17(a). Benefits and Criticisms of Audits
The APC [Accounting Policy Committee] has considered and expresses below its opinions on a number of specific issues affecting financial accounting standards and financial reports. The APC believes that the following items should be included in the single body of accounting concepts, standards, principles and methods: [RMA90, p. 5]
Standards for auditing and other professional accounting services should be established and maintained in the private sector, not by a governmental or regulatory body. To ensure consistency and understandability, the APC [Accounting Policy Committee] believes there should be a single set of generally accepted auditing standards (GAAS) determined by a single rulemaking body. [Footnote reference omitted] [RMA90, p. 9]
There should be one standard of work quality for judging all public accountants, such standard to be set forth in the professional accountants' code of ethics. Levels of performance exceeding this acceptable quality standard may, however, be required by certain regulatory agencies. [RMA90, p. 9]
In addition to determining and reporting whether or not financial statements comply with generally accepted accounting principles, independent auditors have the responsibility to evaluate the overall fairness of financial statements (including the viability of the going concern) and their freedom from material misstatement. These responsibilities emanate from the auditor's access during the audit process to financial and related data not available to third-party users of the statements. [RMA90, p. 9]
Financial statement reliability is enhanced when the statements are attested to by certified public accountants (CPAs) whose examinations were made in accordance with GAAS. Reliability and credibility decreases as the level of assurance provided becomes less positive. Uncertainties in the mind of bank lenders increase as the credibility of the financial statements decreases; increases in uncertainty generate increased risk; and, increased risk usually results in increased borrowing costs. [RMA90, p. 10]
The APC [Accounting Policy Committee] believes that auditors should recognize that their services are performed primarily for the benefit of third-party users of financial statements. The legal doctrine of "privity", that third-party users cannot rely on audited financial statements unless they are named in the contract between the auditor and the company being audited, is inimicable to the interests of all three parties. [RMA90, p. 10]
__________
[Context] Meeting of the Investor Discussion Group on October 16, 1992. During the discussion of the types of information investors use to achieve their objectives, one participant mentioned a benefit of having audited financial statements.
Participant I-9
We tend to believe what we see in the audited financial statements from any of the major firms. If something would put us on notice, like an aging of receivables where receivables are beyond the normal trade terms, it would be very helpful to us. There are some industries where management is very truthful, there are other industries where managements lie. The movie business, the discount companies, the textiles are less truthful than the drug industry most of the time. The point is we think your responsibility is equal to us as investors as it is to the Board of directors that you're reporting to and you should know these industries very well. Put us on notice to ask the proper questions rather than treat the financial statements of a third rate retailer the same as you would for [name deleted]. [Also included in 17(b)] [TI 10/16, p. 20]
[Context] Meeting of the Investor Discussion Group on March 17, 1993. Part of the meeting was devoted to the topic of auditor involvement.
Committee/Staff/Observer
Our first seven questions deal with auditor involvement with external reporting. Question 1 asks: What are the benefits, if any, of an audit of financial statements that are most beneficial to your work? That is, what aspects of current auditing would you be most willing to lose, if any? In responding please consider audits only as currently performed. Do not consider what auditors could do, for that is the subject of a later question. [TI 3/17, p. 2]
Participant I-7
I'm not a CPA; I only have anecdotal evidence through my daughter who is a CPA. The audit procedures on revenues are very vital, as well as for inventories, receivables and payables. I count very heavily on the fact that these key elements in my work have been checked (not necessarily every item) by the auditors. [TI 3/17, p. 2]
Participant I-12
I find the greatest use of auditing in that there is a certain reliability given to the financial statements and a certain standard that we feel we can rely on. [TI 3/17, p. 2]
Participant I-11
Having the knowledge that a presumably independent professional has examined the books and hasn't found any material misstatement is what is of value in the work auditors do. [TI 3/17, p. 2]
Committee/Staff/Observer
Is there anything implicit in the auditors' role that you would be most unwilling to lose? [TI 3/17, p. 3]
Participant I-11
It's a package. If I lose any part of it, I lose the whole thing. [TI 3/17, p. 3]
Participant I-16
I describe it naively as one more conscience reviewing the financial statements before they go out. Maybe it's a conscience or maybe it's someone who has a liability insurance policy. [TI 3/17, p. 3]
Committee/Staff/Observer
[Participant I-16], how important is that liability insurance policy to you? [Also included in 18(b)] [TI 3/17, p. 3]
Participant I-16
I think it's very important. There has to be some accountability. I'm not in favor of lawsuits but unless somebody suggests another way to make auditors accountable, I think we have no choice. [Also included in 18(b)] [TI 3/17, p. 3]
Committee/Staff/Observer
Your affection for the liability is to put a burden of responsibility on the auditor as opposed to the ability to collect financial benefits? [Also included in 18(b)] [TI 3/17, p. 3]
Participant I-16
Yes. [Also included in 18(b)] [TI 3/17, p. 3]
Participant I-7
If there's a significant mistake on the part of the profession, then liability is called into action; there's a reason for it. The investor who has taken the statements as a basis for making an investment should benefit by that particular liability. [Also included in 18(b)] [TI 3/17, p. 3]
Participant I-16
And the liability has to be tempered by what was involved. Was this just not the greatest work in the world, which isn't a huge liability; nobody guarantees that they're perfect. If there was some kind of collusion, then the liability is quite clear. [Also included in 18(b)] [TI 3/17, p. 4]
Committee/Staff/Observer
I don't think anybody disagrees on the latter, criminal intent and things like that. [Also included in 18(b)] [TI 3/17, p. 4]
Participant I-16
But the standards of performance are subject to some sort of debate. [Also included in 18(b)] [TI 3/17, p. 4]
Participant I-7
Isn't there some debate on the RICO act relative to the profession? Wasn't there something recently indicating that the profession may not be subject to the RICO act? [Also included in 18(b)] [TI 3/17, p. 4]
Committee/Staff/Observer
There was a court case a week or 10 days ago that came down in favor of [name deleted] that said that RICO was intended to go after organized crime, not organized accountants, and that it just went too far in that case. Good plaintiffs counsel have used RICO for 10 years as a sword over the profession. This is the first major case that said that it doesn't apply. [Also included in 18(b)] [TI 3/17, p. 4]
