At-A-Glance
The third, and arguably most complex,
of the joint FASB, IASB convergence
projects deals with financial
instruments. In this issue, we take a
look at the highlights and plans for the
three areas of deliberation:
classification and measurement, credit
impairment, and hedge accounting. For
those of you that bristle at the thought
of yet another costly and complicated
pronouncement like the one on financial
instruments, there is hope in sight. Our
second article revisits the status of
financial standards for private
companies, now that the Financial
Accounting Foundation has had time to
consider the spirited responses to its
controversial proposal earlier this
year. Lastly, we review efforts of audit
watchdog agencies around the world as
they wrestle with how best to stimulate
auditor competition and improve the
quality of audits.
Editor Gerald E. Herter, CPA
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In This Issue
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Financial Instruments Accounting
Standard setters seek convergence amidst global
financial crisis
Though joint FASB/IASB discussions on the
future of financial instrument accounting began
in 2005, the topic rose to red-hot urgency in
2008 when the global financial crisis brought on
a world-wide recession, the likes of which had
not been seen since the Great Depression. The
FASB and IASB created the Financial Crisis
Advisory Group (FCAG) in October, 2008 to
address accounting issues requiring immediate
attention, while considering the longer-range
implications.
On the surface, the definition of a financial
instrument, as stated in IAS 32, sounds
innocuous enough: a contract that gives rise
to a financial asset of one entity and a
financial liability or equity instrument of
another entity. However, a closer look reveals a
much deeper level of complexity.
In their July, 2009 report, the FCAG
acknowledged that while �accounting standards
were not a root cause of the financial
crisis�the crisis has exposed weaknesses in
accounting standards and their application.� The
FCAG identified four areas of weakness:
- The difficulty of applying fair value (�mark
to-market�) accounting in illiquid markets.
- The delayed recognition of losses associated
with loans, structured credit products, and
other financial instruments by banks, insurance
companies and other financial institutions.
- Issues surrounding the broad range of
off-balance sheet financing structures,
especially in the US.
- The extraordinary complexity of accounting
standards for financial instruments, including
multiple approaches to recognizing asset
impairment.
The two boards decided initially to tackle
the financial instrument challenges separately,
then meet later to work out the differences. The
IASB proceeded with three phases intended to
revise or replace IAS 32 and IA 39:
- Classification and measurement of financial
assets and financial liabilities
- Impairment methodology
- Hedge accounting.
IFRS 9 was issued in two parts during 2009
and 2010 to address the classification and
measurement phase, with an effective date of
January 1, 2015. Exposure drafts dealing with
impairment and hedging were initially issued in
November, 2009 and December, 2010, respectively.
The FASB covered the three areas together,
issuing an Accounting Standards Update Exposure
Draft Accounting for Financial Instruments and
Revisions to the Accounting for Derivative
Instruments and Hedging Activities, in May,
2010, which address ASC 825 and 815.
Numerous workshops, comment letters, and
redeliberations have taken place and continue.
Here are some highlights of the status at this
time. These are tentative until final releases
are issued in the future.
In the area of classification and
measurement, although IFRS 9 has already been
issued, the IASB has agreed that it can be
amended to address constituent concerns and FASB
differences. Generally, most equity securities
are to be measured at fair value with changes
reflected in net income. The joint FASB and IASB
Boards have tentatively agreed that, for debt
instruments, there will be three possible
categories:
- A financial asset can be
reported using the amortized cost method if the
business strategy is to hold the asset to
collect contractual cash flows; that is, if cash
flows are solely payments of principal and
interest on the principal amount outstanding;
- Where the debt investment is held for sale
while also collecting contractual cash flows,
the interest is recognized in net income, while
the financial asset is recorded at fair value
with changes in fair value recognized in other
comprehensive income.
- Any other debt
investments would be recorded at fair value with
changes recognized in net income.
For the impairment topic, the Boards jointly
issued a Supplementary Document to their
individual Exposure Drafts: Financial
Instruments: Impairment in January, 2011.
