A Recap of Major Accounting Issues in 2007

The accounting and auditing professions had a busy year in 2007, grappling with all manner of new problems and concerns and trying to wrestle old ones into control. 2008 promises to be no different; below is a recap of major accounting issues last year and how they are likely to affect financial reporting executives in the next 12 months.

Auditing Standard No. 5

2007 began with significant hand-wringing over what the Public Company Accounting Oversight Board might finally do with its notorious Auditing Standard No. 2—the much-maligned rule governing the audit of internal control over financial reporting, criticized as driving excessive, unnecessary audit activity. The PCAOB revealed its solution in Auditing Standard No. 5, a slimmer, more principles-based version of its predecessor, AS2, that called for a top-down, less-tedious approach to the audit.

Companies should begin seeing the fruits of the PCAOB’s labor in 2008 in the form of a risk-based audit, more focused on areas that present the greatest chance of financial misstatement and less focused on checklists and testing of low-level transactions.

Hinchman

Grace Hinchman, senior vice president at Financial Executives International, says early evidence shows the new regulatory approach (AS5 coupled with new interpretive guidance from the Securities and Exchange Commission to guide management through its own process of internal control assessment) is working.

“Generally the anecdotal feedback is very positive, but the proof will be in the telling,” she says. “We are continuing to monitor the cost-benefit analysis of [Section] 404 for accelerated and nonaccelerated filers. It’s too early to say if it is sufficient for making 404 as effective and efficient as everyone is hopeful it will become.”

Tyranski

Glenn Tyranski, head of financial compliance at the New York Stock Exchange, says feedback from NYSE companies so far suggests auditors are still very cautious. “We continue to try to be encouraged at least by the tone at the top,” he says, referring to PCAOB Chairman Mark Olson’s repeated calls for a risk-based approach and promises that audit firm inspections will reflect a call for more judgment. “Audit firms won’t be convinced of that until they go through the inspection cycle.”

Meanwhile, smaller companies facing their first cycle of reporting on the effectiveness of internal controls may catch yet another break from the Securities and Exchange Commission. SEC Chairman Christopher Cox told Congress he will appeal to his fellow commissioners to give smaller companies two years to issue management reports without an accompanying audit, instead of the one year that rules now provide.

Fair-Value Measurement, Fair-Value Option

Financial Accounting Standard No. 157, Fair Value Measurement, took effect in large part with the close of 2007. It established a single—and controversial—definition for fair value as it is used throughout accounting literature and outlined a three-tiered approach for how to measure fair value. The new rule didn’t require new uses of fair value, but cemented the notion that values should be based on exit prices and observable market activity, not entry prices or entity-specific transactions.

In the same vein, FAS 159, Fair Value Option, was adopted in early 2007 to give companies the choice of reporting certain of their financial assets or liabilities at fair value. The Financial Accounting Standards Board’s intention was to allow companies the flexibility to measure related assets and liabilities using the same measurement method, enabling derivative-like accounting without the complexities of derivative accounting. The goal was to minimize the accounting-driven volatility that often flowed through to earnings as a result of using different measurement methods.

In its quest for clarity, FASB also dished up more questions and complexity, observers say. “FAS 157 is something our members are struggling with,” Hinchman explains. “It’s easier to fair value some things, but not so easy to fair value other things.”

As 2007 came to a close and the effective date for FAS 157 approached, FEI and the Institute of Management Accountants (among many others) called on FASB to offer a one-year reprieve to allow more time to learn the intricacies of the new rules. FASB largely declined, offering a one-year delay only for certain non-financial assets and non-financial liabilities and scoping lease transactions outside of FAS 157 to enable lease accounting rules to be addressed separately.

FAS 159, meanwhile, took effect at the close of 2007 with some entities, mainly financial institutions, electing early adoption. Tyranski says the result of the new fair value rules for public companies is significant complexity. “Preparers and auditors are getting quickly up to speed on what all this means,” he says. “There’s not a lot of practice and some of it sounds counterintuitive. It’s extremely complicated.”

Companies and investors should brace for volatility, Tyranski warns. “It’s not going to be uncommon to see dramatic changes in balance sheets as companies suddenly take mark-to-market adjustments,” he says. “There’s the potential for sizable quarter-to-quarter swings.”

Sub-prime Accounting Issues

The collapse of credit markets in 2007 has created a litany of questions about how to account for such a sudden and uncertain loss in loan and security values. Various groups, including the Securities and Exchange Commission, have called for careful application of fair-value rules and plenty of disclosure.

Randy Marshall, managing director at the consulting firm Protiviti, says the massive failures focused in sub-prime lending raise three major areas of uncertainty: valuation, adequacy of loan loss reserves, and liquidity.

The uncertainty looms large not only for financial institutions that originate and service such loans, but also for the scores of investors who bought securities based on those now-troubled loans. And it occurs just as companies are already wrestling with the complexities of implementing FAS 157 and FAS 159.

Under the new three-level hierarchy of measuring fair value prescribed in FAS 157, companies should pay closest attention to observable market prices when establishing fair value and rely on theoretical models only when no active market exists. But the credit collapse, Marshall says, complicates how to define an “active” market. Some securities are so devalued buyers and sellers have been virtually sidelined waiting for market uncertainty to pass.

Marshall

Some securities that are based on now-troubled lines are “fairly vanilla,” Marshall says, with “a direct line of sight to an active market.” Others, however, are more complex instruments with a less direct line to an observable market. “These assets are inherently much more difficult to measure and value in the existing market because there are so many variables that go into these instruments,” he says. “It’s very difficult to get a reasonable degree of assessment there.”

Accounting for reserves to cover prospective loan losses is complex at the best of times, Marshall says. The current climate only makes things worse, since reserves are based on historical performance data. “Because historical performance has been relatively benign and recent performance has been dramatically different, it will challenge what will be a reasonable base for the drivers,” he says. “It’s always a tough area.”

Taxes Under FIN 48

Accounting for taxes has long been one of the more complex areas of U.S. Generally Accepted Accounting Principles, and it only grew more complex in 2007 with the implementation of Financial Interpretation No. 48, Accounting for Uncertainty in Income Tax.

FIN 48 requires companies to report where they may have some uncertainty about tax positions they’ve taken with the Internal Revenue Service and other tax authorities. Companies have worried—and rightly so, based on early indications from the IRS—that revenue collectors would use the disclosures required by FIN 48 as a roadmap to find weak spots in the corporate tax return.

So far, the IRS is adhering to a long-standing policy of restraint, where agents will not request the underlying workpapers that explain the various tax accruals described in published financial statements. But legal questions remain about whether they might begin asking for those papers, and IRS auditors are getting training on how to study the disclosures as part of their preparation for the tax audit.

Henley

Steve Henley, national tax practice leader with CBIZ Accounting, Tax & Advisory, says companies remain concerned about the roadmap issue, but they’ll proceed on FIN 48 in 2008 in a more orderly fashion than in 2007.

At the start of 2007, companies were hopeful that FASB would grant a one-year delay to give more time for implementation; the board declined. Later in 2007, FASB granted the delay to private companies, but public companies proceeded at the start of 2007 with a hurried process to get first-quarter disclosures in order, Henley says.

“2008 will be the year they try to build compliance into their processes,” he says. “They may decide to bring some people in-house instead of using outside resources. As they go through the analysis, they’ll take time to recalibrate and think about what kind of tax analysis they could do.”

Henley says companies should generally expect IRS agents to become more aware of FIN 48 disclosures and use them to a greater degree in the tax auditing process, especially checking for movement of uncertainties from quarter to quarter as companies continually track their tax positions.