17(c). Audit Reports
[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-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(a)] [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 17(a) and 9] [TI 3/17, p. 5]
Participant I-12
I'm not even sure that that's the arena of the auditors [to detect and report the potential effects of major changes in environments]. 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(a)] [TI 3/17, p. 5-6]
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(a)] [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(a)] [TI 3/17, p. 6-7]
__________
Committee/Staff/Observer
Question 5 deals with the form of the auditors' report. Professional standards currently require highly standardized audit reports of financial statements. We have very little flexibility to customize reports. Thus, audit reports are the same from company to company. As an alternative to standardized reports, they could be more tailored to the specific company and circumstances. The meeting materials offered three examples of customized reporting:
1. The report would discuss in more detail the specific scope of the auditors' work.
2. The report would discuss in more detail the specific results of the work performed.
3. The third example would offer some qualitative evaluation of a company's reporting in addition to the opinion about whether the financial statements are fairly presented.
Our question is: should audit reports remain highly standardized, or should they be more tailored to the specific company and circumstances? [TI 3/17, p. 12]
Participant I-12
We do need a standard of audit report that we can rely upon. But there should be no reason why an auditor could not add additional commentary. The audit report has become boilerplate in some respects. Auditors have a viewpoint and can offer us insights that could be of use, and I don't think that they should be discouraged from doing that. It should be communicated to us, somehow, that just because an auditor says something a little different from boilerplate, that that doesn't necessarily mean that what he is saying is bad. We need to allow auditors more flexibility to use their expertise and make some comments of use to us. [TI 3/17, p. 12-13]
Participant I-16
I agree on that point. The auditor in doing his work comes up with a lot of information that should be of interest to the owners of the business. The only way to communicate that is not to tell management but to tell it in the audit report so that the owners get the full flavor of what the auditor has learned through his analysis of the company's reporting. The types of comments that could be made include: general comments on the historical reliability of the company's estimates, its reporting practices versus peer companies in the same businesses, and how material this is to what is reported. [TI 3/17, p. 13]
Participant I-7
Item c (in the meeting materials) says it best to me. [TI 3/17, p. 13]
Committee/Staff/Observer
[Which is] offer qualitative evaluation of a company's reporting. What does it mean to you? [TI 3/17, p. 13]
Participant I-7
I'm not sure whether I can ask an auditor to measure one company's reporting against another. In the course of an audit, the auditor comes across certain paths in which estimates and assumptions are made; if those estimates and assumptions are continuously made in favor of the company and they are material relative to the bottom line, I'd like to know that on a qualitative basis. [Also included in 9] [TI 3/17, p. 13]
Committee/Staff/Observer
How would you deal with the fact that auditors very often cannot deal with competitors? So in major industries, each company is audited by a different auditor. How do you get a meaningful comparison of a peer group by the auditor? [Also included in 9] [TI 3/17, p. 13]
Participant I-7
It would be extremely difficult to ask the auditor to know what's going on elsewhere in the industry. But in the course of the audit, you know that certain assumptions and estimates are made, and you know enough about the particular business that making different estimates would have a material effect; that could be disclosed. [Also included in 9] [TI 3/17, p. 14]
Participant I-12
I would be particularly interested in the management control systems and the management information systems. The businesses that I cover are highly qualitative and it's very difficult for me to make any assessments of those systems, except over a rather lengthy period of time. Coming back to the example on real estate partnerships, I think an auditor can fairly say that this particular business has x% of revenues exposed to real estate partnerships, and there has been a recent change in tax laws which may change that. Sometimes, it may have a massive impact on the bottom line. That kind of information would be of use. [TI 3/17, p. 14]
Committee/Staff/Observer
[Participant I-12], when you say management control systems, do you mean systems used to prepare financial statements or systems that help management manage the company, or both? [TI 3/17, p. 14]
Participant I-12
