“It is better to be both right and consistent. But if you have to choose—you must choose to be right.” – Winston Churchill
A lifelong baseball fan, I admit I had trouble accepting the advent of instant replay in the majors. The human element, while flawed, has always been a part of the game we love. Without debating the merits of replay and whether it has helped the game, the goal has been to “get it right.” No matter how awkward and confusing the process, making the right call is critical.
In business, accounting and financial reporting are not getting any easier. Despite the best efforts of standard setters and the accounting profession, the world of finance is simply becoming more complex. Complexity in practice leads to greater scrutiny by investors and regulators, leading management and auditors to more closely analyze transactions that may seem mundane on the surface. Most observers point to the Sarbanes-Oxley Act of 2002 as a watershed moment, but it was just one of many points along the way that has led to the current state of oversight. Companies may feel as if they are regulated by their auditors, but in fact they are regulated through their auditors. A few events of note in this evolution are:
Peer Review Program
Initially, the AICPA began the peer review program for firms to help each other improve. Over time, this program went from one of coaching and helping each other to one of professional regulation. Today, with the AICPA’s enhanced peer review efforts, the stakes are high for firms in the program. Poor performance and repeated findings can lead to curtailing or ending an audit practice.
Following the collapse of Enron due to convoluted (at best) accounting practices, Congress formed the Public Company Accounting Oversight Board to police the audits of public companies. Firms that serve public companies are subject to inspection on at least a tri-annual basis, and often more frequently.
Public Company Failures
While each day seems to bring news of another corporate failure, but certain ones have impacted audits more than others. For instance:
- Enron – While complicated, the upshot of this failure was that management inappropriately kept significant liabilities and continencies off the books and out of the footnotes. Since then, new rules governing recording and disclosures of derivatives attempt to guide management and auditors in evaluating these transactions. The rules are, needless to say, complicated and confusing which leads to additional scrutiny.
- WorldCom – The fraud that brought this company down was somewhat simple – senior executives authorized and posted accounting entries with little to no basis in fact. Today, auditors are required to scrutinize journal entries for such irregular, unusual, and potentially fraudulent activity.
New Accounting Guidance
Accounting standard setters continue to write new guidance in an attempt to keep up with the evolution of business. For example, the new rules concerning revenue recognition and leases are an effort to better align US guidance with those of the international community. However, changes from a traditional rules-based approach to one that is more rooted in principles is causing consternation among public and private companies alike.
With all of these changes swirling, management may feel as if their audit firm is being overly cautious. At the same time, understanding that auditors are subject to four levels of inspection provides some color to the caution:
- PCAOB – Public company auditors are subject to inspection once every three years
- Peer Review – All audit firms, whether they audit public or private companies, must have a peer review performed once every three years.
- DOL Inspection – Firms auditing employee benefit plans are subject to DOL inspection.
- Internal Inspection – All firms must conduct annual internal inspections.
The level of change and scrutiny has led us to a business environment that is not for the timid. Understanding the stakes and the second-guessing that can occur, it is more important than ever that both management and their audit firms take seriously their duties to get their financial reporting right.
“That’s all I cared about….was getting it right.” – R. Lee Ermey