exchange-traded in Istanbul and corporate sustainability performance of an index creation will take place in companies with a high level of understanding about sustainability, and in particular, Borsa Istanbul companies in Turkey are the increase of knowledge and practice. As it is known, Corporate Sustainability is the adaptation of economic, environmental and social factors to corporate activities and decision-making mechanisms together with the management of the risks that may arise from these issues in order to create long-term value in companies. In addition, the Borsa ˙Istanbul Sustainability Committee was established in 2015. The aim of the committee is to ensure the full and effective implementation of sustainability, to ensure the sustainability strategy and to monitor the performance and to integrate sustainability into decision-making mechanisms and business models.

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There is an index period in the BIST Sustainability Index in November–October, once a year. In 2014, the companies included in the BIST 30 index and in 2015 the companies included in the BIST 50 index were subject to valuation. In 2016, the list of companies subject to valuation was expanded to include those from BIST 100 companies in addition to the BIST 50 index. The list of companies subject to valuation is revised in December every year and announced by Borsa ˙Istanbul. Below is a list of companies included in the index for the period November 2018–October 2019 (Borsa Istanbul 2018) (Table 12.1). The understanding of sustainability among companies in Turkey and especially Istanbul Stock Exchange is intended to increase both knowledge and practice. The Index gives companies the opportunity to compare their corporate sustainability performances locally and globally. With the Index, a performance evaluation tool is presented to companies to make improvements and set new targets, and opportunities Table 12.1 List of companies included in the index for the period November 2018–October 2019 1

AKENR

AK ENERJI

26

OTKAR

OTOKAR

2

AKBNK

AKBANK

27

PGSUS

PEGASUS

3

AKSA

AKSA

28

PETKM

PETKIM

4

AKSEN

AKSA ENERJI

29

POLHO

POLISAN HOLDING

5

ANACM

ANADOLU CAM

30

SAHOL

SABANCI HOLDING

6

AEFES

ANADOLU EFES

31

SKBNK

SEKERBANK

7

ANELE

ANEL ELEKTRIK

32

SISE

SISE CAM

8

ARCLK

ARCELIK

33

SODA

SODA SANAYII

9

ASELS

ASELSAN

34

HALKB

T. HALK BANKASI

10

AYGAZ

AYGAZ

35

TSKB

T.S.K.B.

11

BRISA

BRISA

36

TATGD

TAT GIDA

12

CIMSA

CIMSA

37

TAVHL

TAV HAVALIMANLARI

13

CCOLA

COCA COLA ICECEK

38

TKFEN

TEKFEN HOLDING

14

DOHOL

DOGAN HOLDING

39

TOASO

TOFAS OTO. FAB.

15

DOAS

DOGUS OTOMOTIV

40

TUPRS

TUPRAS

16

EREGL

EREGLI DEMIR CELIK

41

THYAO

TURK HAVA YOLLARI

17

FROTO

FORD OTOSAN

42

TTKOM

TURK TELEKOM

18

GARAN

GARANTI BANKASI

43

TTRAK

TURK TRAKTOR

19

GLYHO

GLOBAL YAT. HOLDING

44

TCELL

TURKCELL

20

ISCTR

IS BANKASI

45

ULKER

ULKER BISKUVI

21

KCHOL

KOC HOLDING

46

VAKBN

VAKIFLAR BANKASI

22

KORDS

KORDSA TEKSTIL

47

VESTL

VESTEL

23

LOGO

LOGO YAZILIM

48

VESBE

VESTEL BEYAZ ESYA

24

MGROS

MIGROS TICARET

49

YKBNK

YAPI VE KREDI BANK.

25

NETAS

NETAS TELEKOM.

50

ZOREN

ZORLU ENERJI

216

B. Sabuncu

to develop their corporate transparency and accountability and risk management skills related to sustainability issues are provided. The Index also provides a means by which investors can differentiate between companies that adopt sustainability and corporate social responsibility principles and invest in them. Turkey in sustainability reporting activities have been undertaken, mostly by day as a separate reporting made in the report has been increasing. Many businesses record their reports on GRI’s database and register their reports at various levels. However, it is considered to be too early to say that this is done regularly and widely. However, it is undeniable that sustainable reporting which continues to increase in importance in Turkey and that various endeavours relating to this field are taken (Kar˘gın et al. 2013: 39–40). In Turkey, sustainability accounting and reporting of pursuing profit and nonprofit organisations are on a voluntary basis. Borsa ˙Istanbul works on this subject intensively. Companies that implement sustainability accounting and sustainability reporting shall become preferred by foreign investors. Improving sustainability in order to compete in the international market in Turkey, making sustainability accounting practices applied by the company will provide benefits to companies in global competition. Furthermore, it should also be maintained through the efforts of society and non-governmental organisations in Turkey, not only companies. Various strategies and projects, especially economic, environmental and social areas, should be developed and sustainability accounting should be implemented from large companies to small companies.

12.7 Conclusion In today’s global world of information, companies are not considered to be independent and separated from their communities, and companies are not only responsible against company partners but are also responsible for their social partners. In order for companies to assess the risks and opportunities that arise when it comes to sustainability, they first need to know their social stakeholders well and they need to measure social and environmental issues, as well as economic issues, both to the company and its stakeholders. Ensuring the participation of all enterprises in the subject of sustainability reporting is important for the continuity of the reports. The use of sustainability in environmental and social terms can be achieved by understanding the benefits of sustainability by every segment of society. The principles of sustainability in terms of information pollution and the reflection of company information to the stakeholders with pure form help in transferring useful data to society. When using economic, environmental and social resources, companies are expected to use their resources not only for production but also for the benefit of society. Businesses are expected to implement and maintain such activities. Thus, companies will increase both in-house welfare and external stakeholders in the long term. Through transparent reporting, customers will be able to find more realistic comments when reviewing a company.

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The fact that institutions are accountable attracts investors. While developed countries and large companies use sustainability more, developing and small-scale companies use sustainability reporting less frequently. It is expected that the use of more reliable and efficient sustainable systems will increase in the financial and banking sector in the following years, as a result of the acceleration of sustainability efforts, the support of civil society organisations and the demand of stakeholders. Large-scale enterprises are trying to create value by using social, economic and environmental resources more efficiently than other companies. Small-scale companies are focusing more on making sustainability cost-effective. Since it is voluntary to publish sustainability reports, it can be said that not all companies give the same importance in this regard. Social responsibility spending by companies in developed countries is greater than in developing countries such as Turkey. Sustainability principles also contribute to employee performance, and corporate culture is positively affected by this. In recent years, many large banks have been involved in the sustainability process in Turkey and still continue in their efforts. Environmental sustainability is one of the dimensions of corporate sustainability concept Examination of the development process in Turkey and issuing corporate sustainability report businesses to demonstrate the activities carried out within the scope of environmental policy is of great importance at this stage. The sustainability strategy is based on three main indicators: economic, environmental and social. Sub-indicators such as rules of business ethics, corruption, waste, natural resources, social contribution and human rights should be determined by the companies in consideration of their stakeholders. The adoption of a sustainable future concepts and practices in Turkey in this direction should be continued and increased efforts to implement. However, it should be known that sustainability is a common matter not only for a few big companies but for the whole business world. For this reason, large industrial enterprises need to be expanded to the base of sustainable production projects. The way to do this is that we are taking more and more steps in public-university-private sector cooperation.

References Altınay AT (2016) Entegre Raporlama ve Sürdürülebilirlik Muhasebesi. Süleyman Demirel Üniversitesi Sosyal Bilimler Enstitüsü Dergisi 3(25):47–64 Altunta¸s C, Türker D (2012) Sürdürülebilir tedarik zincirleri: sürdürülebilirlik raporlarinin içerik analizi. Dokuz Eylül Üniversitesi Sosyal Bilimler Enstitüsü Dergisi 14(3):39–64 Betanir. https://betanir.wordpress.com/2017/01/28/brundtland-raporu-nedir-what-is-brundtlandreport/. Accessed 20 Nov 2018 Borsa ˙Istanbul (2018) https://www.borsaistanbul.com/duyurular/2018/10/26/bist-surdurulebilirlikendeksi-kas%C4%B1m-2018-ekim-2019-donemi-sirketleri-belli-oldu. Accessed on 02 Jan 2019 Dyllick T, ve Hockerts K (2002) Beyond the business case for corporate sustainability. Bus Strategy Environ 11(2):130–141 Giddings B, Hopwood B, O’Brien G (2002) Environment, economy and society: fitting them together into sustainable development. Sustain Dev 10(4):187–196

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GRI (Global Reporting Initiative). https://www.globalreporting.org/information/about-gri/Pages/ default.aspx. Accessed 01 Jan 2019 Hernadi HB (2012) Green accounting for corporate sustainability. Club of Economics in Miskolc TMP 8(2):23–30 IIRC https://www.ey.com/uk/en/services/assurance/climate-change-and-sustainability-services/ ey-integrated-reporting-and-sustainability-report-assurance-services. Accessed 02 Feb 2019 Kar˘gın S, Aracı H, ve Akta¸s H (2013) Entegre raporlama: yeni bir raporlama perspektifi. Muhasebe ve Vergi Uygulamaları Dergisi 1:27–46 Kaypak S¸ (2011) Küreselle¸sme sürecinde sürdürülebilir bir kalkinma için sürdürülebilir bir çevre. Karamano˘glu Mehmet Bey Üniversitesi, Sosyal ve Ekonomik Ara¸stırmalar Dergisi 13(20):19–33 Çalı¸skan AÖ (2012) ˙I¸sletmelerde Sürdürülebilirlik ve Muhasebe Mesle˘gi ˙Ili¸skisi Mali Çözüm Dergisi (112):133–160 Roca LC, ve Searcy C (2012) An analysis of indicators disclosed in corporate sustainability reports. J Cleaner Prod 20:103–118 SASB (https://www.sasb.org/governance/standards-board/. Accessed 02 Jan 2019 Schaltegger S, ve Burrit RL (2010) Sustainability accounting for companies: catchphrase or decision support for business leaders? J World Bus 45:375–384 T.C. Enerji ve Tabii Kaynaklar Bakanlı˘gı, https://www.enerji.gov.tr. Accessed 02 Feb 2019 Yanık S, Türker ˙I (2012) Sürdürülebilirlik ve sosyal sorumluluk raporlamasindaki geli¸smeler (Tümle¸sik Raporlama). Üniversitesi Siyasal Bilgiler Fakültesi Dergisi 47:291–308

Birsel Sabuncu graduated of Dokuz Eylül University, Faculty of Economics and Administrative Sciences, Department of Business Administration. She completed her master’s and doctorate at Pamukkale University, Institute of Social Sciences. She started her career in banking and private sector and continues as an academician at the university. She has papers, articles and books about accounting.

Chapter 13

The Effects of Digital Transformation Process on Accounting Profession and Accounting Education Bilal Zafer Berikol and Mustafa Killi

Abstract Information and Communication Technology (ICT) has been developed very rapidly, so our age has been characterized as the information age. Rapid technological developments cause significant changes in micro and macroeconomic levels. With the rapid change in ICT, mobilization has become a valuable tool in our age when knowledge is the most valuable asset. ICT can be described as a range of information, electronics and telematics technologies, using modern microelectronics, telecommunications, and computing to improve all kinds of appliances, techniques and processes that influence different areas of human life. Recently, associated with the digital transformation process, many enterprises have begun to use modern cost and management accounting tools through institutional integrated information systems. ICT competencies are one of the basic technical skills required by accounting graduates. To meet this requirement and help students to be ready for working life, the accounting programs of universities are required to include ICT software tools in accounting courses. Studies show that integrated information technologies are used in accounting courses as limited. Students who take accounting education must be educated to know the data analytics for analyzing masses of big data, to be knowledgeable about data security and cybersecurity, to be prepared for developments in transition to digitalization. The profession of accounting is one of the professions that have to keep up with the change in the world which is in the process of rapid digitalization. It is thought that it is important to ensure equipped with the latest technology of students who are studying in the field of accounting. New technologies emerging in current accounting education are required to support the learning development of students. Therefore, the use of digital technology tools used in accounting in accounting education processes should be encouraged. Digital technologies must play a supportive role in development in the learning process B. Z. Berikol (B) Business Administration Department, Faculty of Kozan, Çukurova University, Adana, Turkey e-mail: [email protected] M. Killi International Trade and Logistic Department, Osmaniye Korkut Ata University (OKÜ), Osmaniye, Turkey © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_13

219

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of students in accounting education. In some universities, these information technology tools and systems are used to assist teaching in accounting courses to teach their students to accounting concepts at the basic level. In this study, Documentary Research Method, which is one of the qualitative research approaches, was used. Documentary Research Method; It refers to collecting and organizing previously obtained, archived, organized, and documented data from various sources (library, internet, etc.) with an archive search, establishing meaningful connections on the data instead of operational analysis and making some inferences. Thus, it is aimed to contribute to the literature with this study. Keywords Digital transformation · Accounting profession · Accounting education

13.1 Introduction Since the 1990s, information and communication technology (ICT) has been developed very rapidly, so our age has been characterized as the information age. Rapid technological developments cause significant changes in micro- and macroeconomic levels. This new economic environment is called as “digital economy,”, “new economy” and “knowledge economy.” The most distinctive difference of the twentyfirst-century digital economy from the twentieth-century industrial economy is that ICTs play a dominant role as the basic innovation source (Quiggin 2014:140; Berikol 2008:3). In the studies conducted in this field in the early 2000s, the aim was to raise awareness and transform into information society under the name of information society. However, as a result of the developments at the global level, the concept of digital society has been highlighted instead of transforming it into information society (Türker 2017:213). The basic characteristics of this new economy based on information and communication are continuous accelerating technological developments, uncertainty of the differences between industry branches, increasing informatics and knowledge-intensive activities, globalization of markets, formation of big data masses, communication between objects through the Internet. Nowadays, technological developments become effective in every field and exercise influence over both societies and professions. When we consider the concept of digital economy in general, it can be said that it covers to proseses collecting, processing, transform into and distributing of information (Erdo˘gan 2004:39). In traditional economies, information is collected, processed and distributed. However, the distinctive character of the digital economy is that there are advanced-complex computer systems and software programs that collect, process, transform and distribute information much faster than in traditional economies (Nordhaus 2002: 5). The table below shows some features of the digital economy (Table 13.1). Now it is seen that digitalization is more important in our daily lives, can be found and is accessible for everyone with devices such as computer, notepad or smartphone; it becomes an integral part of our daily life with social networks and becomes a vital necessity (Arraou 2016:53). Digital transformation is not only regarded to the use of

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Table 13.1 Characteristics of digital economy Knowledge economy

The most important strength of firms is knowledge not production factors

It is a digital economy

Digital economics which provides cheaper and reliable communication is essential

It forms the virtual world

With the formation of virtual markets, the inter-agency economic process has started to realize in virtual markets

Molecule-based economy

In the digital economy, the foundation of enterprises is the individual. The individual operates on its own, and the new component infrastructure will grow through the equipment that the individual has established

Network economy

Countries and businesses are building informatics infrastructure networks among themselves. Without the power of informatics, it is impossible to operate the digital economy

It will eliminate the intermediaries

Many institutions in the private and public sector will have direct contact with their consumers through networks, and intermediaries will be largely eliminated

The basis of the new economy is innovations The principle of the firms is to pass by themselves the fashion of the products they produce. If they do not do it themselves, another company will do it It is a global economy

The role of knowledge is to create a single world economy. The result of digital economy is globalization

New media sector

The key sector in the digital economy is the media sector that the most use to informatics technologies

Speed

Speed in terms of business success and economic activities is the key variabl

Source Tapscott 1996

technology, but also about achieving competitive advantage using technology (Main et al. 2018:19). The effects on all areas of daily life of digital transformation have been that so fast and effective with technological and infrastructure innovations, staying away from the online world means put a serious distance with success and improvement. As a result of this new understanding, e-transformation also makes it a part of the electronic world (www.soykanozcelik.wordpress.com, 25.11.2018). Nowadays, the accounting profession has entered into an important change and development process at the global level with the developments in information and communication technologies. With the development of information technologies, accounting practices started to be made in electronic environment in both public and private sectors. In this context, the informatics systems used by the Republic

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of Turkey Ministry of Finance and Treasury are accepted as an example for public financial management systems among the world countries (Tektüfekçi 2013: 83). It is seen that the developments in information and communication technologies affect the thinking and practice of accounting education in the world and in our country. At the present time, depending on the development of information technology, paper and pen are replaced by e-invoice, e-declaration and e-book and it is thought that educated staff will be needed in the subjects such as independent auditing, fraud, unfair competition, loss of tax base, information security in accounting profession. In this sense, the accounting personnel need to keep up with the digital transformation.

