Ocotober 2002

The Charge: Failure to See the Big Picture in Financial Reporting. The Plea: Guilty!

By John P. McAllister

At first, I was going to plead guilty on behalf of the entire U.S. accounting profession. Realizing that this would be quite presumptuous, I decided to limit my guilty plea to myself. Readers will be free to join me in this guilty plea or to plead innocent.

Much has been written recently of financial reporting and auditing failures. Yes, the focus has been on a few spectacular cases, but most indications point to something more than a few isolated incidents. Most of what I have read has been published in the United States, written by (I imagine) U.S. citizens. However, I also subscribe to Accountancy the journal of the Institute of Chartered Accountants in England and Wales.

Two essays about the implications of Enron that appeared in the April 2002 Accountancy (pages 97 and 100) almost stopped me in my tracks. Both writers suggested that the excessive concern of U.S. accountants and auditors about compliance with detailed accounting standards has overshadowed the more important concern of a fair overall presentation. I had never before thought of our processes in this context. Perhaps more importantly, I found their contention to be haunting. Could it possibly be true?

Should fair overall presentation indeed be the primary objective of financial reporting and, therefore, the primary concern of auditors? I’m certain the average investor would agree that it should; however, I sought out the language in our standard audit report for my own answer. The second paragraph includes the assertion that we evaluate “the overall financial statement presentation.” The third paragraph includes the opinion that the financial statements “present fairly.” I started to think that our friends across the Atlantic might be right.

Yes, the “present fairly” opinion is completed or modified by the phrase “in conformity with generally accepted accounting principles.” But do we really wish to base the credibility of our profession on the argument that GAAP compliance yields (or is equivalent to) fair presentation? I think not. Even our Rules of Conduct allow for deviations from GAAP if compliance would result in misleading information. GAAP may well be the expected means of delivery, but fair presentation would have to be the desired (and expected) outcome of a world-class financial reporting and auditing process.

An oft-expressed defense of the focus on GAAP compliance is the supposed protection against legal liability. The rationale is usually this: “I can prove the financials were in compliance with GAAP more easily than I can prove they constituted a fair presentation.” The Enron case offers a stark rebuttal of this argument. Will it help to prove GAAP compliance when fair presentation was so obviously absent? I think not.

This compliance versus fairness dichotomy is an extremely important issue for financial statement preparers and auditors around the world. The International Accounting Standards Board’s (IASB) stated objective is to achieve agreement on global accounting standards through convergence of national and international standards. To facilitate convergence, the IASB’s structure includes representatives of several national standards-setters, including FASB. Not surprisingly, FASB has been and will continue to be a very active player in this field. Also, not surprisingly, the IASB wants (needs?) FASB’s cooperation and support.

But here’s the dilemma. The United States has always claimed to have the best standards in the world. In this context, best has usually meant a high level of detail. If, however, fair presentation is the primary objective, not compliance, accounting standards that are less detailed may actually be more effective. The greater the level of detail, the greater the effort on the part of preparers to get around the rules: Consider Enron and the 3% rule for special purpose entities (SPE). Both Enron and Andersen believed (at least initially) that the accounting for the SPEs was in accordance with GAAP. Would they have also argued that the result was a fair presentation? I think not! Should FASB push the IASB in the direction of highly detailed standards? I think not!

Yes, I plead guilty to a failure to see the big picture in financial reporting. Today, as a professor, and yesterday, as an auditor, my concern has been compliance with the rules. I need to change my focus to fair presentation.

How about you? How do you plead?

John P. McAllister, PhD, CPA, is chair and professor of accounting at Kennesaw State University in metropolitan Atlanta. He is a member of the NYSSCPA.A

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