17(b). The Scope of Auditing
[Context] Meeting of the Investor Discussion Group on October 16, 1992. Throughout the meeting, when investors discussed their objectives and approaches to evaluating equity securities, comments were made on the scope of auditing.
Participant I-9
I hope that the accounting profession will look at the things that are suspect; for example, for a toy company, look at the receivables and make sure the goods can't be returned after Christmas; for a supermarket chain with lots of leases, make sure the discounted present value of the leases is a fair number; if [name deleted] is using a lower inflation rate on health care benefits to discount because the company would be insolvent if it used a current discount rate, I want to know this. So look at what is of significance for making an investment in a particular industry and don't let the companies bamboozle the profession because it is in their best interest to do so. [TI 10/16, p. 6]
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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(a)] [TI 10/16, p. 20]
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Participant I-9
I don't think it's worth the costs for the companies I follow to have segment reporting on a quarterly basis. What I would ask is that it be consistent from year to year. With respect to pharmaceutical, for example, if you switch a drug from the ethical sector to the over-the-counter sector, make some sort of adjustments in the figures of the prior years so we can look at the trends on that. I go back to the point about what the auditor should look at for a particular industry. With respect to pharmaceutical, the companies are now showing price increasing data; it would be nice to have an auditor to say whether that data is reasonable. Research is also a big item; why not segment out what is basic research from research on drugs and give the FDA categories (phase 1, phase 2, and phase 3 breakdowns)? The other problem in the area is that companies are international; for example, [name deleted] has 40% of its business in the U.S. and is headquartered in London. You convert the U.S. earnings to British accounting and then reconvert it back to ADRs and you can get two reports that have to be reconciled for a company that is half in the U.S. and half abroad. And you will have more problems with the Swiss companies. The other problem is marking to market on currencies. We don't understand the accounting standards. Those areas call for particular expertise where accountants could be very helpful. [Also included in 1(b), 3(c), and 3(d)] [TI 10/16, p. 23-24]
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Participant I-6
A couple of simple ones: book value, debt ratios. Trying to do the book value is difficult on a company based on their quarterly numbers. First of all, most companies don't report actual shares outstanding, they give the average for the quarter; that doesn't help you get a book value number. Debt ratios: every company that I follow has its own little twist to it. I think the value that the accounting profession could bring is some standardized ratios that would be reported and audited on an annual or quarterly basis and have very specific definitions for those ratios. [Also included in 1(c), 11(c), and 13] [TI 10/16, p. 51-52]
[Context] Meeting of the Investor Discussion Group on March 17, 1993. Part of the meeting was devoted to the topic of auditor involvement.
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(a)] [TI 3/17, p. 7]
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Committee/Staff/Observer
Our fourth question asks about expanding the auditors' role to audit information that is part of external reporting but that is not currently audited. As you know, the auditors' report currently covers the financial statements and the related notes. It does not cover other areas of external reporting. Our question is: would you find it useful if the auditor were to audit information in some or all of those other areas that are outside the scope of financial statements? And if so, which information? The meeting materials identified some unaudited areas for your consideration. [TI 3/17, p. 9]
Participant I-12
It could be very useful to take a look at other parts of reporting. The auditor's training is in accounting and it would be most appropriate to comment on any area in which management is disclosing numbers. As an example, a lot of financial companies have begun to disclose enormous amounts of information in a financial supplement, outside the purview of SEC reporting. They do that because that gives them the flexibility to present their businesses in the way that they look at them. That provides a sounder basis for analysts to communicate with management. Sometimes you wonder where those numbers came from and the underlying assumptions. Perhaps some review of those numbers periodically might be of use. [TI 3/17, p. 9]
Participant I-7
If we look at the MD&As, they're almost like a cookie-cutter. I'd like to see the auditor get involved when there are things that have taken place, in terms of material exposures or perhaps benefits to the organization, and that are not touched upon by management. I'd like to see the auditor infuse that information in the MD&A. [TI 3/17, p. 10]
Participant I-16
I have some reservations on the expertise level of the auditors. If anything, you want management to feel free to say more about their view of the company. I don't think the auditors should be expected to have mastered the nuances of the business to get involved in that; it's management's job. Having the auditor comment on such things as the adequacy of internal controls is very appropriate and could be helpful. [TI 3/17, p. 10]
Participant I-12
The MD&A may also be an area that would be more appropriately handled by the SEC, in terms of what kinds of things belong there. I agree with the notion of having an independent opinion of internal control and information systems because that leads back to the reliability of the information that we're getting. Also, the auditor could play a role in the MD&A in terms of bringing out environmental changes and the company's exposure to those changes. And perhaps greater discussion of assumptions that underlie all the numbers. [Also included in 2(b) and 9] [TI 3/17, p. 10]
Participant I-7
How much does the profession gets involved in setting standards for particular companies; for example, standards for quality of products, costs standards, etc? [TI 3/17, p. 10]
Committee/Staff/Observer
It largely depends on the client. [TI 3/17, p. 10]
