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May 1994

Let's try to learn from our problems. (auditing profession) (Accounting & Auditing Alert)

by Carmichael, Douglas R.

    Abstract- The FASB and the AICPA are facing mounting criticism for their failure to develop satisfactory professional standards just as auditing professionals are coming under fire for failing to comply with existing standards. Discontent with the auditing profession is particularly acute in the area of audits of financial institutions, specifically in the valuation of loan receivables and investments in debt securities. There are those who contend that the losses that loan and securities portfolios entail have not been recognized on a timely manner. To avoid such criticisms and avert audit failures, the auditing profession must device a system to provide clearer and more timely guidance on auditing. Effort must also be exerted to analyze alleged audit failures and to ensure that the lessons they provide are learned by standard setters and auditing practitioners.

Particularly in the area of audits of financial institutions--banks, savings and loans, finance companies, insurance companies, and other lenders--there has been criticism of the valuation of loan receivables and investments in debt securities. Losses inherent in loan and securities portfolios, it is charged, have not been recognized on a timely basis.

Some observers attribute this problem to defects in the historical cost accounting model and the slowness of the FASB to issue standards that mandate presentation of these assets in all circumstances at current value. These observers point out that current value would be more objective than historical cost because it is based on an estimate of the value of these assets now. On the other hand, so-called historical cost values are largely dependent on similar estimates of value, but, believe it or not, actually depend on projections that sometimes look ahead seven to ten years or more.

This anomaly results from the fact that, under historical cost, measurement and recognition of unrealized losses in portfolios are dependent on management's judgments about what will happen in the future. Both historical cost and current value require estimates. In both cases, the estimating method is the same, but the time horizon is actually further away for historical cost. Based on current value, there is a loss, but management maintains that the value will recover in several years and that the current unrealized loss should not be recognized.

It is the independent auditor's job to evaluate management's valuation of loan and securities portfolios and decide whether the evidence supports management's proposed valuation in the financial statements. In the absence of an accounting standard that mandates current value treatment for all loans and securities, the auditor's job is admittedly more difficult. However, it is still the auditor's job.

The conventional wisdom from almost everyone who has looked at the issue in the last 15 years is that allegations of prominent audit failures, i.e., the failure of a large public company or the revelation of major overstatements of assets and earnings shortly after receiving a clean audit opinion, at most reflect failure in application of the standards. In other words, the auditing guidance was adequate--it was just not followed. In contrast, there have been repeated calls for more explicit accounting guidance and intense criticism of accounting standards setters.

The underlying reason for this conclusion on the adequacy of auditing standards reveals the fallacy in the analysis. It is almost always possible to assert auditing guidance is adequate because the most general principles of auditing are at the top of the hierarchy (rank or ordering) of GAAS while the most general principles of accounting are near the bottom.

The auditor has to evaluate management's application of existing GAAP. That responsibility is increased rather than diminished when GAAP is not as explicit as some would like on a particular issue, e.g., whether debt securities are held for investment, sale, or trading.

Adherence to GAAS requires the auditor either to obtain sufficient, competent evidence to reach a judgment on compliance with GAAP, or state that there is a scope limitation. In other words, if it is not clear whether there is compliance with GAAP, the client does not get the benefit of the doubt. The issue becomes how do you audit the transactions and events in particular circumstances and reach an audit conclusion?

If, for example, management is selling debt securities in a significant volume, the auditor needs to decide whether that evidence contradicts management's representation that it intends to hold debt securities remaining in the portfolio to maturity.

In the past, what has sometime happened is that auditors have given management the benefit of the doubt and gotten into difficulty in litigation. Established bodies within the accounting profession, such as the quality investigations committee of the AICPA's Public Oversight Board (POB) have reviewed these cases and concluded that auditing standards did not require change. However, I suggest that this result may be due largely to the fact that the basic principles of auditing are at the top of the hierarchy of GAAS.

As even-handed professionals, how can we look at so many comparable situations, e.g., accounting guidance and auditing guidance for valuation of loan and debt portfolios, and conclude more specific guidance is needed for accounting, but the auditing guidance is adequate? It is true that the auditing guidance is adequate enough to measure whether auditors met existing professional standards. However, if the auditing guidance were more explicit in the first place, perhaps there would be fewer audit failures. Perhaps we could avoid the situations of the POB looking at case after case of alleged audit failures and concluding that no change is necessary in auditing standards.

What then is the answer? How can we learn from our problems? First, we can establish a mechanism to provide more timely and detailed guidance on auditing. On the accounting-standards side, there is an Emerging Issues Task Force that reaches consensus positions on current accounting practice issues. We need a similar body in auditing. The Audit Issues Task Force as presently functioning, is not the answer. The new body would supplement and not supplant the AICPA's Auditing Standards Board.

Second, we need to thoroughly examine alleged audit failures and make sure the lessons to be learned are communicated promptly and clearly to standard setters and practicing auditors. This suggestion has been made before, including most recently by the POB in its special report, and a professional issues task force was recently formed in response. However, the information is still filtered through too many layers. For example, the people who issue the auditing guidance should examine workpapers and testimony of audit team members first hand.

Doing an adequate job in these areas will require a much greater expenditure of resources than the profession now spends in developing auditing standards. However, compared to the costs of litigation of alleged audit failures, it would be small and well-spent.

Douglas R. Carmichael, PhD, CPA, is an editor of The CPA Journal and professor at Baruch College. The views expressed above are those of Dr. Carmichael.

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