By David L. Landsittel
While there are many issues currently facing the auditing profession, three in particular carry with them challenges that must be addressed in the near future: earnings management, fraudulent financial reporting, and internal control: focusing on the process.
Many, including the SEC chair and chief accountant, have expressed concern about public companies inappropriately “managing” earnings—intentionally recording accounting misstatements in order to adjust reported earnings—presumably to obtain a targeted earnings figure or facilitate an earnings growth. The concern is that auditors may be too tolerant of such adjustments, rationalizing that the effect is not material, even though the adjustment itself could be considered prima facie evidence that the company’s reported results would otherwise elicit an undesirable investor response.
Following from this concern is the observation that given the current high market price-earnings multiples, even a penny-a-share deviation in reported earnings compared with analyst expectations is likely to trigger an investor response that could affect market capitalization by millions of dollars. Accordingly, the view is that auditors should adjust materiality judgments to recognize the sensitivity of the current market environment.
A number of initiatives have been undertaken in response to this concern. First, with the Big Five firms serving as a catalyst, the Auditing Standards Board (ASB) has recently approved a new standard dealing with how unbooked audit adjustments are communicated—assuring that top management and the audit committee are specifically aware of unrecorded adjustments and that management is responsible for concluding in its representation letter that the effect is not material. The goal is to encourage the recording of proposed audit adjustments, eliminating the need to evaluate whether their effect is material.
Second, the Big Five have agreed to incorporate into their audit policy guidance advice as to the kinds of “qualitative” factors to consider in evaluating the materiality of proposed adjustments. Generally accepted auditing standards require the auditor to consider qualitative (as well as quantitative) factors but offer few examples of specific qualitative factors to consider. The Big Five guidance is now available on the AICPA website, and the ASB has indicated an intent to incorporate similar guidance into the auditing literature.
The SEC’s recently issued SAB 99 discusses qualitative factors to consider in evaluating materiality that are reasonably consistent with the Big Five guidance and is helpful in encouraging registrants to record proposed audit adjustments.
Finally, important audit research conducted under the direction of Professor Bill Kinney of the University of Texas has examined “earnings surprise”: Conclusions do not appear to support the notion that the current market environment is so different as to require a fundamental change in how auditors view materiality.
Notwithstanding the preceding initiatives, the concern about earnings management triggers a number of challenges for the auditing profession.
Challenge No. 1: Aggressively working to eliminate or minimize any unrecorded audit adjustments. The best way to attack concern about auditors being too tolerant of intentional misstatements is to eliminate the acceptance of misstatements in the first place. While SAS No. 89 and SAB 99 provide tools, it is up to the profession to use these tools effectively. The profession needs to explicitly call attention to unrecorded audit adjustments, regardless of immateriality. Auditors should challenge management to justify not recording proposed audit adjustments. If the adjustments are indeed immaterial, the marketplace effect would be inconsequential and recording them would not produce an adverse investor response.
Challenge No. 2: Seeking greater consensus on what constitutes a material adjustment. There is much variation in how different firms and professionals evaluate materiality quantitatively. There are three dimensions to these differing approaches:
First, the profession lacks a single quantitative threshold establishing a presumption of materiality absent intervening qualitative factors. Anecdotal evidence and common wisdom suggest that individual thresholds vary widely, from 3% to 10%. The profession would be well served in closing this gap.
Second, there are differing views on how a prior year misstatement affects the measure of the materiality of a misstatement. As an example, assume an audit client needs an inventory obsolescence reserve. The shortfall is $1,800 at the end of the current year, and was determined to be $1,500 at the end of the preceding year. Some argue that an evaluation of materiality would measure the misstatement as $1,800 since, under GAAP, recording the adjustment to fix the problem would result in a charge to current income of $1,800 (as the effect in the prior year was previously assessed as immaterial, eliminating the opportunity for restatement). Others would measure the misstatement as $300 since the “real” effect on current income would be the difference between the current and preceding years’ reserve shortfall.
A third significant difference in practice arises in evaluating the effect of misstatements on interim periods. Some say that the evaluation of interim misstatements should be measured solely by the effect on the interim period, while others believe that the effect should be annualized. For example, assuming earnings of $1 million per quarter, should the materiality of a $100,000 interim misstatement be evaluated against $1 million or against the $4 million annualized income amount (as would be done in the annual audit)?
Still another controversial area is the motive of management: Specifically, should a misstatement that otherwise might be deemed immaterial be viewed as unacceptable because of a motive to manage earnings? SAB 99 would seem to say yes. And, of course, the underlying premise questions how a misstatement could be “immaterial” if it in fact arose because of a desire to manage earnings. The difficulty for the auditor arises, of course, in evaluating management’s motives.
Challenge No. 3: Obtaining further understanding as to whether marketplace environmental changes should affect materiality decisions. Kinney’s previously mentioned research on earnings surprise tentatively concludes that investors’ decisions have not been fundamentally affected over time by such environmental factors as high market capitalization and price/earnings ratios and increased prominence of comparing reported earnings against analyst consensus figures. In fact, the research notes that other contemporaneous factors have resulted in an investor response that is contrary to the direction of the earnings surprise 46% of the time.
