|
To make sure you receive future emails,
please add {[EM-EMAIL ADDRESS]} to your address book or safe list.
|
|
Issue 6 | June 2016
|
At-A-Glance
Whenever new financial reporting and
auditing standards are issued following
an event like the Enron scandal at the
onset of the 21st century, companies and
auditors look for ways to maneuver
around them, or at least minimize their
negative impact. Increasingly in recent
years, companies have turned to non-GAAP
measures to show financial results in a
more favorable light then GAAP allows.
Though these techniques may be allowable
within reason, as long as they are not
more prominent than the GAAP results,
the US Securities and Exchange
Commission (SEC) has become concerned
with the overly excessive attention paid
to non-GAAP measures, and the
questionable rationale behind some of
them. Our first article echoes the SEC’s
concerns and warnings.
Auditors are not exempt from the
challenges presented by new and more
onerous auditing standards. Often the
concern focuses on the added costs of
performing audits within the highly
competitive environment in which
auditors operate. Even if unintentional,
oversights can occur when an auditor is
pressured by time limits. However, when
an upcoming work paper inspection
threatens to uncover shortcomings, an
auditor may be tempted to wrongly alter
work papers belatedly, in order to avoid
being called out for a deficiency. As
our second article strongly cautions,
such actions can have devastating
effects on the practitioner. The Public
Company Accounting Oversight Board
(PCAOB), as well as state regulators, do
not take kindly to improprieties of this
nature.
With the increase in new standards
and regulations, the debate continues as
to their effectiveness. Our third
article reports on two new studies that
seek answers, finding that more research
is needed, and that studies focused on
narrowly defined measures tend to
provide more practical results.
Also, if there are accounting or
auditing topics around the world you
would like this newsletter to delve
into, please let me know.
Editor Gerald E. Herter, CPA |
|
In This Issue
|
|
Boosting Profits with Non-GAAP Alternative
Financial Reports
SEC attempts to reign in questionable
embellishments of financial results
We have followed the successes and setbacks
in recent years of the efforts to converge
international accounting standards, which goal
has been to produce uniformity in financial
statements that are consistent and comparable
throughout the world. The United States has
resisted these efforts, preferring to stick with
generally accepted accounting principles (US
GAAP), instead of the widely adopted
International Financial Reporting Standards
(IFRS).
Even so, a majority of large US companies are
not even respectful of US GAAP, presenting
self-serving alternative financial results more
prominently, diverging blatantly from the
established norms.
In a move to control the use of non-GAAP
measures, the SEC put rules in place in 2002.
Only partially successful, these rules were
modified and clarified in 2010. Still, the
exploitation continues to grow. Not surprising,
the non-GAAP reporting often reports higher
earnings than GAAP. The Analyst’s Accounting
Observer, a research service, has been following
the trend for several years. Their annual
studies have shown that companies using non-GAAP
measures, which included about two-thirds of the
S&P 500, reported earnings an average of 22%
higher than GAAP in 2014. The service indicated
that 2015 numbers thus far appear to be even
higher.
The SEC has grown increasingly concerned with
both the extent of non-GAAP reporting, as well
as the extremes of the rationale used to justify
the technique. Various SEC officials have taken
to the speaking circuit to sound the alarm and
warn that closer scrutiny would be a priority
going forward.
One obvious abuse quoted by the SEC officials
involved a company selling subscriptions that
are paid for upfront. Under GAAP, revenue from
the subscriptions is reported over the period
the subscription covers. However, under a
non-GAAP approach, the subscriptions are
considered the sale of a product, whereby the
full revenue is reported at the start of the
subscription. As SEC Deputy Chief Accountant,
Wesley Bricker, stated in a recent speech, “The
effect of the measure is that the company
accelerates revenue recognition to the billing
date…In this instance, the measure does not
appear to help investors understand and analyze
core operating results. Rather, it is a
replacement of an important accounting principle
with an alternate accounting model that does not
match the company's subscriptions business or
earnings process and proceeds to calculate
earnings based on this non-GAAP revenue.”
US Companies are required to report under
GAAP, while any supplemental non-GAAP analysis
presented is not to be more prominent than the
GAAP reporting. However, business analysts and
reporters often focus their attention to the
non-GAAP measures, defeating the intent of the
SEC rules.