Participant I-7
I feel that this is a key element, that is, the auditor getting involved in a program where estimates are made. [TI 3/17, p. 11]
Participant I-11
A central issue to these discussions is what the role of the auditor is or should be. I think that we may be looking at auditors to do more than they should be doing, using that as an excuse not to do it ourselves. The broad issue is that the financial statements of a company are supposed to accurately reflect the operating performance of that company. The proper role of the auditor is to provide independent judgement that the financial statements do provide an accurate reflection of the operating results. If you think of the role of the auditor in those terms, then expecting of the auditor to get involved in things like the MD&A or the company's forecasts are not appropriate functions for the auditor. On the other hand, issues relating to uncertainty of estimates are related to the auditor's role. To the extent that it is economically feasible, we ought to have a lot more information in that area. There is some limit based on cost-effectiveness. For example, I'm not sure that it is cost-effective to have a quarterly audit. [Also included in 9 and 17(d)] [TI 3/17, p. 11]
Participant I-12
I would agree with that. I know that a lot of companies that I cover have their statements audited not only quarterly but before they report, which I find astounding for companies who report 10 days after the end of the quarter. I don't see any need to have an audit done more than annually. I also think that there are areas where the auditor might become involved; measurement uncertainties, for example. Another area for auditors would be looking at transactions with related parties (including major suppliers and major customers). In close relationships like that, that's where a company has the greatest potential for trying to cook the books. An auditor could look at those transactions and determine whether they're being accounted for on an arm's length basis. [Also included in 9 and 17(d)] [TI 3/17, p. 11-12]
Committee/Staff/Observer
Should there be any auditor involvement with quarterly reports or once a year is enough? [Also included in 11(d) and 17(d)] [TI 3/17, p. 12]
Participant I-16
I think the quarterly issue has to be deferred towards the later discussion of what you want quarterly reports to be, in terms of whether they should be like annual reports, that is, discrete periods, or whether they should be an integral part of the whole year (thus, with some smoothing). You need to decide that before deciding whether they should be audited or not. [Also included in 11(d) and 17(d)] [TI 3/17, p. 12]
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Participant I-7
Coming back to [committee/staff/observer]'s comment about companies in the same major industry having different auditors, it puts auditors at a great disadvantage when asked to express an opinion about management's forecasts compared to analysts following a specific industry and being able to look at the whole forest. Auditors don't have the sense of what's going on from a competitive point of view. I see no reason for the auditors to be involved with management's forecasts. [Also included in 12 and 17(c)] [TI 3/17, p. 18]
Committee/Staff/Observer
Let's suppose you have the financial statements of an institution that has a large portfolio of real estate loans. This group and others have told us that they would expect the auditor to evaluate management's assumptions about whether those real estate properties are going to be profitable or not, and to make judgements about whether the carrying values of the assets are appropriate or not, whether they should be reserved, and you expect the financial reporting to reflect the appropriate adjustments. How is that different from other kinds of projections? [Also included in 9 and 17(c)] [TI 3/17, p. 18]
Participant I-12
For real estate properties, there are current appraisals on most of these properties. Theoretically, banks and other financial institutions have set aside reserves to appropriately reduce the value of the assets to reflect the current situation. I don't know if real estate prices are going to go up or down; I will look at all of that and I'll make an estimate of my own. What I would like the accounting profession to do is to make it clear to me what the basis of all of that is. A question analysts ask a lot is: what percentage of original value have your nonperforming real estate loans be written down? If we know how much has already been written down, we then have some information that will help us make estimates about how much more write-downs should be made given our general outlook. I would like to know what has already been done and what the status is. Managements are always making estimates; analysts try to know what the assumptions are and make their own estimates that can be radically different. I'm not sure the accounting profession needs to get involved in future estimates; the most important function of financial statements is clarity. [Also included in 9, 12, and 17(c)] [TI 3/17, p. 19]
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Committee/Staff/Observer
The bulk of the MD&A compares the current and the previous period in narrative form. What's in that MD&A that troubles you with auditor involvement? [TI 3/17, p. 20]
Participant I-16
There is generally nothing in the MD&A that concerns me at all; it is generally a meaningless statement. Auditing it doesn't make any difference. [Also included in 13] [TI 3/17, p. 20]
Committee/Staff/Observer
Auditing doesn't make any sense because it's not useful, not because it's not within the purview of the auditors' role? [TI 3/17, p. 20]
Participant I-16
What you want to do is to make the MD&A more meaningful and to me it would be making it meaningful without auditing it. [TI 3/17, p. 21]
Participant I-11
