THE TIDE IS TURNING: Current Developments in Accounting and Auditing

For about 100 years, the control of accounting rules and auditing standards rested in the hands of the accounting profession with very little input from other sources other than the SEC for rules relating to publicly-traded companies.

Following Enron, WorldCom and other major corporate scandals,

Note how the current changes came about. The numerous scandals and restatements of financial statements were caused not only by unscrupulous managers who were flagrantly falsifying the books, but also by the very complex accounting rules that evolved. Some regulations run to hundreds of pages and leave themselves open to different interpretations. In an effort to boost earnings, management uses every possible loophole to increase profits but still remain within the guidelines. This includes the use of aggressive revenue recognition, estimates and asset valuations which, when they later turn out to be incorrect, causes major restatements. The blame should not be placed only on the shoulders of accountants and rule makers. In the past two decades business has become so complex and global that transactions never contemplated previously are being concluded every day. Revenue recognition - a relatively simple concept in the past - has become a major issue as businesspeople construct very complicated deals with different types of revenue streams and conditions. For public companies, in particular, there is pressure to boost earnings and share prices. The concept of "conservatism" has disappeared in the preparation of fmancials.

Corporate governance has also undergone major changes. Regulators recognize that it is mainly management that perpetrates the frauds and weak controls assist in rampant abuses of accounting rules. While most of the changes affect public companies, there is a trickle-down effect to companies of all sizes. The focus is now on independent boards of directors, qualified audit committees and internal control evaluations, as well as major increases in fines for white-collar crime.

Public accountants were taken by surprise by the reaction to the scandals and audit failures. And within the past two years much of the power to regulate the profession has been taken away from them. The Sarbanes-Oxley law made substantial changes, including the creation of the Public Company Accounting Oversight Board, which now reviews firms performing audits of public entities. The American Institute of Certified Public Accountants (AICPA) and various state boards, realizing that they have lost power, are now trying to become proactive in improving controls and self-regulation, mincluding transparent peer reviews of accounting firms.

Auditors have always maintained that the purpose of the audit was not to discover fraud. Legally, they were correct. In fact, one of the oldest judgments in auditing case law in England states that "auditors are watchdogs, not bloodhounds". The public, however, had the perception that the auditors were in fact "checking the books" and that their report was a stamp of approval on which they could rely. Auditing standards have now been changed and the auditors must now approach audits with skepticism. Auditors are required under FAS 99 to conduct a review of the possibility of fraud in engagements. The audited clients are now going through fraud questionnaires with the auditors, who also interview staff members to analyze where the possibility of fraud could exist. CPAs are being trained to focus on the main conditions which give rise to fraud, i.e., greed/pressure to meet targets and opportunity and rationalization why the action taken was justified.

The Financial Accounting Standards Board (FASB), an independent body created by the sec, is still the main accounting rule-making body. However, for the first time, greater emphasis is being placed on user input rather than guidance only from preparers and auditors. While the major changes taking place are geared for the protection of investors in public companies, there has finally been a realization that banks, lenders and other creditors also have a vested interest in getting accurate financial statements. And these entities can provide valuable input to improve the quality.

A User Council has been established, of which the writer is a member, and regular meetings are held to discuss how financial accounting disclosures can be improved. This is the first time that we have been given a direct line to the FASB. We have also been consulted as to whether private companies should be subject to the same accounting rules as public companies. Yet the cost of financial statement preparation may well become disproportionate for small companies who do not prepare statements for outside shareholders. One of the recent speakers at the CFA Committee for Cooperation with Accountants was Daniel Noll, director of accounting standards at the AICPA, who discussed this issue with us. The general consensus should not be two sets of rules, but there may be some items which private companies could omit, e.g., pension liability disclosures, and it should be left to individual lenders to discuss the waiving of compliance with specific items. CFA is assisting in the AICPA study of the subject by sending out a questionnaire to members.

Auditors now realize that it's "back to basics." Prior to Enron, the trend for accounting firms was to diversify into all types of consulting services. Auditing was considered a commodity. At one stage there was even a suggestion that "CPA" should be changed to "Certified Professional Advisor." In a sense, this is what actually happened, to the detriment of the quality of auditing. Unfortunately, things had to get worse before they got better. Now tremendous emphasis is placed on audit quality and auditor independence. There has even been a suggestion that for auditors to be truly independent, they should not be hired by the management on whom they are reporting. This revolutionary idea: public companies should set up an audit-selection committee comprising nonmanagement shareholders, lenders and some independent members. This committee would appoint the auditors and fix their compensation. This is the first time it has been suggested that lenders have input in the process.

It is impossible for auditors to check every transaction. This would make the cost of the audit prohibitively expensive. Statistical sampling is the accepted standard and, provided no exceptions are found within the sample, it may be assumed that the transactions being checked are correct. With business becoming more complex, auditing has become much more difficult. Auditors now realize that they must focus on revenue recognition, off-balance liabilities and fair value of assets. One major problem: employees of the audit firms initially checking the documents- the foundation for building the financial statements-have the lowest level of experience in the firm. By the time information reaches the senior and experienced staff it is too late. Experienced auditors, who can perform a "smell test", are needed in addition to the technical checking which takes place. This involves a detailed understanding of the client's business and the industry in which they operate.

Most lenders do not rely on audited financial statements for lending purposes and instead accept reviewed statements, even for larger loans. Thankfull,y the AICPA has issued new guidelines on performance of review engagements and standards for accounting and review services. They will take effect for periods ending on or after December 15,2004. The chairman of the AICPA Accounting and Review Services Committee stated, "We are at a point where we felt there needed to be some clarification to make the review more meaningful". This is exceptionally good news for users of reviewed statements. The new provisions expand guidelines and analytical procedures, methods of inquiry and development of expectations. While the consideration of fraud has always been a part of the review engagement, the standard also includes new specific provisions on fraud. A required inquiry regarding fraud and management will now have to sign off as to whether any knowledge of fraud or suspicion exists, involving management or others, which could have a material effect on the financial statements.

Regarding "expectations", CPAs are given specific instruction on how they should compare client financial data with expectations based on their understanding of the entity, along with the industry in which it operates. CPAs have always used a variety of analytical procedures from simple comparisons to complex models i.e., trend analysis, ratio analysis and benchmarking, but now these methods have to be documented. This also includes comparing actual results with forecasts from the entity and, with nonfmancial information, may be significant.

The CPA's inquiries during the review must be sufficiently flexible and open ended to identify any new consistencies between expectations and results and to resolve any inconsistencies to the extent possible and appropriate. As all this information now has to be documented, including what procedure the accountant used, lenders should ask for copies of these documents. If prepared correctly, they should provide invaluable information about the operating results and variances from projections and/or industry norms.

More changes have taken place in financial reporting in the last three years than during the last 100 years. Many changes benefit lenders. And lenders are being invited to participate in the improvement of accounting and auditing standards as never before. We should not lose this opportunity of sailing with the tide which has turned in our favor.