‘The Future of the Accounting Profession’ Report

By Robert Bloom

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— Richard W. Fisher, Chair, The American Assembly, November 2003

Founded in 1950 by Dwight Eisenhower as an affiliate of Columbia University, the American Assembly (http://www.americanassembly.org/index.php) is a national, nonpartisan public affairs forum “illuminating issues of public policy by commissioning research and publications, sponsoring meetings, and issuing reports, books, and other literature.”

“The Future of the Accounting Profession,” the Assembly’s 103rd report, was coordinated by a blue-ribbon steering committee from finance, accounting, and education, including Paul Volcker, William Donaldson, Robert Denham, David Tweedie, Arthur Levitt, William McDonough, Derek Bok, Katherine Schipper, Washington SyCip, Clifton Wharton, and Roman Weil. Donaldson and Weil were also keynote speakers. This Assembly included background papers commissioned for the benefit of its participants, and discussions, along with question-and-answer periods. The mission of the project was to consider the status of accounting: the current situation, the desired future situation, and how to attain it. The participants voiced their own views rather than their institutions’. The report was reviewed and, where necessary, modified by the participants at the end of the conference.

On the whole, the participants were satisfied with recent regulatory changes, including the actions of the Public Company Accounting Oversight Board (PCAOB), created under the Sarbanes-Oxley Act of 2002 (SOA) to reform accounting practice, and with recent steps by accounting firms to enhance their own practices. The report stresses the subjectivity and judgmental nature of financial statements. Participants contend that too much is expected from audits, because financial statements are not precise and exact. The public, not to mention audit committees, may be calling for a degree of certainty in audits and accounting that cannot be achieved. This situation is usually referred to, though not in the report, as the “expectations gap.” The participants recommended that auditors exercise judgment to a greater extent, for example in detecting fraud. The profession needs to be revitalized to attract more qualified individuals. The participants also thought that the profession ought to be insulated from frivolous legal challenges. Finally, corporate boards should have more qualified audit committee members.

An Era of More Bright Lines, Less Judgment

Emphasizing that auditors should be “gatekeepers” whose primary allegiance must be to the public, the report recounts the events in the 1990s that led to the scandals in 2000 and beyond. While the report says accountants were not the only parties to blame, “all too many independent auditors lost their autonomy and judgment—and ended by blurring the line between right and wrong.” The audit became “a commodity with little intrinsic value,” yielding to management desires to release misleading financial statements. In essence, although the report does not explicitly say so, accounting self-regulation failed.

The participants maintained that accountants employ many “bright-line” rules when they should be using their judgment. Arguing that the dichotomy between “principles” and “rules” is artificial, the participants believe that “principles must accompany rules, and vice versa.” Put another way, principles and rules are closely related. The real issue, the participants maintained, is whether accountants and auditors can exercise professional judgment.

Some participants were concerned about the organizational structure of the Big Four firms—each a loose confederation of partnerships having individual legal entities yet often using the same overall name. Such firms do not necessarily use their resources effectively, because experienced auditors are often not on the scene where they are needed the most to pinpoint signs of trouble. A number of participants thought that auditing should not be totally separated from consulting, because the two functions can be closely linked. Moreover, this linkage appeals to high-quality professionals seeking employment in the Big Four. The report does not address, however, whether auditors may compromise their independence by also engaging in consulting with the same client.

The report forecasts that the balance sheet of the future will include assets reflecting alternative valuation methods in order to offer users a wider menu of relevant information on the statement as well as in accompanying notes, emphasizing the uncertainties inherent in the figures offered. Although the report fails to specify whether intangibles not heretofore reflected on the balance sheet would now be included, it appears to recognize that such a financial statement would appear to be appropriate in a dynamic business environment: “Including additional non-financial performance metrics … could help future users compare companies within a specific industry.” The participants also called for “different attestation standards for different parts of the financial statements,” with the report also proposing that auditors provide “limited attestation” for more subjective information—say, of a procedural nature.