Intended to improve transparency and identify
losses sooner, the proposal still raised issues
on complexity, practicality and timing.
Consequently, after further deliberations,
tentative decisions reached in May, 2012 call
for a �three-bucket� approach for classifying
debt instruments based on deterioration of
credit quality. Moving away from the �incurred
cost� method of determining impairment, which
tends to focus on historical assessments and can
impede recognition, a forward looking �expected
loss� approach would be used. All debt
investments would generally start in Bucket 1.
When a loss event is expected within twelve
months, the total lifetime expected losses would
be recognized. At this point, the asset is moved
either to Bucket 2 when financial assets are
evaluated as a group, or Bucket 3 when financial
assets are evaluated individually. In all cases,
lifetime expected losses are reflected.
The IASB Exposure Draft on Hedging, issued in
December, 2010, stated that �The objective of
hedge accounting is to represent in the
financial statements the effect of an entity�s
risk management activities that use financial
instruments to manage exposures arising from
particular risks that could affect profit or
loss.� This objective has proven much easier to
describe than to attain. Current GAAP accounting
can result in mismatching in some cases, where
the investment gains or losses are recorded on
the income statement, while the hedging gains or
losses get posted to stockholders equity through
comprehensive income.
In part to address IFRS differences from US
GAAP, the FASB issued a Discussion Paper in
February, 2011 to assess whether the IASB
approach would be a better place to start in the
hedging area. Indicative of the limited
relevance to private companies, only two of the
71 comment letters were from this sector. The
primary issue raised by them related to interest
rate swaps, which private companies use to
mitigate interest rate risk arising from
variable rate long-term loans. The constituents
did not feel that hedge accounting would be
useful in this context. Conversely, in the
public arena, with the recent $2 billion hedging
failure by JP Morgan Chase, the call for better
oversight is heightened. The regulatory issue
may focus around whether the hedge was used
appropriately for the conventional purpose of
managing risk, or was a speculative, profit
motivated investment. But the accounting Boards
will likely be analyzing how best the evolving
standards can report such transactions in either
case.
In a related area, the joint Boards considered
their differing positions on the financial
statement presentation of offsetting financial
assets and liabilities, where IFRS is more
restrictive than US GAAP as to when offsetting
is allowed. While not coming to agreement on the
accounting, the Boards did institute common
disclosures in December, 2011, so that users can
make them comparable.
We have barely scratched the surface of
reporting for financial instruments. The goal of
the FASB and IASB to produce readily
understandable pronouncements in this area may
be unrealistic. However, if they can at least
agree on a common set of standards at some
point, that would be a remarkable achievement in
itself.
For further information, see
Financial Instruments Accounting - Joint Project of the FASB and the IASB
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FASB vs. SME�s � New Private Company Council to the
Rescue?
Financial Accounting Foundation Heeds Call of
Constituents
Dealing with the complexities of some pronouncements,
like the financial instruments proposal, may be an
exercise in futility for those whose focus lies
predominantly with non-public entities. In our March
issue, we expressed the frustration directed at the FAF,
parent body of the FASB, for rejecting the call of their
own Blue Ribbon Panel for an independent, authoritative
panel for private company standards.
Amazingly, the FAF subsequently listened to the
overwhelming response that challenged the attempt at a
structure that left the FASB completely in charge. Over
7,000 comment letters were received, with 63% opposed
and 29% in favor of the proposed Private Company
Standards Improvement Council. (PCSIC).
The final report was issued on May 30. The
recommendation for a simpler name was likely the easiest
part of the decision that called for replacement of the
PCSIC. Accordingly, the establishment of the new Private
Company Council (PCC) was announced.
While some may still be skeptical of the new
arrangement, substantive changes have been incorporated
to assure that the role of the FASB will be more
peripheral rather than central. The sleeker, 9 to 12
member, Council will include a variety of users,
preparers and practitioners, including a chairman, none
of whom will be FASB members. An FASB member will serve
as liaison and along with other FASB members will attend
the five or more deliberative meetings per year, but
none of them will take part in administrative or
educational sessions.