Participant I-7
They have done it in our industry also. [Also included in 18(b)] [TI 3/17, p. 4]
Committee/Staff/Observer
Our second question deals with any disappointments that you have with audits and audit reports on the financial statements. That is, what should auditors do better in auditing and reporting on the financial statements that you would find helpful in your work? In responding to this question, please consider only audits as currently defined. Whether the auditors' role should be expanded is the subject of a future question. [TI 3/17, p. 4]
Participant I-16
One of the things that bothers me is the auditors' current position of either saying "good housekeeping-seal of approval" or "there's something that bothers me here". I presume that in looking at a lot of different clients, the auditors get some idea of where there are choices to be made, either in terms of what principles you chose to apply, or the types of conservatism embodied in estimates. It would be very helpful if auditors could give us some sense, on a qualitative basis, for all companies, at least in broad bands, of how a company's practices compare against its peer companies. It would be better than to say that 99.9% of companies are O.K. and nothing more is said other than this packaged audit statement. [Also included in 17(c)] [TI 3/17, p. 5]
Participant I-7
We have discussed in previous meetings that in going through your procedures, estimates were made so that not everything is specific to the dollar. Estimates are made in your audit procedures that are of such significance that, if a different route had been chosen, there may have been a material change in the end result. We'd like to know about that. [Also included in 9 and 17(c)] [TI 3/17, p. 5]
Participant I-12
Where the greatest problems have come up is when the auditors have to rely on assertions and opinions of management. In a world that is changing as rapidly as ours, managements are highly capable of misleading themselves. I'm not sure if this is really the arena in which auditors should work, but it seems to be where I've seen the biggest issues come up. For example, everyone is sort of going along business as usual, then there's a major change in the environment, and nobody catches the fact that this will have a material effect in terms of the financial statements. [Also included in 9] [TI 3/17, p. 5]
Committee/Staff/Observer
How would the auditor get involved in that? How is that a disappointment in auditing? [TI 3/17, p. 5]
Participant I-12
I'm not even sure that that's the arena of the auditors. I harked back to the change in tax law in 1986 which had enormous implications on the future of real estate partnerships. One would think that perhaps such things should be given more prominence in the financial statements or audit reports. Things of that nature should somehow be highlighted. [Also included in 9 and 17(c)] [TI 3/17, p. 5-6]
Committee/Staff/Observer
[Participant I-12], is it an audit issue or an accounting issue? To the extent that the accounting is driven by management judgments or decisions, is that maybe where your concern is? Or is your concern with respect to auditors auditing the subjective and the intangible? [Also included in 9] [TI 3/17, p. 6]
Participant I-12
It seems to me that it's all wrapped up together. The accounting profession is accounting for various transactions and that gets colored by whatever the current rules are; if you change the rules, the accounting will change. So it is an accounting issue. There is also an auditing element in that the auditors ought to be caught up with those changes and changes in the environment, and they should have a role to play in the reporting process. But I don't know what that role is. [Also included in 9] [TI 3/17, p. 6]
Committee/Staff/Observer
It sounds like what you and [participant I-16] are saying is the same. Our audit report now is kind of a one-size-fits-all report, very standardized. But the world is becoming more and more subjective, decisions have to be made more rapidly, and the impact on longer term assets is more and more uncertain; so it would be useful if the audit report could reflect that environment. [Also included in 9 and 17(c)] [TI 3/17, p. 6]
Participant I-16
When I first became a financial analyst 20 years ago, the major concern one had was the choice of accounting principles of management and how they could affect the numbers. Over the last 5 years, we know that what's really important are the estimates. When you see the enormous write-offs that companies have made in the last few years, they're basically saying that for years they have overstated their earnings by making bad estimates. Yet, auditors have not acknowledged that problem in their report. They also do not acknowledge when a company, every year for 5 straight years, has a huge write-off of assets in the fourth quarter, which says that they have been misleading people for eternity by capitalizing expenses. [Also included in 9 and 17(c)] [TI 3/17, p. 6-7]
Participant I-12
I'm not sure that management is deliberately misleading people. One of my issues with accounting and auditing is the use of assumptions and estimates and making those transparent. Because they're not always transparent to an analyst. There is a lot of room to change the appearance of financial statements based on the assumptions and estimates. [Also included in 9] [TI 3/17, p. 7]
Participant I-11
I'm going to make a radical statement. As audits are currently performed and reported, I think auditors do a very good job. If you define the audit assignment as what it is defined today, I think by and large the quality of audits is excellent. What most of us have been talking about in these sessions is less whether auditors are doing well what they're doing now, but whether there are other things they should be doing. [Also included in 17(b)] [TI 3/17, p. 7]
Participant I-12
Some of my compatriots and sometimes even I have wondered about the independence of auditors. The outside accounting firm staff lives in the company for lots of the companies I deal with because those companies are so large and so complex. It's a concern. [TI 3/17, p. 7]
Committee/Staff/Observer
What causes you to wonder? [TI 3/17, p. 7]
Participant I-12
If an auditor is sitting at a desk in [a company], looking at statements and working with the same people day in and day out, that person knows those people very well. He may begin to feel more like an employee of [that company] than the auditing firm. I don't know if that's true and I would agree with [participant I-11] that, for the most part, auditors do a very good job. But I know my compatriots have raised this issue from time to time: just how independent are the auditors? [TI 3/17, p. 8]
Participant I-7
Our profession, certainly the sell-side, has the same independence problem. When given the choice of two directions, unless the liability issue is significantly raised, the auditor, like the analyst, will take the choice that is more favorable to management. [Also included in 18(b)] [TI 3/17, p. 8]
[Context] Meeting of the Creditor Discussion Group on December 8, 1992. Part of the meeting was devoted to the topic of creditors' objectives and approaches. During the discussion, comments were made on auditor involvement.