Both. I cover financial companies. There are lots of financial control systems, for example the hedging system, asset and liability management systems; these are critical systems for these companies to run their businesses. It's very difficult for an analyst to know what they're doing; are they controlling the business, do they have open positions or are they speculating? From the existing information we have, we don't know. Some assessment of those control systems, the amount of latitude that it leaves management to engage in speculation in financial markets, would be useful. Maybe I'm asking too much but this is the heart and soul of the businesses that I cover. It's very difficult from the outside to make any assessment of it. Auditors would run across those systems a great deal during the course of their work and they could give us some input. Any business that does hedging nowadays has to have some financial control systems to keep order. [Also included in 19] [TI 3/17, p. 14]
Committee/Staff/Observer
Question 6 deals with expanding the auditors' role, not his report, but what he is doing. In current practice, auditors audit management representations in the financial statements, and offer their opinion about whether those representations fairly present what they purport to present. Generally, the auditors make no representations themselves, other than the three paragraph opinion on the financial statements. Alternatively, the auditor could do more. In addition to offering an opinion on management's representations, the auditor could report their own representations, perhaps through analysis and commentary, based on their audit work. The auditor could analyze and comment on a number of topics such as key estimates used in preparing the financial statements, risks and uncertainties facing the company, trends and changes in the financial statements, the quality of the company's system of internal control, and others. Our question is: would you find it useful in your work if the auditors expanded their reporting to include the auditors' analysis and commentary, in addition to their opinion on the management's financial statements? If so, what should be included? [TI 3/17, p. 15]
Participant I-11
I would find it very useful and some of the things we were talking about in the prior question would belong in this sort of "AD&A", and all of the above should be included. It would be a vehicle wherein the auditor could express its qualitative judgements about where, within the spectrum of GAAP, this particular client's practices lay, what level of confidence the auditor has in the financial control systems, etc. The only thing I'm concerned about is that the AD&A would become the same sort of meaningless boilerplate that the MD&A is so often. But I think it's a good idea. That might lead to a fourth normal paragraph in the standard audit report with some statement about the AD&A. [TI 3/17, p. 15]
Participant I-12
It would be very helpful to learn about all those things, to get some viewpoint from someone who sees things far more closely than we do; the management information systems, management's assumptions, range of accounting principles that they are using. All of those things would be extremely useful. [Also included in 9] [TI 3/17, p. 15]
Committee/Staff/Observer
Where does financial reporting end and financial analysis begin? [Also included in 1(d)] [TI 3/17, p. 16]
Participant I-16
Financial analysis is about making forecasts on future trends and performance of a business and then putting a value on the securities relating to that business. The financial analyst starts with the financial statements, which are very important. We're not suggesting that the auditor do financial analysis work; I don't presume that the auditor should make a statement on the future trends of a business but rather statements on the role of estimates in the financial numbers that purport to represent past transactions. Secondly, about the adequacy of control systems, I'm less convinced that it could be done; I'm not sure it is essential because that's something that a financial analyst should be able to do. It might be more important to the lay shareholder as opposed to the professional financial analyst. [Also included in 1(d) and 9] [TI 3/17, p. 16]
Committee/Staff/Observer
Given that the kind of information that you are talking about would be important to you, would it make a difference whether that information is included as part of the auditors' report or AD&A as compared to being included in a note to the financial statements? [TI 3/17, p. 16]
Participant I-7
It would have a greater impact in an AD&A. [TI 3/17, p. 16]
Participant I-12
I agree with that. [TI 3/17, p. 16]
Participant I-11
Yes. [TI 3/17, p. 16]
Committee/Staff/Observer
[W]ould you find projections of future performance prepared by management and audited to be of value? [Also included in 12] [TI 3/17, p. 17]
Participant I-12
No. [Also included in 12] [TI 3/17, p. 17]
Participant I-16
