When a client makes an accounting change, an auditor must determine whether the effect is sufficiently significant as to require report modification. Auditors have long been required to make such judgments, but SAS 2 did not rule out issuance of a consistency modification for changes with a seemingly immaterial effect. SAS 58 apparently reduces this flexibility when it states that auditors should not refer to consistency when the effect of the change is immaterial. This article analyzes reporting under SAS 2 to provide insight into situations in which CPA firms have modified reports because of consistency matters. The approach is to first identify companies that have changed accounting principles and then to determine whether the audit report included a consistency modification.

The Evolution of Audit Reporting for Changes in Accounting Principles

From 1933, until the issuance of SAS 59, auditors have been required to include an explicit statement on consistency in the audit report. This requirement was originally instituted when GAAP did not require such disclosure. Thus, a consistency modification included in an audit report provided information which, unless the client voluntarily disclosed such information, was not otherwise presented in the financial statements.

Subsequently, the APB passed Opinions 20 and 22. Issued in 1971, Opinion 20 requires specific management disclosures regarding an accounting principles change, including the nature and justification for the change, its effect on income in the period of the change and the related per share amounts, and pro forma disclosures of income and earnings per share for all periods, presented. Opinion 22, issued in 1972, requires the presentation of a summary of the significant accounting principles followed, regardless of whether there has been a change in principles.

In 1978, the Cohen Commission concluded that the requirement for auditors to report on the consistency of application of accounting principles was unnecessary and should be eliminated. The Commission reasoned that current accounting standards ensured the proper treatment and disclosure of any changes in accounting principle that had occurred in the periods covered by the report.

In 1987, the ASB proposed implementation of the Cohen Commission's recommendations, 1) to eliminate the reference to consistency, in the standard audit report and 2) to eliminate consistency modifications when a change in accounting principle occurred.

SAS 58 removed the reference to consistency in the standard report but retained the previous requirement that a consistency modification be included in the audit report when an entity changed accounting principles. The decision to retain the consistency modification appears to be consistent with the preference for accounting change disclosure by the SEC.

SAS 58 also changed reporting requirements in that it specifically states that a consistency modification is not appropriate when the effect of a change is not material.

Approach

The approach was to examine the financial statement disclosures for accounting changes from a large sample of firms under the reporting requirements of SAS 2. Data was gathered from annual report footnotes and the accompanying audit report for situations in which reporting firms had made one of three changes in accounting principles: 1) adoption of SFAS 52, Foreign Currency Translation; 2) LIFO adoption; and 3) adoption of SFAS 43, Accounting for Compensated Absences. A review of the AICPA's Accounting Trend,; and Techniques revealed that these were three of the most common accounting changes that took place during the 1980s. Also, this collection of accounting changes includes both discretionary (LIFO) and mandated accounting changes (foreign currency translation and accounting for compensated absences).

We used the National Automated Accounting Research System (NAARS) to search for instances in which firms made one of the three accounting changes. The search procedure followed the general format described below:

1. From NAARS, the audit opinion file was searched using key words related to each of the specific types of accounting changes. This procedure was designed to find examples where audit reports were modified for consistency.

2. From NAARS, the footnote file was searched using the same key words but adding the constraint that the entity was not in the group identified in step (1). Because APB Opinion 20 requires accounting principles changes to be disclosed by the reporting company this procedure was designed to find companies receiving unqualified opinions, that is, firms changing accounting principles but not receiving opinions modified for consistency.

3. After examining the audit opinions, footnotes and financial statements for the firms identified in steps (1) and (2), candidate companies were eliminated from the sample if the dollar amount of the income effect of the accounting change was not given, or it was not explicitly stated as immaterial. The income effect of the change in accounting principle was taken from the annual report footnote describing the accounting change. The emphasis of the analysis presented is to summarize situations in which CPA firms did and did not modify their audit reports when a change in principle had occurred.

Results

The type of audit opinion (modified or unmodified for consistency) was summarized for each of the three accounting principles examined by categories of income effect by audit firm. The income effect categories are derived from the work of Holstrum and Messier. (G. L. Holstrum and W. F. Messier, jr., "A Review and Integration of Empirical Research on Materiality," Auditing: A journal of Practice and Theory, Fall 1982.) They examined a large body of literature related to auditors' materiality judgments and concluded that, 1) items more than 10% of income are generally considered material by users, preparers, and auditors and 2) items that have less than a 4% or 5% effect on income would normally be considered immaterial by all groups. The area between 4% and 10% may be viewed as a "gray" area, a range of income effect where individual judgment and other factors may influence the decision regarding materiality. In this range, one might expect little agreement among different decision makers regarding materiality.

For accounting changes having an effect on income of 10% or more in the year of adoption, a high degree of consensus exists among auditors. Altogether 78 of 81 accounting changes in this category received audit opinions modified for consistency.

This consensus extends across both audit firms and type of accounting principle changes. Furthermore, consensus is apparent for both a mandated accounting change, foreign currency translation, and a discretionary change, LIFO adoption. The adoption of SFAS 43 concerning compensated absences resulted in few instances in which the income effect of the change exceeded 4%.

Surprisingly, even in the 4% to 10% gray area, most of the audit opinions were modified for consistency by all audit firms. In fact, 68 of 76 (89%) accounting changes with income effects of between 4% and 10% resulted in consistency modifications. No differences in audit reporting decisions among auditors is apparent. Most of the accounting changes within this income effect range were LIFO adoptions, a discretionary accounting change, and all of these changes were modified for consistency.

In the income effect category of 0% to 4%, a range generally regarded as not material, the results are also somewhat surprising. In this category there is a high frequency of opinion modification, 77 consistency modifications out of a total of 127 accounting changes (61%). However, unlike the higher income effect categories, there are noticeable differences among the firms. For example, one large firm modified 20 of 27 74%), while another modified only 6 of 22 (27%) reports.

The last income effect category is composed of those instances in which the reporting company's financial statements indicate that the accounting change has no material effect on income. Nevertheless, consistency modifications frequently resulted. For all accounting changes studied, 72 of 278 (26%) immaterial accounting changes resulted in audit reports modified for consistency. The frequency with which immaterial changes received consistency modifications again appears to vary by audit firm and also by type of accounting principle change.

How Will SAS 58 Alter Auditors' Reporting Decisions Regarding GAAP Changes?

Under the new standard, SAS 58, auditors' reporting responsibilities appear to be more sharply defined. SAS 58 limits the use of the explanatory paragraph to those accounting principle change situations that have a material effect on the comparability of the financial statements. It is explicit with regard to immaterial accounting changes. These changes should not be highlighted in the audit report.

SAS 58 does not explicitly address changes in accounting principles that have an immaterial effect on the financial statements of the current period but may be expected to have a substantial effect in later years. The guidance in these situations remains substantially unchanged. AU 420.19 does not prohibit recognition in the audit report of accounting principle changes that have no current material effect but are expected to have material effect on future financial statements of the client:

"If an accounting change has no material effect on the financial statements of the current year, but the change is reasonably certain to have substantial effect in later years, the change should be disclosed in the notes to the financial statements whenever the statements of the period of change are presented, but the independent auditor need not recognize the change in his report."

This guidance seems to contradict the guidance of SAS 58 that apparently precludes auditors from referring to consistency when accounting changes have no material effect on the comparability of the financial statements.

Because the language of SAS 58 appears to limit the use of the consistency paragraph to only those situations in which the effect of the change is material to the comparability of the financial statements, an auditor might wish to document the basis for decisions to include, as well as not to include, a consistency modification.

Gene Chewning

Kurt Pany

Steve Wheeler