December 2001

Calling It Like It Is

During the American Institute of CPAs 29th Annual National Conference on Current SEC Developments, Bob Herdman, the new chief accountant at the U.S. Securities and Exchange Commission, told the 1,500 CPAs in the audience that “Tough economic conditions…exacerbate the challenges faced by auditors.” As it has been a long time since our last recession, he reminded the CPAs that a tough economy often requires the auditor to make tough calls.

The uncertainties caused by Sept.11 have pervaded our economy. This year, we need to be skeptical in our audits. Likewise, CPAs working in industry need to make sure that their companies honestly portray their financial condition and clearly describe their business condition in their management discussion and analysis. Now is a time for truth and realism.

Even before Sept. 11, it was clear that the economy was declining. The AICPA issued Practice Alert No. 2001-2, “Audit Considerations in Times of Economic Uncertainty,” and recently issued an audit risk alert, “Current Risks: Accounting, Auditing and Professional Developments.” While not official positions of the AICPA, practice alerts represent the views of the members of the Professional Issues Task Force (PITF) of the AICPA’s SEC Practice Section, and the audit risk alert proffers the perspectives of the AICPA staff. This is the AICPA at its best: members taking advantage of their experience to help other members improve the efficiency and effectiveness of their audits, and Institute staff developing materials to help the members.

These alerts are designed to assist the auditor in understanding the business and economic climate and in planning the audit based on any increased risks resulting from the downturn. A decline in business capital spending and investment, erosion of the stock markets, fall-offs in earnings and an increase in the unemployment rate have resulted in a bleak short-term picture. While lower oil prices and increased government spending provide economic stimulus, uncertainty is the general rule. Furthermore, the U.S. economy drives the global economy, so the uncertainty spreads worldwide.

The alerts identify the following issues and concerns that could affect a client’s financial statements:

• Going-concern
• Impairment of long-lived assets, goodwill and other intangibles
• Securities valuation declines
• Collectibility of receivables
• Inventory obsolescence and valuation
• Deferred taxes and other charges
• Manipulation of accounting estimates and accruals
• Improper revenue recognition
• Improper recording of restructuring charges
• Understatement of expenses
• Unusual and nonstandard accounting entries
• Internal control concerns
• Off–balance sheet transactions
• Fraudulent financial reporting

The auditor’s response must be one of heightened skepticism. Management faces increased external pressures in sketchy times. While not assuming that management will succumb to such pressures, the auditor must plan the audit to respond to additional business, industry and inherent risks. Liquidity problems, quality of earnings issues and industry declines should cause the auditor to extend procedures. Likewise, significant changes in management or the board, plans to sell all or a portion of the business, or management compensation arrangements tied to company performance are all indicators of increased risk.

An Appeal to CPAs in Industry

My commentary is not directed solely at auditors. CPAs in industry, whether serving as controllers, CFOs, or in some other financial or business capacity, are clearly in the hot seat this year. Senior management is so attuned to exceeding last year’s numbers that striving to meet or beat analysts’ expectations has become standard operating procedure. The name of the game has been how to put the “best spin” on the numbers. We’ve rationalized so many “pro forma” versions of the numbers that the actual numbers have become lost. This year the name of the game must change to “reality bites.”

For our economy to recover we must have a real baseline to measure growth. We must know the realities and accurately measure the costs of terrorism. Otherwise we cannot plan properly for the future. As CPAs in industry, you are key to assuring the reliability and integrity of the financial statements. Remember, the auditor is not the opponent in a game, rather a safety net, a check and balance for your work.

The biggest challenge to financial management in this time of economic uncertainty is to resist pressures to manage earnings, adopt inappropriate accounting practices and manipulate the numbers through non-recurring transactions and changes in estimates. However, also important during these times is the role of disclosure.

Public companies are required by the federal securities laws to consider making disclosure of the risks faced in an economic downturn. Generally accepted accounting and auditing standards similarly require all companies to disclose risks and uncertainties. While boilerplate language may have sufficed in the past, this is the time to rethink and properly articulate the risks and uncertainties your company faces. Management’s discussion and analysis (MD&A) is generally only included for public companies and has certain required features. Yet it is a model best practice even for nonpublic companies.

The role of MD&A in an annual report is not only to analyze actual performance, but also to present investors with an understanding of the company’s prospects for the future. MD&A requires management to consider trends, demands, commitments, events and uncertainties affecting the company. The effects of Sept.11 and a recession are difficult to project. The actual costs are hard enough to capture, no less those costs likely to occur that could be material to the company. Yet these should also be discussed. David Porter, of Jones, Day, Reavis & Pogue, in an article titled “Mandatory Disclosure in a Recessionary Environment—Management’s Discussion & Analysis for the Potentially Troubled Company” (Investor’s Relations, April 2001), provides a list of areas and questions management should ask itself in preparing MD&A to determine if they have addressed key trends, events and uncertainties. The key areas include:

• Changes in trends of revenue growth
• Increasing or decreasing prices for energy
• Increasing or decreasing interest rates and tougher credit markets
• Currency fluctuations
• Effects of highly leveraged transactions
• Special effects of recession on others

The related questions and disclosure examples in the article serve as an excellent guide. Emphasized is the need to have key players involved in the review of the MD&A, including all members of senior management as well as the audit committee. I highly recommend this article to you.

Summary

Economic uncertainty presents challenges to both the auditors and the financial leaders. As CPAs we must demonstrate in such uncertain times the highest level of professional due care. We must maintain the public interest and present the clearest and most accurate picture of our client’s or our company’s financial condition. It is no longer a time to allow the analysts to lead; we must take the reins. This year-end, probably more so than any other, we must help restore our nation’s confidence and call it like we see it. As often said before, the truth shall set us free.

president@nysscpa.org