The risks around financial reporting have never been more real for audit committees. Increasing pressure from regulators and economic events, combined with massive changes in accounting rules looming on the horizon, should be worrying audit committees like never before.
Accounting experts point to several sections of corporate financial statements where audit committees should pay close attention to the numbers—both how the numbers are reached in current reporting periods, as well as how that accounting process will change in the future. And it takes more than a passing glance at the numbers for audit committees these days to discharge their duties properly, warns John Barry, a partner with PricewaterhouseCoopers and leader of the firm’s corporate governance practice.
“In today’s day and age, audit committees need to understand the technical accounting more and more,” he says. “Their responsibilities have formally increased. They need to be very involved.”
Daly
Most experts agree that the biggest financial reporting risks arise where management must use its best judgment and estimate some elusive items, such as the fair market value of intangible assets or contingencies for events that haven’t yet happened.
“All of these estimates are very, very fragile,” says Ken Daly, CEO of the National Association of Corporate Directors. “Audit committees have to be particularly vigilant about those assumptions, particularly assumptions that deal with shifting sentiment in the marketplace.”
Wright
The two most immediate examples are measurement of fair value and write-downs of distressed assets. Anytime that happens, and especially when market data is scarce, audit committees should be asking plenty of questions about the judgments and assumptions that go into such calculations, says Chris Wright, managing director at consulting firm Protiviti. Write-downs (also called impairments) for debt or goodwill are particularly touchy. So are judgments about when a company should consolidate (that is, report on its own balance sheet) any subsidiaries or other entities where the company has less than a 100 percent interest.
Daly says audit committees should also scrutinize the assumptions that go into defined-benefit calculations, as well as claims of obsolescence for items like inventory or receivables. “When you combine the poor economy with ever-increasing investor expectations, financial reporting fraud tends to increase,” he says—and anywhere that judgment must be made, the risk of fraud exists.
Lipman
Fred Lipman, a partner with law firm Blank Rome and president of the Association of Audit Committee Members, says the process a company follows to make judgments deserves a hard look from audit committee members, to assure that the process remains consistent. He sees that problem arising today mainly when a company must decide whether an impairment is temporary or not, which can carry significant consequences for the balance sheet and income statement. “You have to show some consistency in how you decide these kinds of issues, and you have to be able to justify it,” he says.
Bigger Concerns
Of course, audit committees have plenty of external events in the financial world to worry about as well. The Securities and Exchange Commission, for example, is investigating repurchase agreements following the bankruptcy of Lehman Brothers. Any number of other groups—regulators, standard setters, governance activists, accounting purists, and more—are exploring problems in securitization, debt restructurings, loan loss reserves, impairments, the use of fair value, and much more.
‘In today’s day and age, audit committees need to understand the technical accounting more and more … They need to be very involved.’
—John Barry,
Partner,
PricewaterhouseCoopers
Further on the horizon, however, much larger financial reporting issues loom. The Financial Accounting Standards Board is churning out new proposals at an unprecedented pace, part of a larger quest to make U.S. Generally Accepted Accounting Principles more consistent with International Financial Reporting Standards. Theoretically the boards will achieve convergence by June 2011; few people really expect them to meet that deadline, but FASB has already proposed substantial new standards for revenue recognition, financial instruments, comprehensive income, and fair value measurement. More new proposals for leases, going concerns, discontinued operations, and presentation of financial statements are coming soon.
Howard
Richard Howard, a partner at the regional audit firm Mayer Hoffman McCann, says audit committees must assure that management has a plan in place to study all the new proposals and analyze how they might affect the business. That plan should include not only current accounting practices but also the company’s systems for tracking and collecting data that would be necessary to comply with the new rules.
The company should also be looking to see whether changes in accounting rules would affect how loan covenants or default provisions in contracts are defined, and whether the company should act now to prevent any surprises in the future, Howard says.
For example, changes in accounting for leases will likely bring a flood of assets and liabilities onto corporate balance sheets. FASB is proposing to abolish the current distinctions between capital and operating leases, in a way that will end the current approach of expensing lease payments; that’s bound to alter a company’s leverage and key financial ratios that drive decision making. Audit committees should be telling management to be aware of those kinds of issues, Howard says.
Schnurr
QUESTIONS TO ASK
Which accounting standards give your company the most compliance challenges today?
Which proposed changes to accounting standards could cause the most turbulence for the company’s financial statements or accounting systems?
Are any of the company’s accounting practices today under regulatory scrutiny or subject to controversy?
Will the company have sufficient staffing and budge to handle changes to financial reporting in the next several years?
Have past cuts to staffing or budget undermined the company’s financial reporting function already?
—Tammy Whitehouse
Revenue recognition is another financial reporting concern where audit committees should review management’s assertions today and be looking for changes ahead. Jim Schnurr, senior national professional practice director with Deloitte & Touche, says FASB’s plan for a new standard on revenue recognition will hit virtually every company to some degree.
Companies in some sectors, such as technology, could see big changes in the conclusions they reach; others may only see a change in the process they use to reach conclusions about when to book revenue. “In some cases, it may not change the answer, but it may change how they get there,” Schnurr says. “And the systems that need to be put in place to comply with the standard may be very significant.”
Resources
All those strains on financial reporting will also raise questions about whether your company has the right resources—and enough of them—to handle the workload, Daly says. “Audit committees can’t be expert in accounting matters, but now is a very good time to investigate the capabilities within the financial reporting section of the CFO suite, to determine the readiness of the financial reporting team to deal with the tsunami of accounting matters that are on the horizon,” he says.
Even without worries about future changes, companies should be concerned about whether they have adequate resources for the demands of today, says Wayne Kolins, a partner and national director of assurance for audit firm BDO Seidman. “With the restructurings that many companies have gone through, some have wound up reducing their financial reporting resources,” he says. “That could lead to issues with controls and with keeping up with the complexity of the rules and the judgments.”
Barry
PwC’s Barry says that regulators are only getting tougher in today’s environment, and it’s incumbent on audit committees to be sure companies can answer difficult questions. “The advice we’re giving audit committees is to ensure things are buttoned down not only in financial reporting, but even in responding to comment letters” from the SEC, he says. “Be clear, crisp, and forthright.”
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