Toward a Unified Theory for Reporting

For nearly thirty years, until his death in 1955, Albert Einstein searched for a unified theory of physics. Confronted with an incomplete understanding of the universe, he also was motivated by profound antipathy toward quantum mechanics—the theory that says the universe is created of microscopic waves and particles that are somewhat interchangeable and whose location cannot be known until they are observed.

What does Einstein's work have to do with corporate reporting? More than you might think. More than a half century later, investors and others seeking information from audit committees and auditors can sympathize with Einstein's quest. Like him, they are confronted with an incomplete state of understanding. Like him, they cannot observe what they most desire to understand. As Martin Baumann, the PCAOB's chief auditor noted recently, one reason for investor concern is “uncertainty about what is actually done in an audit.”  

Not only is direct observation impossible, but the tools we use to indirectly observe are flawed. Today's audit committee reports and auditor reports have become dominated by boilerplate and legalese.

Take the pass-fail and perfunctory opinion about internal controls. Norman Marks, a thought leader at the Institute of Internal Auditors, took aim at this reduction of relevant information to near non-existence recently in his private blog. “What does a ‘satisfactory' rating in an audit report mean?” he wrote. “Your guess is as good as mine … can you rest assured that the risks they reviewed are being managed at acceptable levels? Are the people, processes, systems, and organizational structure in the area covered by the audit performing to your expectations? A satisfactory rating doesn't tell you. A satisfactory rating is unsatisfactory. It fails to tell the stakeholder want they need to hear: whether the risks in the area under audit are being managed the way they should.”

If audit reports are devoid of details, what about audit committee reports? They are not exactly fulsome, either. Consider, for example, the recent call to action by the Audit Committee Collaboration. It suggested such minor enhancements as clarifying the audit committee's scope of duties, defining its membership, clearly explaining what the audit committee considers when it hires or retains an audit firm, how and why it selects a lead audit partner, and how it decides to compensate, oversee, and evaluate the auditors.

In other words, an audit report should tell investors what the audit committee did during the year and why. Yet, judging from audit committee member responses at a recent University of Delaware forum, audit committee members are nervous about even these modest improvements. They cite the bogeyman of increased liability. That seems perverse: Why is there a reticence to be explicit about doing the job well, when that would be an affirmative defense in any lawsuit?

A Global Problem

Of course, the problem is not just an American one. Around the world, investors, regulators, and policy makers are seeking to improve the information investors get from auditors and audit committees, and they seem to be making progress. In the United Kingdom, for example, regulators required auditors to begin including three new pieces of company-specific information in this year's audit reports: (1) The audit scope; for instance, is 100 percent of the corporate group audited and, if not, what percentage was audited and how were the group parts selected? (2) The materiality threshold and how it was applied to the audit; and (3) The areas the auditors believe hold the greatest risk of restatements.

We're not about to get a unified regulator here in the United States, so let's try for the next best thing: Have the SEC and PCAOB coordinate their reforms.

Already the investment community in Britain has focused on the new disclosures. According to Citigroup, many of the audits used a materiality threshold of 5 percent of pre-tax profits, and some were as high as 10 percent. “In our view, many analysts and investors will be surprised at this relatively high level of materiality.” Overall, the banking group's view is that the new level of information will be salutary to the financial system. “The new information may be helpful in prompting better dialogue between companies and their shareholders on accounting and audit issues. We also suspect that companies may be prompted to provide better disclosure on matters highlighted in the auditor's report,” the banking firm wrote in a research note.

Skeptics note that the United Kingdom has a different regulatory system than the United States, and they have a point. Britain boasts a unified agency, the Financial Reporting Council, overseeing both accountants and auditors. Here in the United States, the Public Company Accounting Oversight Board oversees auditors while the Securities and Exchange Commission sets standards for financial disclosure. The regulatory picture becomes more complex when you consider that companies are actually chartered by states and the SEC only has jurisdiction on the disclosures of companies with multi-state interests, while the PCAOB only has jurisdiction on audit firms which perform audits of publicly traded companies.

This fractured oversight sometimes results in tangled efforts to improve transparency. The PCAOB, for example, has proposed changing the auditor reporting model to include a discussion of “critical audit matters,” meaning those issues that most concerned the auditors in reaching their opinions. Companies and auditors generally object to that proposal on the grounds that it might force audit firms to reveal information that the company itself has not yet disclosed in its financial statements. In effect, say these critics, the PCAOB proposal is a back-door attempt to improve the company's financial disclosures; perhaps a good idea, but one which is the jurisdiction of the SEC and not the PCAOB. While the FRC has done something similar, there is no question about its authority to do so.

A Coordinated Regulatory Effort

Investors, of course, just want the information irrespective of whose responsibility it is to compel it. We want audit reports and audit committee reports and company financial statements to work together to improve the overall quality of information provided.

We're not about to get a unified regulator here in the United States, so let's try for the next best thing: Have the SEC and PCAOB coordinate their reforms.

Right now, at exactly the time when the PCAOB is considering various changes to the auditor reporting model, and while the Audit Collaborative is trying to improve audit committee reporting, the SEC is considering how to streamline financial reporting. The current amalgam of required financial information has been an accretion of bits and pieces over the years that may no longer be needed by investors (high and low stock prices for the year, for example) or that may include duplicative information.

SEC Chairman Mary Jo White has made it clear she would like a streamlining of corporate financial reporting to be her legacy. But many investors are skeptical of the SEC's motives and what a stand-alone streamlined reform package might ultimately look like, given the fierce lobbying likely to come from the Chamber of Commerce and other corporate interests. Coordinating the PCAOB's efforts to improve auditor reporting and throwing the regulatory weight of the SEC behind improved audit committee reporting might just be the grand bargain that would work politically for investors, corporations, directors, and auditors, even while properly sorting out who should be disclosing what.

The SEC and PCAOB could start with a joint hearing asking not just what reforms should be made, but which report—the company's financial statements, the audit committee report, or the auditor's report—should include the disclosure.

Einstein never found his unified theory. But he was dealing with physical absolutes: With particles and waves, with electromagnetism and gravity. While regulatory regimes, self-interest, liability issues, and other issues may seem to be irresistible forces and immovable objects, in the end man-made issues are malleable. Given our fragmented regulatory system and the natural inclination of people in power to try to keep power (think of the multi-decade effort to merge the SEC and Commodities Futures Trading Commission), a unified framework for financial information might be impossible to achieve. But we could, at least, try for a logically coordinated one.