Participant C-4
Backlog is the lifeline of a contractor, obviously. We can use that information to make some pretty accurate projections of where they're heading. We get backlog information on a quarterly basis, and we'll compare the beginning and ending gross margins, do a statistical correlation of those margins. Then when we get a year end financial statement, using percentage of completion basis and we'll adjust that cost to complete number based on historical correlation, and then make a projection of where we think this contractor is headed with the backlog he has on hand. So, it's vital information for us. I would say the accounting profession does not do that detail in general for smaller contractors in any audit work on the cost to complete for contractors. I think they're relying on what management tells them. I don't know how much hindsight review is actually going on in the accounting industry on cost to complete information. [Also included in 1(b), 11(c), and 13] [TC 12/8, p. 52-53]
__________
Participant C-3
The reason I asked that question is this is an area where you currently have some accounting rules that govern not only the accounting but the disclosure, which is kind of different from some of the other issues that we've been talking about where there aren't any rules or any requirements. I'm not sure if this is an audit issue, or an SEC issue for a public company. [Also included in 1(b) and 2(d)] [TC 12/8, p. 56]
Participant C-11
It's judgment, isn't it? So it's a question of not just the management but the auditors having to make a judgment as to materiality, and being pro-disclosure. And oftentimes people aren't pro-disclosure if it's bad. So it's a problem. [Also included in 1(b) and 2(d)] [TC 12/8, p. 56]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of value information. During the discussion, comments were made on auditor involvement.
Committee/Staff/Observer
I would just be curious to know if having audited versus not audited financial statements would make a difference in any of your answers? If you didn't have audited statements, those who would like to see the fair value indicated somewhere, if there was no attestation, does that make a difference? [Also included in 4] [TC 2/2, p. 8]
Participant C-17
I'm not going to have some guy (management) come and tell me this is what he thinks his business is worth, without any kind of independent verification. [Also included in 4] [TC 2/2, p. 8]
Participant C-13
Wasn't what [participant C-11] was saying run in contrast to that? Because supplementary disclosure are not necessarily verified. [Also included in 4] [TC 2/2, p. 8]
Committee/Staff/Observer
I thought that what I was hearing was that [participant C-11] was saying that they would be benchmarked however to some audited statements somewhere. Did I misunderstand? [Also included in 4] [TC 2/2, p. 8]
Participant C-11
They could be. In the current data framework that we have, there's certain supplemental data that's just as important as anything in the financials. I think that this is an awkward subject to talk about. But I think that many users don't necessarily have enormous confidence in the integrity of the statements that have been reported on over the past decade. I don't think that I would necessarily say that just because it's audited by a huge firm, it would mean that I would take them at face value. [Also included in 4] [TC 2/2, p. 9]
__________
Participant C-2
The point is the cost of determining that in light of that information. And I think for many credit granters we're working with financial statements of small businesses. I think if cost to develop that information becomes more onerous than it presently is, we're going to drive those businesses away from audited financial statements to our detriment. [Also included in 4 and 5(a)] [TC 2/2, p. 11]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of display. During the discussion, comments were made on auditor involvement.
