Toward Reasonable Assurance

Toward Reasonable Assurance
PCAOB Auditor Urges Skepticism on Behalf of the Investing Public

Auditors should apply principles-based accounting to create reasonable assurance in the reliability of financial reports, the Public Company Accounting Oversight Board’s chief auditor said in a recent speech.

“We see that standards are a framework within which the professional’s judgment can be exercised,” Douglas Carmichael said during a May 5 speech in New York. “They’re not an end onto themselves.”

Carmichael, the keynote speaker at the Fourth Annual Financial Reporting Conference at Baruch College, noted that while rules-based accounting can provide some protection, rules can be worked around to conform with management’s wishes, leaving the door open to fraud.

Carmichael said it was the auditor’s obligation to work toward reasonable assurance by being skeptical, placing the interest of the investing public above a corporation’s and scrutinizing companies’ potential for withholding documentation, overriding internal controls and otherwise concealing information from the auditor.

“Public responsibility transcends relationships with clients,” Carmichael said.

Carmichael’s words echoed sentiments recently expressed by others on the need to move toward principles-based accounting and for regulators to help professionals exercise judgment in rooting out fraud. It is partially because of this that the PCAOB and the Securities and Exchange Commission are creating guidelines for compliance with Section 404 and that representatives of the Financial Accounting Standards Board have been talking about principles-based accounting in relation to convergence with international standards.

Carmichael said that, before the PCAOB launched, there were many who were concerned that the audit function was “sliding into a rules and standards approach,” and that since the regulating body began functioning, those people worried that the necessity to detect fraud would result in even more rules-driven standards.

Carmichael suggested that auditors need to use the rules but apply the principle that their bias should always favor the investors, and that they should assume that there is always an opportunity for management to commit a fraud, regardless of the auditor’s past experience with that client.

“The auditor should recognize that management has a unique ability to commit fraud,” he said.

Auditors need to scrutinize the client’s prior activities and judge if the outcome matches the intent. The obligation under SAS 99 to brainstorm possible fraud is useful in this light, and to attain “reasonable assurance,” auditors should have the same amount of skepticism about “material misstatement”—which Carmichael said is ill-defined in the literature—as they would about risk.

A principles-based approach has practical use in conducting an audit. Being skeptical can help auditors catch some common fraud schemes. For example, Carmichael said, noticing a customer list consisting mostly of P.O. boxes should send up a red flag. Skepticism about management relationships can help auditors catch fraud, such as collusions between CEOs and CFOs to overstate earnings. Auditors also should remember that a copy is more easily manipulated than an original. And even if auditors can’t always authenticate a document, they should be familiar enough with documents to spot inconsistencies.

The characteristics of fraud may prevent an auditor from achieving absolute assurance of a financial statement but not reasonable assurance, Carmichael said. Skepticism in favor of the investors will help, he reiterated, and while the literature does not specify what approach the auditor should take, there are procedures—such as scrutiny of journal entries—to help uncover management overrides of internal controls.

In response to a question from the audience, Carmichael said that he didn’t see investors as having unreasonable expectations, since they understand that there are risks involved.

Regarding cost, Carmichael said that that issue has been raised with Section 404 requirements, and that the PCAOB is supposed to issue guidance on cost control by the middle of May. Carmichael said he didn’t see this as asking for more work, just more effective work in reading journal entries and other things to help auditors spot fraud.

Other Discussions

The all-day event, at Baruch College’s Robert Zicklin Center for Corporate Integrity, featured speakers from the FASB, the SEC, firms and other organizations.

Speakers gave updates on regulatory activity, including discussions of the many new statements coming out of the SEC, such as Statement 151 on convergence and reconciliation, and Statement 153 on exchange of assets.

Members of one panel commended the FASB on its recent work.

“They have been doing much more to reach out to the user community to get their feedback,” said Patricia McConnell, senior managing director at Bear Stearns. “Statement 123R (accounting for conditional asset retirement obligations) is a good example of that.”

Colleen Cunningham, president of the Financial Executives Internationals, agreed.

“We also feel listened to,” she said.

The conference continued with panel discussions on business combinations and equity-based compensation.