Yes. I don't see why that has to be audited, but I think that is something that management should be encouraged to do. If I own 100% of a business and I had somebody running it, I would ask to see his plans for the coming year. I understand that for a company with 1 million shareholders, you're not going to put out that kind of detail. But giving some indication of what you anticipate being able to accomplish in the future, the obstacles that you have to overcome, and the opportunities that you pursue, I think management should be encouraged to provide broad guidelines on that. And I don't think they should be encumbered by the auditors in that regard. I think that's between management and shareholders and I don't think the auditor has a role in that. If the auditor did have a role, it would dampen the explicitiveness of what management is saying; you don't want boilerplate, you want something that is meaningful. [Also included in 10(c) and 12] [TI 3/17, p. 17]
Participant I-7
Coming back to [committee/staff/observer] 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(b)] [TI 3/17, p. 18]
Committee/Staff/Observer
I'd like to challenge that. Management makes a projection which is based upon estimates and assumptions. You said you want us to be involved in historical financial statements, in either expanding in a note or in an AD&A, by having standards to disclose more about measurement uncertainties. Those same uncertainties enter into a projection. As a starting point, couldn't the auditor be properly involved in a projection by expressing an opinion about whether management's assumptions are realistic (based on x dollars, x volume, x units)? [Also included in 9 and 12] [TI 3/17, p. 18]
Participant I-12
That's our business, that's what we do. There's no need for us if the auditor is going to do it. [Also included in 9 and 12] [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(b)] [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(b)] [TI 3/17, p. 19]
Committee/Staff/Observer
A question on the concept of AD&A. The words that were used were discussion of estimates, principles, and controls. But AD&A sounds a lot like MD&A, and MD&A deals with discussion of the results of operations for the period. Did any of you who used the word AD&A mean to suggest discussion of the results of operations in addition to the three other items? [TI 3/17, p. 19]
Participant I-11
I did not. [TI 3/17, p. 19]
Participant I-12
I agree. [TI 3/17, p. 19]
Participant I-16
I wouldn't have used the word AD&A. [TI 3/17, p. 19]
Committee/Staff/Observer
Whether you call it something different or not, would you encompass an analysis of operations? [TI 3/17, p. 20]
Participant I-16
No. I think the 3 things that [committee/staff/observer] mentioned (estimates, principles, and controls) are the purview of the auditor. [TI 3/17, p. 20]
Committee/Staff/Observer
Is that because that information will allow you to better assess the quality of earnings and would not be the auditor's assessment of the quality of reported earnings? [TI 3/17, p. 20]
Participant I-16
Yes. Clearly it would be if the auditors would say these are the numbers that report the company's past, how they were compiled, how reliable they are, how sensitive they might be to change in estimates, how sensitive they might be to change in the accounting principles chosen, and are the controls adequate so that management knows what's going on. [TI 3/17, p. 20]
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(b)] [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(b)] [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(b)] [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(b)] [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(b)] [TI 3/17, p. 22]
Committee/Staff/Observer
Why not have management write it and the auditor attest to it? [TI 3/17, p. 22]
Participant I-11
What are you going to attest to? [TI 3/17, p. 22]
Committee/Staff/Observer
I'm talking about the historical aspect of an MD&A, not the prospective aspect. If you agree that the auditor might be able to write a pretty good analysis of operations, but that it is management's responsibility to do that, wouldn't it be useful to you if the auditor lent some reliability to that information? [TI 3/17, p. 22]
Participant I-16
I would not grant that an auditor could write a good MD&A. If an auditor could, he's not doing his auditing job; he's spending too much time learning the nuances of the business. Management can write a much better MD&A than the auditor. Secondly, if the auditor is going to get involved in making projections or auditing projections about the future, the auditor is no longer independent. He now has a vested interest in the future financial reports corresponding to those forecasts; his objectivity is lost and I can no longer rely on his opinion. [Also included in 12] [TI 3/17, p. 23]
Committee/Staff/Observer
I meant and said to [participant I-11] to exclude the prospective aspect of the MD&A, just the analysis of the historical aspects. [TI 3/17, p. 23]
Participant I-16
I would still say it's inappropriate. We're paying management a ton of money to know more about their business than anybody else does, and I want to hear what they know. [TI 3/17, p. 23]
Participant I-11