13.2 Literature Reviews Several studies conducted by some researchers on the contributions to accounting profession and accounting education of digital technologies are summarized below. ˙I¸sgüden Kılıç and Anadolu (2018) aimed to investigate the effect of accounting practices developed in the digital age on the prevention of accounting frauds that may arise in enterprises. For this purpose, they conducted a survey on accounting professionals and concluded that digital technologies would contribute to the prevention and detection of accounting fraud. Ci˘ger et al. (2018) investigated the effects on accounting applications and accounting education of big data, which is one of the components of Industry 4.0. In this study, it is stated that big data which enterprises benefit from in every field will make important contributions to accounting applications and universities that providing education undergraduate and graduate level in accounting field will meet the need of qualified labor force by integrating big data subjects into curriculum programs by cooperating with both professional organizations and related technology enterprises. Aslan and Özerhan (2017) conducted a survey on how big data will affect the accounting profession in the next 10 years. According to the results of the survey, they found that accounting profession members had different perspectives on the impact on the accounting profession of the big data according to the demographic variables. In a study conducted by Ta¸skıran (2017), he sought answers to the question of how higher education institutions and academicians could be given more effective training to student groups with different trends and expectations in the digital age. For this purpose, by examining related studies in worldwide is discussed how to adapt to the digital age in the field of higher education in Turkey and tried to give answers. In the study conducted by Koral Gümü¸so˘glu (2017), the effects on the digital transformation process of the main factors such as changing social demands, learner,

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instructive profile and institutional understanding with the widespread use of information technologies and what to pay attention to the struggle against difficulties faced during this change were discussed. Parlak (2017) aimed to analyze the outcomes and results of the practice, after evaluating the opportunities in education in the digital age in general, examining new and best practices related to digital learning environments and applications. In the study conducted by Pan and Seow (2016), it was emphasized that the widespread use of information technologies in enterprises in digital age changed the nature of accounting activities and this situation spread use of information technologies among accounting professionals. In the research, it aims to review selected articles published between 2004 and 2014 based on selected search phrases. The findings of the review may serve as an important input for current and future accounting curriculum revisions. Gaviria et al. (2015), in their study, aim to reflect on the use of information and communication technologies in accounting education as a strategy to improve the learning and teaching processes of the students of the Finance Department of the Medellin Institute of Technology. In this study, the virtual learning object and the teaching method are suggested to provide students with the ability to better teach, interpret and analyze accounting programs through a virtual mediator. Vendruscolo and Behar (2015) tried to determine what competencies are required for accounting teaching in the digital age by a survey study applied to the lecturers who give accounting courses in Brazilian universities. According to the results of the study, accounting instructors emphasized the need for continuing education in order to adapt to the ever-developing digital technology.

13.3 The Effects of Digital Transformation on Accounting Profession With the rapid change in ICT, mobilization has become a valuable tool in our age when knowledge is the most valuable asset. ICT can be described as a range of information, electronics and telematics technologies, using modern microelectronics, telecommunications and computing to improve all kinds of appliances, techniques and processes that influence different areas of human life (Gaviria et al. 2015: 994). Therefore, ICTs can be based on all kinds of information processing and informatics tools that process, store, summarize, improve and provide information to communicate, share and socialize. Bill Gates (1999) calls this the “Digital Nervous System.” In order to operate in the digital age, a new digital infrastructure is needed which is similar to the human nervous system. This infrastructure consists of digital processes that enable an enterprise to perceive the environment, show the necessary reactions, determine the customer needs and the dangers of the competitors and take the necessary decisions when needed. This system requires both hardware and software, and

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enables companies to work smoothly, to react quickly to emergencies and opportunities, and to transmit the necessary information to company employees in a timely manner (Türker 2017:213). As today’s modern business world is strongly linked to technological advances in many ways, the impact on business functions of technology is enormous (Özdo˘gan 2017: 210) and digitalization, artificial intelligence, the 4th Industrial Revolution and the e-practices will bring the accounting profession to a very different situation than it is today (Tekba¸s 2017). Progress in information technology has changed the accounting function in businesses and the role of accountants (Seethamraju 2010:1). Accounting records transactions and events that are expressed in monetary terms. Although these records have been physical records in the past, they are now almost completely digital. For example, toward the end of year 2000, while only one-quarter of all the world’s stored information was digital (Cukier and Mayer-Schoenberger 2013:28), today more than 98 percent of this information is digital (Warren et al. 2015:397). It is stated that the institutions have stored much more data in the last two years than the data collected in the previous 2000 years (Syed et al. 2013: 2448). These developments in the technological area also affect the accounting practices (Aslan and Özerhan 2017:868). Nowadays, computer competence has become an important part of the technical ability of an accountant. All companies use a computerized accounting system and various management accounting tools provided by information technologies. These systems use various computer functions to properly record financial information and to generate financial statements and reports. Therefore, accounting application software is widely used, and now employers expect accounting graduates to have expertise in accounting software (Hancock et al. 2009: 57). MYOB, QuickBooks, NetSuite, AccountEdge and Sage Peachtree are some of the most popular computerized accounting systems used by small and mediumsized enterprises (SMEs) all over the world. These software packages help SMEs manage inventory, customers, sellers, employees, payroll, debtor current accounts, payee cu Instutional integrated information systems such as SAP, Oracle, which provide support for accounting and other commercial functions, have been used by large enterprises in recent years.rrent accounts, costing, banks, fixed assets, financial statements and reports (Seethamraju 2010: 4). In addition, many companies use various advanced management accounting tools such as activity-based costing, balanced scorecard and strategic corporate governance. These tools are information and communication technologies and are placed in advanced ICT solutions. Data mining, data warehouse and Extensible Business Reporting Language (XBRL) are other technologies used. In addition, with the increasing importance of Big Data that one of the components of Industry 4.0, finance and accounting experts are expected to have technical and analytical skills. It is stated that businesses will have the tools to collect and store various big amounts of data and therefore accountants will be expected to estimate the company’s financial performance, to develop budgets, to have the skills to use non-financial data and to assist decision-making process (Morgan 2015).

13 The Effects of Digital Transformation Process … Table 13.2 Profession groups that are the most suitable to automation

225

Possibility

Profession

0,99

Tele marketer

0,99

Tax advisors

0,98

Insurance experts

0,98

Referee and other sport officer

0,98

Law reporter

0,97

Waitstaff

0,97

Estate agents

0,97

Farm laborer brokers

0,96

Secretary and executive assistants

0,94

Couriers

Source Frey and Osborne 2015

The process of digital transformation that emerged with technological developments shows that in the future approximately 40% of the work of accounting professional will disappear. The work of accounting professionals such as payrolling, bookkeeping and submitting declarations is predicted to be the most affected by the digital transformation process (www.ismmmo.org.tr, 26.05.2018). In the digitalization process, profession groups that are the most suitable to automation are shown in Table 13.2. In the second line of Table 13.2, it is seen that tax advisors which is a branch of the accounting profession is the second profession group that is most prone to automation. According to Sevim (2009: 36–41), it is seen that the use of digital accounting applications provides many benefits to enterprises. Approval of transactions, closing accounts and creating financial statements has gained speed, routine transactions have begun to be realized easily and quickly with fewer errors, and thus the efficiency of decreasing accounting works has increased. As collection of receivables and payment of debts can be realized in a planned manner, effectiveness and efficiency in the cash management can be ensured. As security measures were increased, efficiency was ensured in internal control and auditing. In America and European countries, attention has been drawn to the changes that the accounting profession will experience in the digital age for many years. According to Islam (2017), the accounting profession will face important changes in the next three decades, and professional organizations, their members and educational institutions should respond. It is stated that the developing smart and digital technology will affect the future of the accounting profession and that there are works of professional organizations and academicians on this subject but not enough.

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13.4 The Effects on Accounting Education of Digital Transformation It is clear that it is necessary to have knowledgeable and sufficient human resources in order to achieve success in this process where digital transformation is rapidly occurring. However, it is of great importance to realize many similar investments with the cooperation of the state and private sector in order to meet the needs across the country. After solving the quantitative problem, it is necessary to focus more on the subject of qualification and curriculum under Industry 4.0. Countries such as Germany, determining a state program on this subject, have been updating their curricula (www.kalder.org, 30.11.2018). Today, students who continue their university education are the last representatives of the Y Generation1 . Y Generation students are significantly different from previous generations with their enthusiasm for technology, their use of multimedia and online solutions. Most Y Generation students often use media tools to better understand the content of the courses (Seethamraju 2010: 9). Prensky (2001: 2) describes the Y Generation as digital natives and the X Generation as digital immigrants. Students identified as digital natives speak digital languages such as Internet, video games and computers as in native languages. The defenders of this idea argue that this generation not only has advanced skills in the use of digital technologies, but also because they are constantly exposed to these technologies, they act differently and develop different learning styles (Margaryan et al. 2011:430). Therefore, the education system should be restructured to meet the needs of this new generation that closely follows the technology (Koral Gümü¸so˘glu 2017:33). Universities are required to act strategically on physical facilities, technical infrastructure and professional development to attract the best students and offer them an effective learning environment. Higher education institutions which can achieve this take a significant competitive advantage (Dede 2005: 15–19). Digital technologies must play a supportive role to development in the learning process of students in accounting education. In some universities, these information technology tools and systems are used to assist teaching in accounting courses to teach their students to accounting concepts in the basic level. One of the important effects on accounting education of the digital transformation process is gradually increasing interest to the digital game-based learning approach in recent years. Digital game-based learning which brings together learning and entertainment is a teaching strategy structured through computer-based applications. Whether digital game-based learning is an effective tool for accounting teaching or it is a way to increase student motivation is discussed by accounting educators (Carenys and Moya 2016: 598). New technologies emerging in current accounting education are required to support learning development of students. Therefore, the use of digital technology tools used in the accounting in accounting education processes should be encouraged. The information technology components required to become an accounting 1 The

generation which was born in 1980–1999 and took place in as Y Generation in the human resources literature.

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professional in accordance with IES 2 (Initial Professional Development-Technical Competence) International Training Standard 2 which constitutes the content of the accounting profession education programs published by the International Federation of Accountants (IFAC) should include the following topics and qualifications (IFAC 2014: 7): • To be able to analyze the adequacy of general information technology controls and related application controls, • To be able to explain the contribution of information technology in data analysis and decision making, • To be able to use information technology to support decision making with business analytics. In accounting educations, the accounting professionals are expected to gain the knowledge and skills to obtain at least one or more of the roles of informatics systems manager, designer or controller. At the licensing point, IFAC states that it is in the expectation that the accounting professionals will have competence in at least one of the above-mentioned roles (Fidan and Suba¸sı, 2015: 92). Accounting professional organizations such as IFAC strongly attach importance to the integration of ICTrelated courses with accounting programs (Pan and Seow,2016:168). In the report named “What students need to succeed in a rapidly changing business world” which was published by PwC2 to accounting students are recommended the new skills that are likely to be needed as well as basic accounting skills. This new skill is indicated below (Pwc 2015: 11): 1. 2. 3. 4.

Ability to research and identify anomalies and risk factors in underlying data, Find out new sources of data and use insights to add new value to the business, An ability to understand relational and non-relational databases, The ability to use multivariate statistics from extraction, inference statistics, visualization tools, optimization methods, machine learning and estimated analysis tools, 5. Ability using new data analysis techniques and algorithms, to insulate and research specific transactions that might have led to changes to the data/accounting ledgers. In the modern world, technological developments, social change and innovative thinking are inevitable. Undoubtedly, the future of the accounting profession will be digital. Traditional methods (paper, checkbook, receipts, etc.) will eventually be eliminated, and everything will be done through digital-based accounting. In order for the accounting profession not to be defeated to technological changes, it is seen that it is necessary to restructure the accounting vocational education in this framework by determining the changes in the technological field in the future (Tekba¸s 2017). In the report, PwC (2015: 13) made a curricula suggestion to develop new technical skills demanded by companies. This curriculum recommendation is given in Table 13.3. 2 PwC: Price Waterhouse and Coopers & Lybrand which is a global company in the field of auditing

and management advisory service.

228 Table 13.3 New curriculum recommendation

B. Z. Berikol and M. Killi Four levels of focus Advanced (year 5/master’s in accounting)

Advanced computing/statistics applied in accounting courses

Application Applications in accounting (year 3, 4/accounting major) major courses Intermediate (year 3/expanded business core for accounting)

Computing/statistics

Foundation (year 1, 2/business core)

Computing/statistics

Source Pwc 2015:13

The study conducted by Coyne et al. (2016: 168) recommended topics such as cloud computing, data analytics, ER diagrams, file systems, hardware, information lifecycle, IT controls, NoSQL, open-source software, operation system, process diagrams, relational database model, SQL and virtualization for undergraduate and graduate courses. Besides, Gamage (2016:601) recommends an integrated approach to place data analytics topics into present courses such as business statistics, accounting information systems, financial accounting, managerial accounting, auditing and taxation. In this sense, training of instructors who will give these lessons is gaining importance. Students who take accounting education must be educated to know the data analytics for analyzing masses of big data, to be knowledgeable about data security and cyber security, to be prepared for developments in transition to digitalization. The profession of accounting is one of the professions that has to keep up with the change in the world which is in the process of rapidly digitalization. It is thought that it is important to ensure equipped with latest technology of students who are studying in the field of accounting.

13.5 Conclusion In recent years, associated with the digital transformation process, many enterprises have begun to use modern cost and management accounting tools through institutional integrated information systems. ICT competencies are one of the basic technical skills required by accounting graduates. In order to meet this requirement and help to students to be ready for working life, the accounting programs of universities are required to include ICT software tools in accounting courses. Studies show that integrated information technologies are used in accounting courses as limited. In order to prepare graduates to the future, it is important to embed in the accounting courses given in the related sections of the digital technologies used in the accounting applications.

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Consequently, there is a need to review the existing accounting curricula to ensure to transfer into practice new curricula to have a strong foundation in data analytics. In this context, there is a lot of works to be done for accounting educators to prepare students for digital future.