Participant C-13
I understand that problem, but to a certain extent, you're going to have to rely on management. There, too, you're raising a problem. But you've got the oversight of the auditors and the SEC, between that and your own investigation and knowing what the nature of the business is, you should be able to establish what these items are. [Also included in 5(a)] [TC 2/2, p. 15]
Participant C-5
I just had a company analysis case where we came across a very distorted day's inventory ratio. And it turned out they were doing a ton of spot trading on inventory. And it had only come up in a discussion of some senior people as we were talking about the case and wondering what didn't look right here. This was something in audited financials that I should have had a better sense of. [Also included in 5(b)] [TC 2/2, p. 19]
__________
Participant C-17
Kinds of stuff that would come to my mind [for disclosure] is capital expenditure and inventories. What is mandatory or what's repaired, what's unfunded? ... Backlogs or the businesses that are affected by backlogs. What is it? Comparative basis? The inventory, the display, finished, in process, raw, supplies, whatever you may call it, slow moving? Receivables? It drives me nuts when I can't find a provision. Or you can't find what the allowance is, you don't always see a provision. So how do I know what the bad experience is? Borrowing: I hate trying to figure out what maturity horizons are. Fixed assets: categories? Plant? Leasehold improvements? It frustrates me when I look at the liability side and I can't identify trade payables because it's buried in with unrelated payables or accruals. Those kinds of issues come up. I think what most analysts do is they have a group of favorite ratios and they're pretty standard. And you tend to analyze the company around these but when you can't get to the data. When you can't even identify how to do the calculation, then you're forced to go back to management, and you're not sure, you have no independent verification. [Also included in 5(b) and 13] [TC 2/2, p. 19-20]
__________
Participant C-4
I think there is a tendency for abuse on the asset side by management. I think what happens is consistently, items are showing up in current assets that are obviously long-term assets if they're assets at all. So I don't know how much work is by accountants to verify the management's intent. [Also included in 5(b)] [TC 2/2, p. 21]
__________
Participant C-5
One of the concerns you have in this is whether the flows have really been audited themselves. If the direct format is used, there's more of a sense that there's a verification of the gross cash flows included in the statement. Maybe it gives you a higher level of comfort. [Also included in 5(c)] [TC 2/2, p. 25]
[Context] Meeting of the Creditor Discussion Group on March 11, 1993. Part of the meeting was devoted to the topic of auditor involvement.
Committee/Staff/Observer
The first question is what do you gain most from an audit or what would you least like to lose? [TC 3/11, p. 1]
Participant C-10
The thing I'd be most unwilling to lose would be the feeling of independence. That's really critical to understand that the auditors are not subject to being influenced by managements. I'd like the assurance that they have been able to test reasonableness. So I guess maybe my point there is reasonableness. That ties in with the independence, but it's the other side of it. [TC 3/11, p. 1]
Participant C-5
The concept of confirmations and physical counts and so forth is valuable. Whatever work we do is typically based off management's internal financials and looking at concentrations of receivables or inventories. But we always lean back on the fact that the auditors have done those confirmation procedures and verification procedures. In the context of middle market lending, that's the most valuable aspect of it. The one that we don't do. [TC 3/11, p. 1]
Participant C-7
I think one of the benefits on the credit side is the consistency over time for comparability, as we make our credit decisions with our borrowers and continue to monitor the relationship. We are measuring the same things over time so that we have a feel for the true performance of our borrowers. [Also included in 2(c)] [TC 3/11, p. 1]
Participant C-2
The whole assurance factor certainly encompasses some of the other points that are made here. That internal controls have been reviewed, and hopefully management is being counseled as to where there may be weakness. And just the conformity to GAAP and the assurance that that provides the creditor. [TC 3/11, p. 2]
Committee/Staff/Observer
[Participant C-2], is it assurance with respect to the financial statements and paper you get? Or assurance with respect to the relationship of the company to the auditor and whatever that's conveying between the two? [TC 3/11, p. 2]
Participant C-2
To me, I don't see that second relationship as much as being encompassed in the way I think about assurance, but it would certainly encompass the independence concept that was mentioned. Assurance that an independent, unbiased, knowledgeable expert has come in. Through their testing and sampling and so forth, they have looked at enough transactions, traced them through, confirmed receivables, ensured consistency from period to period. Those kinds of assurances. [TC 3/11, p. 2]
Participant C-4
The most important thing that the auditors do obviously is external verification of documents and balances. We also rely very heavily on an audit to uncover material weaknesses in internal controls and procedures. And we also like the fact that with an audited financial statement, we have the ability to sue CPAs. [TC 3/11, p. 2]
Participant C-14
I think an important area where we look to the auditors is on contingent liabilities. I'm not sure the extent of the work is enough, but there is some comfort that we take in knowing that the auditors have weeded through the various legal contingencies and determined materiality of the ones they'd looked at. And that, with regard to the potential liabilities, have conferred with the company's counsel, and come to a determination of how much potential liability there is. Again, there probably could be more work in that area, but I think what's done there now is important. [TC 3/11, p. 2-3]
Committee/Staff/Observer
How many others see the world as [participant C-4] sees it? [Also included in 18(b)] [TC 3/11, p. 3]
Participant C-5
I would say we're exactly the opposite. We have not pursued that avenue in any situation and it just doesn't even enter into our judgement. We're looking for more the assurances as to the practice and the procedures, and have never really looked at the depth of the pockets. So, I would take almost a contrasting view that it just doesn't even enter the thinking process. [Also included in 18(b)] [TC 3/11, p. 3]
__________
Participant C-11