In warning his audience to upcoming SEC
enforcement measures, Bricker emphasized four
points regarding non-GAAP measures:
- First, preparers should consider how
their disclosure controls and procedures
apply to the disclosure of non-GAAP
measures;
- Second, despite the fact that GAAP
measures sometimes get forgotten once
analysts and the press start commenting on a
company's results, investors should refer
back to a company's financial statements so
that the non-GAAP measures are put into the
proper context;
- Third, audit committees should be
paying close attention to the non-GAAP
measures a company presents, including the
required related disclosures, and the
processes it follows to consider both the
appropriateness and reliability of the
measures;
- Future rulemaking in this area is
possible.
For further information, see
SEC
to 'Crack Down' on Use of Non-GAAP Measures
|
Altering Audit Workpapers? - Don’t Even Think
About It!
PCAOB alert warns of the danger to an audit
firm’s license to practice, much less its
reputation
Bad publicity on a number of fronts has left
police departments hard pressed to restore
credibility to their reputations in recent
years. One of the damaging factors has been the
allegation of evidence tampering, brought to
glaring national attention by the claim at the
1995 O.J. Simpson murder trial, that a bloody
glove had been planted at the murder scene by a
police detective.
Though the accounting profession is thought
to have a better reputation than the police
(though not by that much)*, implications from
episodes like the Enron scandal and more recent
financial collapse have strained that respected
image. For that reason alone, the need for the
recent PCAOB Staff Audit Practice Alert
No. 14, Improper Alteration of Audit
Documentation, is very disturbing.
While noting the serious nature of improper
work paper alteration, the PCAOB reports that
“Evidence identified in connection with certain
recent oversight activities has heightened the
staff's concern about such misconduct.”
Peer reviews for audit firms, and the more
formal PCAOB inspection process for those
auditing public companies, have been around for
a while now. Nonetheless, the placement of the
auditor’s work under the scrutiny of independent
reviewers can still be nerve wracking to the
most meticulous of practitioners. Discovering
even a minor oversight, while gathering work
papers for the review, can give rise to the
temptation to make corrections prior to turning
the work papers over for review. Not only is
that unethical, but can lead to devastating
legal liability, if discovered. With modern
techniques, detection is more likely than ever.
Over time, the PCAOB and state authorities
have established specific rules for closing and
archiving work papers. The PCAOB rules, for
example, state that the work papers must be
finalized no later than 45 days after the audit
report is released, after which no work papers
may be deleted, and changes or additions must be
documented with the date, name of person adding
or changing, and the reasons why. Though such
late documentation is an acknowledgement of a
deficiency, the consequences upon review are
likely to be much less severe, than those
resulting from trying to hide or cover up the
changes.
The PCAOB recently disclosed that in the past
several years, a majority of disciplinary
orders, resulting from failures to cooperate
with inspections and investigations, included
“improper document alteration.” Out of these
orders, the registrations of 15 firms were
revoked and 33 individuals were sanctioned, of
which 27 were barred and 2 were suspended from
“further association with a registered firm.”
In one California case, upon notification
from the PCAOB that the firm and specific
engagements were to be inspected, the
responsible CPA announced to the firm that the
“audits needed to be ‘cleaned up’ prior to the
arrival of the Board’s inspectors.” Then for one
of the audits, the CPA “directed the staff to
make several changes to the audit documentation.
Among other things…to fill out several audit
programs that had not been completed at the time
of the audit” and “to backdate changes to the
work papers to the time of the audit.” On
another audit, “the engagement team altered and
added information to…written analyses in several
of the work papers.” Of course, none of this was
disclosed to the inspectors. When these
improprieties were discovered, the responsible
CPA was censured and barred from being an
associated person of a registered public
accounting firm, with the caveat that after five
years had passed, the CPA could petition the
PCAOB for reinstatement.
Even the best firms can make mistakes in
performing and documenting audits, as PCAOB
inspection results readily point out. However,
as in other sectors of society, trying to cover
up such lapses is often seen as much worse than
the oversights themselves.