References Arraou P (2016) The certified accountant and digital economy, ordre des experts-comptables, Paris. http://ceccar.ro/ro/wp-content/uploads/2016/10/expert-comptable-economie-numerique_ ENG.pdf Aslan Ü, Özerhan Y (2017) Big data, muhasebe ve muhasebe mesle˘gi. Muhasebe Bilim Dünyası Dergisi. Aralık 19(4):862–883 Berikol BZ (2008) Yeni Ekonominin Finansal Krizler Üzerine Etkileri: Türkiye Kasım 2000-Subat ¸ 2001 Krizleri. Çukurova Üniversitesi ˙Iktisadi ve ˙Idari Bilimler Fakültesi Dergisi 12(2):1–15 Carenys J, Moya S (2016) Digital game-based learning in accounting and business education. Acc Educ 25(6):598–651. https://doi.org/10.1080/09639284.2016.1241951 Ci˘ger A, Kınay B, Angı GG (2018) Büyük Verinin Muhasebe Uygulamaları ve Muhasebe E˘gitimi Üzerindeki Etkileri. Muhasebe ve Denetime Bakı¸s Dergisi 53:215–234 Coyne J, Coyne E, Walker K (2016) A model to update accounting curricula for emerging technologies. Am Acc Assoc 13(1):161–169 Cukier K, Mayer-Schoenberger V (2013) The rise of big data. Foreign Aff 92(3):28–40 Dede C (2005) Planning for neomillennial learning styles: implications for investments in technology and faculty. In Oblinger DG, Oblinger JL (eds) Educating the net generation, 15.1–15.22. https://www.educause.edu/ir/library/pdf/pub7101o.pdf. Accessed 03 May 2018 Erdo˘gan S (2004) ˙Iktisat Politikası Uygulamaları Üzerindeki Etkileri Açısından Yeni Ekonomi. Kocaeli Üniversitesi Sosyal Bilimler Enstitüsü Dergisi 2(8):38–48 Fidan EM, Suba¸sı S¸ (2015) Türkiye’deki Muhasebe Ö˘gretim Elemanlarının Sayısal Ça˘gda Teknoloji Kullanımına ˙Ili¸skin Durum Tespiti. Çankırı Karatekin Üniversitesi Sosyal Bilimler Enstitüsü Dergisi 6(1):85–112 Frey CB, ve Osborne M (2015) Technology at work-the future of innovation and employment. OxfordMartin School and Citi. https://ir.citi.com/jowGilw%2FoLrkDA%2BldI1U%2FY UEpWP9ifowg%2F4HmeO9kYfZiN3SeZwWEvPez7gYEZXmxsFM7eq1gc0%3D Gates B (1999) Dü¸sünce Hızında Çalı¸smak, (Çeviren: Ali Cevat Akkoyunlu). Do˘gan Yayıncılık, ˙Istanbul Gaviria D, Arangob J, Valenciac A (2015) Reflections about the use of information and communication technologies in accounting education. Procedia—Soc Behav Sci 176:992–997 Hancock P, Howieson B, Kavanagh M, Kent J, Tempone I, Segal N (2009) Accounting for the future: more than number volume 1 final report, Australian learning and teaching council (ALTC) Report. https://eprints.usq.edu.au/6333/5/Hancock_HowiesonKavanagh_etal_v12009_ PV.pdf. Accessed on 15 May 2018 https://www.ismmmo.org.tr/Yayinlar/Yasam-Dergisi–2, 71 (Ocak-Subat). ¸ Accessed 26 May 2018 http://www.kalder.org/upload/files/PDF/Once_Kalite_Dergisi/2016/2016-Ocak-Subat-Mart.pdf. Accessed 30 Nov 2018 https://soykanozcelik.wordpress.com/2018/09/25/dijitallesen-dunyada-e-donusum-ve-e-coz umler/. Accessed 30 Nov 2018 IFAC (2014) Initial Professional Development – Technical Competence (Revised) Final Pronouncement, https://www.ifac.org/system/files/publications/files/IAESB-IES-2-%28Revised%29_0. pdf. Accessed on 01 Jun 2018 Islam MA (2017) Future of accounting profession: three major changes and implications for teaching and research. Tech Rep. https://doi.org/10.13140/RG.2.2.31024.66563

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Kılıç B˙I, Anadolu Z (2018) Dijital Ça˘gın Yarattı˘gı Muhasebe Uygulamalarının Muhasebe Hilelerinin Önlenmesine Etkisi. Muhasebe ve Vergi Uygulamaları Dergisi, Nisan Özel Sayı, pp 55–97 Gümü¸so˘glu EK (2017) Yüksekö˘gretimde dijital dönü¸süm. Açıkö˘gretim Uygulamaları ve Ara¸stırmaları Dergisi 3(4):30–42 Main A, Lamm B, McCormack D (2018) What boards need to know about digital transformation. The Corp Governance Advisor 26(1):18–22 Margaryan A, Littlejohn A, Vojt G (2011) Are digital natives a myth or reality? University students’ use of digital technologies. Comput Educ 56(2):429–440 Morgan A (2015) The impact of big data on accounting. https://www.linkedin.com/pulse/impactbig-data-accounting-anita-morgan-dba-cpa-cfe. Accessed 26 May 2018 Nordhaus (2002) Productivity growth and the new economy, Brookings Pap Econ Act 2:211–65 Özdo˘gan B (2017) The future of accounting profession in an era of startups. In Soner G (ed) Accounting and corporate reporting—today and tomorrow, pp 210–221. http://doi.org/10.5772/ intechopen.69264 Pan G, Seow P (2016) Preparing accounting graduates for digital revolution: a critical review of information technology competencies and skills development. J Educ Bus 91(3):166–175. https:// doi.org/10.1080/08832323.2016.1145622 Parlak B (2017) Dijital Ça˘gda E˘gitim: Olanaklar Ve Uygulamalar Üzerine Bir Analiz, Süleyman Demirel Üniversitesi ˙Iktisadi ve ˙Idari Bilimler Fakültesi Dergisi 22 (Kayfor15 Özel Sayısı), 1741–1759 Prensky M (2001) Digital natives, digital immigrants. On the Horizon 9(5):2–6. https://doi.org/10. 1108/10748120110424816 PwC (2015) Data driven What students need to succeed in a rapidly changing business world. February. pp. 1–25. https://www.pwc.com/us/en/faculty-resource/assets/PwC-Data-dri ven-paper-Feb2015.pdf. Accessed 20 May 2018 Quiggin J (2014) National accounting and the digital economy. Econ Anal Policy 44:136–142 Seethamraju R (2010) Information technologies in accounting education. Proceedings of the AIS SIG-ED IAIM 2010 conference. http://aisel.aisnet.org/siged2010/12/ Sevim A (2009) Dijital Muhasebe, Anadolu Üniversitesi Yayınları No: 1903, ˙I˙IBF Yayınları No: 208, Eski¸sehir Syed A, Gillela K, Venugopal C (2013) The future revolution on Big Data. Int J Adv Res Comput Commun Eng 2(6):2446–2451 Tapscott D (1996) The digital economy. Mc Graw Hill, New York Ta¸skıran A (2017) Dijital Ça˘gda Yüksekö˘gretim. Açıkö˘gretim Uygulamaları ve Ara¸stırmaları Dergisi 3(1):96–109 Tektüfekçi F (2013) Bilgi Teknolojilerinin Muhasebe Uygulamalarına Entegresyonu ve Bütünle¸sik Sistemlerle Olan Etkile¸sim. Organizasyon ve Yönetim Bilimleri Dergisi 5(2):79–90 Tekba¸s ˙I (2017) Dijital Ça˘gda Muhasebe Mesle˘ginin Yeniden Tasarımı: Mali Mühendislik. http:// www.muhasebetr.com/yazarlarimiz/ismailtekbas/027/. Accessed 15 May 2018 Türker M (2017) Dijitalle¸sme Sürecinde Küresel Muhasebe Mesle˘ginin Yeniden Sekillenmesine ¸ Bakı¸s. Muhasebe Bilim Dünyası Dergisi. Mart 20(1):202–235 Vendruscolo MI, Behar PA (2015) Accounting professor qualification in digital age: a perception study on brazilian professors, 12th international conference on cognition and exploratory learning in digital age (CELDA 2015) Maynooth, Greater Dublin, Ireland 24–26 Oct 2015, Proceeding Book, ISBN(Book): 978-989-8533-3-2, 28–34. https://files.eric.ed.gov/fulltext/ED562143.pdf Warren JD, Moffit KC, Byrnes P (2015) How big data will change accounting. Account Horiz 29(2):397–407

Bilal Zafer Berikol is an Assistant Professor (Asst. Prof.) at Business Administration Department, in the Faculty of Kozan in Çukurova University, Turkey. He received Bachelor’s Degree from Mersin University in Business Administration Department in 1998. Then, he completed

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Master’s Degree from Mersin University in Department of Tourism Business Administration and Hospitality in 2003. Afterwards, He graduated from Accounting Ph.D. in Çukurova University (2014). His areas of interest include Cost and Management Accounting, Auditing and Data Analytics. He has participated in many international and national conferences and has many publications on several topics. Mustafa Killi is Associate Professor in International Trade and Logistic Department at Osmaniye Korkut Ata University (OKÜ), in Turkey. He received Bachelo’s degree in Public Administration at Uluda˘g University, Master’s degree and Ph.D. in Business Administration from Kahramanmara¸s Sütçü ˙Imam University (KSÜ) , Turkey in 1994, 2005 and 2014 respectively. His areas of interest include Financial Accounting, Cost and Management Accounting, International Financial Reporting Standarts. He has participated in many national and international conferences and has many publications on various topics.

Part IV

Ethics and Sustainability in Auditing

Chapter 14

Evaluation and Rating of Corporate Governance and Internal Auditing in Turkish Public Companies Arzu Cevahir and Kıymet Tunca Çalıyurt

Abstract The aim of this study is to determine the perception levels of the public companies regarding the importance of the internal control system and to investigate the awareness of the internal control systems by evaluating the existing applications of the internal control units for the internal control system. The study consists of four chapters. In the theory part of the research, the concept of internal control, analysis tools, and components of internal control as a system is mentioned. Then the regulations concerning internal control in Turkey and in the world were discussed. Finally, in the research section, the evaluation of the awareness of internal control over 47 public enterprises and the conclusions reached within the scope of the subject were presented and recommendations were made. Keywords Control · Internal control · Awareness · Publicly traded company · Corporate governance

14.1 Introduction For reasons such as globalization, technological developments and the sheer number and complexity of the transactions related to the activities of businesses, business

This chapter is part of the master thesis written by Arzu Cevahir under supervision of Prof. Dr. Kıymet Tunca Çalıyurt. This study was produced from a master’s degree titled “Internal Control Awareness in Businesses: Practice in Public Companies” written by Arzu CEVAH˙IR in Trakya University Institute of Social Sciences, Department of Business Administration Accounting and Auditing. (Supervisor: Prof. Dr. Kıymet Çalıyurt). The survey and criterias were used in this thesis have been created by Prof. Dr. Kıymet Caliyurt and firstly used in the thesis have been written by ˙Ilyas Turgay. A. Cevahir · K. T. Çalıyurt (B) Trakya University, Edirne, Turkey e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_14

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management need reliable information about increasing efficiency in business activities, preventing cheating and mistakes, and protecting assets. At this point, the importance of the internal control system for businesses emerges. As a result of international accounting scandals such as the collapse of Enron and the WorldCom scandal, the Sarbanes Oxley Act was enacted in the USA in 2002 and Business Administrations were held responsible for establishing and ensuring the effectiveness of internal control systems. In addition, this law requires independent auditors to provide an opinion regarding management’s assessments and to perform this opinion by signing the internal control system report personally. All these developments have led to an increase in the importance of business management, independent auditors, and audit committees on the internal control system and to conduct more detailed investigations rather than providing superficial insight into the effectiveness of the system. At this point, internal control evaluation models such as COSO have an important place in evaluating and expressing opinions about the effectiveness of the internal control system of managers and auditors. The internal control system is generally established in order to provide reasonable assurance to the concerned persons in the proper accounting of the financial events related to the enterprise, in the preparation of reliable financial reports, in the protection of the operating assets against all kinds of damages, in the conduct of the business activities in accordance with the laws and regulations, and in providing accurate and reliable information to the management and it is a process performed by business management and personnel. An effective internal control is a key to achieving the above-mentioned objectives of operating the system. In order to talk about the effectiveness of internal control, five components of the internal control system such as control environment, control activities, risk assessment, information and communication, and monitoring and function must be fulfilled. In short, these components are the basic criteria for an effective internal control system. The aim of this study is to determine the perceptions of the internal control units of publicly traded companies operating in our country regarding the importance of the internal control system and to determine the existing practices of these units regarding internal control systems and thereby to evaluate the awareness of control systems. For these purposes, the work consists of four parts. In the first part of the study, the internal control system, some basic concepts related to the internal control system and the five components of the internal control system that are effective in internal control are mentioned. The second part, titled analysis tools and components of the internal control system, describes the elements that make up the internal control system and the components, also known as the COSO model. At the third section, we are informed about the national and international regulations in the establishment of the internal control system. In the fourth part of the study, the perception of public companies’ internal control systems and the state of their current practices in terms of the internal control system and the awareness of the internal control system and its products were investigated.

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14.2 Basic Structure of Internal Control System Definition of Internal Control The definition of the concept of internal control is made in the form of a system consisting of policies and procedures generated by the management in order to guarantee the management staff at the stage of achieving the objectives of the business. This system can also be considered as the tool used by the management in the business to provide control. Other issues in which the internal control system is seen as tools, which are included in the work flow, which are affected by the persons and which reach the objectives of the enterprises. The internal control system is also a mechanism that is involved in solving problems that are related to enterprises such as financial reporting, audit committee, budgeting, and external audit. In addition, national and international studies have also defined the internal control system.1 If we examine the concept of internal control from the perspective of our country, it is observed that the accepted definition has some differences with the international definition and that these differences cause the internal auditors in our country to face inadequacy and complexity during the implementation in terms of understanding the international internal control arrangements and models. In our country, the concept of control is generally perceived as checking whether a completed transaction is in compliance with the legislation or not. However, the concept of control in the international arena generally has a managerial meaning and is stated as a practice in which the methods at the stage of realization of the transaction are included, which have the possibility of spreading and continuity within the processes, and in which not only the relevant person but all the employees are responsible.2 According to the COSO model, it is possible to list the objectives of internal control as follows (COSO 2013): • Effectiveness and efficacy in activities, • Reliability of reporting, • Compliance with laws and regulations. However, it would be wrong to perceive the internal control system only as form, procedure, or manual, because internal control is also a system that embraces organization, staff, and management (Fig. 14.1). COSO uses a 3-D model to identify the components it argues. As can be seen from the figure, the front-facing section shows the internal control components. The upper part covers the effectiveness and efficiency of the activities, the criteria targeted in internal control, the reliability of financial reports, and the compliance with laws. The sections are on the right side of the figure. These parts differ according to the structures of the enterprises.3

1 Cook

and Winkle (1980). (2012). 3 Moeller (2009). 2 Özbek

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Fig. 14.1 COSO internal control elements (COSO Cube)

At the bottom of the cube is the control environment, which is the most basic building block of the components. The control environment plays an important role for employees to be aware of their control responsibilities and to carry out operations. Management determines the control activities to be put forward by performing risk assessment within the environment generated. After this process, information is collected to the monitoring stage via information and communication channels 4 . The process is monitored through the monitoring phase and changes are made if necessary. These components are designed to be applicable to all businesses. However, although there is a common denominator, there are differences between businesses at some points. The points that vary from business to business are as follows: • • • • •

The size of the enterprise in the sector, Organizational structure of the enterprise, Operating area of the enterprise, Complex and varied operations in the enterprise, Laws and obligations in the social structure of the enterprise.

The Scope of Internal Control and Internal Control as a System If a business or institution wishes to establish an internal control system, it must ensure that all its activities are inclusive, because the amount of internal controls, its 4 Moeller

(2009).

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qualifications, and style must vary depending on the risks involved. The framework of internal control has to cover all technical, operational, commercial, financial, and administrative activities of the institution. In addition, internal controls should not be limited to the controls related to accounting or financial reporting alone5 . On the other hand, the internal control system should include methods and procedures to increase the efficiency of the company, such as adherence to the policies set by the management, protecting the entity’s assets, preventing and detecting errors and corruption, ensuring the accuracy and reliability of its accounting records, and ensuring that financial reporting is accurate 6 . Basic Principles for an Effective Internal Control System What businesses need to do in order to establish and implement an effective control system is to take the principles that make up the internal control system into account. These conditions are summarized as follows7 ; • Internal control must be a whole and sustainable. • The internal control system should be concerned not only with the financial and accounting departments but also with all departments or units. • Internal control should be organized in order to achieve a basic goal and allow the expert to use both his/her imagination and his/her own ability and criticism.

