Financial Reporting; Pension Reform; More

The world’s six largest auditing firms have issued two reports advising capital markets on how to improve financial reporting, reduce the risk of fraud, and shift accounting practices away from a detailed, bright-line system toward a more principles-based approach.

The heads of the Big 4 firms—Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers—as well as second-tier firms Grant Thornton and BDO Seidman—issued their reports at the Global Public Policy Symposium in New York last week.

Titled “Global Dialogue with Capital Market Stakeholders: A Report from the CEOs of the International Audit Networks” and “Principles-based Accounting Standards,” the reports call on key players in the financial reporting process to do more to improve reporting quality and move toward greater use of accounting principles rather than hard, detailed rules. The firms say the elements of a high-quality, principles-based accounting standard are more faithful representation of economic reality, responsiveness to users’ need for clarity and transparency, consistency of rulemaking under a clear conceptual framework, an appropriately defined scope, use of plain language, and room for use of judgment.

Gannon

D.J. Gannon, a partner with Deloitte & Touche and leader of the firm’s IFRS Center of Excellence for the Americas, says the various players are moving in the right direction: rulemakers are working to converge U.S. accounting rules with international rules; regulators are talking about a need for principles and judgment; and preparers and audit firms are striving for more transparency. “The reality is there are all kinds of moving parts here, and the challenge is to make sure the parts are moving forward,” he says.

Neuhausen

Ben Neuhausen, national director of accounting for BDO Seidman, says a more consistent conceptual framework to govern the standards-setting process would be an important foundation. “If we could establish some basic philosophy and eliminate some of the inconsistencies and gaps in today’s conceptual framework, that would set the foundation in terms of key decisions,” he says.

The Financial Accounting Standards Board has been working to rewrite its conceptual framework in tandem with the International Accounting Standards Board to converge the rulemaking processes, but the effort often gets sidelined by other rulemaking projects.

“If FASB were then to write a standard, they would need to say what they think the economics of the transaction are, and how that translates into accounting requirements, so even those with a different view of the economics will understand the approach and be able to apply it,” says Neuhausen.

Do Proposed Pension Changes Create Earnings Volatility?

As accounting rulemakers press forward with a likely requirement for mark-to-market, fair-value accounting for pension assets and liabilities, a new study confirms market fears that the result will create substantial volatility in earnings.

The Georgia Tech Financial Analysis Lab recast five years of financial statements, from 2002 to 2006, for 24 of the 30 companies making up the Dow Jones Industrial Average, to see what current-period reporting of actuarial gains and losses would look like. (Data was not available for six of the 30 companies.) The lab wanted to see what might happen in earnings figures if the Financial Accounting Standards Board proceeds as expected to eliminate “smoothing” of pension gains or losses.

FASB already adopted Financial Accounting Standard No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, in September 2006 to require companies to reflect the funded status of retirement plans on the face of the financial statements and to eliminate delayed recognition. In a promised second phase of pension accounting reform, FASB wants to do away with techniques to smooth the reporting of gains and losses and to require fair-value accounting of pension assets and liabilities each reporting period.

In its analysis, Georgia Tech found significant swings in earnings after adjusting actual figures to surmise how they might look under the proposed accounting treatment. In 2002, for example, a year of overall weak market performance, median pension expense for the 24 companies would have been 887 percent higher than actually reported. In 2006, on a year of overall strong market performance, median pension expense for the collective group would have fallen 109 percent over those actually reported. (Companies report pension expenses as the net of pension expense and pension income, so a decline of more than 100 percent represents a figure that is below zero.)

Mulford

Chuck Mulford, director of the Georgia Tech lab, says FASB’s proposed direction would result in the appearance of companies carrying more risk. “It does give a clearer picture of what’s happening, but it’s going to take some adjustment on the part of analysts to get used to seeing big swings in income statements,” he says.

PCAOB: Some ‘Appendix K’ Requirements Still Apply

Now that the Securities and Exchange Commission has scrapped the reconciliation requirement for certain international filers, audit firms are asking questions about how that relates to their requirements under a separate auditing standard, known as “Appendix K.”

Tom Ray, chief auditor of the Public Company Accounting Oversight Board, addressed the subject at a recent conference of the American Institute of Certified Public Accountants, saying several provisions of Appendix K are affected by the SEC’s recent action.

Appendix K is a quality control standard adopted by the PCAOB when the regulator was formed under Sarbanes-Oxley. The objective of the standard is to improve the quality of SEC filings by companies whose financial statements are audited by foreign audit firms. It establishes requirements for a filing review to be performed by someone who knows U.S. accounting and auditing requirements, to be performed annually in connection with internal inspection programs.

Ray

Ray said the SEC’s decision to end the requirement that certain foreign filers reconcile their financial statements to U.S. Generally Accepted Accounting Provisions has implications for Appendix K requirements, which may compel audit rule changes. “The PCAOB staff is evaluating whether changes should be made to Appendix K, including whether it should be replaced with something else or eliminated and other possible changes to the Board’s standards and rules that may be necessary to clarify how PCAOB standards apply when financial statements are prepared according to IFRS,” he said.

Until then, Ray offered some guidance on how to navigate Appendix K given the end of the reconciliation requirement. For example, Ray said, the filing reviewer is required to discuss with the partner in charge of an engagement how familiar the engagement team is with U.S. accounting and auditing standards. “These provisions, which are specific to U.S. GAAP, are not applicable to a filing that contains no U.S. GAAP or U.S. GAAP reconciliation,” he said.

On the other hand, other filing review procedures such as reading the document to be filed with the SEC and discussing familiarity with certain auditing and independence standards, are still applicable even in filings that contain no U.S. GAAP, he said. Ray also reviewed inspection procedures as well as provisions around documentation and resolution of differences, some of which still apply even without a GAAP reconciliation.

IFAC Offers Guide on Auditing Standards at Smaller Entities

The International Federation of Accountants has published a one-stop guide for how to apply international auditing standards to smaller or medium-sized entities.

IFAC’s “Guide to Using International Standards on Auditing in the Audits of Small- and Medium-Sized Entities” provides a detailed analysis of ISAs and their requirements in the context of a risk-based SME audit, though it stops short of providing checklists or forms. IFAC says its member bodies around the world might prefer to develop accompanying tools such as training manuals, software, checklist forms or audit programs to facilitate implementation, IFAC technical manager Paul Thompson says.

Thompson

“Since the risk-based suite of ISAs were introduced in 2004, we’ve received a lot of requests from auditors to provide some sort of assistance on implementation,” says Thompson. “One of the best ways to do that is to provide an implementation guide. We’re trying to help auditors conduct efficient, effective SME audit in conformance with ISAS.”

IFAC’s International Auditing and Assurance Standards Board recently completed its redraft of existing ISAs to make the provisions clearer and easier to translate. The board is open to comments on the final two exposure drafts—ISA 210 (Redrafted), Agreeing the Terms of Audit Engagements and ISA 710 (Redrafted), Comparative Information-Corresponding Figures and Comparative Financial Statements—through April 15.