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Audit & Accounting Alert Newsletter

Issue 6 | June 2013

At-A-Glance

Gerry Herter

Change has been with us a long time, as attested by the fifth century BC Greek philosopher Heraclitus, who coined the phrase “The only thing that is constant is change.” Indeed, changes in the accounting profession fill the paragraphs of the Audit & Accounting Alert each month. This month is no different. In our first article, we report on the changes in leadership at the FASB, SEC, and FRC, and ponder what they portend for the future direction of the profession in the United States and the United Kingdom.

When speaking of change, we also can thank nineteenth century French novelist, Jean-Baptiste Alphonse Karr, for the phrase “The more things change, the more they stay the same.” In our second article, the change comes in the form of a new study of auditor deficiencies, which shows that the shortcomings are the same ones that prior inspection reports have observed.

Finally, our third article on the just released lease proposal may, for some, bring to mind German-American psychologist Erik Erickson’s quote: “All change is perceived as loss.” However, the FASB and IASB have succeeded in coming together in simultaneously issuing virtually identical new exposure drafts for lease accounting. Time will tell if the objectives of the radical changes in this complex area are achieved.

Editor Gerald E. Herter, CPA

In This Issue 

New Leadership for Major American and British Accounting Bodies

Changing of the guard at FASB, SEC and FRC

With a new leader on the way for the FASB, speculation abounds whether incoming Chairman, Russell Golden, will take the venerable standard setter in a new direction. His predecessor, current Chairman Leslie Seidman, came to power at a time of controversy, upon the sudden retirement of Robert Herz in 2010. Back then, the FASB under Herz, pushing for strict fair value accounting by banks after the financial crisis, met stiff resistance from banks and Congress. After his retirement, the FASB refocused their approach somewhat.

Seidman was recognized by Jeffrey Diermeier, chairman of the Financial Accounting Foundation Board of Trustees, for setting “a high standard as a champion of excellence and independence.” Though only Chairman for three years, Seidman has been on the Board the maximum ten years allowed, so must step down. Following a similar path as Seidman, Golden started out on the FASB staff in 2004, later serving as technical director and chairman of the Emerging Issues Task Force, before being appointed to the Board in 2010. Currently serving a second term extending through 2017, Golden could be reelected through 2020.

Golden has stated that his main priorities will be convergence with global standards and private company accounting standards. Echoing his predecessor’s resolve for high standards, Golden emphasizes “putting the interests of investors first; working to make financial reporting as clear, transparent and useful as possible; and never losing sight of the balance between costs and benefits.” 

Though joint work with the International Accounting Standards Board (IASB) on revenue recognition, leases and financial instruments is winding down, and despite the fact that the United States has not yet decided whether to adopt IFRS, the FASB was nevertheless named a founding member on the IASB’s new Accounting Standards Advisory Board (ASAF). With representation worldwide from twelve national accounting standard-setters and regional bodies with an interest in financial reporting, the ASAF was formed to provide a more direct channel for offering technical advice and feedback to the IASB. How Golden approaches this new opportunity may foretell the FASB’s future reputation on the world accounting scene. 

In April, the SEC confirmed Mary Jo White as SEC Chairman. As the first former prosecutor in that role, the expectation would be for renewed emphasis on vigorous enforcement. Indications are that more attention will be paid to occurrences of accounting fraud. After the inexplicable failure of the SEC to detect the massive Bernie Madoff fraud, the agency restructured operations to enhance detection. White can assure that follow-through continues in this area.

White is pushing ahead to complete the Dodd-Frank regulations, and has recognized the need to take an international focus in rule making. Seeking to add efficiency to cross border regulation, the agency has proposed “substituted compliance” in the derivatives domain. White acknowledges that “we live neither in a ‘my way or the highway’ world nor a world of whole-cloth acceptance of another jurisdiction’s regulatory regime. It builds on the SEC’s ongoing efforts toward cooperation and collaboration with foreign authorities…”

How White relates this attitude toward international accounting standards could prove enlightening. She points out in a May 1 speech that the SEC has been accepting IFRS based financials in filings by foreign private issuers, without U.S. GAAP reconciliations, since 2007. Also, she touts the active engagement by the FASB with the IASB, but then cautions that “the promise of global accounting standards fades if there is not consistency in their application, implementation, and enforcement.”

China will also continue to be a challenge, with the ongoing dispute over auditor workpapers from Chinese company audits. That struggle is not likely to go away since, as White notes “we have brought numerous cases against China-based issuers involving market manipulation, accounting and disclosure violations, and auditor misconduct among other charges.”

Meanwhile, in the United Kingdom, Baroness Hogg has announced that she will step down as chairman of the Financial Reporting Council (FRC), Britain’s regulator of the accounting profession and financial reporting. Though her three year term was completed in April, a successor has not as yet been named. Hogg has served on the FRC almost nine years in total, including a three year stint as Deputy Chairman as well.