14.3 Internal Control Procedures Internal control procedures are the procedures, policies, and methods that management adds to the environment of the business in order to achieve the goals of the business. These procedures have different purposes and can generally be classified as the procedures and methods related to the following topics8 . • Execution of transactions within the framework of appropriate powers, • The division of labor in order to reduce the prevention and concealment of errors and corruption, • Designing and use of necessary documents to ensure proper recording of transactions, • Limiting authority to use assets for adequate protection of assets and records, • Comparison of liability records with existing assets. The control procedures clearly stated above are generally classified as follows9 : • General controls, 5 Akyel

(2010). (2011). 7 Güven (2006). 8 Duman (2008). 9 Bozkurt (2012). 6 Adilo˘ glu

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• Application controls, • Controls on assets, • Data security.

14.3.1 Analysis Tools and Components of Internal Control System Evaluation of Internal Control System The EU has mentioned three different audit models related to the internal control model.10 The first model is the Portuguese southern internal audit model. Portugal has an organization called the General Inspectorate of Finance. This organization is directly affiliated to the Ministry of Finance. The second type model is the Internal Audit Unit under the Ministry of Finance, based in the England. The task of the unit is not responsible for all public revenues and expenditures, as it is thought. The latest model is the classic northern model, which is under the responsibility of ministries in the Netherlands and reports annually to Parliament. However, after the Watergates scandal in the USA, the law (Foreing Corrupt Practices Act) caused by the investigations in the 1970s caused regulations to apply the transactions within the framework of the laws to make the transactions most accurate.11 In the next process, an audit approach should be implemented to ensure that the responsibilities in the internal control system are properly fulfilled according to the recommendation of the AICPA Report entitled “Report of the Special Committee on Internal Accounting Control.”12 Conformity Tests Compliance audit aims to audit whether the businesses are performing their duties correctly and inform senior management staff about this issue. This audit is carried out not only within the institution but also by the CMB, state, and professional chambers. In this context, the audits within the enterprise are carried out within the framework of the rules, policies, and agreements made by the management staff.13 Materiality Tests The tests applied to determine monetary errors and misstatements in financial statements are called materiality tests. The financial statements of the business and transactions based on the activities of the enterprises are in the form of monetary amounts. Therefore, fraud and mistakes made through these transactions are reflected in the financial statements. The materiality test is also performed to find and expose errors 10 Köro˘ glu

and Uçma (2006). (2006). 12 Yılancı, s. 116. 13 Uluta¸s (2007). 11 Yılancı

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and cheats that exceed the internal controls of the entity and to determine whether the information contained in the financial statements is incorrect. However, the materiality test is not conducted directly on the financial statements, but on the basis of evidence for the transactions that constitute the basis of the financial statements.14 The Problems Arising from the Deficiencies and Weaknesses in the Internal Control System The deficiencies and weaknesses in the internal control system are to be defined as the lack of adequate control procedures in operation. This situation also increases the likelihood of corruption and error in the financial statements. The existence of control weaknesses in the system depends primarily on the determination of existing control procedures. The next step should be to determine what possible significant corruption and errors may be due to the lack of control procedures, because a weakness is in proportion to the magnitude of the possible errors and corruption that may arise from it.15 With all these, it is mentioned that the controls required in the enterprise are not available or that the controls are missing when the controls are not planned so that they can achieve the intended objectives. Documentation of Information Obtained During the Evaluation of Internal Control System The auditor documents all the information obtained about the internal control system through various documents, in which document to be used varies according to the volume and structure of the business. Therefore, auditors use three methods to define the internal control system. Methods are as follows:16 • Note-taking Method • Flowchart method • Survey method

14.3.2 Regulations on Internal Control National Regulations on Internal Control Turkey makes many regulations related to the public sector and private sector. These regulations actually show how much internal control is needed. The regulations made in our country regarding the internal control system are as follows: • • • •

Regulations made By Law No. 5018 Regulations made by Turkish Commercial Code (TTK) Regulations made by Capital Markets Board (CMB) Regulations made by the Banking Regulation and Supervision Board (BRSA)

14 Erdo˘ gan

(2005). (2004). 16 Köro˘ glu and Uçma (2006). 15 Kepekçi

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International Regulations on Internal Control The internal control system of enterprises is effective in ensuring that the activities of the enterprise comply with the laws and regulations. In this case, the development of internal control systems in more than one country can also find application areas in public and private institutions. It is understood from international studies that more importance is attached to the internal control system. The regulations regarding the internal control system in the international arena are as follows: • The arrangements made by COSO • The regulations made by the International Organization of High Supervisory Bodies (INTOSAI) • American Institute of Certified Public Accountants (AICPA) • The arrangements made by International Federation of Accountants (IFAC) • The arrangements made by Basel II The Factors to Be Considered in Establishing Internal Control System There are some factors that need to be considered before the internal control system is set up. Through these factors, the concept of internal control will function much better. • Responsibility of management • Risk • Cost of the system

14.3.3 Internal Control Awareness in Businesses: Practice in Publicly Traded Companies The Purpose and the Hypothesis of the Research The research section of the thesis aims to evaluate whether internal audit activities are carried out appropriately in publicly traded companies in Turkey and awareness of the implementation of internal control activities and procedures. The fact that publicly traded companies subject to the Capital Markets Board has an obligation to comply with the corporate governance principles published by the Board, to inform the public and to be transparent is an important factor in determining the sample. Since it is thought that the companies that meet this requirement will have more participation in the works done, publicly traded companies have been identified as the target group. Within the framework of the research, descriptive information and practical information about the companies, internal audit managers, internal audit activities, and the activities shaping the internal audit activities were asked in the form of survey questions and the answers obtained were evaluated in order to prove the accuracy and validity of the hypothesis.

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H01: In accordance with the Corporate Governance Principles of the Turkish Commercial Code, publicly traded companies have an awareness of the implementation of internal audit and internal control activities. Importance of Research The studies on publicly traded companies are becoming increasingly important all over the world. Publicly traded companies are the largest in the country. The lack of corporate governance practices of publicly traded companies is a common problem. The problems with corporate governance in publicly traded companies are expected to be resolved. The importance of the thesis is that internal audit that is proposed in the new Turkish Commercial Code for all companies, especially for publicly traded companies as a function of improving institutionalism. Determination of Sample The research universe was designated as publicly traded companies traded on the exchange. Therefore, the universe of the research was determined as 514 pieces. During the selection of samples in the study, first a message was sent to the internal auditors and then a survey was directed to the companies whose internal auditors could be reached. In this way, healthy survey results were obtained from 47 companies. This ratio indicates that 9% of the publicly traded companies could be reached. Findings and Analysis In this part of the study, the answers to the questionnaire were evaluated on a questionbased basis. To present the summary table, the next heading was prepared. General Evaluation of Compliance of Internal Audit Activities within the Framework of Mandatory and Recommended Basic Criteria. Since the overall averages of the answers to the survey reflect only the question based valuation results, it does not allow us to fully determine the overall situation. For this reason, the answers given by the companies were examined one by one with the 17 criteria that form the basis of the survey and the general situation of the companies was tried to be determined. The basic criteria for compliance with internal audit activities as mandatory and recommended are shown in Table 14.1. Evaluating and rating of corporate governance and internal control of public companies modal was created by Prof. Dr. Kiymet Caliyurt for the master thesis of ˙Ilyas Turgay. The main criteria applied for measuring whether the activities related to internal audit are appropriate are divided into two groups: the first degree criteria (9 pieces), which require compliance with legislation, communiqué, and regulation, and second degree criteria (8 pieces), which require compliance with IIA recommendations. The three most non-conforming criteria of the companies participating in the study and the three most non-conforming criteria of the companies requiring first degree compliance are indicated in Table 14.2. When the first degree compulsory criterion is evaluated separately from the second degree criteria, it can be said that 45 companies (95.7%) do not comply with the

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Table 14.1 Mandatory and recommended basic criteria related to internal audit activities The criteria requiring first degree compliance The companies should employ internal (such as law, regulation, degree and legislation) auditors and/or establish an internal audit department An audit committee should be formed within the structure of the Board of Directors The audit committees of companies must be composed of independent and non-executive members Early diagnosis of risk committees, the members of which are independent persons, should be formed The company’s internal control procedures must be written. Internal auditors must carry out at least 2 or more audits per year The internal auditor/internal audit department should conduct a compliance audit against the board of directors Internal risk analysis should be carried out Internal control procedures and/or procedure changes should be communicated to the company employees in writing The criteria requiring second degree compliance An Internal Audit Committee must be (compliance with IIA recommendations) established within or outside the Board of Director At least one of the company’s internal auditors must have a CIA certificate At least one of the company’s internal auditors is required to be a member of IIA and to monitor their activities The internal audit department/internal auditor must be functionally subordinate to the Audit Committee and/or the Board of Directors The internal audit department/internal auditor must be administratively subordinate to the senior management of the institution The companies with subsidiaries/affiliates are required to include the internal audit reports prepared by their subsidiaries and/or affiliates in the company decision-making mechanism The regulations and powers of internal audit must be approved by the Board of Directors and/or the Audit Committee (continued)

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Table 14.1 (continued) The internal audits are required to be evaluated by an independent external auditor at least every 5 years Source Model of evaluation and rating of corporate governance and internal control of public companies by Kıymet Tunca Çalıyurt Table 14.2 Basic criteria where the level of compliance is low

The criteria requiring first degree compliance (such as law, regulation, decree, and legislation)

The criteria requiring second degree compliance (compliance with IIA recommendations)

The criteria with highest levels of non-conformity

The number of companies that fail to comply

Percentage (%) share in total of companies that fail to comply

Formation of audit committees of companies from independent and non-executive members

45

95.7

Conducting at least 2 or more audits per year by the internal auditors

22

46.8

Carrying out conformity audit against the Board of Directors by the internal auditor/internal audit department

20

42.6

At least one of the 26 company’s internal auditors having a CIA document

55.3

At least one of the company’s internal auditors being a member of IIA and follows its activities

18

38.3

Evaluation of internal audits by an independent external auditor at least every 5 years

18

38.3

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criteria of “The audit committees of companies, composed of independent and nonexecutive members” which is very low in compliance. Following this criterion, it can be stated that 22 companies (46.8%) and 20 companies (42.6%) did not comply with the criteria of “internal auditors, conducting at least two or more audits per year” and “conducting conformity audits against the board of directors by internal auditor/internal audit department.” Although the vast majority of companies have internal audit committees, it can be said that this committee is composed of independent and non-executive members, which is almost unprecedented. It is thought that it will be important for transparency to remove the internal audit processes from a self-supervising understanding and to be carried out by impartial and non-executive members. It is necessary to perform internal audit at least twice a year in accordance with the Turkish Commercial Code and almost half of the companies have experienced internal audit processes fewer than this. In addition, in Article 375 of the New Commercial Code, the realization of “supervision of the persons in charge of management, especially in accordance with the laws, articles of association, internal guidelines and written instructions of the board of Directors” is transferred to the Internal Audit Units. But in our study, it is determined that almost half of companies have not such a practice. When the criteria that require adaptation of the second degree compliance are examined, it is observed that the most striking negativity is 55.3% (with 26 companies), the criteria that “at least one of the company’s internal auditors has a CIA document” is 38.3% (with 18 companies), the criteria that “at least one of the company’s internal auditors is the member of the IIA and follows its activities,” is 38.3%, and the criteria that “evaluation of internal audits by an independent external auditor at least every 5 years.” In order for the internal audit processes carried out in companies to be appropriate and efficient for their purpose, it is necessary to have individuals who can be proven to have mastered these audit processes. In Turkey and around the world, there are institutions such as the International Institute of Internal Audit and the Turkish Institute of Internal Audit that aim to make internal audit a profession and try to establish the standards of this profession. Among the activities of these institutions, the internal auditor organizes meetings, trainings, and conferences on various issues in order to realize the professional maturity of the individuals and to contribute to keeping their knowledge levels fresh. These institutions also issue certificates as a result of training in order to make individuals competent in internal audit and prepare Certified Internal Auditor (CIA) certificate as a result of examinations. In our study, it was determined that the internal audit mechanics of the companies involved in the internal audit mechanism did not have internal auditors having the documents given by the authorized institutions, and employing certified auditors, which is of recommendation, was not fulfilled. The compliance of the companies participating in the study with the compliance criteria is shown in Table 14.3. According to the analysis, none of the companies participating in the research met the criteria of the first degree compliance. In contrast, it was determined that 55.3% of the companies included in the study (26 companies) did not meet 1 or 2 criteria out of 9 criteria requiring mandatory compliance, 36.2% (17 companies) did

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Table 14.3 Levels of compliance with eligibility criteria The number of criteria not met

The number of companies

Percentage (%) share of companies In total

The citeria requiring Those which do not meet 26 first degree compliance 1 or 2 criteria

55.3

Those which do not meet 17 3 or 4 criteria

36.2

The citeria requiring second degree compliance

Those which do not meet 5 criteria or over 5 criteria

4

8.5

Those which completely meet the Criteria

7

14.9

Those which do not meet 19 1 or 2 criteria

40.4

Those which do not meet 14 3 or 4 criteria

29.8

Those which do not meet 5 criteria or over 5 criteria

14.9

7

not meet 3 or 4 criteria, and 8.5% of the companies (17 companies) did not meet 3 or 4 criteria. It was determined that there were seven companies (14.9%) that met all of the second degree recommended criteria. Furthermore, the number of companies that did not meet 1 or 2 of the second degree compliance criteria was determined to be 19 (40.4%), the number of companies that did not meet 3 or 4 of the criteria was 14 (29.8%), and the number of companies that did not meet 5 or more criteria was 7 (14.9%). In this case, it may be stated that the publicly traded companies participating in the research have failed to fully comply with the mandatory and recommended compliance criteria. However, it was concluded that more than half of the companies (nine companies) comply with the first degree mandatory compliance criteria, and more than half of the companies (85.1%) comply with the second degree recommended compliance criteria (eight companies) (Table 14.4). In Tur˘gay’s master thesis (2013) entitled “Internal Audit in Corporate Family Companies.” it was determined that 3 of 67 companies (4.48%) exactly comply with the first degree compliance criteria; however, in our study, it was also determined that there was no company that fully complied with the first degree compliance criteria. In the study of Tur˘gay (2013), the number of the companies that fully comply with the first degree compliance criteria is quite low, and in our study the lack of a fully compliant company indicates that the obtained results are in agreement with the study in question. In our study, the ratio of those which complied with 1 or 2 of the first degree compliance criteria was determined to be 55.3% and the ratio of those which complied with 3 or 4 criteria was determined to be 36.2%. In the study of Tur˘gay

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Table 14.4 Compliance levels of companies with eligibility criteria in Tur˘gay’s study (2013) The number of criteria not met First degree mandatory compliance criteria

Those who exactly meet the criteria

Percentage (%) share of companies in total

3

4.48

Those which do not meet 34 1 or 2 criteria

50.74

Those which do not meet 27 3 or 4 criteria

40.29

Those which do not meet 5 criteria or over 5 criteria Second degree recommended criteria

The number of companies

3

4.49

Those which do not meet 18 1 or 2 criteria

26.86

Those which do not meet 38 3 or 4 criteria

56.70

Those which do not meet 11 5 criteria or over 5 criteria

16.44

(2013), this distribution is 50.74 and 40.29%, respectively. According to this, since the harmony rates in the two similar studies are close to each other, the results are thought to be consistent with each other. In this study, while the proportion of those which did not meet 5 or above criteria was determined as 8.5%, in Tur˘gay’s study (2013) it was determined as 4.49%. This ratio is in line with Tur˘gay’s study (2013) in terms of compliance with the first degree criteria. While the Tur˘gay’s study (2013) did not include a company that complied with all of the second degree compliance criteria, it was determined that 14.9% of the companies included in the study were fully compatible. Accordingly, in this study on publicly traded companies, it was determined that the second degree eligibility criteria were higher than the companies specified in the study of Tur˘gay (2013). In the study of Tur˘gay (2013), the ratio of the number of companies that did not meet 3 or 4 of the second degree compliance criteria was determined to be 56.70%, and in this study this ratio was determined as 29.8%. Accordingly, the rate of compliance of corporate family companies with the second degree criteria was found to be lower than that of publicly traded companies, and considering that the study was conducted in 2013, it may be thought that this is due to a temporal transformation or it may be stated that it is also due to the chronic structure of corporate family companies.

