2013 to Bring More Waiting on Accounting and Audit Answers

Last year, Compliance Week said that 2012 would be a pivotal year for accounting and auditing developments. We predicted that, at long last, answers to the big looming questions, such as a decision on adopting International Financial Reporting Standards, would come. Like just about everyone else, we were wrong.

Worse still, answers on the big open accounting questions seem as far off as ever. The coming year promises to hold many of the same complexities and uncertainties in accounting and auditing as the one just ended, giving public companies good reason to buckle up for another wild ride.

That doesn't mean accounting standard setters, audit regulators, and the Securities and Exchange Commission won't be busy looking over corporate shoulders. 2013 will be a year when companies can expect to face significant scrutiny on any area where there is change, says Tim Ryan, a partner and head of the assurance practice at PwC. Whether that rests on internal or external factors, anything that suggests change is an area where there will likely be judgment, and those areas in accounting and auditing tend to be the most difficult, he says.

“Where ever there's a change in the environment, that's where we want to make sure companies are focused,” Ryan says. Changes in economic conditions flow through to an untold number of accounting and auditing judgments and estimates—fair-value measurements, impairments, contingencies, deferred tax assets, pensions, and many more. “Those are the inherent judgments that are going to be out there as long as there is financial reporting,” he says.

Rick Ueltschy, a partner and leader of the audit practice at Crowe Horwath, says persistent economic uncertainty and pressure on judgments will make asset impairments a continued area of focus for companies and their auditors. “On one hand we're technically in a recovery, so you see some accelerated business and maybe certain asset impairments are less likely to occur,” he says. “On the other hand, sometimes assets get weaker over time and they finally crack or become impaired during a prolonged downturn.”

Concerns about change and judgments represent one of several reasons that audit committees should make it their New Year's resolution to get more engaged with external auditors, says Frank Placenti, a partner and chairman of the corporate finance and governance practice at law firm Squire Sanders. The PCAOB has issued guidance in the year aimed at audit committees to help them better understand how they can question auditors on inspection results and to get better dialogue going between audit committees and auditors. “One of the real issues for the next several years for audit committees is to exert greater control over the audit agenda,” he says.

IFRS on Hold

The good news: Companies can quit wondering whether and when they might be expected to prepare to adopt International Financial Reporting Standards. The SEC is taking its sweet time in making some kind of definitive determination on IFRS and offering companies no reason to believe they should prepare for it. As Adam Brown, a partner with BDO USA's national assurance practice, considers the hot-button issues that companies should brace for in 2013, he says: “We know it isn't IFRS.”

Companies also can cross off their list of worries the threat of mandatory audit firm rotation. Facing crushing negative feedback and unable to generate any evidence to suggest audit quality would improve under a system of term limits for audit firms, the Public Company Accounting Oversight Board is regrouping and looking for other ways it can draw more professional skepticism out of independent external auditors.

“Sometimes assets get weaker over time and they finally crack or become impaired during a prolonged downturn.”

—Rick Ueltschy,

Partner,

Crowe Horwath

Cindy Fornelli, executive director at the Center for Audit Quality, says she is hopeful regulators and the profession will spend 2013 exploring other ways besides rotation to achieve the objective. “We heard a lot of good ideas about how we can help inject independence, objectivity, and professionalism not just for independent auditors but also for audit committees and preparers,” she says. “I'd like to see us focus on those areas as a path forward,” she says.

The PCAOB's latest initiative along those lines—an alert to audit firms reminding them of existing standards that require them to approach audit engagements with a skeptical mindset—is a clear warning to auditors, says James Comito, a shareholder at audit firm Mayer Hoffman McCann. “They certainly have our attention,” he says. Auditors are likely to heed the PCAOB's call for auditors to not rest too easily with evidence that confirms management's assertions, but to dig further in search of contradicting evidence as well. “You'd be remiss if you didn't start to think, ‘what's it going to take for us to demonstrate our skepticism?'” he says.

IMPEDIMENTS TO SKEPTICISM

Below is an excerpt from the PCAOB's Staff Audit Practice Alert No. 10, which discusses challenges to auditor application of professional skepticism.