The MD&A should be a discussion by management of the operating events that produce the financial statements. We all know that's not what it usually is. It's usually a regurgitation of the numbers. Similarly, the AD&A would be the auditors' discussion of the way the accounting principles and techniques were applied to the operating events to produce the financial statements. In that context, I think it's appropriate to have the auditors involved in estimates. For example, taking the real estate portfolio example, the balance sheet shows that on the balance sheet date there was an asset called real estate portfolio, and the value assigned to that asset was reached by making certain assumptions or estimates. In order to judge the accuracy of that figure, a user needs to have an idea of what those estimates were. As far as estimates in the future are concerned, I think [participant I-12] is right; that is what we're doing and I don't get any additional comfort by having an auditor tell me that management's estimates are good or bad because I'm making my own anyhow. A few years ago, when [name deleted] tried to do a big deal based on some projections of air travel that had factors and yields going nothing but up, that deal never got done because independent financial analysts said the assumptions were preposterous. [Also included in 12, 13, and 17(c)] [TI 3/17, p. 21]
Participant I-16
Perhaps there is a problem here with two different types of transactions. For manufacturing companies, we're dealing with transactions that occur in the future. Companies are going to provide a service and be paid for it. While in many financial business, transactions occurred 5 years ago and what we're putting in the financial statements are the results of those past transactions. For example, insurance companies selling a policy where you're not going to find out for 5 years whether the person dies or not, or gets sick, or his house collapses. Or lend money to a hotel and you don't know whether the hotel is going to be able to service the debt. Maybe there are different types of transactions here, but most of the transactions we deal with outside of financial transactions are prospective transactions. A forecast does not relate to questions of what happened in the past. A forecast of how many of [name deleted] is going to sell next year, I don't think that the auditors' job, that's my job as a software analyst. But if I were doing a bank, I would have to know what is the status of the loans I made 5 years ago because that has a bigger impact on my reported earnings of 1993 than the loans I make in 1993. [Also included in 12 and 17(c)] [TI 3/17, p. 21-22]
Committee/Staff/Observer
[Participant I-11], you and others have observed that MD&As are often inadequate. I suspect that many auditors could write a good MD&A. Why would you not want the auditors to do that? [Also included in 17(c)] [TI 3/17, p. 22]
Participant I-11
I suspect that the auditors could write a better MD&A than those that are being written today. But I think that it is putting a responsibility on the auditor that he is really in principle ill-equiped to deal with. The MD&A should be a discussion of the operating events that transpired during the year. Management is being paid to cause those events to occur; so they're the logical people to tell us about it. [Also included in 17(c)] [TI 3/17, p. 22]
Participant I-12
And they're responsible to the shareholders. It seems to me that those who are responsible ought to be reporting back to the shareholders. The way the auditor is going to write an MD&A is going to be vastly different from the way management writes it. [Also included in 17(c)] [TI 3/17, p. 22]
Committee/Staff/Observer
Does that suggest that that be audited? You want to know bad enough to pay for it? [Also included in 17(c)] [TI 3/17, p. 23]
Participant I-7
Yes. For example, if you know that inflation is 3%, and management has decided to put a 0% increase for labor costs, I'd like an understanding of that. And that is within the auditors' role to give us comfort on that. [Also included in 17(c)] [TI 3/17, p. 24]
[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-5
We are typically getting an income statement and a balance sheet, we are not getting a statement of cash flows, or we're not getting a statement of capital changes. What concerns us is the need to establish some standards for the degree of verification that might go on. Rather than asking for more disclosure, we would trade that for some verification at that level, an audit verification. [Also included in 1(b) and 2(d)] [TC 12/8, p. 43]
Participant C-8
We've often done the opposite, and agreed to forego the verification for more disclosure, more schedules of the various assets and liabilities on the balance sheet. [Also included in 1(b) and 2(d)] [TC 12/8, p. 43]
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Participant C-5
I don't agree with providing projections in the public financials and with auditors contributing to those in a published financial statement, even for a private company. We do get projections, we wouldn't do any term finance without projections. Any credit greater than a year, we require projections. We do a separate bank case which is our own assessment of that and which is much more a downside analysis. What we do use them for are two key purposes. One is management is forced to reconcile their ability to do certain things in the future such as capital expenditures. We don't have to worry about two years from now management coming back and in and wanting to discuss a dramatic new capital expenditure program, because we've had an adequate discussion of those items well in advance of that. A second item and what we really do use management projections for is we tie our fences right off of that. Every covenant is tied just off of management numbers. So whether they want to be optimistic and rosy and put a 25% sales growth in there, we'll be just under them at 24% with our hurdle. And when they come back in, we'll charge them default rate pricing until you get that corrected. Projections are a valuable tool, and we wouldn't ignore them, but we would end up discounting them just like we discount managements' projections if they came from an auditor and would be part of the financial package. It would add to cost, it wouldn't add to value, necessarily. There are pieces of current historical information with more detail that would allow us to make our own judgments about those projections which are not adequately disclosed, like capital expenditures. That's what we need to do our analysis better. [Also included in 1(b), 1(c), and 12] [TC 12/8, p. 71-72]
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Participant C-4
I can't remember the last time I've seen a going concern opinion on a financial statement. I don't know how much forward looking work auditors are doing when they're doing their audit work, and then how much historic hindsight review they're doing when they're auditing of financial statements. It's not happening, particularly as I mentioned earlier, in the percentage of completion accounting. [Also included in 12 and 17(c)] [TC 12/8, p. 74]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of auditor involvement.