14.4 Discussion With the increase of targets in businesses, their activities have become increasingly complex. The companies developing in global competition give priority to control, audit, and risk management. Companies manage the risks for their future growth in

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the most effective and efficient way, and the adequacy of internal controls and the ability to be audited are the priority of the enterprises. In large-scale enterprises, management should ensure the effective functioning of the internal control system by establishing an internal control system and by establishing a reliable internal audit unit. Disruptions in the control function weaken the operation of decisions. This results in a negative outcome for the business, but it also causes the confidence of decision-makers in the market about the business to be shaken. In order to avoid negative issues, establishing an effective internal control system, improving the internal audit function, and being subject to independent audit are the right decisions for the business. The establishment of an effective internal control system in enterprises is positive but it does not bring any definite results. The lack of internal control system, such as unreliable information, illegal transactions, and asset losses and the lack of effective use of resources, as well as the cost of having excessive control can cause significant negative consequences to the enterprise. The internal control system must be continuously monitored and evaluated through the Internal Audit Unit or by independent auditors at regular intervals. The effectiveness and efficiency of activities affected by internal control system, board of directors, managers, internal auditors and employees, compliance with relevant legal legislation and reliability of financial reporting and achieving the main corporate objectives, management is a system generated to provide reasonable assurance to internal and external stakeholders. The awareness of transparency and accountability that started with institutionalization, the need for reliable financial information, and the increasing importance of performance management necessitate the establishment of an internal control system. As can be understood from the information provided so far, it is concluded that the effectiveness of the internal control system in companies is determined by the perspectives of the managers. In this study, how the internal control system is perceived by the internal control unit managers, who play the greatest role in establishing, implementing, and developing the internal control system, the situation of the current practices for the internal control system, as well as the perception levels of managers and the status of current practices, the number of employees in the internal control unit, and finally, the awareness of publicly traded companies about internal control have been studied. Within the scope of the survey, the hypothesis that “in accordance with the Corporate Governance Principles of the Turkish Commercial Code, publicly traded companies have an awareness of the implementation of internal audit and internal control activities” has been studied. The suitability of internal audit in publicly traded companies was evaluated over averages of 74 questions asked. The results were examined by making comparisons on individual or related responses. When the answers to the questions are evaluated separately for each question, it is concluded that more than half of the companies generally comply with the criteria asked. The important problems and solution suggestions identified in the general evaluations made on the overall averages of the questions are listed below.

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• It was concluded that only 61.7% of the companies participating in the study had a member auditor of the Turkish Internal Audit Institute, a professional organization. Again, 44.7% of the companies involved in the survey have internal auditors who have obtained CIA certificates in the internal audit department. Membership in IIA, which is a professional organization, and having the International Internal Audit Certificate were found to be insufficient. Companies should increase their studies to ensure the development of the internal audit profession and to achieve the desired standards. In addition, the majority of the companies participating in the survey do not pay attention to the existence of internal auditor certification in the employment of internal auditor. In addition, there is no regular participation in IIA’s training activities aimed at achieving professional development. The purpose of the IIA and its Turkey representative IIA is to provide professional guidance for auditors, to establish auditing standards and to revise the standards in accordance with the situation. In addition, through the trainings, internal auditors are provided to follow up-to-date practices. In particular, the members of the internal audit profession should be specifically members of this professional organization and should be able to follow up-to-date practices and the support of the company’s management should be obtained in this regard. • The changes and revisions to internal control environment and procedures are communicated to employees in a significant number of companies (84.8%) via written notification and written announcements via e-mail. Written notices to employees are the best method of notification. When compliance with the criteria is evaluated, it is observed that 11.4% of companies do not behave appropriately. Thanks to the use of e-mail in internal announcements and notifications, the employee can be reached and managed at any time. Since these notifications and announcements are official documents, they prevent future problems. • By asking the question “Is the computer-aided internal audit technique applied in your company?”, it was attempted to determine whether computer-aided auditing techniques were used in companies and the importance attached to computer-aided auditing by the company and its internal auditors. However, the answers of the surveyed company indicate the fact that computer-aided internal audit activities are not yet available at the desired levels in internal audit studies. Only 31.1% of the companies surveyed benefit from computer-aided auditing techniques in their internal audit activities. Today, where almost all the business activities are carried out from the computer environment, this rate is not sufficient. • 91.1% of the companies involved in the survey have written internal control procedures. Internal control procedures are revised by the audit committee or the Board of Directors when necessary. While stressing the need for a systematic approach to revising internal control procedures, it is observed that 51% of the surveyed companies do not have such an approach and avoid risk-oriented approaches. Companies generally revise their internal control procedures by taking action after risk arises or when a risky situation occurs. Business internal audit units should abandon this approach and adopt an approach to identify and prevent the risks continuously and in advance. The control environment should be revised periodically in accordance with regularly assessed risks.

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• When examining the distribution of transmission information to the Audit Committee or Board of Directors of the internal control system of enterprises, it is concluded that 81.4% of the companies participating in the survey convey information about the internal control system directly to the audit committee or Board of Directors, while 83.7% report 4 times a year or more. To attain the intended results of internal control of an entity, the facts that the resources used by the enterprise to be in harmony with the desired objectives, its being protected against waste, mismanagement and fraud, acquisition of secure information, protection, to be able to reported have been mentioned in the literature section. The results of the research show that the majority of the companies involved in the research are reporting to the management and to our question that at what intervals does the internal audit department report to the management was answered by 83.7% of the companies that reporting is done 4 times or more per year. Submitting the audit reports to the highest management level of the company is one of the important factors that increase the reliability of audit reports. It is general advice to forward the reports to executive independent management levels. Therefore, an analysis has been concluded that we can evaluate for the companies as positive and important. • It is concluded that about 50% of the companies involved in the study did not act appropriately according to the criteria that “IIA should conduct external observer assessments at least every 5 years.” When the results of the analysis methods used in the study are evaluated in general, the concluded fact is that most of the companies lack of compliance with the implementation of internal audit and internal control activities. In the light of these findings, it is determined that our country’s publicly traded companies have not yet been able to raise awareness in this regard. Therefore, the hypothesis that “according to the Corporate Governance Principles of the Turkish Commercial Code, publicly traded companies have an awareness of the implementation of internal audit and internal control activities” is rejected.

References Adilo˘glu B (2011) ˙Iç Denetim Süreci ve Kontrol Prosedürler. Türkmen Kitabevi, Istanbul Akyel R (2010) “Türkiye’de ˙Iç Kontrol Kavramı, Unsurları ve Etkinli˘ginin De˘gerlendirilmesi”, CBÜ ˙I˙IBF Dergisi, Cilt:17, Sayı:1, Manisa Bozkurt N (2012) “Muhasebe Denetimi”. (6. Baskı), Alfa Yayınları, ˙Istanbul Çalıyurt, KÇ, Tur˘gay ˙I Halka Açık Aile Sirketlerinde ¸ Kurumsal Yönetim ve ˙Iç Denetim Uygulamalarinin De˘gerlendirilmesi ve Derecelendirmesi, (Evaluating and rating corporate governance and internal auditing practice in publicly held family companies) Trakya Üniversitesi ˙Iktisadi ve ˙Idari Bilimler Fakültesi Dergisi, 6(2):121–135. https://dergipark.org.tr/tr/download/article-file/ 400885 Cook W and ve Winkle M (1980) Auditing: philosophy and technique, 2nd edn. Hougton Mifflin Company, Boston, Aktaran: Aksoy;”Basel II ve ˙Iç Kontrol” COSO (2013) COSO Internal control—integrated framework https://www.coso.Org/Documents/ 990025P-Executive-Summary-final-may20.pdf, Eri¸sim Tarihi: 07.05.2019

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Duman Ö (2008) “Serbest Muhasebecilik, Serbest Muhasebeci Mali Mü¸savirlik ve Yeminli Mali Mü¸savirlik Sınavları ˙Için Muhasebe Denetimi ve Raporlama”, (2. Baskı), Tesmer Yayın, No:78 Ankara Erdo˘gan M (2005) Denetim. Maliye ve Hukuk Yayınları, Ankara Güven FM (2006) ˙I¸sletmelerde ˙Iç Kontrol Yapısının Yeri ve Önemi. Yüksek Lisans Tezi, Marmara Üniversitesi, Sosyal Bilimler Enstitüsü, ˙Istanbul Kepekçi C (2004) Ba˘gımsız Denetim. Avcıol Basım Kitabevi, ˙Istanbul Köro˘glu Ç, Uçma T (2006) ˙I¸sletmelerdeki ˙Iç Kontrol Sisteminin Etkinli˘gi ve Dı¸s Denetimdeki Önemi, Mevzuat Dergisi, Sayı: 103 Moeller R (2009) Brink’s Modern Internal Auditing, 7th edn. Willey, Amerika Özbek Ç (2012) “˙Iç Denetim-Kurumsal Yönetim-Risk Yönetimi- ˙Iç Kontrol”, Cilt: 1. Türkiye ˙Iç Denetin Enstitüsü Yayınları, ˙Istanbul ˙Iç Denetim. Yüksek Lisans Tezi, Sosyal Bilimler Tur˘gay ˙I (2013) Kurumsal Aile Sirketlerinde ¸ Enstitüsü, Muhasebe ve Denetim Tezli Yüksek Lisans Programı, Trakya Üniversitesi, Edirne, Türkiye Uluta¸s V (2007) Muhasebe Denetiminde ˙Iç Kontrol sistemi ve ˙Iç Denetimin Önemi. Yüksek Lisans Tezi, Kocaeli Üniversitesi, Kocaeli Yılancı FM (2006) ˙Iç Denetim Türkiye’nin 500 Büyük Sanayi ˙I¸sletmesi Üzerine Bir Ara¸stırma, Nobel Yayınları, 2. Baskı, Eylül, Ankara

Arzu Cevahir Istanbul, Turkey has been working as Accounting Supervisor in the private sector. She graduated from Sakarya University, Faculty of Business Administration, Department of Business Administration in 2016. She received his master’s degree in Trakya University Institute of Social Sciences Accounting and Auditing Department in 2019. Her areas of interest are Management Accounting, Internal Control and Audit. Kıymet Tunca Çalıyurt, CPA, CFE, graduated from the Faculty of Business Administration at Marmara University, Istanbul, Turkey. Her Masters and Ph.D degrees are in Accounting and Finance Programme from the Social Graduate School, Marmara University. She has worked as auditor in Horwath Auditing Company, manager in McDonalds and finance staff in Singapore Airlines. After vast experience in private sector, he has started to work in academia. She is holding CFE and CPE titles. Her research interests are in accounting, auditing, fraud, social responsibility, corporate governance, finance and business ethics, with a special interest in aviation management, NGOs, women rights in business. She has been as visiting researcher in Massachussetts University Amherst Business School. She is the founder of the International Group on Governance, Fraud, Ethics and Social Responsibility (IGonGFE&SR) which was founded in 2009. In 2009, she also founded the International Women and Business Group, which organizes a global, annual conferences. Kiymet has published papers, book chapters and books both nationally and internationally on fraud, social responsibility, ethics in accounting/finance/aviation disciplines in Springer and Routledge. She is book series editor in Springer with the title Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, and book series editor in Routledge with the title Women and Sustainable Business. Some book titles: Emerging Fraud (with Sam Idowu), Corporate Governance: An International Perspective (with Sam Idowu), Women and Sustainability in Business: A Global Perspective, Sustainability and Management: An International Perspective (with Ulku Yuksel), Globalization and Social Responsibility (with David Crowther), Regulations and Applications of Ethics in Business Practice (with Dr Jiang Bian), Ethics and Sustainability in Accounting and Finance, Volume I. She is acting as member in editorial board Journal of Financial Crime, Social Reponsibility Journal, International Journal on Law and Management, Journal of Money Laundering Control. She is regular speaker at International Economic Crime Symposium in Jesus College, Cambridge University. She is member in editorial board Social Responsibility Journal, Journal of Financial Crime, International Journal of Law and Management. She is partner of Herme Consulting in Trakya University Technopark.

Chapter 15

New Paradigm in Auditing: Continuous Auditing Hülya Boyda¸s Hazar

This study is related to the Ph.D. thesis titled “Sürekli Denetimde Dijital Analiz Tekni˘ginin Kullanılması ve bir Uygulama” (The Use of Digital Analysis Techniques in Continuous Auditing and an Application) which was submitted to Marmara University, Institute of Social Sciences, Istanbul, Turkey, in 2013.

Abstract Organizations are losing substantial amounts of money and facing immeasurable ethical repercussions because of fraud. Regulatory requirements in auditing are increasing with the rate of fraud to boost the investor confidence. The volume and variety of data being created in the organizations are forcing auditors to find more effective and efficient methods as they face the challenges. Once a year audits where sampling is used on audit evidences are not sufficient in the modern business environment. The concept of continuous auditing is the answer to this paradigm. Continuous auditing is considered to be any audit method where the audit is performed on continuous basis. The fundamental idea is that the audit of a transaction is done as it is happening or in a very short time, and a report is issued after the audit. As a result, the anomalies are detected and the audit report is written in real time. The frequent analyses of data enable auditors to perform control and risk assessments in real time or near real time. Continuous control assessment refers to the audits performed on the controls. Continuous risk assessment refers to the identification of systems and processes with risk above the acceptable risk level. In continuous auditing, all the audit activity is done in the electronic environment where only the digital analysis tools and techniques are used. Audit tests are performed on the audit data and the audit report is created by the computer system. The auditor himself develops or uses audit package software to perform audit procedures. As a result, all the records are analyzed easily and quickly on big data in a relatively short time. Initial set up of the continuous audit software requires time and relatively a high level of expertise. However, the same modules may be used repeatedly lowering the cost of continuous auditing in the long run. Moreover, continuous auditing allows remote access to H. B. Hazar (B) Department of Business Administration, Istanbul Aydin University, Istanbul, Turkey e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_15

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company data which enables auditors to perform the audit activity without going to the site of audit. This lowers the audit cost and increases the time efficiency. Continuous audit applications require substantial set-up efforts. Most of the work is done in the system design and pre-implementation stages. Once the audit model is created, it can be used by iterating the modules. The fundamental stages of continuous auditing are development of the audit model, automation of audit methods, data analysis and reporting. The concept of continuous auditing is very new and implementation methods are in the research stage. This audit method is not yet widely used and presents significant difficulties in implementation. With the continuation of research in this field and the development of information systems, the problems experienced in the implementation of continuous auditing practices will be eliminated and its use will increase. Keywors Continuous auditing · Continuous monitoring · Control assessment · Risk assessment · Audit · Real time audit · Digital audit · Computer audit · Digital tests · Digital analysis

15.1 Introduction Organizations are facing increasing regulatory requirements in auditing as well as increasing rate of fraud. As a result, auditors are trying to find new methods where they are more effective and efficient. Classical auditing methods and once a year audits are no match to the challenges of the modern business environment. Thorough and frequent audits are needed. The answer to this paradigm is the concept of continuous auditing. Continuous auditing is considered to be any audit method where the audit is performed on continuous basis (Warren and Smith 2006). There have been numerous definitions of continuous auditing. However, the most commonly known one is the one in the CICA/AICPA’s 1999 research report (Raschke et al. 2018): “A continuous audit is a methodology that enables independent auditors to provide written assurance on a subject matter, for which an entity’s management is responsible, using a series of auditor’s reports issued virtually simultaneously with, or a short period of time after, the occurrence of events underlying the subject matter.”