I think it's good to know that the auditors must be nervous about the fact that somebody might sue them, and use a little bit more diligence than they might otherwise do. So I think the auditors should feel a little nervous. That they'd better really get into the stuff or they might be sued. I think that is helpful. On the internal controls, I do think that there's some difficult areas that I would want to feel comfort about, as to what kind of examination really did take place. And I'm thinking of some of these huge off-balance sheet items, such as the foreign exchange contracts, hedging type things. I think it's an interesting avenue to think about. The standard audit letter does not give any feeling one way or another that the critical areas have been looked at in depth. [Also included in 17(c), 18(b), and 19] [TC 3/11, p. 4]
Participant C-4
Just one other point about the ability to sue auditors. We see that more as a club, and as a possible incentive for auditors. We, in a number of instances, find situations where a CPA may be reluctant to change from a review to an audit, because of some of their concerns. And that provides useful information for us in those instances. So, the real use is as a lever against the auditor. [Also included in 18(b)] [TC 3/11, p. 5]
__________
Committee/Staff/Observer
Question 2. Now that we have explored the things that we wouldn't want to give up, what things might we want to improve upon? What has been the greatest disappointment to you in terms of using audited information? [TC 3/11, p. 7]
Participant C-11
I should preface this by saying I'm not exactly sure what goes on in individual audits. And I have a sense that some improvements that I'm going to mention are already beginning to occur. Anyway, I think that the traditional focus has been on the micro- individual transaction verification. I think that the audit should be directed from the point of view of where the risks are, on an aggregate basis, a macro basis. And how are they measured, from a credit point of view and whether that process is good because so much is dependent on systems now. So, that is one thrust of what is in my mind. A second thrust is also macro. I think that many opinions that auditors have to ultimately make have to do with going concern and impairment, and things like that. I do not think that the accounting profession is trained to think as broadly as it has to about how to determine and think about those issues. I think that the security analysis discipline is needed more and more by the auditing firms as they look at some of these very critical issues. So many of the failures that we've had -- I am not speaking now about fraudulent, but about more blatant conceptual failures, such as the S&L's -- in my mind have come because everything was looked at but people forgot to understand what the business was and how badly it was being managed. And maybe a third point is that outside users want independence from auditors. But there is a real question here, as to whether the auditors are always truly independent or are, by business pressures, more concerned with maintaining customer relationships. As opposed to be willing to stand back and say: "this company is going down the tubes." Those are broad comments but they are at least in my mind some of the problems that may have brought us to difficult audit conclusions in the past. [TC 3/11, p. 7-8]
Participant C-12
I would agree very much with the idea that the pressure of maintaining a good business relationship clouds the independence of auditors. Most of my work with auditors comes in due diligence sessions, where you sit down with somebody and they explain how fine everything is and how accurate everything is. And we're doing this in presence of the company's management. I know that there's just a real lack of independence. And I understand, because I'm often in the same position myself. You know there is real pressure to maintain that relationship. I don't have an answer to how you fix that, but it seems to me that independence is a very difficult thing to maintain in a very competitive business world. I think while it's important to look at macro issues, I'd echo what people said earlier, that I'd really count on the auditors to do the micro issues as well. Because I can't do that. In some ways I can do some of the macro things myself. [TC 3/11, p. 8]
Participant C-5
The role of the auditors of our bank has shifted to much more forecasting, reviewing our forecast, our projections, and so forth. They also opined on our reserves quarterly. My value in the auditors is to understand where we think we're going, and to issue financial statements that allow the user to having that same understanding, to decide for themselves. If you've got a concern about Texas real estate and the thrift is in Texas, I would like to know how much of the real estate is in Texas, as opposed to maybe up in Colorado or in Pennsylvania. And so the presentation of financial statements needs to be designed that way. The supplemental financial information would need to be designed in a way that the user could make their own determinations about the projections, forecasts, the future direction of the company. What I found, however, is in going forward, as auditors have had to put opinions on projections, they've applied a conservative bias. As creditors, we create a best case, which is our sort of operating assumption, very different from what management projects itself -- their management case. We then have a worse case. We've got three case scenarios. I don't need the auditor to give me the worst case. I need to know the legitimate case. And actually I struggle at times, because I really almost don't want their opinion; I want them to give me an update so that I can have my own opinion. And I don't get that out of the financial statements. The conservative bias has created a philosophy around our bank to lend on forecasting that's not the most accurate forecast or the best estimate, but the most conservative estimate of a forecast. That's not what creditors really need. They'll do that themselves. [Also included in 17(b)] [TC 3/11, p. 8-9]
__________
Participant C-14
I agree with that [that is, the auditors should not interpret and analyze the information] because I think it would even put more pressure and cloud the objectivity of the auditors. You have to have a base of some kind, to not only judge the accuracy of the information, but then state an opinion on it. I think the kinds of things they could do is more focus on validating , for example, asset values. It is an area that has been a disappointment. When a company comes out and does an inventory or asset write down, the first thing that goes through your mind is: "Well, where were the auditors in validating the presented numbers on the balance sheet on this?" [Also included in 17(b)] [TC 3/11, p. 10]
Committee/Staff/Observer
Are you saying that auditors aren't asking the reasonableness question? Or are not asking it enough? Or asking it correctly? [Also included in 17(b)] [TC 3/11, p. 10]
Participant C-14