Participant C-4
As the more distressed the situation becomes, we start focusing our attention on the liquidation values, and at that point, we may not necessarily be relying on what a CPA audit tells us. We may actually go to an expert and get some appraisals ourselves, which would be beyond the scope of the normal audit. To have fair market value information included in an audit is not something that is of great benefit to us normally. It's nice to have as an additional disclosure. [Also included in 4] [TC 2/2, p. 4]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of disclosure on operating opportunities and risks. During the discussion, comments were made on auditor involvement.
Participant C-17
In financial statements today, what's being evaluated is really what the risks are. It's not so much the opportunities. But I certainly get a little uncomfortable when you start talking about getting together with the auditor to project opportunities. You know, I'm not sure that's what we should do. [Also included in 10(a)] [TC 2/2, p. 29]
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Participant C-11
Talking about the specific examples in the meeting materials, some of them very good, where there could well be a near term quantifiable change occurring because of certain items. I think, ultimately, the preparer has a responsibility to understand and determine what those elements might be. An interesting subject here, is to what extent does the auditors also have responsibility to ascertain and know whether the management has properly identified quantifiable near-term things that could happen, that would have an impact on the various financial statements? [Also included in 10(b)] [TC 2/2, p. 35]
Participant C-4
There ought to be some specific identifiable questions that auditors should be able to come up with. What impact are some of these contingencies going to have on current cost? That ought to be the focus. Just like there are specific questions for extraordinary items that might come up. It's part of the audit process although we recognize that management is responsible for the financial statement. We also know in practice that the smaller the company, really the CPA's more responsible for financial statements than management itself. [TC 2/2, p. 35]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of disclosure about measurement uncertainties. During the discussion, a comment was made on auditor involvement.
Committee/Staff/Observer
I understand that one type of disclosure would be boilerplate, the acknowledgment that it's inherently risky. The second type of disclosure could deal with how much do you want to know about these estimates. If we go to page 24, it proposes that there could be a variety of approaches to telling users more about things that underlie assumptions. Sometimes it could be something as simple as the aging of accounts receivable to show a little bit more about how the bad debt reserve might relate to it. In other cases, it might be much more complicated to talk about, for example, warranty experience and quality controls inherent in manufacturing process, and some other fairly in-depth discussions. Is this useful information? Is the financial report the correct place to put it? What is your feeling as a user, if that is what you want? How do you deal with it? How would you expect the package to look to make it useful? [Also included in 9] [TC 2/2, p. 50]
Participant C-5
I don't know if I would have an auditor provide that. [Also included in 9] [TC 2/2, p. 50]
[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
Let me pursue this off balance sheet topic that some of you have raised. There is off balance sheet disclosure now. I'd like to have a better feel in terms of what you view the auditor relationship with that off balance sheet information as it exists now is. Do you see that as either ill-defined, well-defined, or needs redefining? [Also included in 19] [TC 3/11, p. 5]
Participant C-11
The off balance sheet disclosure that we now have just recently been getting is not useful to me. It's just a bunch of big numbers and it doesn't get into the qualitative aspects of the risks. But addressing the question you're speaking of, I was not necessarily speaking of off balance sheet items versus on balance sheet items. I was thinking of critical areas where, in the case of financial institutions, a massive number of individual transactions take place, and those can be audited on an on-the-spot basis. What is more critical to me is that the whole process of whatever those transactions are, be analyzed as a process, in terms of whether the right data is captured. For instance, are there really hedging transactions being captured or are there a combination of hedging and speculation? So, it's not the individual transaction I'm thinking of. It's the whole process or business that's being undertaken, and whether the proper information is coming in an aggregate form in the right way. And whether the systems involved do capture things properly. And that could be on and off balance sheet. [Also included in 19] [TC 3/11, p. 5]
Participant C-12
I think maybe off balance sheet is a whole separate discussion. What we're getting now is minimal information of substantial exposures. And we're getting no explanation of what's involved in these exposures. What the financial risk is, what the credit risk is, how it breaks down. But I think that's a separate topic altogether. [Also included in 19] [TC 3/11, p. 6]
Participant C-5