Continuous auditing is based on two fundamental issues: 1. The audit of a transaction is done as it is happening or in a very short time, so that the anomalies are detected in real time. 2. A report is issued after the audit. This report can be a formal one or a list of anomalies. The realization of these fundamental issues enables auditors to give written assurance on the audit domain in real time. Therefore, it is critical to collect all the necessary information in real time (Searcy et al. 2002). The greatest change facing accounting and auditing in the next 15 years is technology (Alles et al. 2000). Modern-day enterprise resource planning (ERP) systems

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are capable of recording high volumes of transactions and monitor business processes in real-time basis (Singh et al. 2014). Advancements in information technologies, high risk factors, increased regulatory demands related to antifraud measures, the volume and variety of data being created brought continuous auditing into spotlight (Hardy and Laslett 2015).

15.2 Components of Continuous Auditing: Continuous Control and Risk Assessment Continuous audit methodology is used by auditors to understand the critical controls, rules and exceptions of the entity. The frequent analyses of data enable auditors to perform control and risk assessments in real time or near-real time (Coderre 2005). Continuous control assessment refers to the audits performed on the controls (Cankar 2006, p. 71). By monitoring the adequacy of management’s monitoring activities, it is necessary to measure the effectiveness of the controls with an independent eye and to investigate whether it is possible for the organization to correct any possible problems quickly. Continuous risk assessment refers to the identification of systems and processes with risk above the acceptable risk level. Auditors identify risk areas of the organization, and rank and prioritize these risks. In this way, they provide more efficient use of limited audit resources. Auditors’ control and risk assessment activities are independent of management’s monitoring activities and risk management. Conducting audits does not imply that management may delegate the monitoring responsibility to auditors. Management is still responsible for risk assessment, and design, implementation and updating the controls. The audit evaluates the effectiveness of this corporate risk management system as established by the management and provides opinions on its compliance with the laws. Auditors should not be involved in the design of related systems to remain impartial and independent.

15.3 Major Differences Between the Traditional Audit and the Continuous Audit Concepts In continuous auditing, all the audit activity is done in the electronic environment where only the digital analysis tools and techniques are used (Mokhitli and Kyobe 2019). Audit tests are performed on the audit data, and the audit report is created by the computer system. The auditor himself develops or uses audit package software to perform audit procedures. In the traditional audit, there are people who perform the audit process, that is, the auditors. They examine records and documents, both

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electronically and on paper. Most of the time, the analysis is done by auditors, not by the computers. In continuous auditing, all of the records can be analyzed easily and quickly. Since computer systems are used to perform audit tests, it is possible to execute audit procedures repetitively on big data in a relatively short time. In the traditional method, a sample set of records may be audited. The auditors use a sampling method to choose the records that they will examine. A sample of records is a very limited portion of the audit domain when there are a large number of records to be audited. In the traditional audit, audit activity is performed at certain periods followed by an audit report. However, in continuous auditing records are audited in real time and anomalies are immediately reported to the auditors. The cost of continuous auditing in the long run is lower than the conventional audit. Initial setup of the continuous audit software requires time and relatively a high level of expertise. However, the same modules may be used over and over again. Moreover, audit tests can be performed in less time and with fewer people. Continuous auditing allows remote access to company data. Unlike in the traditional audit, the auditors do not have to be on site to perform the audit activity. They can access the company data and extract the records they want without leaving their offices. This feature enables auditors living at different geographical areas and with different expertise levels to work together. The stages of the audit activity are different in the traditional and the continuous one. The stages of the traditional audit include planning, fieldwork and reporting. The stages of continuous auditing are automation of audit methods, development of audit model, data analysis and reporting.

15.4 Benefits of Continuous Auditing In recent years, audit objectives, assurance levels, timing, audit techniques and audit reporting have changed dramatically in favor of continuous auditing. In many ways, continuous auditing improves audit quality and effectiveness. The benefits of continuous auditing can be listed as follows: • Increasing the effectiveness of audit activities: Audit functions take place almost in real time. This enables frequent control and risk assessments on the operations of the organization. This has a positive effect on interim and annual reports (Lee et al. 2014). Financial reports are perceived as more reliable. • Increasing value-added activities: One task of the audit is to provide advice on the activities of the organization. Since detailed analysis of operations and activities is performed during the audit, auditors can make recommendations efficiently while protecting the ethical values. These recommendations add value to the organization. • Forming real-time opinions: Since continuous auditing is a real-time audit, auditors have the opportunity to inform related people immediately if an anomaly is

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detected. In today’s competitive business world, there is a greater need for timely information instead of using the past data for decision making. Extending the audit scope: Computer systems have the potential to examine large amounts of records in a short time. Since continuous auditing is a type of audit performed entirely on information systems, all or nearly all records can be examined. Improving the reliability of the audit: The fact that all records, analysis and reporting are in the electronic environment minimizes human error and bias. Accurate and thorough analysis of data, complex analytics capability and consistent applications of the audit tests increase the reliability of the audit. Increasing transparency: Designing continuous audit models requires detailed analysis and documentation of the business processes and the audit model itself. Transparency and standardization in approaches are achieved by this detailed documentation. Acting independently from the IT department: According to the audit standards, auditors should be able to act independently from other departments in conducting audit functions. Extracting and analyzing data from the entity’s database is easy with audit software. The audit software used in continuous auditing can reduce the support the auditors receive from programmers. Developing the audit plan: Continuous risk assessment determines the scope of the audit. Risk factors in the processes are taken into consideration to determine the scope and timing of the audit. Supporting audits in specific areas of interest: Auditors may decide to conduct audits on certain data or processes based on the results of continuous risk assessment. The elements of the audit, such as the scope of the audit, its objectives and the data to be examined, are decided according to the findings of the continuous risk assessment. Reducing the cost of audit: Recent studies show that corporations are motivated to adopt continuous auditing technology to better utilize capacity and save economic resources (Rikhardsson and Dull 2016). Same audit modules are used automatically in continuous auditing. Audit costs are reduced by reusable computer techniques since the amount of man /hour required in the audit process is less than other audit types. Reducing audit waste: There are seven different types of audit waste: overauditing, waiting, delays, audit process, working period, review, errors (Searcy and Woodroof 2003). Continuous audit practices greatly reduce audit waste. Achieving standardization and timeliness in reporting: In continuous auditing, the audit report is prepared by the information system and sent to the related parties immediately after the audit tests are performed. Moreover, the standardization in the form and content of the report improves the quality of reporting. To ensure the follow-up of the audit results: The auditors have the opportunity to see the results of their evaluations and advice of the previous auditing activities. The audit activities are carried out so frequently that they can see how much of their suggestions were taken into consideration by the management and how they affected the performance of the business.

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• Combining skills from different fields: It allows the integration of skills from different fields. Continuous auditing requires knowledge of accounting and information technologies. • Communicating effectively with external auditors: When internal auditors use continuous auditing, they have well-documented business processes. This in return enables external auditors to be well informed about the risks and the controls of the organization. The exchange of expertise and knowledge between the internal and external auditors improve the audit quality (Weins et al. 2017). • Increasing company value: Continuous auditing is a new assurance service that adds value to the entity. In a controlled experiment conducted in 2008, it is found that investors feel safer and they consider the company risk lower when the company is continuously audited (El-Masry and Reck 2008).

15.5 Historical Development of Continuous Auditing In the 1960s, audit modules were implemented into the software to automate testing the controls. These attempts were the first examples of audit automation. Due to difficulties in use of these modules at the time, it did not find a widespread use. In the late 1970s, its use declined even more (Coderre 2005, p. 3). In the early 1980s, some auditors began to use digital analysis techniques to analyze data. The concept of continuous monitoring emerged. This concept, whose main premise was to focus on risky areas by providing automation in data analysis, was embraced by academic circles. However, information technology was not developed enough for the auditors to use these unfamiliar analysis techniques (Coderre 2009, p. 104). In the 1990s, parallel to the development of information technology, the use of data analysis techniques to control the effectiveness of internal controls increased. In a survey among auditors in 1994, 93% of respondents said they believed that computer technologies would increase in importance within five years. In the same survey, it was asked which software that the auditors needed most to achieve their goals. Word processing, tabulation and data extraction modules were the top three choices of the auditors (Coderre 2009, p. 104). In the 1990s, internal auditing and external auditing were separate and distinct functions. While the external audit was concerned with the compliance of the financial statements, the internal audit’s role was to serve the management in a variety of matters. In the early 1990s, external audit firms assumed some internal audit roles. Some large institutions outsourced their internal audit activities to external audit firms (Moeller 2009, p. 60). The Sarbanes–Oxley laws enacted in 2002 had an impact on the auditing standards of most countries, particularly the USA. With this law, the responsibilities of internal auditing increased. Testing the effectiveness of internal controls gained importance with the new corporate governance approach. Today’s competitive business environment requires taking precautions against the risks that may occur in the

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organization. Since delayed reactions can lead to huge losses, taking precautions or actions immediately after the risks occur is important. These developments led people in the audit profession to look for new audit approaches and develop audit software. The change in audit understanding and the development of computer technologies brought the concept of continuous auditing back to the agenda. The concept of continuous auditing was first used by John Kearns. Kearns stated that processing large volumes of data was possible due to the advancements in information systems, rendering continuous audit process possible. Academic studies on continuous auditing began to increase along with the developments in computer technology as continuous auditing became possible over time (A˘gca 2006). The first continuous auditing application was developed at the AT & T’s Bell Labs. It was called continuous process auditing system (CPAS), and it was developed as a paperless audit model for internal audit (Yeh and Shen 2010). After AT & T, corporations such as Siemens, HCA, Itau Unibanco, IBM, HP, MetLife and Procter & Gamble became the first practitioners of continuous auditing (Chan and Vasarhelyi 2011.). In 1999, American Institute of Certified Public Accountants (AICPA) and Canadian Institute of Chartered Accountants (CICA) made a joint decision and called on researchers to investigate the concept of continuous auditing and develop applications (Onions 2003). This approach had a great impact in the academic circles, and many continuous audit models have been created in the 2000s. Recent financial scandals led authorities to change auditing standards and make extensive changes in the legal framework. Legal obligations increased the importance of auditing in today’s business world. The need for financial markets to verify information immediately required that audit reports be prepared and disclosed to the public as soon as possible. Moreover, auditing is expected to increase corporate efficiency rather than compliance assessments. These factors changed audit understanding. It became imperative to make in-depth and real-time analysis on corporate data, which is only possible with continuous auditing (Sarva 2006). Recent technological advancements enabled continuous auditing attainable. It is found that organizations use computer systems in audit at different levels. There are four levels of technology in organizations (Coderre 2009, p. 28): • Beginning: Administrative purposes such as budgeting, time management and reporting • Medium: Data extraction, limited data analysis, use of spreadsheet and presentation software • Integrative: The use of technology at all stages of the audit; risk identification, identification of data to be examined, electronic worksheets and reporting • Advanced: Continuous auditing and extensive use of Intranet. A 2007 study showed that the rate of continuous auditing tests being used by internal auditors was twice as high as that of managers to monitor business processes and related controls. Therefore, internal auditors are considered to have the greatest role in the development of continuous auditing practices (Lehmann et al. 2010, p. 58).

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15.6 Developing Continuous Auditing Applications Continuous audit applications require substantial setup efforts. Most of the work is done in the system design and pre-implementation stages (Vasarhelyi 2002). Once the audit model is created, it can be used by iterating the modules.

15.6.1 Steps to Develop Continuous Auditing Applications Continuous auditing applications are generally developed in six steps (Aquino et al. 2008): 1. Identification of priority audit areas: Critical business processes are identified. The risks related to these processes are classified and rated. For each risk, accessibility to digital audit data, benefits and costs of continuous auditing are determined. The risk area of which the audit results have the highest contribution to the organization is selected. 2. Determining the rules and the continuous audit model: The rules are the guidelines of auditing. These rules will be programmed, repeated frequently and changed when necessary. 3. Determining the frequency of which the application is repeated: The frequency of which the continuous auditing application should run is predetermined. The objectives and the cost of the audit determine the frequency of the audit. 4. Setting the parameters: Parameters are adjusted to indicate anomalies in data. The initial parameters are corrected when necessary. 5. Determining actions taken after the audit: Actions need to be taken are determined if anomalies or error are detected in data during the audit. 6. Feedback: Who and how the audit results will be shared are planned.

15.6.2 Preparation to Develop Continuous Auditing Applications Define the audit goals An audit goal states the purpose of the audit. It is the explanation of why the continuous audit application is created. The purpose statement defines the general framework of the audit activity that will be performed. Although the purpose statement is not a detailed list of things to be done, it should clearly indicate the goal to be achieved as a result of the audit. Examples of purpose statement are as follows: • To assess the adequacy of internal controls of the procurement process at the headquarters and branches of the corporation

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• To assess the compliance of the records related to fixed assets to accounting standards • To determine that enterprise resource planning software users performed their tasks without exceeding the privileges assigned to them. Audit objectives should be clearly defined before starting the analysis. This will ensure effective use of time and resources. Moreover, it will clarify which controls are assessed and which ones are beyond the scope of the audit. Auditors should avoid the following mistakes when setting audit objectives (Mainardi 2011, pp. 69–69): • Lack of communication: Auditors should have a good communication among themselves and with the employees. The scope of the audit and the reasons for the tests to be performed should be clearly stated so that the auditors may perform their tasks as a team with the support of the employees. Failure to explain the audit objectives well may cause insecurity among the employees toward the auditors. • Inadequate explanation: The audit objectives should provide sufficient information as to why the continuous audit application is being developed. Enough details should be given so that a person who has no previous knowledge of the subject can understand the reasons for the audit. • Inadequate link to corporate goals: Audit objectives should be linked to corporate goals. The role and the risks of the department, which will be audited, should be stated clearly. • Setting the audit objectives that are impossible to realize: There is a belief that if the scope of audit is kept wide, the continuous audit application will be more successful. However, this approach makes the objective of the audit unattainable. If the objectives of continuous auditing are too many and involve many different operational processes, it becomes difficult to manage the application and report the results.

15.6.3 Getting the Support of the Management Senior management should be informed of all stages of the audit, including data access, assessment methods, how and when reporting will be made. If this is not done, a reaction may occur against the continuous audit and may cause the audit activities to slow down. Auditors who participate in continuous auditing applications should have technical knowledge on computer systems and the related software. The audit data needs to be extracted from the corporation’s enterprise resource planning system and analyzed by the audit software. All the assessment and reporting activities are done digitally in continuous auditing. Therefore, auditors that work in such projects should be aware of the technological challenges and should improve their knowledge on information technologies (Mokhitli and Kyobe 2019).

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15.6.4 Determining the Audit Software In order to conduct continuous auditing, it is necessary to access, extract and analyze data electronically. The audit software should be selected according to the corporate data’s format and quantity. Therefore, the selection of computer programs that will be used in the audit plays an important role.

15.6.5 Understanding the Business Processes It is imperative to understand the business processes that will be audited. Globalization and the development of complex processes increase evaluation risks for auditors (Hunton and Rose 2010). It is not possible for an auditor who is not familiar with the corporation’s processes to develop an application that will provide opinions on transactions and controls. Information on the business processes can be attained by undertaking the following activities: • Research should be made in the library and Internet on the main activities of the corporation. The audit will be done on a process, which is a part of the main activity. • Documentation related to the previous audits may supply invaluable information on the objectives, scope, risks, controls, analyses and results. • The business process should be observed by the auditor to get information about related activities from the employees who undertake them. • It is helpful to graph the business process. All activities, risks and controls are shown graphically in detail. • Information system of the corporation should be analyzed thoroughly because the records, which will be audited, are generated from this system. • The whole business activity, including suppliers and customers, needs to be understood. This may give important information on inputs, outputs and processes. • Auditors should be well informed of the related laws, regulations and policies.

15.6.6 Determining the Important Controls and Risks The purpose of continuous auditing is to increase the effectiveness of controls and reduce risks. Therefore, it is necessary to identify important controls and risk categories to plan the audit. The auditors make a risk assessment of the corporation and decide which controls should be examined. Auditors should first understand the internal structure of the organization in order to provide an opinion on the controls. The internal control structure can be analyzed in parallel with the report of the Committee of Sponsoring Organizations (COSO).