The two new provisions that may very well determine
whether the PCC is successful involve agenda setting and
FASB endorsement. The PCC and FASB are to jointly agree
on criteria for determining whether and when exceptions
or modifications to GAAP are warranted for private
companies. When agreed upon, these criteria will be
exposed for public comment before finalizing. The PCC
will then use these established criteria for setting
their agenda.
The PCC will conduct deliberations on proposed issues
and require a two-thirds vote to recommend a GAAP
modification or exception. A proposal that passes will
be sent to the FASB for endorsement. The FASB will have
60 days to consider the proposal or explain the delay.
Endorsement requires a simple majority vote. If
endorsed, the proposal is exposed for public comment,
after which the final version is voted on by the PCC and
sent to the FASB for a final endorsement vote. If not
endorsed, written reasons are to be provided along with
possible changes that could result in endorsement.
This final step of endorsement indicates that the
FASB still has the ultimate say on proposals. The report
is interestingly silent on what happens if a proposal is
not endorsed. The presumption is that the proposal dies.
The FAF points out, however, that hopefully, endorsement
will not be controversial since the FASB and PCC will be
working closely together all through the process, so
that concerns can be dealt with along the way.
AICPA President, Barry Melancon, though clearly
critical of the FAF�s earlier plan, expressed support
for the effort in the new initiative: ��we recognize and
appreciate that the FAF has taken solid steps in the
right direction regarding the Private Company Council.
The AICPA is encouraged by this approach and awaits more
of the details of the FAF decision.�
In the next breath though, Melancon announced a new
AICPA endeavor: �In addition to advocating for
appropriate differences in U.S. GAAP to recognize the
unique circumstances of the private company environment,
we will be launching a complementary OCBOA (Other
Comprehensive Basis of Accounting) financial reporting
framework. The enhanced and simplified financial
reporting framework will be a cost beneficial solution
for smaller privately held entities that do not need to
comply with U.S. GAAP.�
We will have to wait and see how the FAF�s Private
Company Council fares. If past problems continue, the
AICPA OCBOA undertaking may prove to be a more practical
solution for private companies.
For further information, see
Establishment of the Private Company Council
Audit Profession Under Scrutiny
Where are we 10 years after Enron?
In 2002, following the collapse of Enron amidst
massive accounting fraud, Arthur Andersen, one of the
giants of the accounting profession, was brought down.
Since then, ten years of legislation, pronouncements and
public relations campaigns have sought to restore the
quality of audits and the reputation of the auditors
that perform them.
The irony of it all is that even before the Enron
fraud was revealed in October, 2001, new standards were
in the works to strengthen the audit process. SAS 99,
Consideration of Fraud in a Financial Statement Audit,
already under development in 2001, was assumed to be a
response to Enron, since the standard was formally
issued in 2002. Even so, the Sarbanes-Oxley Act of 2002,
and SAS�s 104-111, the new risk assessment standards of
2006, were clearly designed to address the weaknesses
uncovered.
According to a May, 2012 survey of close to 600
executives and professionals, conducted by Protiviti, a
subsidiary of Robert Half International Inc., 69%
reported significant or moderate improvement in their
internal controls over financial reporting since
compliance with Sarbanes-Oxley Section 404(b), while 18%
reported minimal improvement, and only 13% felt there
was no change.
While those positive rates are encouraging, coming
from companies preparing financial statements, success
rates on recent auditor inspections do not bode as well.
In our February issue, we discussed efforts under way on
both sides of the Atlantic to address rising concerns
about the state of the audit profession. The PCAOB�s
response to shortcomings uncovered during audit
inspections was the Concept Release on Auditor
Independence and Auditor Rotation. Meanwhile, the
European Commission proposed actual legislation designed
to increase the quality of audits by enhancing
independence and making the audit market more dynamic
and diverse. That legislation is on hold while Britain�s
Competition Commission considers ways to aid access to
audits by firms other than the Big 4.
