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Jan 1992

Reporting and related auditor involvement in 1995.

by Dieter, Richard

    Abstract- Changes in the financial information requirements of the marketplace necessitate corresponding changes in current financial reporting and auditing practices. By 1995, it is forecasted that reporting and auditing will have evolved with particular emphasis on qualitative and quantitative forward-looking information, current values, sustainable earnings and cash flows, appropriately-timed release of information, and sustained involvement by independent auditors in the flow of financial information to the marketplace. The American Institute of Certified Public Accountants has already formed a special committee to address the changing needs for financial information. Their report may be available by May 1993.

It is unlikely that a new financial reporting requirement and related delivery mechanisms will occur in the near term. What is much more likely is a shift to a concept that emphasizes: 1) more forward-looking and predictive information in both quantitative and qualitative forms; 2) current values; 3) sustainable earnings and cash flows; 4) more timely release of information; and 5) continuous involvement by independent auditors in the financial information flow to the marketplace. A new phase in the process was recently begun. In mid- 1991, the AICPA formed a special committee on financial reporting to recommend ways in which external reporting can be made more relevant to users of financial information. Its report is due by May 1993.

Taking a forward horizon to 1995, let's envision the changes that realistically might take place that are consistent with the needs of the marketplace.




Financial statements covering past events and transactions will remain an important element of the financial information in 1995. However, the significance of the traditional historical financial statements will continue its downward trend, but at a much slower pace, as enhancements are built into these reports to improve their usefulness as an element of the predictive information needed by investors. Nevertheless, the primary usefulness of such statements will remain as a device for authenticating past estimates of future cash flows.

Improvements in the usefulness of historical financial statements will be concentrated in the following areas:

1. Increased Emphasis on the Qualitative Factors that Impact the Company. This includes increased information about risks, opportunities and uncertainties that may impact future earnings and cash flows. The SEC's increased emphasis on Management's Discussion and Analysis and its recent Interpretive Release (33-6835) are steps in the right direction. While the release continues the SEC's past distinction of not requiring projections, it clearly expects registrants to discuss a "trend, demand, commitment, event or uncertainty that is both presently known to management and reasonably likely to have material effects on the registrant's future financial condition or results of operations."

2. The Income Statement Will Evolve to a Point Where Sustainable Earnings are More Easily Determinable. To achieve this goal will require cooperation from both the FASB and SEC and elimination of the term "operating income" and other arbitrary regulatory prohibitions that exist today, such as classification of restructuring charges as part of operating income.

3. The Display Concept of Current Assets and Liabilities Will Fade Away. Not only the display concept, but with it a long list of technical issues of little importance to investors will also fade away. Rather, assets and liabilities will simply be listed in terms of their relative liquidity and maturities. Existing loan agreements that rely on these designations will have to be modified.

4. A Gradual Trend to Recognize in the Financial Statements the Effects of Economic Changes. For example, the impact of changing interest rates when they occur, as opposed to primarily a transaction- based approach in use today. This seems particularly appropriate for financial instruments whose measurement problems seem less severe than long-term nonmonetary operating assets. This trend will result in more current values being used in historical financial statements.

5. Gradual Reduction in Pressures to Smooth Earnings Volatility Through Accounting Conventions. As a by-product, FASB standards will become less complex and standards will recognize economic events in the periods they occur. For example, much of the complexity relating to accounting for pensions and other postretirement benefits is caused by rules designed to "smooth" the effect of changes into income over a period of years in lieu of recording the changes as they occur.



For over ten years the SEC has encouraged registrants through specific safe harbor provisions to publish foward-looking information (projections), yet very few companies have taken advantage of this opportunity. The reason most often cited as to why companies do not publish even short-term forecasts relates to legal concerns about potential liabilities. Others believe that the reasons relate to 1) the accountability that management would be held to for failure to meet its own objectives, and 2) the long-standing resistance to revealing information from which competitors may glean ideas about future plans.

Another possible reason why there is no loud cry form Wall Street or other sources of capital to prepare forecasts relates to the livelihoods of financial and investment analysts who spend time attempting to forecast an entity's future earnings and cash flows. Companies provide these individuals with more detailed information through exensive interviews, plant visits, and other vehicles and "guide the analysts" to appropriate ranges of future earnings and cash flows. Sitting back, one would think that market efficiency as a whole would be improved if the entity itself published a short and medium-term forecast of future cash flows and earnings instead of playing a "cat-and-mouse" routine with the analyst community.

A regulatory requirement for a company to publish forecasts is not a sensible solution. Rather, the marketplace must "speak" through shareholder requests for such information to 1) assist them in evaluating a company's prospects, and 2) help evaluate the effectiveness of the board of directors/management. An efficient market wuld suggest that to the extent credible short-term forecasts are made available by management, the market should reward these enterprises relative to other enterprises who do not make such information available.


Quarterly Reviews

Independent auditor involvement in 1995 may not be continuous; however, it should evolve to a much greater year-round activity. Today, many public companies have their auditors perform formal or informal reviews of their interim financial statements prior to their release. This practice has improved financial reporting without causing a delay in the release of information to the marketplace. In fact, the SEC recently issued a concepts release asking for comments as to whether it should require all registrants to have interim reviews performed by its independent accountants. Presently the SEC requires certain large registrants to have quarterly reviews performed by their independent accountants. These reviews can be performed currently or on a retrospective basis.