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COSO states five components of the internal control structure: control environment, risk assessment, information and communication, control activities and monitoring. The adequacy of internal controls results from the evaluation of these five components. Auditors evaluate the effectiveness of internal control practices and processes by conducting tests. Analysis of the internal control system is necessary for the auditors to present their opinions on the internal control structure. The reliability of internal controls is also important for the reliability of the audit evidence collected. The content, timing and scope tests of the internal controls are carried out simultaneously with the tests performed on the transactions. The tests of controls begin by examining the controls determined by the management. Once the auditors decide that the controls of the management are appropriate and sufficient, they examine the internal controls related to the transactions. Control and risk assessments are two intertwined activities. The result of one is the input of the other. An increase in risk may be due to control weaknesses. In this case, measures to eliminate control weaknesses are taken. Controls are evaluated according to risk levels. Therefore, measures should be taken according to risk levels. Controls should ensure confidentiality, integrity, accessibility and reliability of information. Continuous control assessment is to conduct analyses by applying predesigned control tests on records in the digital environment. It measures the effectiveness of controls by performing tests to detect problems such as exceeding a limit or blank data fields. Organizations are exposed to a wide range of risks. They need some methods to assess the damages that arise in the event of risks. This is the risk management process. Risk management is a management activity that evaluates the impact of uncertainties to the organization and determines the measures to be taken. The importance given to risk management is different in every organization. While some organizations divide the risks into basic groups as low, medium and high, some organizations try to measure the cost of risks through more advanced analyses. The risk management process is one of the two main components of the audit. The auditors have to assess the probability of the risks occurring and determine their costs to the organization. The activities of the audit department are risk-based. The auditors question the management’s ability to identify and evaluate risks.

15.6.7 Developing the Continuous Auditing Model 15.7 Determining the Scope of the Analysis The auditors need to determine how detailed the controls will be examined. The effectiveness of controls performed by the management and the areas of which the corporate governance focuses are taken into consideration in determining the extent of the audit. If the management is effective in control and risk assessment, the levels determined as a result of these activities may form the basis of the audit. However, if

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management is not effective in this respect, auditors need to carry out a more detailed analysis to determine risk and control levels. Determining the data sources Corporate data is created as a result of business activities which often do not have any meaning by itself. When this data is analyzed and classified, making it meaningful and useful for the decision maker, it becomes information. Records in the corporate database include log information, record length, record type, by whom made these records are created and when, etc. as well as values related to the activities. The auditor determines how to use the data in the enterprise resource planning software and forms the audit model. He has to find out where he can extract the required data from the corporate database as well. The objectives of the audit will determine the data that will be needed. In continuous auditing applications, information is not only in monetary terms. There may be financial, operational or compliance information on any corporate activity. Determining the audit evidence The auditor needs audit evidence to form his opinions. For each assessment he makes, he needs to work with a sufficient amount of audit evidence. Continuous audit applications can only use digital data. This data has to be stored in databases where its integrity is well protected. Timing of the audit Audit applications test various arguments. For example, the auditors may assess whether certain issues have occurred, such as the existence of a particular asset or liability, the reliability of internal controls and compliance with related rules and regulations. The related audit evidence is in electronic format for continuous audit applications. The timing of the audit should be in such a way that the continuous audit application could find the audit evidence. For instance, some electronic evidence may disappear or change after a certain period. Therefore, the timing of the audit should be planned before the audit evidence is lost. Data access Data access is a critical part of any audit. It is necessary to reach the audit evidence effectively. The fact that there are numerous data formats and data storage technologies results in the existence of various data access methods. It is not enough to know the corporate information system in general terms to access the data. The auditor should know the modules of the source file, what information it contains, the metadata related to the file and how it can be accessed. For continuous auditing, data should be accessed electronically. The access method is chosen depending on the purpose of the audit. However, the technical characteristics of the information system, such as the amount of data and data traffic between computers, should also be considered. Relevant data must be extracted from

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the enterprise resource planning system to be processed by the continuous auditing application. The first step is to find out where that data is stored in the corporate database. The next step would be to determine the methods to access it. If the auditor will analyze the corporate data in a software other than the enterprise resource planning software of the corporation, he must extract the data to the audit software. The files, which are extracted, may have different file types and formats. Errors may occur, especially when merging information from different databases. It is crucial to understand the technical structure of these files. These records should be combined in a common format. Data analysis The corporate data, which is extracted from the enterprise resource planning software, should be checked for data integrity before starting the analysis. The auditor must ensure data integrity of the audit evidence, which he will analyze and use to make assessments. If an audit is performed without testing data integrity, the results may be incomplete or incorrect. The auditor should treat the data received with professional skepticism. Testing the integrity of the data will increase confidence in the accuracy of the analysis results. After data integrity is achieved, digital analyses are performed on the data to achieve the audit objectives. Internal controls are analyzed by testing the controls of the enterprise resource planning software, and transactions are analyzed by substantive procedures (Raschke, Saiewitz, Kachroo and Lennard, 2018). Studies show that there are differences in the predictive ability and detection performance of digital tests (Kogan et al. 2014). No single test performs better on all aspects. It is desirable that multiple digital tests or statistical methods are applied onto the audit data instead of selecting only one of them to detect anomalies. Evaluating results When determining the timing and scope of continuous auditing tests, the objectives of continuous auditing, risk understanding of the organization and risk monitoring practices of the management should be taken into consideration. The risks are listed with respect to their importance. The continuous auditing applications are created starting from the highest risk areas. Continuous auditing applications can be run in certain periods as well as in real time. The timing varies depending on the magnitude of the risk and the extent to which the management is performing the risk monitoring task. Problems are identified by examining the results of continuous auditing. Transactions that fail from control tests are proofs of control weaknesses. It is normal to report many anomalies in transactions erroneously when the continuous audit is first established. Test parameters are corrected over time. Each process has different risks and exceptions. Exceptions are irregular or suspicious transactions identified by the continuous auditing model (Li et al. 2016). It is almost impossible to model a continuous audit application that takes into account all risks and exceptions.

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Any exception does not indicate an error or fraud in the process. Trying to identify and implement all potential fraud factors into the original design, or subsequent redesign, of the rule set may result in complete failure (Gonzalez and Hoffman 2018). The audit model can be improved, and the application can function near perfect. Reporting There are two types of continuous auditing reporting: formal reporting and reporting exceptions. Official reporting is a full audit report structure that describes the activities of the continuous audit application in detail. The exception reporting resembles a working paper that summarizes continuous audit activities. The report type used in continuous auditing can be arranged as a mixture of these two report types.

15.8 Conclusion Corporations are facing increasing rates of fraud. Corporate accountability, business competition and regulations put pressure on corporations to have more effective and efficient audits. Once a year, audits are insufficient to meet the present-day expectations. These concerns led the way to the concept of continuous auditing. Continuous auditing is any method where auditing is done digitally by information systems in real time. The audit model is developed by iterating digital tests on the audit evidence. Results and feedback of these tests determine whether or not the model should be corrected. Most of the effort is put in developing the audit model. Once the model is functional, it can be run as many times as needed by the computer system. The concept of continuous auditing is very new, and implementation methods are in the research stage. This audit method is not yet widely used and presents significant difficulties in implementation. With the continuation of research in this field and the development of information systems, the problems experienced in the implementation of continuous auditing practices will be eliminated and its use will increase.

References A˘gca A (2006) Sürekli Denetim: Denetimde Bir Devrim mi Yoksa Bir Hayal mi? MODAV Muhasebe Bilim Dünyası Dergisi 8:63–78 Alles MG, Kogan A, Vasarhelyi MA (2000) Accounting in 2015. CPA J 15(20):70–72 Aquino CEM, Da Silva WL, Vasarhelyi M A (2008) Moving toward continuous auditing: establishing audit priority areas can lead to a more effective continuous audit process. Tech Forum. [online] Available at: [http://www.entrepreneur.com/tradejournals/article/183444836. html] [Accessed 17 Jan 2009] Cankar ˙I (2006) Denetimin Yeni Paradigması: Sürekli Denetim. Sayı¸stay Dergisi, 61, s. pp 69–81

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Chan DY, Vasarhelyi MA (2011) Innovation and practice of continuous auditing. Int J Account Inf Syst 12(2):152–160 Coderre D (2005) Continuous auditing: implications for assurance, monitoring, and risk assessment. Global Technology Audit Guide, The Institute of Internal Auditors, USA Coderre D (2009) Internal Audit. A.B.D.: Wiley El-Masry EE, Reck JL (2008) Continuous online auditing as a response to the Sarbanes-Oxley Act. Manag Audit J 23(8):779–802 Gonzalez GC, Hoffman VB (2018) Continuous auditing’s effectiveness as a fraud deterrent. Audit: A J Pract Theory 37(2):225–247 Hardy CA, Laslett G (2015) Continuous auditing and monitoring in practice: lessons from metcash’s business assurance group. J Inf Syst 29(2):183–194 Hunton JE, Rose JM (2010) 21st century auditing: advancing decision support systems to achieve continuous auditing. Account Horiz 24(2):297–312 Kogan A, Alles MG, Vasarhelyi MA, Wu J (2014) Design and evaluation of a continuous data level auditing system. Audit: A J Pract Theory 33(4):221–245 Lee JW, Kang M, Oh Y, Pyo G (2014) Does continuous auditing enhance the quality of financial reporting? Korean evidence. Asia-Pac J Account Econ 21(3):284–307 Lehmann C, Ramamoorti S, Weidenmier Watson M (2010) Maximized monitoring. Internal Auditor, June 2010, pp 56–59 Li P, Chan DY, Kogan A (2016) Exception prioritization in the continuous auditing environment: a framework and experimental evaluation. J Inf Syst 30(2):135–157 Mainardi RL (2011) Harnessing the power of continuous auditing: developing and implementing a practical methodology. Wiley, USA Moeller RR (2009) Brink’s modern internal auditing, 7th edn. A.B.D.: Wiley Mokhitli M, Kyobe M (2019) Examining factors that impede internal auditors from leveraging information technology for continuous auditing. In: 2019 conference on information communications technology and society (ICTAS), information communications technology and society (ICTAS). Durban, South Africa, 1–6 March 2019, IEEE Raschke RL, Saiewitz A, Kachroo P, Lennard JB (2018) AI-enhanced audit inquiry: a research note. J Emerg Technol Account 15(2):111–116 Rikhardsson P, Dull R (2016) An exploratory study of the adoption, application and impacts of continuous auditing technologies in small businesses. Int J Account Inf Syst 20:26–37 Sarva S (2006) Continuous auditing through leveraging technology. Journal Online. [online] Available at: [http://www.isaca.org] [Accessed 17 Jan 2009] Searcy DL, Woodroof JB (2003) Continuous auditing: leveraging technology. CPA J 73(5):46–48 Searcy D, Woodroof J, Behn B (2002) Continuous audit: the motivations, benefits, problems, and challenges identified by partners of a big 4 accounting firm. [online] Available at: [http://csdl. computer.org/comp/proceedings/hicss/20] [Accessed 14 Mar 2010] Singh K, Best PJ, Bojilov M, Blunt C (2014) Continuous auditing and continuous monitoring in ERP environments: case studies of application implementations. J Inf Syst 28(1):287–310 Onions RL (2003) Towards a paradigm for continuous auditing. [online] Available at: [http://www. auditsoftware.net/community/how/run/tools/Towards%20a%20Paradigm%20for%20Continu ous%20Auditin1.doc] [Accessed 19 Feb 2011] Vasarhelyi MA (2002) Concepts in continuous assurance. rutgers university, continuous auditing and research laboratory. [online] Available at: [http://raw.rutgers.edu/carlab] [Accessed 28 Feb 2012] Warren JD Jr, Smith LM (2006) Continuous Auditing: An Effective Tool For Internal Auditors. Internal Auditing 21(2):27–35 Weins S, Alm B, Wang T (2017) An integrated continuous auditing approach. J Emerg Technol Account 14(2):47–57 Yeh C, Shen W (2010) Using continuous auditing life cycle management to ensure continuous assurance. Afr J Bus Manage 4(12):2554–2570

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Hülya Boyda¸s Hazar (BA, MA, Ph.D.) is an Assistant Professor at the Faculty of Economics and Administrative Sciences, Istanbul Aydın University (Istanbul, Turkey). She is the assistant director of the Department of Business Administration. She has been lecturing to national and international, from over 40 countries, undergraduate and graduate students, and conducting thesis studies with graduate students. Her current research interests include cost and managerial accounting, financial reporting, auditing and the use of technology in the accounting field. Her books and articles have been published by prominent publishers and high impact journals. She has presented her researches in various national and international conferences.

Chapter 16

Enhancing Risk Management Procedures in Audit Firms: Acceptance & Continuance Stoyan Deevski

Abstract The purpose of this paper is to look into the problems of risk management policies and procedures at audit firms. The paper starts with an introduction to the importance of establishing formal risk management policies and procedures at audit firms and how it is related to the increasing expectations of investors, creditors and other stakeholders. Governments impose ever more stringent regulations in an attempt to respond to those expectations. The author points out some basic principles of risk management policies at audit firms and analyses how the problems can be approached. One of the most important points is that there is a strong need for welldesigned policies and procedures even before the client relationship has started. The author presents some important (in the author’s view) policies and procedures, which would help audit firms manage and control business risk arising from accepting clients and engagements that should not have been serviced either due to regulatory restrictions, or due to the fact that the relationships create independence, ethics or similar issues. The paper concludes with a note on the importance of implementing proper acceptance and continuance policies as part of the broader risk management process of ensuring long-term profitability and business continuity of audit firms. Keywords Risk management · Audit · Acceptance & contunuance JEL Classification M42 · G32

16.1 Introduction Expectations of investors, creditors, governments and other stakeholders towards the work of statutory auditors are constantly increasing. As a result of this, the audit profession becomes more and more regulated. In responding to the increased level of regulations and the higher expectations, audit firms implement stringent internal rules that aim to minimize the business and operational risks they face. Despite that, S. Deevski (B) University of National and World Economy, Sofia, Bulgaria e-mail: [email protected] © Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4_16

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many audit firms continue to encounter difficult and sometimes quite complicated problems arising from situations where there has been a lack of proper internal risk management policies in place or lack of any risk management procedures at all. There is no doubt that operational risk management becomes ever more important. Chernobai et al. (2012) state that even in the banking industry, where traditionally credit and other financial risks were of most significant interest to the management and those charged with governance and operational risk was regarded as a mere part of “other” risks, the view has changed. The operational risk is viewed as a major risk that companies face. Similar statement is made by Andreeva (2016) with regard to the insurance industry. One of the most important points at which there is a strong need for well-designed policies and procedures is even before the client relationship has started. If risk management fails at this point, it is often already too late once the engagement has started and the issues have come to the attention of the audit firm and regulatory agencies. Many of the audit networks have some version of formal know-your-client, client acceptance and engagement acceptance policies and procedures. However, this is not the case for some of the mid-sized and small audit firms, where there are no formalized risk management rules. Johnstone (2000) relates the client acceptance decisions with the business risk and audit risk to show the importance of these initial decisions. The purpose of this paper is to lay out some important (in the author’s view) policies and procedures, which would help audit firms manage and control business risk arising from accepting clients and engagements that should not have been serviced either due to regulatory restrictions, or due to the fact that the relationships create independence, ethics or similar issues.

16.2 General Principles of Risk Management Policies The basic risk management policies that audit firm adopt need to be agreed and approved by the leadership team. As such, the risk management policies contain minimum standards for all employees and with which all employees have agreed to comply. In the case of network firms, it is expected that members will adopt and implement these risk management policies and will supplement them as necessary depending on local circumstances. In supplementing the risk management policies, however, member firms should not change or modify the policies such that they are inconsistent with the policies adopted by the leadership team, as this may result in inconsistency between member firms or a particular member firm not adhering to agreed minimum standards. Once member firms have adopted and modified each policy as necessary to fit their local circumstances, they should make it available to their professionals and monitor their compliance. Of course, without continued monitoring on the part of the leadership team with regards to the compliance the assessment of the effectiveness of the risk management policies will not be efficient.