I'm basing my opinions on empirical evidence. I'm not saying that what you do isn't right, but I'm saying that it's not working, because we see companies -- [names deleted] -- doing their every year restructuring and write-downs. If the auditors aren't onto [name deleted] by now, you know, they're missing something. So I'm sure that the work is appropriate and it's adequate, in terms of validating that the procedures that [name deleted] uses to account for its asset values are GAAP. But then I think the auditors have to step back and say: "Does that number look right?" Based on the profitability relative to other people in the industry, are those asset values they're carrying in line with the cash flow earnings they're generating? And I would say that holds for inventories as well. [Also included in 17(b)] [TC 3/11, p. 10]
__________
Committee/Staff/Observer
Okay. And then, going from that standard of performance [that you expect from the auditors] and looking at question number two, do you have some disappointments in that regard? [TC 3/11, p. 11]
Participant C-13
In retrospect, the comments that [participant C-14] just made about continuous write-downs and asset values cause the outsider to question the accuracy and reliability of the numbers that were previously presented and cause the loss of confidence in the ones that are currently being presented. [TC 3/11, p. 11]
__________
Participant C-1
I think that's the real issue: is the data really independently observed? And from my standpoint, in terms of work-outs, I can tell you that I don't think it is. If you have accountants who are doing audits for minuscule amounts of money, or zero profit, who are then coming in and doing consulting work, work-out work, executive comp work, how can that possibly be independent? Also, the quality of audit is so varied. And the quality of the people doing the audits is so varied. In some cases, the way they audited the inventories or the receivable is wrong, or it's not accurate, or they haven't spent enough time. [Also included in 17(b)] [TC 3/11, p. 12]
Committee/Staff/Observer
When you say the inventory was wrong, do you mean that it wasn't there, or that the cost of it was incorrect? Or do you mean that the company couldn't get the value that's on the balance sheet in a fire sale? [Also included in 17(b)] [TC 3/11, p. 12]
Participant C-1
We have, in retailing especially, a continuous change in strategy. And auditors seem to ignore the fact that inventory that has been there for three years is not going to be sold. And the cost is not a good price. And it doesn't get written down. It's a value question, and it's a question that if it's not getting sold, why is it still there as a current asset? [Also included in 17(b)] [TC 3/11, p. 12]
Participant C-4
I see a real problem with inventory and receivables consistently being carried as current assets when they are never realized in the current cycle. I think the hindsight review is inadequate in a lot of areas and on those items in particular. [Also included in 17(b)] [TC 3/11, p. 13]
Participant C-17
I think that what really shakes the confidence of the user community is the propensity to have a series of surprise adjustments or write-offs. And it always seems to group itself around periods of economic stress. Clearly, something is not happening. I think that what we want is simple enough: adequate disclosure. All of us want independence. In terms of the accountants' participation in projections and all that sort of thing, we really would rather hear it from our company. We want consistency. It's very difficult to make accurate assessments about what's going on with a company if they're changing the way they make their presentation every quarter, or even every year. And lastly, the one that really comes home, again in periods of stress is that we have some confidence in the reliability of the numbers we're looking at. That they were accurately tested in terms of statistical evaluations. They were realistically valued in terms of their collectibility and their working inventory. There are certain areas, such as inventory and receivables, that are consistent sore spots that I become more and more suspect of, especially as we go into a cyclical downturn. [Also included in 2(c)] [TC 3/11, p. 13]
Participant C-6
At the level of the businesses that I deal with, which is on a much lower level than many of the people here, we strive to obviously get better than a compilation statement, and if we can get a review statement, well, we're very happy about that. But in many cases, we just get no disclosure whatsoever, that is, no footnotes, in a review statement. It's beyond me how an accountant can put out a review statement without putting any footnotes in the statement. Basic information, such as liens on assets, term loan covenants, inventory receivables are not discussed, and possibly bad receivables that may be in there. That's the most disappointing thing to me. When I strive to get a review statement, but get no footnotes, I think that's lacking. [Also included in 17(e)] [TC 3/11, p. 13]
Committee/Staff/Observer
Would it be more beneficial to the user community to have information that may make you able to better assess the need for surprise adjustments, say in receivables or inventories? [Also included in 5(b) and 9] [TC 3/11, p. 14]
Participant C-17
Yes. I went back and looked at a spreadsheet that I used to use in 1972, when I started. And it has all kind of little captions that I used to be able to fill out, like aging of receivables. I could go through the receivables and I saw what was actually written off. I can't always do that today. In my mind it's a question of more disclosure and consistency. It's like when you get a fraud, for instance, the apparel manufacturer, [name deleted]; you get those kinds of situations, and they begin to pop up in groups and it shakes people's confidence. You wonder what actually happened. And how did they reach the size that they did? And how did it go on for the amount of time that it did? Some of these frauds are absurd in terms of their lack of sophistication. And yet it wasn't caught. And that's the thing that's most disturbing. You begin to wonder, was the auditor truly independent? Was he caught up in a battle between his peers in terms of staying on the account? I don't know, I'm just saying that it is disturbing. [Also included in 5(b) and 9] [TC 3/11, p. 14]
__________
Participant C-7
Looking at the market we service, similar to [participant C-6], we're talking smaller companies. We're seeing I'd say a migration in types of financial reporting, from audits to reviews, reviews to compilations, because of costs. Our concern is in trying to build the perfect machine, you don't consider the market, and the cost benefit of what you are trying to impose. Now for a Fortune 500 publicly trading company, given their size, it's easy for them to bear that expense. When you start getting into, let's say the owner-manager-type companies, I'm concerned about the costs that you're imposing and that instead of improving financial reporting, you're going to have unintended costs by creating all these standards and you're going to impair financial reporting at the lowest level. [Also included in 2(d) and 17(e)] [TC 3/11, p. 16]