The marketplace's insatiable appetite for quarterly information calls for a high level of integrity in this information. In fact, particularly for high-growth companies, it is difficult to determine whether the marketplace puts more emphasis on yearly earnings versus quarterly earnings. The quality of this information is enhanced if independent auditors are involved on a timely basis. Enhancements will result from independent auditor involvement and pressure on management to improve systems that produce more reliable interim information. This step, which for many companies is already being done, should not represent a major burden for all public companies to adopt in the near future.

Financial Forecasts

On the presumption that the marketplace stimulates management into providing, at a minimum, a one-year forecast for public consumption, independent auditors are prepared to provide certain assurances with respect to this information. In 1985, after years of study and debate within the profession, the AICPA issued its statement on standards for accountants' services on prospective financial information, "Financial Forecasts and Projections," and in 1986 issued an accompanying document, "Guide for Prospective Financial Statements."

In summary, this standard, among other things, outlines the procedures an auditor would perform to enable him or her to attest to 1) whether the company's financial forecast (prospective financial statements) is presented in conformity witt AICP guidelines, and 2) whether the assumptions provide a reasonable basis for the company's forecast. The auditor, for obvious reasons, would not be in a position to attest to the achievability of the forecast since that is dependent on future events and management's future actions.

Having the independent auditor provide these assurances to a company's forecast, particularly one-year forecasts, is a natural adjunct to the audit of the historical financial statements since in many cases the audit evidence related to the carrying amount of the company's assets and liabilities is dependent on future events and circumstances. The auditor often discusses with management its plans and uses these plans, including support for them, as part of its examination of the historical financial statements. In addition, one of the final audit procedurs often performed in an audit of historical financial statements is to review the company's next-year budget (forecast). The purpose of this procedure is to ascertain whether the company's future plans contain any evidence contrary to that obtained during the course of the audit. It may also be a key element in the auditor's evaluation of the going concern assumption implicit in historical financial statements.

Since independent auditors 1) should be thoroughly familiar with the key factors that drive the economic activities of the company and therefore its forecast, and 2) already use the budget (forecast) in their audit of historical financial statements, it would seem a natural extension of the auditor's work to be in a position annually to issue an examination report on the company's forecast. While this would entail some additional procedures by the auditor, it would seem likely that much of the work could be done during the company's budget process before year-end and consequently allow the company to issue its yearly historical results and next-year forecast at the same time.

Qualitative Information

Public companies have been providing qualitative information about their historical financial results for many years in a wide variety of formats. While the FASB has chosen to stay out of this arena, although its charter provides it with authority over more than just financial statements, the SEC has been proactive, primarily through its Management's Discussion and Analysis (Md&A) requirements. In 1987, the SEC published a concepts release requesting comments on, among other things, auditor involvement in MD&A. As expected, most of the comment letters, a vast majority of which were submitted by registrants, rejected auditor involvement on the basis of cost and the fear that the contents of MD&A would become boilerplate language with a negative bias on risks and uncertainties.

On the other hand, as evidenced by the recent SEC special review of Md&As, a significant percentage of Md&As were considered seriously deficient. In FRR No. 36 (5/89), the SEC indicated that of 218 registrants reviewed, amendments of their filings wer required by 72 registrants, primarily related to deficiencies in MD&A. A second group reviewed by the SEC staff resulted in a somewhat similar percentage of required amendments. While the SEC staff does not attempt to ascribe reasons for the high rate of major deficiencies, the following come to mind:

* Failure to follow the rules;

* Rules are not explicit enough;

* Staff expectations are set too high;

* Careless preparation--lack of involvement/interest by top management; and

* Unwillingness to discuss negative factors or areas of uncertainty.

The SEC has provided additional guidance (Interpretative Release 33- 6835) to registrants to assist them in preparing MD&A. This guidance does not add new requirements to MD&A but does 1) clarify the present requirement to discuss forward-looking information and 2) provide several examples of situations that require specific discussion.

With this background, the natural question is whether independent auditor involvement with MD&A can provide value to the marketplace in view of the SEC findings. The independent auditor clearly has the necessary skills and knowledge to perform a valuable public service by providing assurances that management does a forthright job of explaining its historical results. A possible reporting vehicle for the auditor presently sits dormant on the AICPA's Auditing Standard Board agenda awaiting a demand for the service.

The real risk is whether auditors will become overly legalistic and rely on boilerplate language in their approach to reviewing MD&A. If that occurs, the value of the service is clearly diminished. Auditors need the proper frame of mind in performing their review to assist management in producing an MD&A that: 1) is readable and understandable; 2) is prepared without undue optimism or pessimism; 3) focuses upon material items in a broader sense than materiality is used in the historical financial statements; and 4) complies in all substantive ways with the SEC rules and guidelines. If management and auditors can hold to these objectives, the service and product will receive market acceptance.


By 1995, the changes in financial reporting suggested in this article will be viable. The marketplace will decide the role of the independent auditor with this new information. Our challenge is to be prepared to service these needs. We have the skills, and all that is necessary is a desire to participate in the expanding role of providing meaningful and timely financial information to the marketplace.

Richard Dieter, CPA, is a Partner in the headquarters office of Arthur Andersen & Co., and is the firm's Director of SEC Practice. He is a member of the AICPA, the AICPA SEC Regulations Committee, the ASB Task Force on SEC Matters and Forecasting, and the Massachusetts Society of CPAs. He is the author of numerous articles on financial and accounting topics.

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