Beyond GAAP: Issues Involving the Sarbanes-Oxley Certification Language

By John E. McEnroe

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APRIL 2005 - The standard U.S. unqualified audit report states that the audited financial statements present fairly, in all material respects, an entity’s financial position, results of operations, and cash flows, in conformity with GAAP. Statement on Auditing Standards (SAS) 69, The Meaning of Present Fairly In Conformity with Generally Accepted Accounting Principles, addresses the use of GAAP and fair presentation. It states that an auditor should not express an unqualified audit opinion if the financial statements contain a material departure from GAAP unless, due to unusual circumstances, adherence to GAAP would make them misleading. Furthermore, it states that the use of GAAP “almost always” results in the fair presentation of the financial statements. There is the possibility, however, that literal application of GAAP might, in “unusual circumstances,” result in misleading financial statements. In such a case, the auditor should express a qualified or adverse rather than an unqualified audit opinion. A later paragraph indicates that GAAP recognizes the importance of reporting transactions in accordance with their substance and that the auditor should consider whether the substance of the company’s transactions or events differs materially from their form.

Earnings Management and Conformity with GAAP

Over the past decade, much attention has been given to the issue of earnings management within the framework of GAAP, especially by then–SEC Chairman Arthur Levitt. This focus, in conjunction with considerable media attention, served as prescient warnings prior to the implosion of companies like Enron and WorldCom. In response to these events and other prominent auditing failures, President George W. Bush signed the Sarbanes-Oxley Act of 2002 (SOA), which involves, among other matters, corporate governance and oversight of the accounting profession. In accordance with SOA, the five-member Public Company Accounting Oversight Board (PCAOB) was established, effectively replacing the Auditing Standards Board (ASB) as the setter of auditing standards for publicly traded companies in the United States.

A key provision of SOA is section 302, Corporate Responsibility for Financial Reports. Section 302(a) requires a publicly traded company’s principal executive and financial officers to certify the financial and other information in the quarterly and annual reports. These officers must certify various matters involving the company’s internal controls and certify that, based on their knowledge, the report does not contain any untrue statement or omission of a material fact that would make the statements misleading. The most important certification might be that, based on the officers’ knowledge, the information in the report fairly presents, in all material respects, the financial condition, results of operations, and cash flows as of and for the periods presented in the reports.

The SEC states that the officers’ certification statement involving material accuracy and completeness is the same as the existing statutory disclosures for these matters. This certification statement regarding fair presentation is not limited to a reference that the financial statements and other financial information have been presented in accordance with GAAP. The SEC explained its position as follows:

We believe that Congress intended this statement to provide assurances that the financial information disclosed in a report, viewed in its entirety, meets a standard of overall material accuracy and completeness that is broader than financial reporting requirements under generally accepted accounting principles. In our view, a “fair presentation” of an issuer’s financial condition, results of operations and cash flows encompasses the selection of appropriate accounting policies, proper application of appropriate accounting policies, disclosure of financial information that is informative and reasonably reflects the underlying transactions and events and the inclusion of any additional disclosure necessary to provide investors with a materially accurate and complete picture of an issuer’s financial condition, results of operations and cash flows.

Given this extended definition of a “fair presentation,” the following question arises: Can an executive be held liable for a permissible accounting transaction that is in conformity with GAAP but is not deemed to result in fair presentation? For example, assume the entity, as a lessee, structures a lease as an operating lease within GAAP. The SEC, however, views it in substance as a capital lease. Would the SEC take action against the executives for certifying such a common business transaction?

The answer may be found in the requirements of SAS 90, Audit Committee Communications. It states that in each SEC engagement, the auditor should discuss with the audit committee the auditor’s judgment about the quality, not just the acceptability, of the company’s accounting principles employed in its financial reporting. Furthermore, given that management has primary responsibility for selecting the entity’s accounting principles, management should be actively involved in this discussion.

The scope of this discussion should include the consistency of the accounting policies and their application, and the completeness and clarity of the financial statements, including any disclaimers. The discussion should be “open and frank” and also include items that might affect the following qualitative attributes of financial statements: neutrality, representational faithfulness, and verifiability of the accounting information contained in the financial statements. SAS 90 lists examples of items such as:

  • New accounting policies, or changes in them;
  • Estimates, judgments, and uncertainties;
  • Unusual transactions; and
  • Accounting policies relating to significant financial statement items, including the timing of their recognition.

Last, SAS 90 cautions that objective criteria have not been developed as a tool for the consistent evaluation of the quality of the company’s financial statements. Rather, the evaluations should be based on the entity’s specific circumstances.

Thus, the auditor has specific responsibilities under SAS 90 involving the appropriateness of the GAAP employed by the entity. A logical extension would be that the auditor should also advise management whether the financial statements comply with the certification requirements of SOA. In the case of the capital lease, the auditor would probably advise the client that if the transaction is material, the omission of the asset and the liability from the financial statements would not result in fair presentation and may well result in SEC action against the executives who signed the certification statements.

Suggested Actions

A number of steps could be taken to avoid such a situation. FASB could review the entire taxonomy of GAAP in an effort to eliminate any opportunities to engage in earnings management or other engineered GAAP. The PCAOB could revise the audit report language and replace “present fairly in accordance with GAAP” with the European phrase “give a true and fair view” or the certification language “fairly presents in all material respects.” The PCAOB could revise the language in SAS 69 to state that the use of GAAP does not “almost always” result in fair presentation. Finally, the PCAOB could issue an auditing standard that specifically requires language in the audit opinion to explicitly state that the financial statements comply with the certification requirements of Sarbanes-Oxley.

John E. McEnroe is a professor in the school of accountancy and MIS in the College of Commerce at DePaul University, Chicago, Ill.




















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