Hogg’s stature has grown over her tenure, defending the accounting profession at times, while maintaining the necessary independence of a regulator. She served during the financial crisis and afterwards, restructuring the agency into a more responsive, yet efficient and effective organization.

In the debate over mandatory auditor rotation, Hogg favors retendering, concerned that in certain sectors “there may be only a couple of firms capable of doing the audit. In those sectors, rotation would be simply a matter of revolving doors, with no real competition or incentive to offer superior quality.  Even where three or four major firms are in play, we think it would be inimical to competition and quality to restrict choice by excluding the incumbent.” She defends the role that audit committees have to take seriously their responsibility for conducting a responsible retendering process. We’ll have to wait and see how her successor will respond.  

For further information, see Russell G. Golden Named Chairman of the Financial Accounting Standards Board and  Mary Jo White Sworn in as Chair of Sec and  Baroness Hogg steps down as FRC Chairman


Auditor Shortcomings cited in New Fraud Study

Findings consistent with other recent reports

The Center for Audit Quality (CAQ) is an independent organization, formed in 2007 and affiliated with the AICPA, whose vision is “dedicated to enhancing investor confidence and public trust in the global capital markets by:

  • Fostering high quality performance by public company auditors;
  • Convening and collaborating with other stakeholders to advance the discussion of critical issues requiring action and intervention;
  • Advocating policies and standards that promote public company auditors’ objectivity, effectiveness and responsiveness to dynamic market conditions.”

In May, 2013, CAQ issued a study, An Analysis of Alleged Auditor Deficiencies in SEC Fraud Investigations: 1998–2010, prepared by the authors of a 2010 COSO report, Fraudulent Financial Reporting: 1998–2007, An Analysis of U.S. Public Companies. Drawing from the COSO report and subsequent data, the authors compiled and described the nature of the deficiencies that warranted sanction by the SEC of the auditor or the audit firm.

The study is quick to point out that SEC allegations of fraudulent financial reporting are rare. Considering that annual filings by the approximately 9,500 companies add up to some 120,000 filings over the 13 year period, the discovery of 347 cases amounts to only .3% of all filings. The 87 of those cases leading to SEC sanctions against auditors amount to less than .1% of all filings. Nevertheless, the CAQ emphasizes the importance of continued awareness and vigilance toward the predominant factors that cause fraudulent financial reporting to go undetected by the auditor.

Not surprising, the findings are consistent with audit firm inspection reports by the PCAOB, AICPA, International Forum of Independent Audit Regulators (IFIAR), and UK’s Audit Commission, as highlighted these past few months in the Audit & Accounting Alert. The audit problem areas noted and their frequency are listed here:

Audit Problem Area Per cent of Cases
1. Failure to gather sufficient competent audit evidence 73% (59 cases)
2. Failure to exercise due professional care 67% (54)
3. Insufficient level of professional skepticism 60% (49)
4. Failure to obtain adequate evidence related to management representations 54% (44)
5. Failure to express an appropriate audit opinion 47% (38)
6. Incorrect/inconsistent interpretation or application of requirements of GAAP 37% (30)
7. Inadequate consideration of fraud risks 33% (27)
8. Inadequate planning and supervision 35% (25)
9. Failure to adequately address audit risk and materiality 21% (17)
10. Inadequate preparation and maintenance of audit documentation 20% (16)
11. Failure to adequately communicate with the audit committee 17% (14)
12. Failure to recognize / ensure disclosure of key related parties 15% (12)
13. Failure to adequately perform audit procedures in response to assessed risks 15% (12)
14. Inappropriate confirmation procedures 15% (12)
15. Failure to evaluate adequacy of disclosure 15% (12)
16. Internal control-related issues including over-reliance on internal controls, failure to obtain an understanding of internal control, and failure to obtain an understanding of the entity and its environment 14% (11)

From these results, the study focused on four areas that were determined to be the key issues, and offered suggestions that firms should consider for evaluating and strengthening their own audit function. The four areas are: 

  1. Failure to Exercise Due Professional Care - may be caused by (a) a lack of understanding, which can be addressed through education, training, hiring , and performance evaluation assessments, or ( b) execution failure as a result of time pressure, multi-tasking, or inadequate engagement level quality control review procedures, which employee surveys may help to uncover.
  2. Insufficient Levels of Professional Skepticism – may be caused by (a) a lack of awareness of the natural tendency to trust, which can be dealt with by training, education, supervision, and the quality control system, or (b) execution failure, which can be reduced by reminders, accountability assessments, enhanced quality reviews, and hindsight analysis to detect skepticism-lacking patterns of behavior .
  3. Inadequate Identification and Assessment of Risks – may be caused by oversimplifying the complexities of risk assessment because of over optimism or inexperience with fraud, which may require more sophisticated risk management training.
  4. Failure to Respond to Identified Risks with Appropriate Audit Responses to Gather Sufficient Competent Evidence – will occur when (a) the first three areas have not been addressed, (b) generic or prior year audit programs are used without adjustment for documented risks, (c) documented risks are not linked to audit procedures, or (d) the audit response is not commensurate with the risks identified. Additional training and/or new tools and techniques may be needed in this case.