I would agree that current disclosure doesn't give us a view of what the risks are. I will also confess in regular conversations with peer institutions on the very subject that, as we measure our risk to each other, everyone has a slightly different approach. The basic approach is similar, but the numbers all come out differently based on how we quantify risk. We are all moving increasingly towards some commonality in that area, but the idea that you would give an opinion and say that what's been presented is a fair representation, without allowing me to know the differences and have the raw data to make a determination of my own, is troubling. I know my aggregate positions with any other counterpart but I have no concept of their aggregate exposure. And the raw information which is provided is clearly insufficient to make some determinations or risk calculations. Whether it's something as complicated as options, forwards, and swaps, or something as simple as purchased intangibles, like servicing rights. Just in the last year, the dynamics of that market have been so significant that we have been throwing credits out of our committee because our own people don't even know the detail behind the numbers. And we have difficulty getting them. Management can't provide them. If they can't provide them to us as a negotiating creditor, I doubt the auditors have been able to get that kind of information, or really have reviewed it in the right kind of depth. [Also included in 19] [TC 3/11, p. 6]
Participant C-13
There are two issues here. I agree with everything that has been said about disclosure and availability of information for off balance sheet items and liabilities and assets and contingent liabilities. But the other issue is the audit and control issues concerning those items. And I think everything that you've heard in the last three minutes suggests that there's a concern, a serious concern, about the controls that exist. There have been numerous instances of surprises or failure of controls among very large companies. That would suggest that the users are very interested in the audit functions of these off balance sheet items. [Also included in 19] [TC 3/11, p. 6-7]
Participant C-14
I was going to try to differentiate off balance sheet items like swaps and hedges that we talked about in other meetings, because I think we've suggested that there may be better ways to account for them in the financial statements, to present them differently. I distinguish that from things like legal and environmental contingencies where I see a real challenge on the part of the auditors. My understanding is that companies don't want to disclose that kind of information because it helps set up the case for the people coming against the company. I don't know what the answers are but I see that as a more difficult issue to handle than other off balance sheet items. [Also included in 2(d) and 19] [TC 3/11, p. 7]
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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(a)] [TC 3/11, p. 8-9]
Participant C-11
Just to clarify my remark. I was not speaking of the accounting profession giving her blessing on forecasts. I was thinking in terms of doing their own work -- when they do they own work and have to address the going concern question -- what they have to do in their own internal analysis. They have to address those issues and have to come to decent conclusions. I wasn't thinking of public forecasting. [TC 3/11, p. 9]
Participant C-15
Is it really the role of the auditors, or should they present you the information in such a way that you can do the analysis? I don't think we can ask the auditors to interpret and analyze all that information. The role of the auditors should be to present the information in a clear and consistent way. As we're discussing disclosure and so on, clearly there are improvements that could be made in disclosure. And the information should be there for the analyst or the user of financial information to reach his own conclusions. But the auditor shouldn't reach those conclusions for the user. [TC 3/11, p. 9]
Participant C-14
I agree with that 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(a)] [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(a)] [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(a)] [TC 3/11, p. 10]
Participant C-13
I'm having a little difficulty with some part of this conversation because it doesn't seem to me that it's the role of the auditor to set disclosure standards, or determine accounting policies. Those jobs are for standard setters and regulators. And what the institutional investor wants from the auditor is a sense of assurance in the reliability and accuracy of what's presented, rather than asking them to define what disclosures ought to be. [TC 3/11, p. 10-11]
Committee/Staff/Observer
From the perspective of an auditor, I'm not sure what I'm hearing. Is it the role of the auditor to provide reliable, factual information, that you make the assessment about? Or are you saying that the auditor should go beyond that and make judgments about value and whether those assets are collectible, preservable? I thought [participant C-11] was suggesting that the auditor is expected to go beyond reporting on the factual information, to make assessments about future prospects. I'm not sure that that's what I'm hearing from this end of the table. This is a bit confusing, and has been for a long, long time, as to what really is expected from the auditor's report on the financial statements. [TC 3/11, p. 11]
Participant C-5
For example, if [name deleted] has a one-time write-down because of a change in the strategy. Now the issue is: should the auditors have foreseen that the first strategy was not going to be successful and therefore taken a more conservative view? [TC 3/11, p. 11]
Committee/Staff/Observer
Or was that the user's responsibility based on the information provided? [TC 3/11, p. 11]
Participant C-5
This user did it, but I don't know about others. I'm not distressed in the case of Westinghouse, because I do believe at that point, given the strategy that was understood, that it was possible there was also a significant period of deterioration. I'm not so sure that that is a problem. I don't mind auditors making assumptions but I need all the details that went into that assumption. Because your biases are different than mine, I have to make my own opinion. It's my money at risk, not yours. I just need to know that what I'm seeing is good raw data, independently observed and factually correct. [Also included in 17(c)] [TC 3/11, p. 12]