An ongoing issue remains whether materiality judgments are aligned with investor decision making. Would some misstatements evaluated as “immaterial” by management and auditors in fact affect investor decision making if recorded, and conversely, do some issues that are concluded to be “material” really have little or no significance to the investor? Kinney’s conclusions should be the subject of further validation and present specific suggestions for further research.
In summary, regardless of whether the concern that auditors are too lenient in permitting inappropriate earnings management is valid, the profession should work harder to get management to record even immaterial proposed audit adjustments, come to a further consensus on how to measure what constitutes a material misstatement, and support further research on whether the auditor’s evaluation of what is material aligns with investors in today’s marketplace.
Fraudulent Financial Reporting
Management of earnings suggests tinkering with earnings but presumes that the results are not materially misstated or fraudulently misrepresented. Nevertheless, tinkering leads to cooking: Typically, fraudulent financial reporting starts out small and grows over time to become full-blown “cooking the books.”
Fraudulent financial reporting is harmful in many respects. It undermines marketplace confidence and the quality and usefulness of audits. It often results in huge litigation costs. It destroys careers. And it sometimes precipitates excessive regulatory intervention.
Over recent years, the auditing profession and others have been reasonably aggressive in addressing concerns. SAS No. 82 was issued with the goal of sensitizing and clarifying auditors’ responsibilities for detecting material misstatements due to fraud and providing a framework for meeting these responsibilities. More recently, the Big Five have voluntarily initiated policies that require timely interim reviews for all publicly held clients, an initiative that has been supported by proposed SEC regulation. This is important, because fraudulent financial reporting often begins with interim periods; sometimes without the cover-up that would precede the annual audit.
Some current initiatives extend beyond the auditing profession. For example, the National Association of Corporate Directors has released two booklets that address audit committee best practices, one of which specifically provides guidance on the audit committee’s role regarding fraudulent financial reporting. In addition, there has been a marked increase in research; the Committee of Sponsoring Organizations (COSO) recently released an insightful study of fraudulent financial reporting investigations by the SEC from 1987–1997.
In an environment that demands continuous improvement, there are some important challenges for the auditing profession to address in the area of fraudulent reporting.
Challenge No. 4: Joining with other financial reporting stakeholders in spearheading advances in fraud prevention and deterrence best practices. Although there have been individual initiatives by accounting firms and others to provide insights on prevention and deterrence of fraudulent financial reporting, not since the Treadway Commission in 1987 has there been a significant joint effort among financial reporting stakeholders. Additionally, most commentary deals with prevention and deterrence narrowly (e.g., solely the role of the audit committee or the internal auditor).
Since Treadway, some interesting information has been published on the root causes of fraud. For example, the “fraud triangle” outlined by Professor Steve Albrecht at Brigham Young University persuasively notes that all frauds are “ignited” through the combination of three ingredients or root causes: pressure (e.g., pressure to meet profit expectations or to maintain or increase stock values), opportunity (i.e., a lack of internal control over financial reporting), and rationalization (i.e., compromised ethical reasoning justifying the fraud). The Treadway thinking needs to be updated: the financial reporting stakeholders need to join forces to study the root causes and to develop and publish best practice guidance with the goal of meaningfully advancing the state of the art in prevention and deterrence of fraudulent financial reporting.
A specific area that warrants particular attention is the process management follows in addressing analysts’ expectations. If management can be more effective in communicating in the marketplace to assure that analysts’ expectations are aligned with expected financial results, the pressure to cook the books in order to avoid an undesirable earnings surprise will be mitigated.
Challenge No. 5: Taking auditing guidance and standards on fraud to the next level. When SAS No. 82 was released in late 1997, it was not intended to be the answer to concern about the auditor’s responsibilities and performance in detecting fraud. Rather, it was an important step in an ongoing process of continuous improvement in how auditors address their role in detecting material misstatements due to fraud. The AICPA has subsequently sponsored some important audit research in this area.
In moving forward, some important issues remain to be addressed:
Challenge No. 6: More systematically addressing how to add assurance that audit work is accompanied by the necessary professional skepticism. Often, it is noted in after-the-fact evaluations of undetected fraud that had the auditor simply asked that one additional question, or carried out that one additional audit step, the fraud might have been detected. In almost every instance of alleged auditor failure to detect material misstatement due to fraud, lack of the necessary professional skepticism has been asserted.
The auditing literature and the reference and training materials of the various auditing firms exhort the need for professional skepticism. The guidance contains all the right words. But the auditing environment contains many factors that work against professional skepticism. For example, the auditor almost always conducts the work under time pressures and deadlines; the auditor wants to maintain good relations with the client and accordingly may be reluctant to challenge management; and most auditors have never experienced material fraud first-hand and accordingly may be overconfident in presuming its absence.
The profession needs to invest additional resources to systematically address this concern. This should include looking outside the profession for guidance, for example, to behavioral scientists. Notwithstanding the importance of professional skepticism to audit success, never has a major profession-wide investment been made to assure it is adequately maintained.