I did not say that an auditor could write a good MD&A, I said an auditor could write a better MD&A than most of those that are being written today, and there's a big difference. I guess my response is that I'm not sure there's a great deal of value-added by having the auditor tell me that when management said that average selling price last year was up 4% that it really was up 4%. [TI 3/17, p. 23]
Participant I-7
For manufacturing companies, I want to know that average prices were up 4%, or 2%, or down 1%. [TI 3/17, p. 23]
Committee/Staff/Observer
Does that suggest that that be audited? You want to know bad enough to pay for it? [Also included in 17(b)] [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(b)] [TI 3/17, p. 24]
Committee/Staff/Observer
Question 7 relates to your interpretation of a modified auditors' report. In certain cases, the auditor considers whether to modify the standard report. One of those cases is when the company faces material uncertainties in the measurement of a liability or asset. If the auditor concludes that the uncertainty is sufficiently important to require emphasis, he or she adds a fourth paragraph to the standard three paragraph audit report. However, auditors seldom add that paragraph in practice because managements and auditors are concerned about reactions of investors. The meeting materials included a standard auditors' report, modified to emphasize a certain matter. Our question is: what would be your reaction upon reviewing that report related to one of the companies that you follow? [TI 3/17, p. 24]
Participant I-16
There's a possibility that a major loss will occur. I can't tell you the likelihood of it happening, but management tells me it's very low. I can't tell you the amount but I can conceive it to be very large. [TI 3/17, p. 24]
Committee/Staff/Observer
What effect does that have on your recommendation, your pricing, your valuation? [TI 3/17, p. 24]
Participant I-16
If I were not aware of it previously, I would probably have lost my job 10 years ago. This is not meant to be disparaging, but my impression is that this is done by the auditor to protect himself from liability rather than to inform investors. At the point where the auditor puts that note in, it's so well known that it doesn't add anything to the basic knowledge that is in the public domain. [Also included in 18(b)] [TI 3/17, p. 24]
Committee/Staff/Observer
[Participant I-16], there are 3 items listed on page 8 right in the middle (a, b, and c). [TI 3/17, p. 24]
Participant I-16
I chose d; uncertain possibility of large loss which would be material. The key things are that the probability of occurrence is indeterminate and the amount of the loss is indeterminate. Again, when that gets into the opinion, everybody knows it. [TI 3/17, p. 25]
Participant I-11
In today's world, I would interpret it as meaning that the probability is indeterminate, but that the probability is significant. The auditor is worried that this could well happen. In an ideal world, it should mean a, but I don't think that's what it means. Because when 99.5% of the audit reports have three paragraphs, when we see a fourth paragraph, the antenna goes up. [TI 3/17, p. 25]
Participant I-12
When you see the fourth one, you say sell. I think that's the general reaction of a lot of people. If we're not aware of this before the auditor gets it, we should have been fired. You find out a lot in the Qs and Ks that don't always make it to the annual report. [TI 3/17, p. 25]
Committee/Staff/Observer
So why don't you say sell before you see it in the auditors' report? [TI 3/17, p. 25]
Participant I-12
We should have. [TI 3/17, p. 25]
Participant I-7
There are instances where I have not spotted something of a material nature. To me, a fourth paragraph is a major flag because it's very rare. When I see it, the immediate reaction is that there is a very significant problem that I have missed and probably others as well. Because if they hadn't missed it, it takes no more than an hour to whistle through the profession. So, in those instances, it generally means negative action on our part and very quickly. [TI 3/17, p. 25-26]
Participant I-16
My perception still is that before this happens, the item in question has been discussed at great length by the business press and financial analysts. Financial analysts will each year, just before the annual report is issued, wonder if it will be sufficiently unsettling to the auditors that they will give less than a clean bill of health. We wonder each year when the auditors will do that just as credit analysts wonder when will [a rating agency] cut the debt rating on a company whose yield spread has gotten so wide that it clearly is not trading where it's rated. There are certain things that you assume are lagging indicators because they're so momentous when they happened. That's one of the points that we're trying to get at in this continuum; you don't want the auditor to be faced with only one alternative which is so drastic that he has to be so careful and wait until overwhelming evidence is in. We think the auditors know so much more than they're allowed to tell that we want them to have a lower standard for making that information available to us. This is not a criticism of the skills of the auditors; this is a criticism of the fact that you're handcuffed from using your skills to impart information to us. [TI 3/17, p. 26]
