Reflections on the Good Old Days

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Some of the complexities in today’s rules may be unavoidable because the subject matter is complex. Derivatives, for example. Not only are many derivatives inherently complex, but also, at least in my experience, the terms too often reflect not current market conditions, but rather a desire to “cover up” losses on existing contracts, thus deferring the accounting recognition of those losses to future periods (or indefinitely). In these circumstances, detailed rules may be necessary if only to educate companies and auditors who are not experts in derivative instruments.

On the other hand, while fair value is entirely appropriate to use for recording assets and liabilities that will be settled on that basis, its extension to other ongoing transactions introduces pointless complexity, and Beresford covered that point well. Recording a liability at a hypothetical amount that an unidentified third party might charge to assume that liability, rather than the amount a company reasonably expects to actually pay, results in an amount that is neither relevant nor reliable.

The recent scandals in the insurance brokerage industry illustrate the difficulty in determining fair values. As reported in the media, part of the schemes involved obtaining fictitious quotes from one insurance company to make the overcharges of a second insurance company appear reasonable. The insureds, who often were large companies with presumably sophisticated risk management systems, were unable to detect these overcharges. Note that these transactions involved the actual outlay of cash, rather than an accounting estimate. This experience does not inspire confidence in the use of unsupported estimates from third parties.

Elsewhere, Beresford mentions the trend toward principles-based or objectives-based standards and asks, perhaps rhetorically, who can object to them (comparing them to apple pie and motherhood). Until recently, the answer was: FASB and the SEC. When I was on the International Accounting Standards Committee from 1990 to 1994, the IASC strove to write principles-based standards, an approach that FASB clearly opposed. One of its senior people (not Beresford) expressed the view that only scoundrels would support that approach, because they would use the absence of detailed rules to prepare misleading financial statements. Similarly, when I served on the EITF, the then–chief accountant of the SEC often expressed the desire for “bright lines” for issues we discussed. Unfortunately, the presence of detailed rules and bright lines has not, as we have seen, prevented the preparation of erroneous financial statements. Perhaps naively, I continue to support principles-based standards, and it is good to see FASB and the SEC joining the party, even if belatedly.

Setting meaningful accounting principles is a never-ending challenge. Many thoughtful people have observed that there is an important distinction between wisdom and intelligence. FASB has demonstrated that its board members and staff have a high degree of intelligence. Let us hope that they have the wisdom to adopt standards that will result in useful, meaningful, relevant, and reliable financial statements.

Ronald J. Murray, CPA (Retired)
Stamford, Conn.

Editor’s Note: The writer is a former member of the FASB Emerging Issues Task Force (EITF) and Advisory Task Force on the Consolidation Project, the International Accounting Standards Committee (IASC), and the AICPA Accounting Standards Executive Committee (AcSEC).

The article “Audit Firm Rotation and Audit Quality,” by Barbara Arel, Richard G. Brody, and Kurt Pany (January 2005), does a good job of discussing the pluses and minuses of mandatory auditor rotation. Like most treatises and discussions on the subject, however, it misses the major points.

First, audit firms should possess the capabilities to perform an acceptable audit, given necessary industry expertise and appropriate size. Once an audit firm determines that it has the requisite skill set and needed manpower to properly perform the audit, then the only issue is knowledge of the specific company it is going to audit. This impacts the learning curve, and hence the fee (or expenses) involved in performing an audit that meets professional standards, but not the ability to do a proper audit or the quality of the audit performed.

Second, the issue of public perception and impaired independence that results from the auditor being retained for extended periods goes deeper than simply rotating auditors. The overriding issue is lack of independence, whether it is real or apparent. To frame this issue, a basic, rhetorical question that I like to ask an audit firm is whether its fee would be different if it knew it was performing an audit for only one year. If the answer is yes, then the firm has a real lack of independence, based on a financial arrangement where it needs future audits to offset the initial costs. This problem is not erased by mandatory rotation, unless the rotation happens every year. The way around this is for a third party (e.g., a stock exchange, a government entity, or a new body established for this purpose) to hire, pay, and fire the auditors.

In some respects, this is the goal of establishing the audit committee of the board as wholly comprised of outside directors. But I question the efficacy of this when the directors are paid by the company, which makes them very similar to part-time employees. Documenting your independence is difficult when you are drawing a substantial fee from the company.

The more articles and discussion I see, hear, and read about the issue of the independent audit, the more I am convinced we need a new paradigm.

Jeffry Haber, PhD, CPA
Assistant Professor of Accounting
Hagan School of Business, Iona College
New Rochelle, N.Y.