With this study, the CAQ recognizes that while financial reporting fraud may be the act of a perpetrator, auditors have a responsibility “to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.” Reviewing audit shortcomings from the past can be helpful for finding ways to reduce future occurrences.

For further information, see An Analysis of Alleged Auditor Deficiencies in SEC Fraud Investigations: 1998 – 2010


Lease Accounting, Round 2

FASB and IASB issue revised proposal changing and converging long held standard

Over a year ago, in the April 2012 issue of the Audit & Accounting Alert, we recounted the rocky road of lease accounting standards. Having stood in place since 1976 and 1982, respectively, the monumental FAS 13 and IAS 17 were finally subjected to the work of convergence in 2006. The fundamental differences between GAAP and IFRS arose from the bright lines of the “rules based” GAAP as contrasted with the more generalized approach of “principles based” IFRS. Along with meshing the two views, a goal was to have all leases brought on to the balance sheet under a single approach. The Exposure Draft, finally issued in 2010, met with wide resistance.

 Since then, the FASB and IASB have gone back and forth in spirited debate. Discord became so intense that the whole process has taken an additional year before the two sides were able to come together. The revised exposure drafts, FASB’s Accounting Standards Update, Leases (Topic 842) — A revision of the 2010 Proposed FASB Accounting Standards Update, Leases (Topic 840), and IASB’s ED/2012/6 - Leases were issued on May 16, 2013, with a comment period ending on September 13, 2013.

First of all, the Exposure Drafts (EDs) took a practical step in excluding leases with a lease period of not more than twelve months. All other leases are to be recorded by the lessee on the balance sheet as right-of-use assets, with corresponding lease payment liabilities. Unable to settle on one approach for all leases, the EDs proposes two types of lease. For “equipment” leases, the lessee records a right-of-use asset measured by the present value of the lease payments, and amortizes the computed interest like a loan, separately from amortization of the right-of-use asset. For “real estate” leases, the lessee also records a right-of-use asset measured by the present value of the lease payments, but combines the interest and right-of-use amortization into one lease expense, computed on a straight-line basis.

Lessors would use an approach consistent with lessees. For “equipment” leases, the underlying asset is “derecognized” and separate lease receivable and residual assets are established. Interest income on each is recognized over the term of the lease. This approach allows users to analyze the credit risk on the lease receivable and the asset risk on the residual asset, separately. The lessor is also required to disclose how the exposure is managed. Any profit that arises from entering the lease is recognized at commencement of the lease. For “real estate” leases, the lessor retains the property as an asset, and recognizes lease income on a straight-line basis, similar to current practice.

One of the criticisms to changes in the lease accounting standards has been the considerable cost involved in converting, as well as new complexities. The EDs addressed those concerns to some extent by excluding 1) variable lease payments in the lease liability (such as payments based on percentage of sales), 2) optional renewal periods unless there is a significant economic incentive to exercise the option, and 3) short-term leases as mentioned above.

Though the FASB and IASB EDs are essentially the same, only the FASB version allows private companies and non-public not-for-profit organizations to use a risk-free rate to discount the lease liability. Also, the lease liability disclosures do not need to include a reconciliation of the balance from the beginning to the end of the year.

Another widespread objection to the EDs stem from the economic impact on financial statements. Adding major liabilities to the balance sheet, while a primary purpose for the new standard, may potentially harm a company’s credit rating or lead to loan covenant violations. The front-loaded amortization on equipment leases may cause similar effects from resultant lowered earnings. Consequently, the EDs may still have a difficult time in the short-term. However, after the initial impact from implementation, those arguments should, in time, fade away.

Even so, getting to this point has been taken a substantial effort for the FASB and IASB. Considering that the FASB vote in favor of the ED was only 4-3, there is likely to be further deliberation, once the comment period has ended, before a final pronouncement is issued, hopefully in 2014.

For further information, see FASB - Lease Standard and IASB - Lease Standard


Additional A&A News

The following links provide a selection of current articles devoted to highlighting other A&A topics currently making news.

  1. European Parliament Taking Aim at International Accounting Standards
  2. New COSO Guidelines Could Help Deter Fraud
  3. Success of new UK financial reporting standard (FRS 102) needs to be replicated on going concern
  4. SEC Adopts 2013 U.S. GAAP Taxonomy
  5. Governments using accrual accounting set to soar
  6. US-China audit fight: Armageddon averted?

 

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