Participant C-2
I wanted to raise a different issue in answer to this question, and that is in terms of what's the greatest disappointment. The issue of privity and the underlying implication that unless you are in privity with the accounting firm, you may not rely on the information contained in the audit. When I was with a different bank, with a great number of banks in different states, we had a couple of banks in states where privity had to be established. And again, I want to tie on to the comments that have been made earlier: it is not a bank's intention necessarily to sue the accounting firm. However, you do always want to try to preserve your rights. And in those particular banks, we developed some credit policies to try to at least get the banks in privity with accounting firms but we had very little luck getting the accounting firms to return letters basically acknowledging that we were in receipt of the statements delivered by the customer, and could in fact rely on the information in the audits. I do feel that there should be some classes of statement users considered to be automatically in privity with the accounting firms. [Also included in 18(b)] [TC 3/11, p. 16-17]
Participant C-11
I don't think you can define beforehand middle-size companies versus large in terms of what the critical data is and that an audit might have to have. Also, I am all in favor of disclosure and we've certainly talked in the past in these rooms about aging of receivables and things like that. But I don't think that should excuse the auditor from having to think about those subjects if they happen to be put into some disclosure format. I think the auditor is responsible and has to consider the reasonableness aspects of those numbers and in terms of, if they are putting out a clean opinion on these companies, which we are relying on, whether they should have caused things to be reassessed or written down. I think that's an auditor responsibility that has kind of been glossed over and perhaps forgotten. But I think it's there if you're going to put out a clean opinion. [Also included in 5(b) and 17(b)] [TC 3/11, p. 17]
__________
Participant C-11
I know the genesis of this question. It goes back to the previous discussion we've had. There's something wrong with many audits and so we need to find ways to get this subject out in the open. Whether this is an appropriate framework is not the point. It's about how we can improve the qualitative aspects of audits. [Also included in 17(d)] [TC 3/11, p. 20]
Committee/Staff/Observer
Let me make sure I understand your point. What the people who recommended this had in mind is: "Let's use this recommendation as a way to initiate discussions about quality of audits?" [Also included in 17(d)] [TC 3/11, p. 20]
Participant C-11
Yes. [Also included in 17(d)] [TC 3/11, p. 20]
__________
Participant C-7
We've had experience with a number of our customers where we've gone back to them when they've come in with credit requests and said you've got to change your auditors or your accounting firm. We're dissatisfied with the quality of work. [Also included in 17(f)] [TC 3/11, p. 29]
[Context] Meeting of the Creditor Discussion Group on March 11, 1993. Part of the meeting was devoted to the topic of the impact of litigation on auditing and external reporting. During the discussion, a comment was made on auditor involvement.
Participant C-11
I think this is a necessary component. If there is any value to the audit, there has to be the ability to go to court if something has not been done properly. The issue is a broader social issue. We have huge problems with product liability and malpractice liability. Whereas in earlier years people could do outrageous things and never get sued, now it's clearly the other way. And up until now, Congress has not found a way to have reasonable limitations on reckless court proceedings. But I don't think you can avoid the liability question and should not. [Also included in 18(b)] [TC 3/11, p. 62]
[Context] Responses to the postmeeting questionnaire to the March 17, 1993 Investor Discussion Group meeting.
QUESTION 1
Below are several "benefits of an audit" discussed during our meeting or cited by others. Please indicate your degree of agreement or disagreement with each characteristic below as a description of ways audits are beneficial to users:
SA - Strongly Agree
A - Agree
N - Neutral
D - Disagree
SD - Strongly Disagree
Strongly Agree Neutral Disagree Strongly
Agree Disagree
a. An independent 2 3
perspective of the financial
statements.
b. Assurance that someone 5
has examined (verified)
objective evidence supporting
the amounts in the financial
statements.
c. Establishing someone 1 2 1 1
else, in addition to the
company, from whom damages
can be recovered in the event
that the financial statements
are determined to be
misleading.
Participant I-9: This is too
strong, but auditors who do a
poor job should be
penalized.
d. Assurance the company's 1 4
system of internal control is
adequate.
e. Assurance that the 2 2 1
company's system of internal
control has been reviewed and
criticisms/recommendations
have been reported.
f. Assurance that the 1 1 1 1 1
company will remain in
business for the foreseeable
future.
g. Helping insure that 1 3 1
management feels a sense of
accountability to investors
and creditors.
h. Something else. Please 1
describe:
Participant I-16:
Availability of
non-management input to
outside directors
[PMQI 3/17, p. 3-4]
QUESTION 2
Below are several "disappointments of audits" discussed during our meeting or cited by others. Please indicate your degree of agreement or disagreement with each characteristic below as a description of ways audits have disappointed users:
SA - Strongly Agree
A - Agree
N - Neutral
D - Disagree
SD - Strongly Disagree
Strongly Agree Neutral Disagree Strongly
Agree Disagree
a. The independence of 1 1 3
auditors from management is
too clouded by their mutual
business relationship.
b. Auditors' sense of 1 2 2
materiality is too high.
c. Auditors' procedures 3 2
appear to be inadequate
because they too often fail
to identify fraud or other
errors in the financial
statements.
d. Auditors don't consider 1 2 2
issues on a broad enough
scale, such as context of the
company within its industry
and the nature of the markets
in which the company
operates, which results in
overstatement of assets or
understatement of
liabilities.
e. Auditors have too 3 2
conservative a viewpoint;
they need a viewpoint that is
neither a best or worst case
to avoid distorting financial
statement estimates.
f. Auditors fail to detect 1 3 1
uncollectible receivables or
overvalued inventory.
g. "Restructuring charges" 4
in financial statements,
particularly on a recurring
basis, raise questions about
the effectiveness of audits
to detect problems.