Participant C-1
Yes but 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(a)] [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(a)] [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(a)] [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(a)] [TC 3/11, p. 13]
__________
Committee/Staff/Observer
I'd like to better understand where the focus is in terms of the nature of a company's business and the size of a company. When we talk in terms of aging of receivables, quality of inventory, impairment of assets, what would you expect to see from a [name deleted]-type size corporation versus a smaller company? [Also included in 5(b)] [TC 3/11, p. 14]
Participant C-5
I think in the middle market, where you are typically financing the current assets and working capital of the company, the focus is on inventory and receivables. Take a [name deleted], though, and I don't want to know what the carrying value of its plants and facilities is. I have to have a sense of levels of utilization of those plants and facilities. An auditor should realize that a user of the financial information would have certain critical concerns about this company and should be able to provide detail on these that would allow us to make our own assessment. I really want to know your assumptions so that I can say: "I discount those assumptions," or "I accept your assumptions," or "I'm more optimistic." That's where I might make the lending decision and someone else wouldn't. Otherwise we're all making the exact same decision because we've used one opinion on the numbers. But, in the large corporates it's more looking at the expense structure; the fixed variable, the employee component, the discontinuing operations, segment reporting, and the ability to understand business exits that might occur, and which ones would be most probable for the company. [Also included in 5(b) and 17(c)] [TC 3/11, p. 14-15]
Committee/Staff/Observer
And it would be safe for me to leave today with an understanding that maybe your needs with respect to middle market smaller organizations might be different than they would be in a Fortune 500? For the former focus is on perhaps the quality of the underlying assets and perhaps with the latter it's the quality of the underlying control systems and environments, and those kinds of things; is that a fair thing for me to walk away with? [Also included in 1(b) and 5(b)] [TC 3/11, p. 15]
Participant C-1
I don't know if I agree with that at all. Some of the companies that we lent to, that are high-yield companies, are in the Fortune 500. And I think what we're concerned about is the quality of the inventory and the quality of the receivables. If we're lending to a company that the inventory is good for all time to come, fine, but I can't tell you the number of times we've lent money to a company and all of a sudden 20% of their inventory, while it's still good and could be sold, might take ten years to sell it, because no one wants it. And it's been sitting there forever and it's not a current asset, it's really a long term asset. Or, with [name deleted], how many parts do they have that go for a 1980 model that are still sitting in inventory, that really are not going to be liquidated, or not going to be used for the next year; it really is a long-term asset? That's where I become more concerned. You know we're all concerned about environmental problems, and pension problems, and legal liabilities, but the concept that inventory is always a current asset, as we're all trained and taught in business school and undergraduate, just isn't true anymore. [Also included in 1(b) and 5(b)] [TC 3/11, p. 15]
__________
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(a)] [TC 3/11, p. 17]
__________
Committee/Staff/Observer
Question number 4. Would it be useful if the auditor were to audit information that is outside the financial statements, and provide some kind of assurance? If so, please help us understand what is it you might choose between a) and f) in the meeting materials and why would it be helpful to you? [TC 3/11, p. 21]
Participant C-5
I have mentioned that we actually have had quarterly representations as to the adequacy of our reserve. That was something that our management made a decision two years ago now because of the concerns. As to my personal view on this, I assume that whenever I read an annual report the auditor should have some opinion about the supplemental disclosures that are in there. I know that there's a lot of disclaimers about that work. Although I do know in our own internal situation, they do extensive review, and I don't know how many times we've had to modify schedules because of adjustments that the auditors have made. I feel there's a sense of accountability throughout, even though there's disclaimers about it already, and I would like to see it just broadened to include those additional disclosures of factual information, whether it be concentration schedules that we prepare typically, or maturity schedules, or valuation schedules, or mark to market on certain historical cost items. [TC 3/11, p. 21-22]
Participant C-17
There's an underlying theme here, and it divides itself into two parts. The first question that keep coming up is basically: what more can the auditor do? How can he expand his role in order to meet users' needs? And the second part of it is doing what he already does, but doing it better. If I had to make a choice, because of cost reasons and because of the desire to maintain independence, it's basically doing what you do, but giving a greater assurance of what we see is what we think it is. [TC 3/11, p. 22]
Participant C-12
