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Fixing Flaws in the System Should Be Next Reform Step

By Art Berkowitz and Richard Rampell
September 12, 2002 .

Given the corporate scandals of the past year, it's no surprise that we're not sure about the veracity of financial statements. But the discovery of financial fraud is only part of the problem.

Indeed, aside from fraud, the current financial-reporting system has several flaws. Companies can follow the rules and still evade making clear statements about their financial conditions. And while it is right to focus on rooting out fraud, we should also examine the flaws in the current system and look for solutions to those problems.

Flaws in the Financial-Reporting System

For the first time, many investors now recognize that financial statements don't provide a precise picture of the companies in which they have invested. The financial-reporting system currently in use is actually closer to a copy of a 19th century impressionist artist than it is to an expensive digital camera.

Enron's 2000 year-end financial statements provide a stark illustration. And we could also find similar examples in many of the most widely held reputable public companies.

When you (or the Securities and Exchange Commission) receive a company's financial statements, they are presented in formats that meet basic standards known as generally accepted accounting principles. Those standards provide flexibility (as we've discovered) in the way companies account for certain items like inventories. (Enron: "Inventories consist primarily of commodities, priced at market as such inventories are used in trading activities.")

The rules include provisions for estimates of uncertain amounts like "liabilities for price risk management activities." (Enron: "The market prices used to value these transactions reflect management's best estimate considering various factors including closing exchange and over-the-counter quotations, time value and volatility factors underlying the commitments.")

The current standards don't demand that every company's financial statements treat all similar transactions alike, as we recently discussed with stock options. (In-depth discussions of options accounting can be read here 1 and here 2 .) (Enron: "In accordance with APB Opinion 25, no compensation expense has been recognized for the fixed stock option plans.") Moreover, companies have great flexibility in estimating the return on their pension 3 plans. (Enron: "Long-term rate of return is assumed to be 10.5% for the Enron Plan.")

And one thing the current system most certainly doesn't provide is a guarantee of how successful a company will be in the future. Enron, once again, provides a stark example.

Flaws in the Auditing Process

It's not just the squishiness of financial reporting that is problematic. The audit process is also rife with problems. The Encarta dictionary defines audit as a check of accounts; a formal examination, correction, and official endorsing of financial accounts, especially those of a business, undertaken annually by an accountant.

It isn't a guarantee against fraud or misrepresentation, even though investors certainly expect auditors and corporate internal control systems will guard them from misdeeds. However, investors rightly expect that auditors will perform more than a drive-by audit 4 .

The difference between what we believe should happen and what actually happens in the audit process is commonly been referred to as the expectation gap. Enron, WorldCom, Global Crossing and the many other companies involved in recent corporate accounting scandals have done more to highlight and narrow the expectation gap than all of the discussions in the past. Not only have expectations about the reliability of financial statements changed, but so has the accountants' expectations of its own role in the audit process.

Prior to Enron, the auditing profession's biggest concerns often centered on how our role as auditors might be perceived. When training new accountants, seasoned accountants emphasized the need to better reflect the precision of financial information provided in the financial statements. We discussed why it is inappropriate to present financial statements as exact numbers. For the local accountant that means never presenting financial statements of the neighborhood retail store using pennies. It conveys the impression that the numbers are correct to the last penny. That is rarely true.

Instead, most financial statements include estimates about values and judgments about income flows that are best reflected by rounded amounts that are consistent with those decisions. Larger companies may present their financial statements rounded to millions or even hundreds of millions of dollars.

Veteran accountants also reminded new accountants of the need to clearly reflect the level of assurance provided to the users of the financial information. Very few financial-statement users have an explicit understanding of what an audit entails.

While these may be important issues to discuss, they didn't prepare us for what unfolded over the past year -- massive deficiencies in major companies' financial statements.

It may have taken many months of soul searching, but the auditing profession at its highest levels now seems to understand that the flaws in the auditing process consist of more substantive issues than the people's perception of accountants. Some of the organizations and people who fought the hardest against many of the changes included in the Sarbanes-Oxley Act of 2002, are now urging a broader public discussion of the auditor's role in the oversight process.

Barry Melancon, President and CEO of the American Institute of CPAs, delivered a refreshing speech 5 on September 4th to the Yale Club, New York that laid out a structure for restoring the confidence of investors in the financial-reporting system. Samuel DiPiazza, CEO of PricewaterhouseCoopers, co-wrote a recently released book that focused on the issue: "Building Public Trust: The Future of Corporate Reporting."

The Road Back

What we need now is a public discussion of your needs and our role. No topic should be off limits. If the recent corporate scandals emphasize the public's need for more protection from fraud, how should the audit process be restructured? Just as importantly, who is going to pay for it? A financial-statement audit is not a fraud audit. How much fraud protection is enough? The Panel for Audit Effectiveness has proposed 6 that a forensic phase be added to an audit. Are there other alternatives?

We noted that current accounting standards permit flexibility in implementing certain rules. Do the benefits of comparability outweigh the costs to get there or the value of representing a more accurate picture based on the facts and circumstances? The underpinnings of that discussion are taking place now in the debate between more rigid rules and more principal-based standards.

What are sufficient relevant disclosures? Are there times when less is more ? Three pages of detailed descriptions of derivatives or leases don't provide more useful information to the user of financial statements trying to determine if they should buy or sell, lend or not, invest or pass. Several readers have written to us to ask if they are receiving the right kind of information. For instance, why are corporate tax returns not publicly disclosed? Is there relevant information buried in the company's tax return that might tell them more about offshore tax shelters, hidden fringe benefits, or the use and misuse of company funds?

Here are some of our suggestions for narrowing the expectation gap and improving the financial-reporting process.

  Mea culpa We confess. The accounting profession played a major role in the recent scandals. We will no longer try to cover-up our shortcomings and will work toward equitable solutions.

  There are no free rides. As users of financial information, you promise to recognize that there is a cost to the information you expect. You will no longer ask your company's management or auditors to take shortcuts in protecting your rights.

  There are lessons to be learned outside of the U.S. While U.S. GAAP has served us well, we will no longer dismiss international accounting standards as inherently inferior. More and more companies and markets are global in scope. Movement toward a more consistent international accounting standard is in everybody's best interest.

  There is a difference between what is legal and what is ethical. Searching for loopholes to justify what we know is wrong isn't in the long-range best interest of the stockholders or of the capital markets. When someone starts a conversation by stating that there is no law against it, we will ask if it is ethical.

  Reliable financial information is everybody's business. It will take a concerted effort by management, boards of directors, internal auditors, analysts, attorneys, external auditors, and investors to restore confidence in our financial-reporting system.

Let's do it!



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