Challenge No. 7: Developing an improved way to learn from past fraudulent financial reporting cases. For a number of years, the AICPA has had a process in place under the direction of its Quality Control Inquiry Committee (QCIC) to examine whether allegations of audit failure result from the existence of systemic weaknesses that should be addressed. Historically, this process has focused on individual cases and the assessment of whether there are issues arising from an examination of the specific case facts.
Future changes in the QCIC process should include a more thorough longitudinal review extending beyond the focus on a given case. More effort needs to be given to identifying common trends and environmental factors that would be helpful in identifying profession-wide root causes of auditor nondetection of material misstatement due to fraud. Recently, QCIC has developed a method of accumulating a limited database of case information that should assist in a focus that extends beyond the individual case-by-case facts. Hopefully, this will be a step in the right direction.
Internal Control: Focusing on the Process
Two separate but related problems need to be addressed in the area of internal control. The first is a concern that auditors do not have the ability to effectively assess the quality of the internal controls in place. There are two reasons for this. The first is a lack of skill and training. Many auditors are inherently good at focusing on results but less skilled at process-related evaluations. Second, and perhaps more important, some control elements cannot readily be assessed, particularly by an outsider. Two critically important facets of controls fall into this category: evaluating the “tone at the top” and evaluating the sufficiency of controls at owner-managed companies (where the ability to override exists almost by definition).
The second problem is this: The auditor does not assess controls as thoroughly as the investing public assumes. Generally accepted auditing standards require only a limited evaluation necessary to plan the audit, including the scope for testing. But most readers presume that a clean opinion is a stamp of approval not just to the financial statements presented, but also to the processes that underpin that reporting. In fact, studies have indicated that the latter may be valued more highly than the former; that is, investors are aware of the financial results prior to their presentation with the auditor’s report a month or two after year-end. The value of the auditor’s involvement is in the confidence it implicitly provides that the client’s financial reporting process can be relied upon in future disclosures, both interim and annual.
These two problems become more tenuous when considered together. The latter problem—investor misunderstanding of the extent of the auditor’s assessment of controls—can’t be solved if there is inherent difficulty in making such assessments, even if the additional work were to be performed.
Challenge No. 8: Working with other financial reporting stakeholders to further improve the “state of the art” of controls and control assessments. Auditing standards, the Treadway report, the COSO internal control guidance, and other sources present a reasonably coherent sketch of the elements needed to assure an appropriate tone at the top. The same applies, although to a more limited extent, to owner-managed company controls. Unfortunately, the criteria presented in the above material include slippery elements that are hard to evaluate. As a result, what appears to be a company with strong controls and an appropriate tone at the top may be one where subsequent financial reporting difficulties will result in an after-the-fact assessment that the controls and tone were in fact deficient.
To assure the ability of the auditor to develop an effective evaluation of the control elements noted above, the criteria need to be sharpened so that tangible deficiencies can be recognized before the fact. The profession needs to work with management representatives, internal auditors, and others in advancing the knowledge and thinking in this important area.
Somewhat related is the urgent need to further strengthen state of the art of controls and control assessment in the “new economy.” There is a new dimension to business risks that needs to be controlled, one that further extends beyond the boundaries of traditional financial reporting inasmuch as the assets and activities to be controlled include more elements not considered in the traditional accounting model.
Challenge No. 9: Developing an approach to encourage and facilitate
auditor reporting on controls. In order to better align themselves
with investor expectations, auditors need to devote additional resources during
an audit to the evaluation of internal control. One way would be to perform
auditor control reviews sufficient for a report on controls, a practice which
has been advocated previously by the Big Five and the AICPA. Such reporting
Regarding the last point, an Arthur Andersen presentation to the POB Panel on Audit Effectiveness recently noted that in 1978, the book value of all publicly traded companies equaled 95% of market value. Today it is only 40%. Stated another way, the current accounting model does not account for 60% of the assets valued by investors. An important first step toward a continuous reporting model that would include some assurance on new economy assets would entail auditor reporting on the control process, as opposed to the traditional GAAP model of focusing on results at a particular point in time.
The Future Outlook
There are certainly other, equally important, audit challenges besides the nine mentioned above. A longer list might include working to add assurance to global audit quality; developing criteria and standards to provide a better basis for auditing “soft” assets (including new economy assets); improving audit committee effectiveness as an audit quality safeguard; and attracting the best and brightest to the auditing profession.
With such daunting challenges, isn’t the very viability of the auditing profession at risk? To the contrary, the future is bright. The negative myths about the auditing profession need to be dispelled:
Current trends in the marketplace suggest that the future marketplace will need assurance services more than ever:
If the auditing profession can successfully address the many challenges facing it—and its track record suggests that it can and will—its viability will be even further strengthened and assured.
David L. Landsittel, CPA, is a consultant on accounting and auditing matters. He is a retired partner of Arthur Andersen LLP and a former chair of the Auditing Standards Board. This article has been adapted from a speech given at the AAA 2000 Auditing Section Midyear Conference and printed in The Auditor’s Report (Volume 23, No. 2).
James L. Craig, Jr., CPA
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