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In order to assist member firms with their adoption, implementation and dissemination of the risk management policies, each policy has to be accompanied by sample guidance material that provides a detailed discussion of how each policy may apply in particular situations. The guidance material should be intended to serve as a resource for member firms—a baseline from which each member firm can develop its own detailed guidance for its partners, principals and staff. The guidance provided generally is a starting point from which member firms can develop their own guidance for their professionals. Risk management policies, as other rules, are open for interpretation. Having some mechanism or formal procedures for resolving differences of opinion in relation to application of risk management policy would be beneficial to audit firms. Some policies might require consultation outside the audit firm if difference of opinion exists between the leaders within the firm.

16.3 Engagement Leader Responsibilities International Standard on Auditing (ISA) 220 sets out the engagement partner’s responsibilities with respect to relevant ethical, independence and quality control requirements (IFAC 2016a). Engagements should be led by individuals with appropriate knowledge and experience, who have the ultimate responsibility for managing the risks of delivering services to their client. Each engagement requires a clearly designated engagement leader who is a partner with appropriate knowledge and experience unless a non-partner is authorized to carry out the engagement leader role. The engagement leader is ultimately responsible for service delivery and the management of engagement risks and quality. He or she remains responsible regardless of whether another person is providing oversight and support to the engagement (e.g. a quality review partner). The engagement leader cannot delegate his/her responsibility for managing the risks and quality of delivering services to his/her clients. Where multiple partners, or non-partners carrying out the partner role, are involved in one engagement due to its scale, complexity or other reasons, there should be only one engagement leader who takes overall responsibility for the engagement. All partners (including non-partners authorized to act as a partner) involved in the engagement should discuss and agree the roles and responsibilities of those involved (including overall coordination) prior to commencing the work, taking into account the mix of knowledge and experience within the team, the client relationship and any other relevant factors. It is also important that the roles and responsibilities of the respective partners are clearly understood by the engagement team members. Where two or more services are provided to a client in one engagement (e.g. assurance and tax in the same engagement), each line of service involved should designate a leader to be responsible for their part of the service provided. However, having one overall designated engagement leader who is responsible for coordinating the different aspects of the engagement being also the one person receiving all the information related to the

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engagement would facilitate the decision-making process, based on all the relevant facts and information. In practice the engagement leader is expected to know and apply firm’s quality, risk management and independence policies and procedures. In some situations, it would be appropriate to consult with risk management, independence and other specialists. Despite that, if the client service team is not staffed with suitably qualified and experienced people to perform the work and if the team is not properly briefed and supervised there might be unexpected results. That is why the engagement leader has to be sufficiently involved with the work to provide quality service and deliverables. Whilst ultimate responsibility for risk management on each engagement rests with the engagement leader, other members of the engagement team should be aware of the risk management policies and procedures and should play their part in ensuring that these are applied to the engagement.

16.4 Client Acceptability Working with inappropriate clients can result in significant issues. The audit firm should assess each client’s suitability in accordance with the predefined standards of ethical behaviour and quality. Before accepting new clients an assessment of their suitability is required, considering factors such as ownership structure and key individuals; management integrity and ethics; business activities and operating structure (particular attention should be given to any activities which may be illegal or which may have an adverse impact on team’s or firms’ reputation); public profile and impact on the team’s or firms’ reputation; financial condition, including ability to pay fees; potential conflicts; government or other sanctions potentially affecting the client or services provided; commercial and business risks. Where acceptance risks give rise to concern, or in specific circumstances where there is uncertainty over legalities or risk issues it would be beneficial for the professionals to consult with the designated risk management leader. Of course, as in each of the other steps of the audit engagement, maintaining a proper documentation of the reasons for client acceptability would be of help, if not required. ISA 200 requires that audit evidence is necessary to be documented to support the auditor’s opinion and report. One particular source of audit evidence is the firm’s quality control procedures for client acceptance and continuance (IFAC 2016b). It should be noted that assessing the acceptability of the person or entity as a client (i.e. client acceptability) is different from assessing the risks associated with the particular service to be provided (i.e. engagement acceptability). The underlying principle behind client acceptability is that the audit firm only work with appropriate clients in the context of services to be provided. By focusing on the client’s acceptability as a specific decision (as opposed to engagement acceptability) other lines of service can rely on the same client acceptability assessment. It cannot be stressed enough that assessing client acceptability is very different from completing the client acceptance process. Assessing the suitability of a client

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covers both whether the audit firm wishes to be associated with the potential client, as well as whether the firm is able to accept the potential client. For the latter assessment, a number of checks and processes may need to be undertaken, such as anti-money laundering or conflicts of interest checks. Even if these other checks are satisfactory, it does not mean that a firm automatically should work with a client. The whole acceptance process links with risk management policies, and it is the overall assessment which is important.

16.5 Client Identification It is important for the auditors to consider as many factors as practicable for client acceptability. The first thing on the list would be the identity, business reputation, integrity and ethics of the client’s principal owners, key management and those charged with its governance. Any information concerning the attitude of the client’s principal owners, key management and those charged with its governance towards matters that might affect the provision of a prospective service (e.g. aggressive interpretation of accounting standards and the internal control environment) are equally important. In addition, professionals would look into the nature of the client’s operations, including its business practices. The obvious example is that the audit firm would not like to be involved with clients that undertake illegal activities, including but not limited to money laundering. In addition, inappropriate limitations in the scope of work being requested might raise questions about the integrity of the client. Also, the public profile of the prospective client and the underlying reasons for that profile would be of interest when making the decision to accept it or not. Having sense of the operating and control environments of entities involved could give the audit professionals an idea of whether heightened risks of fraud exist (e.g. opportunities, incentives, or pressures). Financial condition and the ability to pay fees, together with information about whether the client is aggressively concerned with maintaining the audit fees as low as possible might also indicate future independence and conflict of interest issues. Any reports on, or results of, professional services provided by previous professional advisers/accountants which are publicly available would be a source of information about the prospective client that could be taken into account. Other information relevant to the prospective service (e.g. reasons for the proposed appointment of the firm and non-reappointment of the previous provider for an audit service) might also influence the decision of whether to accept the client or not. Some of the factors above should be considered in the context of services to be provided. For example, an entity in financial trouble may not be acceptable for audit services because of a going concern issue, but it could be acceptable in the context of a business recovery service that can also be provided by the audit firm. Possible sources of information for assessing client acceptability can include previous professional advisers/accountants; investigative or information agencies; credit rating agency reports; government departments, regulatory bodies and trade associations; lawyers, bankers and underwriters; business contacts and existing

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clients in similar businesses; publicly available information such as annual/interim reports, information circulars and list of sanctions; USA or Organization for Economic Co-operation and Development (OECD) sanctions against countries or individuals; press services or comment, and other information available via the Internet. Where acceptability risks are identified, a decision regarding whether they can be mitigated and managed has to be made. If those risks are considered significant a consultation with the leadership team might be required before deciding the acceptability of a client. In some cases where the prospective client has been accepted after the consultation with leadership team, the client or the prospective service might be designated as high risk and dealt accordingly.

16.6 Reliance on Other Lines of Service for Client Acceptability A client acceptability decision made for audit client can be relied upon to provide any other service. In each instance, it is important to assess how recently this decision was taken and the relevance of the assessment for current purposes. Where there have been significant changes to the client relationship the assessment might not be appropriate without being updated or re-performed. Significant changes in the client relationship may occur when there is a change in the nature of client’s business, including its operations; client ownership, management and/or directors; the client’s financial condition; or any event that may compromise firm’s independence and/or reputation. Even if it is decided to rely on the client acceptability assessment made by another line of service, the audit professional should consider whether a further assessment is required in accordance with specific local, circumstances, regulations and professional standards. An example of a decision tree that can be used to illustrate the client acceptance process is presented in Fig. 16.1.

16.7 Engagement Acceptability It is necessary to assess the suitability of engagements so that the services can be provided on a commercial basis, in accordance with relevant standards and regulations, and significant risks can be managed. Before accepting new engagements and as audit professionals become aware of changes in relevant circumstances throughout the life of the engagement, they assess their suitability and consider whether: • The firm is able to and permitted to provide the service being requested, and the firm will be able to deploy the necessary capabilities and resources to deliver the engagement;

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Fig. 16.1 Summary of client acceptance process. Source Author

• The relevant parties that will rely upon, or be impacted by, the services have been identified. This includes situations where the firm may be working for counterparties in a transaction or litigation, so that any conflicts can be identified and addressed appropriately; • The firm will be able to meet the client’s expectations having regard to the scope of work, terms of business and its willingness to pay fees; • The commercial rewards of the engagement are satisfactory; • The acceptance of the engagement will not impair the firm’s independence or reputation; • Any risks to the team’s physical security can be properly managed or whether the work is too dangerous. The audit professionals should also determine whether the proposed engagement is a higher risk engagement or a non-audit assurance engagement and if this is the case—consult with the leadership team. Identification of any statutory or regulatory requirements that will impact the conduct of engagement would support the decision to accept the engagement or not. Finally, formal documentation for the reasons for acceptance should be maintained as audit evidence. This specifically includes confirming whether any conflicts of interests have been considered with respect to all parties, counter-parties and other potentially affected parties, and whether all required consultations with the leadership team have occurred.

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Client acceptability and engagement acceptability are separate considerations but they can be inter-related. One line of service may rely on the client acceptability decision made by another line of service but before doing so an assessment should be made of the relevance of that assessment for the current proposed engagement. As with client acceptability, engagement acceptability covers both a firm’s wish to undertake an engagement and the ability of the firm to do so. Before performing checks in relation to the firm’s ability to undertake an engagement such as relevant relationships, independence or anti-money laundering checks, audit professionals might consider focusing on whether it is an engagement that the firm can deliver properly. The firm and the proposed team have the capabilities and resources to deliver the work being requested by the client. The firm can meet the client’s expectations of service delivery having regard to the firm’s standard terms of business applicable statutory regulatory or professional requirements and the client’s willingness to pay fees. Additional factors that might play important role in the decision to accept the engagement are whether significant risks relating to the performance of the engagement can be managed. There might be statutory or regulatory requirements, or professional standards, which might impact the conduct of the engagement such as auditing standards (including audit independence), non-audit assurance standards, regulations covering the giving of investment advice, all other applicable professional standards and regulations. For engagements that require services or resources to be provided by other line of services, a direct communication channel established with them would facilitate the determination of whether they are able and willing to provide the services or resources before committing them to the client. Before accepting the engagement a consideration has to be given with respect to any requirements to register with government authorities, including for example, foreign audit oversight bodies. Failure to comply with those rules might result in fines and legal actions. Having considered the proposed engagement itself and whether the firm wishes to undertake it, then the audit professionals should complete the formal engagement acceptance process. This might include a specific question within the firm’s engagement acceptance form(s), across all lines of service, with respect to assessing conflicts of interests and the like. The broad elements of engagement acceptance process are outlined in Fig. 16.2 here.

16.8 Continuance It should be noted that the process of acceptance is a continuous one. As soon as the client and the engagement is accepted, the process of continuance starts. What is meant here is that existing clients and engagements should be reviewed periodically to assess whether they remain suitable. Firms should establish formal

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Fig. 16.2 Summary of engagement acceptance process. Source Author

procedures for audit professionals to re-assess the acceptability of existing clients and on-going engagements in accordance with the firm’s policy and, where relevant, local regulations and upon the occurrence of significant events. Examples of significant events where reassessment may be required are a change of ownership or significant management; appointment of the firm as auditors; resignation of auditors; negative comments in the media; termination of an engagement with the firm; suspicion of irregularities or unethical behaviour; and deterioration of financial soundness. Of course, proper record keeping with regards to the reassessment and continuance decision that matches in detail and quality the information documented with respect to acceptance decision should be kept. This would allow for subsequent supervision and control, as well as monitoring of the performance of the established procedures from the compliance department.

16.9 Conclusion Client and engagement acceptance and continuance decisions underline the importance of the broader problem of operational risk management at audit firms. These decisions could impact the business and audit risks later on when the engagement is in the execution phase. Markets and stakeholders have ever higher expectations with respect to the ethics, independence and the quality of work performed by audit professionals. Governments also play an important role in responding to the increasing pressure from various groups to introduce strict regulations of the audit profession. In this environment, it goes without saying that audit firms should make every effort

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to implement and adhere to stringent policies and procedures with respect to client and engagement acceptance as part of their operational risk management procedures. The paper stressed that the ultimate responsibility of implementing the rules falls on the engagement partners, who should set the right tone at the top of their organizations. They should communicate with audit professionals those rules and monitor compliance. The author has made an effort to summarize some of the important (in the authors view) stages and prerequisites in the client and engagement acceptance and continuance process. Further research is needed to explore the relationships of corporate governance and operational risk management in audit firms.

References Andreeva T (2016) Insurance and risk management, Actual problems of globalization. In: Midas SA (ed) Scientific Journal “Economics and finance”, Thomson Reuters, pp 126–128 Chernobai A, Rachev ST, Fabozzi FJ (2012) Operational risk. In: Fabozzi FJ (ed) Encyclopedia of financial models. https://doi.org/10.1002/9781118182635.efm0091 International Federation of Accountants (IFAC) through the International Auditing and Assurance Standards Board (IAASB) (2016) ISA 200—Overall objectives of the independent auditor and the conduct of an audit in accordance with International Standards on Auditing, http://www.ifac. org/system/files/downloads/a008-2010-iaasb-handbook-isa-200.pdf International Federation of Accountants (IFAC) through the International Auditing and Assurance Standards Board (IAASB) (2016) ISA 220—Quality control for an audit of financial statements, https://www.ifac.org/system/files/downloads/a010-2010-iaasb-handbook-isa-220.pdf Johnstone K (2000) Client-acceptance decisions: simultaneous effects of client business risk, audit risk, auditor business risk, and risk adaptation. AUDITING: J Pract Theory 19(1):1–25. https:// doi.org/10.2308/aud.2000.19.1.1

Stoyan Deevski is Associate Professor in Economics and Business at University of National and World Economy (UNWE), Sofia, Bulgaria. He received Bachelor’s degree in Management and Economics and Master’s degree in Management from Otto-von-Guericke University (OvGU), Magdeburg, Germany in 2006 and 2009 respectively. He also received Bachelor’s degree in Accounting and Controlling, Master’s degree in International Economic Relations and Ph.D. in Economics and Business from UNWE in 2007, 2009 and 2016 respectively. He is Certified Public Accountant. His areas of interest include Cost and Management Accounting, Controlling and Audit. He has participated in many national and international conferences and projects and has many publications on various topics.

Index

A Adjusted return, 40, 43, 44, 55, 60

N Newey-West estimation, 49

E Efficiency, 21, 39–46, 49, 52–60, 80, 162, 168, 182, 184, 207, 225, 236, 237, 239, 249, 259 Efficient Market Hypothesis, 39, 44

P Portfolio diversification, 42, 45, 46, 52, 55, 58, 59 Prais-Winsten estimation, 47–49

F Faruk, 109

G Granger causality, 46, 52–55

T Turnover, 39–43, 45–47, 49, 50, 52–60, 81

U Unit root test, 46, 50, 51

I Impulse response, 41, 46, 51, 55

M Market beating, 40, 42, 45 Market cap, 42, 45, 46, 52, 55–57, 59

V Variance decomposition, 46, 51, 58, 59 Vector Auto Regression, 50 Volatility, 39, 41, 42, 45–47, 50, 52–57, 59, 60

© Springer Nature Singapore Pte Ltd. 2021 K. T. Çalıyurt (ed.), Ethics and Sustainability in Accounting and Finance, Volume II, Accounting, Finance, Sustainability, Governance & Fraud: Theory and Application, https://doi.org/10.1007/978-981-15-1928-4

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