Strongly Agree Neutral Disagree Strongly
Agree Disagree
h. Something else. Please
describe:
Participant I-9: The
assumption is that auditors
who learn of something
materially important to
assessing the value of a
business will force
management to at least
mention this to shareholders.
In most problem investments,
the audited statements for
past periods look fine going
in but the seeds of
destruction are known to
management's investment
bankers and, in some cases,
auditors. Treasurers are
financial watchdogs.
Auditors should also be and
not let management
misrepresent the business.
[PMQI 3/17, p. 4-5]
QUESTION 1
[Context] Responses to the postmeeting questionnaire of the March 11, 1993 Creditor Discussion Group meeting.
Below are several "benefits of an audit" discussed during our meeting or cited by others. Please indicate your agreement or disagreement with each characteristic below as a description of ways audits are beneficial to users:
SA - Strongly Agree
A - Agree
N - Neutral
D - Disagree
SD - Strongly Disagree
SA-7,A-5
a. An independent perspective of the financial statements.
SA-9,A-4
b. Assurance that someone has examined (verified) objective evidence supporting the amounts in the financial statements
SA-1,A-1,N-7,D-3,SD-1
c. Establishing someone else, in addition to the company, from whom damages can be recovered in the event that the financial statements are determined to be misleading
Participant C-4: Not so much for actual recovery, but the threat definitely improves audit quality!
SA-2,A-10,D-1
d. Assurance the Company's system of internal control is adequate.
SA-3,A-9,N-1
e. Assurance that the company's system of internal control has been reviewed and criticisms/recommendations have been reported
SA-1,A-4,N-2,D-3,SD-3
f. Assurance that the company will remain in business for the foreseeable future
A-4,N-6,D-3
g. Helping insure that management feels a sense of accountability to investors and creditors
SA-1
h. Something else.
Please Describe:
Participant C-14: Accounting systems have been tested to the extent that there is a high level of confidence on the part of the auditor that the financial statements represent reality (all actual accounting events) in accordance with appropriate accounting treatment (GAAP).
Participant C-11: F is an important point. This should be true. I do not believe that accountants have properly addressed this in the past - or used the right tools to do so.
Participant C-17: F. above - do want and need going concern qualifiers along with descriptive text as to issue involved.
[PMQC 3/11, p. 1-2]
QUESTION 2
Below are several "disappointments of audits" discussed during our meeting or cited by others. Please indicate your agreement or disagreement with each characteristic below as a description of ways audits have disappointed users:
SA - Strongly Agree
A - Agree
N - Neutral
D - Disagree
SD - Strongly Disagree
SA-2,A-8,N-1,D-2
a. The independence of auditors from management is too clouded by their mutual business relationship.
Participant C-14: Every profession has potential conflicts.
Participant C-4: Move toward creditors engaging auditors should be considered.
A-3,N-5,D-5
b. Auditors' sense of materiality is too high.
SA-1,A-6,N-4,D-2
c. Auditors' procedures appear to be inadequate because they too often fail to identify fraud or other errors in the financial statements.
Participant C-4: In some instances, no audit basis for estimates - % complete.
A-6,N-3,D-4
d. Auditors don't consider issues on a broad enough scale, such as context of the company within its industry and the nature of the markets in which the company operates, which results in overstatement of assets or understatement of liabilities.
SA-2,A-1,N-1,D-9
e. Auditors have too conservative a viewpoint; they need a viewpoint that is neither a best or worst case to avoid distorting financial statement estimates.
SA-3,A-8,N-1,D-1
f. Auditors fail to detect uncollectible receivables or overvalued inventory.
Participant C-4: Or disclose as non current.
SA-1,A-1,N-6,D-4
g. Auditor assertion of "privity" makes seeking auditor accountability difficult.
SA-3,A-1,N-3,D-6
i. "Restructuring charges" in financial statements, particularly on a recurring basis, raise questions about the effectiveness of audits to detect problems.
Participant C-14: Auditor signs off and shortly thereafter huge asset writedowns. How can this be?
A-1
j. Something else. Please describe:
Participant C-8: On the low end, there is the problem of auditors working in industries which they know little about. The same CPA might audit a grocery store one day and a construction contractor the next.
Participant C-11: Comment on i - The problem is more that accounting policy has not provided standards on impairment.
Participant C-4: An audit states that the financial statements and notes are the responsibility of management. In theory, yes - in practice, for companies under $10 mm of sales, the auditors do the financials in a number of instances.
Participant C-17: Statistical sampling and depth of review are not described and are therefore suspect or it is hard to evaluate what degree of reliance is appropriate.
[PMQC 3/11, p. 2-4]