Now Canada has weighed in as well. In its recent
report on the 2011 inspections of audit quality, the
Canadian Public Accountability Board (CPAB) sent out a
�call to action,� expressing disappointment in the
results, based on the high level of deficiencies
detected.
For the Big 4 firms in Canada, GAAS deficiencies were
found in 20-26% of the audit files inspected in each
firm. For other larger firms, 47% of inspected files had
significant deficiencies, while for smaller firms, many
of which were being inspected for the first time,
deficiencies were found in virtually all of the files
inspected. Generally, the problems related to execution,
rather than methodology or risk assessment. Major areas
of deficiencies were:
- Deficiencies in basic audit procedures
- Insufficient or inappropriate audit evidence
- Lack or ineffective use of firm guidance or
consultation
- Audit quality issues in certain offices of
multi-office firms
- Lack of professional skepticism
The CPAB believes the root cause of many of the
deficiencies stems from inadequate supervision and
review at the partner and manager level, as well as a
general lack of professional skepticism by engagement
personnel. The results were additionally troubling to
the CPAB, since Canada has just adopted IFRS. Next year
the firms will need to display proficiency with IFRS,
while at the same time working to correct the
deficiencies found this year.
The Canadian report questioned whether the structure
of accounting firms has kept up with today�s world.
Changes suggested were:
- Adjusting the balance between time spent managing
audit quality and time spent managing client service,
with more emphasis placed on the former.
- Enhancing supervision and review, including more
coaching and mentoring, and real-time instead of
off-site reviews by partners and managers, to improve
the execution of audits.
- Appointing one individual in the firm, with
appropriate authority and recognition, to oversee and be
accountable for audit quality.
The audit deficiencies found in Canada bear
similarities to those reported in the United States and
the European Union. However, referring to the idea of
audit firm rotation, the controversial proposed solution
broached both in America and Europe, the Canadians
proposed an alternative measure that may be more
palatable: audit firm review. �This process would
require the Audit Committee to formally evaluate the
effectiveness of the auditor on a periodic basis and to
report the results of this evaluation to the
shareholders.�
The International Auditing and Assurance Board
(IAASB) continues to develop auditing and assurance
standards and guidance, and set out an ambitious agenda
in the recently released Strategy and Work Program,
2012�2014. For example, in February, a guide on
professional skepticism was issued, and an ongoing
project is exploring ways to enhance, expand and clarify
auditor reporting to provide more transparency and depth
of information provided.
The Canadian report calls on the PCAOB, EC, IAASB and
other agencies to �work together to devise one global
solution to auditor reporting. This would improve
consistency and mitigate investor confusion.� Finally,
CPAB asks perhaps the most pertinent question of all:
Are financial statements and audits relevant today? The
accounting profession needs to find a way out of the
complexity and backward-looking focus, and provide
clear, credible and current information, in order to
preserve the position of prominence bestowed upon it by
the financial community.
LATE BREAKING NEWS: In its annual
report on audit inspections of British firms, released
on June 13, 2012, the UK�s Financial Reporting Council
noted that inspected firm audits requiring significant
improvements dropped to 10% from 14% in the prior year,
while half of the remaining audits inspected were
acceptable but with improvements required, an increase
of 7% over the prior year. Similar to the findings
elsewhere, more professional skepticism and independence
were cited as needs, as well as a better understanding
of goodwill impairment among other items. A concern was
also raised about the potential impact on audit quality
from fee reductions that appear more evident in the
current environment.
For further information see
Meeting the Challenge - A Call to Action
Additional A&A News
The following links provide a selection of current articles
devoted to highlighting other A&A topics currently making
news.
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State of the Profession - AICPA President - June 12,
2012
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A Deal on Lease Accounting
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A New Risk Factor: The JOBS Act
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IAASB publishes landmark green assurance standard
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Converged Insurance Contracts Standard No Longer
Possible
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GAAP is CRAP: The case of JP Morgan
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