In the age of electronic work papers,
detecting changes to work papers is easier than
ever. The tell-tale date stamping that is
automatically and irrevocably placed by
underlying computer code makes the inspector’s
job of assuring compliance a straight forward
task. An awareness of the ease of discovery
should serve as a warning to even those most
tempted to go astray.
*A December, 2015 Gallup Poll on
Honesty/Ethics in Professions gave accountants
90% very high, high or average rankings and 7%
low or very low rankings, as to honesty and
ethical standards, while police officers
received 85% very high, high, or average
rankings and 14% low or very low rankings.
For further information, see
PCAOB Publishes Staff Audit Practice Alert on
Improper Alteration of Audit Documents.
|
Weighing the Impact of Standards and Regulations
Two new studies seek answers from different
vantage points
Standards and regulations are put in place
for various reasons, such as to provide
consistency, compliance, or protection for
particular constituencies or governing bodies.
Debate often ensues as to the effectiveness of
such promulgations. Two recent studies suggest
that measuring effectiveness tends to be more
successful when confined to narrowly defined
subject matter than on a more widely ranging
basis.
The Economics of Disclosure and
Financial Reporting Regulation: Evidence and
Suggestions for Future Research, was
published in December, 2015, by the Journal of
Accounting Research. Justification for the
research arose from the responses to recent
financial crises, the widespread adoption of
International Financial Reporting Standards, and
the globalization of capital market competition.
While acknowledging the importance of analyzing
regulatory impact, the study raised concerns
with attempts to adequately quantify the costs
and benefits, measure the outcomes, and draw
conclusions.
After reviewing a variety of efforts to
assess outcomes, the study concluded that there
is:
- Often difficulty obtaining
evidence of specific consequences from
regulation and the evidence found remains
relatively rare;
- Little evidence of “market-wide”
impact from regulation;
- A heavy focus on disclosure
regulation in the U.S.;
- Huge literature on the effects of
reporting standards internationally, but
little that can attribute those effects to
IFRS; and
- A need for help from governmental
agencies to isolate relevant effects.
Not surprisingly as a result, the study calls
for more research evaluating the dynamics and
process by which regulation arises and evolves,
why regulation is so pervasive, and what the
real effects are, including the macroeconomic
aspects. For better outcomes, discretely defined
parameters need to be established, recognizing
the broader context within which regulations
operate, and considering global regulatory
competition and convergence.
Internal Control Opinion Shopping and
Audit Market Competition, was published
in the March, 2016, issue of The Accounting
Review, with “implications for the current
policy debate regarding audit quality and audit
market competition.” The researchers felt that
there was little effective research in this area
in the United States, while at the same time,
the instances of reporting material weaknesses
in internal control reports were “surprisingly
low.”
Though improvements in internal controls
would be expected since the implementation of
the Sarbanes-Oxley Act, still PCAOB inspections,
as noted in Staff Audit Practice Alert No. 11
(October 24, 2013), found that 15 per cent of
the audits were deficient in their internal
control examinations. Also, comments from SEC
staff implied that internal control deficiencies
may have been under classified, as well.
The researchers used analytical techniques
applied to data from 2005-2011 to answer their
questions as to whether companies shopped for
clean opinions on their internal controls. The
results were in the affirmative. The study
showed that clients were effectively able to
shop for clean internal control opinions, that
this shopping took place usually where there was
a competitive audit market, and when it did
occur, the incidence was higher late in the
reporting period. Also, the evidence revealed
“that significant opinion shopping activity
appears to exist among firms that have clean
opinions in advance of financial statement
restatements.”
The outcomes raise concerns about auditor
independence, the circumstances surrounding
auditor changes, and finding an appropriate
level for audit market competition. There could
be repercussions in the debate over mandatory
auditor rotation if the push for greater
competition increases the occurrence of opinion
shopping.
For further information, see
The Economics of Disclosure and Financial Reporting Regulation: Evidence
and Suggestions for Future Research and
Internal Control Opinion Shopping and Audit Market Competition by Nathan
J. Newton, Julie Persellin, Dechun Wang, Michael
S. Wilkins :: SSRN.
|
|
|
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:
[email protected]
|
|
|
|