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Audit & Accounting Alert Newsletter

Issue 5 | July 2012

At-A-Glance

Gerry Herter

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

In This Issue 

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:

  1. The difficulty of applying fair value (“mark to-market”) accounting in illiquid markets.
  2. The delayed recognition of losses associated with loans, structured credit products, and other financial instruments by banks, insurance companies and other financial institutions.
  3. Issues surrounding the broad range of off-balance sheet financing structures, especially in the US.
  4. 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:

  1. Classification and measurement of financial assets and financial liabilities
  2. Impairment methodology
  3. 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:

  1. 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;
  2. 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.
  3. 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


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:

  1. Deficiencies in basic audit procedures
  2. Insufficient or inappropriate audit evidence
  3. Lack or ineffective use of firm guidance or consultation
  4. Audit quality issues in certain offices of multi-office firms
  5. 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:

  1. Adjusting the balance between time spent managing audit quality and time spent managing client service, with more emphasis placed on the former.
  2. 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.
  3.  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.

  1. State of the Profession - AICPA President - June 12, 2012
  2. A Deal on Lease Accounting
  3. A New Risk Factor: The JOBS Act 
  4. IAASB publishes landmark green assurance standard
  5. Converged Insurance Contracts Standard No Longer Possible
  6. GAAP is CRAP: The case of JP Morgan

Audit & Accounting Alert is a publication of Integra International intended to highlight emerging issues in the profession. The goal is to give Integra members an awareness of developments impacting the practice of Audit & Accounting, enabling them to stay on the forefront of industry trends.

Editor Gerald E. Herter  •  HMWC CPAs & Business Advisors, 17501 E. 17th Street, Suite 100, Tustin, CA 92780-7924
 •  Tel: 1 714 505-9000  •  Fax: 1 714 505-9200  •  Email: gerry@hmwccpa.com