Although PCAOB standards require auditors to appropriately apply professional skepticism throughout the audit, observations from the PCAOB's oversight activities indicate that, as a practical matter, auditors are often challenged in meeting this fundamental audit requirement. In maintaining an attitude that includes a questioning mind and a critical assessment of audit evidence, it is important for auditors to be alert to unconscious human biases and other circumstances that can cause auditors to gather, evaluate, rationalize, and recall information in a way that is consistent with client preferences rather than the interests of external users.

Certain conditions inherent in the audit environment can create incentives and pressures that can serve to impede the appropriate application of professional skepticism and allow unconscious bias to prevail. For example, incentives and pressures to build or maintain a long-term audit engagement, avoid significant conflicts with management, provide an unqualified audit opinion prior to the issuer's filing deadline, achieve high client satisfaction ratings, keep audit costs low, or cross-sell other services can all serve to inhibit professional skepticism.

In addition, over time, auditors may sometimes develop an inappropriate level of trust or confidence in management, which may lead auditors to accede to inappropriate accounting. In some situations, auditors may feel pressure to avoid potential negative interactions with, or consequences to, individuals they know (that is, management) instead of representing the interests of the investors they are charged to protect.

Other circumstances also can impede the appropriate application of professional skepticism. For example, scheduling and workload demands can put pressure on partners and other engagement team members to complete their assignments too quickly, which might lead auditors to seek audit evidence that is easier to obtain rather than evidence that is more relevant and reliable, to obtain less evidence than is necessary, or to give undue weight to confirming evidence without adequately considering contrary evidence.

Although powerful incentives and pressures exist that can impede professional skepticism, the importance of professional skepticism to an effective audit cannot be overstated, particularly given the increasing judgment and complexity in financial reporting and issues posed by the current economic environment.10/ Auditors and audit firms must remember that their overriding duty is to put the interests of investors first. Appropriate application of professional skepticism is key to fulfilling the auditor's duty to investors. In the words of the U.S. Supreme Court:

“By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This "public watchdog" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.”

Source: PCAOB.

2013 will bring some important developments on internal controls. Companies can expect initiatives on two separate but somewhat related issues. First, the Committee of Sponsoring Organizations (COSO) is expected to finalize its revision of its deeply entrenched Internal Control — Integrated Framework after a refresh of the 20-year-old guide. Tracy McBride, vice president of research and accounting policy at Financial Executives International, which participates in COSO and helped revise the framework, says it will be important in 2013 for companies to study the updated framework and consider what changes they might need to make to their control environment as a result.

Companies can expect their auditors to put greater focus on internal controls after the PCAOB recently published a summary of its inspection findings that too often auditors are not properly auditing internal controls. “There will continue to be challenges in the upcoming year with regard to how public companies properly prepare for audits,” she said.

Jason Flemmons, senior managing director at FTI Consulting and a former enforcement officer for the SEC, says companies should pay close attention in 2013 to the SEC's efforts to enforce its regulatory regime on China-based, U.S.-listed companies. The SEC has made clear it is not getting the access it needs through regulatory channels, so it is back in the court system playing hardball with the audit firms, he says. It's too soon for companies to take pre-emptive measures to find a new auditor, but it's plausible that China-based audit firms might face restrictions on their ability to serve as a principal or supporting auditor, he says.

Revenue Recognition Changes Coming

On the accounting side, Dan Noll, director of accounting standards at the AICPA, says companies need to brace for the finalization of one of the biggest new accounting standards to be introduced in years—a broad new approach on how to recognize revenue. The Financial Accounting Standards Board hasn't set an effective date yet for the new standard, but it has promised a finished product in the first half of 2013. “Even with a long effective date, possibly two to three years, I expect there's going to be some serious planning and analysis beginning in 2013,” he says. “Companies will need to start that process of determining whether and how their revenue recognition policies and approaches need to change.”

The coming year will represent a great balancing act, says Fornelli, with auditors, preparers, regulators, and even Congress weighing in on a long list of regulatory issues. “That's going to be both the challenge and the opportunity that lies before all of us in the capital markets this year,” she says.