More Ideas on Audit Reform; Joint Frameworks

A Treasury Department advisory committee has published a new set of recommendations to reform the auditing industry, this time tackling sensitive subjects such as litigation reform, the content of the auditor’s report, and transparency of the audit firms themselves.

The ideas—published as an addendum to previous recommendations published in a May 5 draft report—are sure to touch a nerve. Even the chairman of the committee, Don Nicolaisen, said: “These are subjects that have been discussed and debated for years. Not surprisingly, the sub-committee had a difficult time reaching consensus.”

The addendum asks for views on whether Congress should pass legislation moving lawsuits against most large audit firms from state court to federal court, since the firms are regulated at the federal level. The addendum also recommends that the Public Company Accounting Oversight Board should establish new rules to expand the content of the auditor’s report, require audit engagement partners to sign audit reports, establish indicators of quality for audit firms, and require public annual reports from audit firms.

The report notes the committee (formally known as the Advisory Committee on the Auditing Profession) has tussled over whether it should address the question of litigation against audit firms. The auditing industry fears that unbridled legal liability risks the collapse of another large audit firm, such as Arthur Andersen’s collapse after Enron. Given that only four large auditing firms remain, the collapse of any one of them could throw the business of auditing public companies into chaos. Investor advocates, meanwhile, say they should be allowed to hold audit firms accountable for mistakes they should have foreseen.

The report says Congress should develop a “uniform standard of care with the appropriate and necessary levels of investor protection” that would eliminate differences at the state levels.

Turner

Committee member Lynn Turner, former chief accountant at the Securities and Exchange Commission, says the original May 5 report was voted on and approved by the full committee, but the addendum was not. “Unfortunately, the addendum is just now being issued, three weeks after the original draft report,” he says. “There remain open issues and debate among committee members on these issues.”

Nicolaisen says the committee expects to hold the comment period open through about the end of June, although no specific comment date was published with the addendum. The committee hopes to finish its report in the fall, he says.

FASB Proposes New Disclosure for Credit Derivatives

The Financial Accounting Standards Board is proposing new disclosures that would give a better view of credit derivatives, sealing up yet another way information about risky financial instruments might be kept off the balance sheet.

FASB published a proposed staff position to increase disclosures about credit derivatives and guarantees, amending Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities, and Financial Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees.

FASB says many credit derivatives and financial guarantees are similar instruments, but not subject to similar disclosure requirements by existing accounting rules. FIN 45 calls for specific disclosures about financial guarantees and some, but not all, credit derivatives. The proposed FSP would amend FAS 133 to require additional disclosures about credit derivatives, and would revise FIN 45 to require additional disclosure about the current status of the payment and performance risk of a guarantee.

That would result in similar disclosure requirements for similar instruments, FASB says, enhancing the transparency of how credit derivatives and guarantees affect an entity’s financial position, financial performance, and cash flows.

Given current market turmoil and the lack of liquidity stemming from failed credit arrangements, the Board is fast-tracking the guidance. “The Board believes that because of the large size of the credit derivatives market and the importance of having similar disclosures for similar instruments, the effective date for the proposed disclosures should be as soon as practicable,” the proposal says. It is expected to be finished in the third quarter and become effective for fiscal years and interim periods ending after Nov. 15, with early adoption encouraged.

FASB, IASB Move Ahead on Joint Conceptual Framework

FASB and the International Accounting Standards Board have published two documents outlining their work to establish a common conceptual framework, which is intended to provide a foundation for developing future accounting standards.

One document establishes a preliminary view on what constitutes a reporting entity for purposes of establishing its accounting and disclosure requirements. The preliminary view defines a reporting entity as a “circumscribed area of business activity of interest to present to potential equity investors, lenders, and other capital providers.” Control is the basis for determining the composition of a group reporting entity, and consolidated financial statements should be prepared from the perspective of the group reporting entity, according to the boards’ preliminary views.

Another draft document contains the first two chapters of the conceptual framework itself, seeking views on an improved objective of financial reporting, the qualitative characteristics of information provided by financial reporting, and constraints on providing that information. The two draft chapters take into account initial feedback provided when the boards first published their initial views in July 2006.

The draft says the objective of financial reporting should be to provide financial information that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. It also presents an improved description of “faithful representation,” one of the qualitative characteristics that financial information should possess if it is to provide a useful basis for economic decisions.

FASB Project Manager Jeffrey Johnson says the two documents represent the first of at least four phases currently in development, with another three to four phases planned further down the road. FASB and IASB hope to complete a joint conceptual framework by 2011.

Given the pace of U.S. movement toward International Financial Reporting Standards, Johnson says the project is important to remove inconsistencies in how the FASB develops standards compared to IASB. “Whether the U.S adopts IFRS or not, this effort will benefit financial reporting in the United States,” he says.

Although the boards are currently developing major, converged accounting standards now without the conceptual framework completed, Johnson says the work on the conceptual framework forms thinking around current rulemaking even as it is in development. “As decisions are made in the conceptual framework project, it is used for making decisions on standards,” he says. “When a consensus is reached and you have the information, you can’t unlearn it when doing the standard setting.”