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Audit & Accounting Alert Newsletter

Issue 6 | June 2016


Gerry Herter

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:

  1.  Often difficulty obtaining evidence of specific consequences from regulation and the evidence found remains relatively rare;
  2.  Little evidence of “market-wide” impact from regulation;
  3.  A heavy focus on disclosure regulation in the U.S.;
  4.  Huge literature on the effects of reporting standards internationally, but little that can attribute those effects to IFRS; and
  5.  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.

Additional A&A News

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

  1. SEC says cyber security biggest risk to financial system
  2. What analysts want from financial reports
  3. FRC aligns LLPs and micro-entities regimes with FRS 105 amendments
  4. FASB Proposal Would Simplify Goodwill Impairment Test
  5. Korea Accounting Standards Board Report Says Cost of IFRS Use for Preparers in Korea Outweighs Benefits
  6. The Robo-Accountants Are Coming

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]