I probably get as much, looking at financial institutions, information out of the MD&A as I do out of the balance sheet and income statement and footnotes. Therefore, it would be very important to me to know that I can have as much comfort and faith in those numbers because I do get as many numbers out of the MD&A as I do anywhere else. If I had to pick one thing in expanding the auditor's role, that would be it. [Also included in 1(b) and 13] [TC 3/11, p. 22]
Participant C-10
Yes, I like that. I also would vote in favor of as much as you could do quarterly. Again, I think that depends on the size of the companies and costs. [Also included in 17(d)] [TC 3/11, p. 22]
Participant C-15
[Participant C-12], do you think that you would get as much information out of the MD&A section if it was audited as if it wasn't audited? Some of the discussion is real helpful; do you think that might be sort of reduced if the auditors had to sign off on that? [Also included in 13] [TC 3/11, p. 23]
Participant C-12
Possibly, although the SEC has mandated a lot of that as well. [TC 3/11, p. 23]
Participant C-15
I think that it would be very helpful to have the numbers, if you will, the factual information audited. In terms of the soft type information, it would be difficult for auditors to sign off on that, and I think that it would just be eliminated from the discussion. The "D" part of the MD&A would be shortened. [TC 3/11, p. 23]
Participant C-13
You already had to run it through the legal department. If you have to run it through the auditors as well, it will be even less meaningful. [TC 3/11, p. 23]
Committee/Staff/Observer
So you see it the same way [participant C-15] does? [TC 3/11, p. 23]
Participant C-13
Yes. [TC 3/11, p. 23]
Participant C-5
I believe that the fact that those areas are not opined on is a risk mitigant for the auditor as opposed to a need for scope expansion. Quite frankly, the detail auditors get into in other stuff is no more severe than what they get into on the supplement and the MD&A type disclosures. It's just that whatever you can do to reduce that liability factor is the driver behind not making affirmative statements. Obviously as you move down the scale in the quality of the audit firm, some smaller and medium sized firms will clearly just disregard those sections and make their disclaimers and don't treat it. But in a Fortune 500 type company, I find it very difficult to believe that auditors don't take a sense of ownership and accountability, and probably charge for scope work associated with review of that activity, regardless of the opinion that's issued or the disclaimers. I also want to touch on section (e) in the meeting materials. For mid-size companies, I basically get a consolidated statement (holding company and operating subsidiary) without the detail as to operating subsidiary reporting and so forth. The only thing I guess that could get me over that without having to do a report on the individual operating company itself is to clarify the intercompany transactions which are awash in consolidated reporting. That at least would give me a better comfort level as to the integrity of the operating company financial statements, if I can at least eliminate some of the intercompany and the non-external transactions, and understand the depth of those and sort of the issues between them. [Also included in 18(b)] [TC 3/11, p. 23-24]
Participant C-1
I would hate to lose the information and the facts that are in the MD&A because they all of a sudden have to be audited. For example, discussion of the estimated impact of a strike or a plant closure that wouldn't necessarily be broken out in the normal financial statements. While I think it would be great if auditors looked at that, I'd hate to lose it because it is such an important way that we look at companies. [Also included in 13] [TC 3/11, p. 24]
Committee/Staff/Observer
Is it your impression that the auditors now do not look at the MD&A's? [Also included in 13] [TC 3/11, p. 24]
Participant C-1
No, it's my impression on talking to companies that they will put stuff in the MD&A that, if you read it carefully, will answer your question in terms of one-time charges, that can not be broken down in the financial statements. [Also included in 13] [TC 3/11, p. 24]
Committee/Staff/Observer
Same difference. How much do you think auditors presently do today with regard to the MD&As? [TC 3/11, p. 24]
Participant C-1
I guess I don't think they do that much. [TC 3/11, p. 25]
Participant C-5
I know they do. At least on the large companies. [TC 3/11, p. 25]
Committee/Staff/Observer
The problem is they don't tell you what they do. [Also included in 17(c)] [TC 3/11, p. 25]
Participant C-11
I know that they have always been told by the companies that the auditors review the MD&A type information. I think that's excellent. I would be nervous about making it a formal requirement, and I don't think accountants should in effect write the MD&A. I want to know about the company's business strategy; I'd hate to lose that information. [Also included in 13] [TC 3/11, p. 25]
Participant C-10
You earlier asked me if I agreed with the point about extending the audit to the MD&A. I would just say that I really like the MD&A. We all use it. The question is how do we keep it as valuable as it is, and if anything, have the auditors help increase that value. But at the same time not put limitations on it. [Also included in 13] [TC 3/11, p. 25]
Committee/Staff/Observer
Would you want an MD&A for private and smaller companies? [Also included in 2(d) and 13] [TC 3/11, p. 25]
Participant C-5
I'd obviously like to start moving down in the middle market segment with more MD&A, even if they are LBO-type companies, where we don't have a public reporting requirement. But, at the same time, I would prefer to know that the auditor feels that there is that obligation associated with the MD&A, by not being able to disclaim any obligation with regard to that, even though they've done work around it. [Also included in 2(d) and 13] [TC 3/11, p. 25]