Aware that the consolidation of accounting firms has given companies fewer audit choices, the participants further assert that “regulators [should] seek to maintain public confidence in the surviving Big Four accounting firms.” The report is unspecific about whether the size of the Big Four firms should virtually guarantee their survival. Nor does it offer specific remedies for dealing with any abuses that these firms may be responsible for. For example, the report might have recommended establishment by each of the Big Four of an independent board of directors. Nevertheless, the report does recommend that the PCAOB adopt a “supervisory” approach to regulation, engaging in “fire prevention” rather than extinguishment. The report also calls for accounting firms to place more emphasis on forensic auditing to uncover fraud, although the report offers nothing to clarify the role of the auditor in this respect.

Providing a Margin of Safety

Because the issue of auditor liability is troubling to the participants, they formulated specific suggestions for providing a margin of safety, including the following:

• If the PCAOB’s inspection and evaluation of auditors finds an auditor has satisfactory quality control, that auditor could be given a measure of protection from civil liability.
• The PCAOB plans to scrutinize audits of companies deemed to have a higher risk profile. If these examinations find the audits satisfactory, the auditors could receive an additional measure of protection.

The participants called for the SEC, PCAOB, and FASB to work together to implement, as they see fit, the report’s proposed changes in reporting formats and attestation. Such changes should reduce auditor liability.

The participants contend, in perhaps the report’s most significant recommendation, that auditors, who have to make many judgments and form subjective opinions, need to be protected from legal exposure; therefore, their liability ought to be limited. However, in view of the recent corporate scandals, this proposal would seem to an outside observer to be dead on arrival.

The Assembly participants argued that auditor compensation should stress audit quality rather than selling audit and nonaudit services. Audit opinions “must … dispel the notion that it is acceptable to use an accounting treatment of a transaction that may be in technical compliance with a GAAP rule but which presents a clearly misleading result.” The participants assert that auditors should override GAAP in such instances if necessary, but how that would operate is left unsaid.

On revitalizing audit committees, the report supports a proposed PCAOB rule to require auditors to evaluate whether committees satisfy stock exchange and SEC standards. A number of participants suggested knowledge of the following items as criteria for assessing the “literacy” of audit committee members:

• The transactions that require management to choose between accounting practices and use judgment in making an assumption or an estimate;
• The choices available to management when reporting such transactions;
• The choices made, and the reasons for the choices; and
• Whether the choices made lead to, overall, a fair presentation of the transaction.

The report seems to equate the “accounting profession” with the Big Four, and does not address itself to the many accounting practitioners who do not work for the Big Four, have no SEC clients, and have not been implicated in scandals. By its omission, the report seems to suggest, at least implicitly, that the small accounting practitioner, or non–Big Four auditor, does not play a significant role in American business. That is hardly the case.

The report stresses the notion that financial reporting and auditing are plagued by uncertainties that are not adequately disclosed. The key reason has traditionally been accountants’ apprehension about possible legal liability associated with the preparation and attest functions involving estimates and guesstimates. That is ironic, because failure to disclose the underlying uncertainties could magnify an accountant’s legal obligation for misleading reporting. The report does not note that this has been a perennial issue in accounting.

Another proposal stemming from the Assembly, although not a new one, is that Big Four firms should not necessarily hire accounting majors. New hires from other disciplines could pursue accounting courses and the CPA credential subsequent to joining an accounting firm. The Big Four have actually pursued that path in the past, with mixed results, although the report does not mention this. This observer is aware of this practice by the Big Four in China.

The report says the Big Four could assume a greater role in continuing professional education, recommending greater emphasis, in particular, on ethics, professionalism, and forensic accounting. In this manner, the report asserts that the Big Four “could become the gold standard.” It is not clear whether the Assembly participants are referring only to the education of Big Four staff or to the accounting community as a whole. The report also vaguely calls for the training of corporate directors to be “literate and knowledgeable” of business and accounting, but does not say how that should be done.

A Consensus Perspective Worth Reading

The American Assembly report synthesizes the views of 57 well-known participants on the current state of the accounting and auditing framework. The principal themes are: broadening the financial statements; improving the audit function; applying principles versus rules; reducing auditors’ legal liability; enhancing the functioning of audit committees; and cultivating highly qualified accounting professionals. While most suggestions are broad-brush in nature and lack specific implementation guidance, the group appears to have reached a consensus on a number of thorny issues and controversies. The report is worth reading as a perspective on the current, and future, status of financial accounting.