__________
Participant C-4
We're hitting at what the role of the auditor is. And if we're asking the auditor to make assessments about what the business risks are, I think that's really beyond the scope of what we want. I would be more interested in the auditor disclosing at what level they've audited from a materiality standpoint, and what has taken place from a statistics standpoint. What were the basis for their estimates for doubtful accounts? And on a hindsight basis, how do these current estimates compared to the prior year results? So some format of factual presentation as opposed to their doing the assessment. We'll do the assessment but we would like more information about how estimates were arrived at. [Also included in 9 and 17(c)] [TC 3/11, p. 33]
Participant C-14
Couldn't somebody read the generally accepted audit standards guides and more or less get that information? I don't see where that provides any value. On the one hand, we spent the first half of this morning telling you that we want you to use more judgment in how you look at the quality of the numbers. And then on the other hand, everybody's saying well no, don't say anything that's not standard. I don't think we can have improvement in the quality of the auditing of the information and the assurances it gives without giving you more latitude to be professionals and make judgments and give you some wherewithal to express yourselves. In terms of independence, the degree of standardization in the letter does help maintain your independence; if every letter has certain components but some flexibility within that, then it gives you what you need to be independent and objective but also be critical. [Also included in 17(c)] [TC 3/11, p. 33]
[Context] Responses to the postmeeting questionnaire to the March 17, 1993 Investor Discussion Group meeting.
QUESTION 5
Would you find it useful if the auditor were to audit information in some or all of those other areas that are outside the scope of annual financial statements?
YES 4 NO 1
Participant I-9: Do not try to expand the bounds of your profession! It will only get you in difficulty. The fees aren't worth it!
If YES, which of the following information should be audited? The following examples are items found in public reports; however, your response does not need to be limited to topics currently part of regulatory reporting for public companies. (Please check all that apply.)
Applicable
a. Quarterly financial information 4
b. Financial forecasts or
projections, if presented
c. Management's comments about the 2
company's recent operations, such
as in (1) management's discussion
and analysis of operations, (2) the
president's letter, (3)
management's report on the
company's system of internal
control, if presented, (4)
management's report on the
company's compliance with laws and
regulations, if presented, and (5)
the discussion of legal proceedings
in the 10K
d. Discussion of the company's 1
business, such as (1) the
description of the business in the
10K, and (2) listing of properties
in the 10K
e. Summary of the company's 4
transactions and relationships with
certain related parties, such as in
(1) the security ownership of
certain beneficial owners and
management section in the 10K, (2)
certain relationships and related
party transactions section in the
10K, (3) discussion of compensation
plans in the proxy statement, and
(4) section on compensation of
directors and officers in the proxy
statement
f. Some other section of the
annual report, 10K, proxy
statement, or registration
statement. If so, which section?
[PMQI 3/17, p. 8-9]
[Context] Responses to the postmeeting questionnaire of the March 11, 1993 Creditor Discussion Group meeting.
QUESTION 5
Would you find it useful if the auditor were to audit information in some or all of those other areas that are outside the scope of financial statements?
6 YES 7 NO
Participant C-4: This is the analysts job or other qualified experts.
If YES, which of the following information should be audited? The following examples are items found in public reports, however, your response does not need to be limited to topics currently part of regulatory reporting for public companies. (Please check all that apply.)
2 a. Quarterly financial information
3 b. Financial forecasts or projections, if presented
5 c. Management's comments about the company's recent operations, such as in (1) management's discussion and analysis of operations, (2) the president's letter, (3) management's report on the company's system of internal control, if presented, (4) management's report on the company's compliance with laws and regulations, if presented, and (5) the discussion of legal proceedings in the 10K
Participant C-12: "No" on president's letter, "neutral" on the discussion of legal proceedings in the 10-K.
0 d. Discussion of the company's business, such as (1) the description of the business in the 10K, and (2) listing of properties in the 10K
5 e. Summary of the company's transactions and relationships with certain related parties, such as in (1) the security ownership of certain beneficial owners and management section in the 10K, (2) certain relationships and related party transactions section in the 10K, (3) discussion of compensation plans in the proxy statement, and (4) section on compensation of directors and officers in the proxy statement
1 f. Some other section of the annual report, 10K, proxy statement, or registration statement. If so, which section?
Participant C-11: Let's get the auditor to do a better job on the annual audits themselves. See comment after 4a.
Participant C-17: B - Auditors' should review and disclose the base assumptions which drive the projections, they need not opine on the "reasonableness" or probability of achievement.
[PMQC 3/11, p. 7-8]