Committee/Staff/Observer
Litigation is a tough issue for auditors because attorneys are not very forthcoming in giving us opinions. Would you like it better if every audit report had an opinion that said that all the material litigation the company is subject to is summarized in footnote x; read it and make your own conclusions? [TI 3/17, p. 26-27]
Participant I-16
There are a lot of significant issues that auditors become aware of that are other than an overwhelming piece of litigation. The current auditing standards do not lead auditors to disclose the information that they have. There are a lot of things less serious than litigation that the auditors should disclose. For litigation, I don't have the answer and I don't expect the auditor to handicap the outcome of future litigation. That's why stocks in these companies get marked down and sometimes come back up when a litigation is resolved in a more favorable manner. It's just a huge uncertainty that we have to live with. [TI 3/17, p. 27]
Committee/Staff/Observer
In making your assessment as an analyst, to what extent do you weigh whether an auditor makes reference in his report to the existence of litigation? [Also included in 1(c)] [TI 3/17, p. 27]
Participant I-16
I would assume that if I'm doing my job, I'm aware of the litigation before the annual report is released, then I'm going to make a decision whether I think the auditor is going to qualify his opinion. If the prior report was not qualified and I think the auditor will qualify the next one, I'm going to sell the stock because I think the stock will react negatively to that opinion. Alternatively, if the stock has the negative auditor's opinion, I then might consider whether to buy it thinking that the adverse information is already in the price of the stock. The presence of a negative opinion increases your assurance that everybody knows about it and if you don't think that the case may be lost, you may want to buy the stock. [Also included in 1(c)] [TI 3/17, p. 27-28]
Participant I-7
You've chosen an easy subject in litigation. What would be of great significance for me, as an example, is if you were dealing with a company that was on a completion basis rather than percentage of completion, and the completion contract would take 2 to 3 years, and you're one and a half year into the contract and, as an auditor, you see that there is going to be a material write-off. That's something more difficult to see from an external point of view and I would want to see that as a fourth paragraph. [TI 3/17, p. 28]
Participant I-12
Unfortunately, the auditors' report has become a matter of form; we have lost the substance. The auditors' report should really be [participant I-11]'s AD&A; it needs to cover a lot of ground. What we have today is boilerplate. There are a lot of issues; litigation is one, environmental, etc. We have allowed the auditors' report to become a form and if the form is slightly different, there's this automatic gut reaction. I don't want to lose the basics that are in place but I think the report could be a lot more useful. [TI 3/17, p. 28]
Committee/Staff/Observer
That goes back to the earlier question about standardized reports and it all ties together. [participant I-16], you believe that you would have known paragraph 4 before it ever happened, but don't forget there are thousands of public companies, forget private companies, that have no following on the street, and it might be very informative for the reader of those statements to have the fourth paragraph. [TI 3/17, p. 28]
Participant I-16
I'm just saying that if I bought the stock and didn't know about that and it wasn't in the opinion of the prior year, I'm not doing my job. [TI 3/17, p. 28]
[Context] Meeting of the Investor Discussion Group on March 17, 1993. Part of the meeting was devoted to the topic of conservatism. During the discussion, comments were made on audit reports.
Participant I-11
No, the best guess and I want the auditor to tell me what the best guess is without bias whether it's conservative or liberal. But if it's 50/50, then let's go with the conservative. [Also included in 2(b)] [TI 3/17, p. 30]
__________
Participant I-16
One example of the use of conservatism is the extent to which a company writes down physical or intangible assets or recognizes expenses that will really benefit future periods. Companies get away quite often because it's viewed as conservative but I would like to see when that happens the auditors give some recognition of the fact that the company is boosting its future reported earnings. I can recall a company that acquired a business from another company and did not acquire the brand name; as a result, as part of the cost of the acquisition, they wrote off the next two years of advertising. They said that they were being conservative in writing down the value of what they had acquired, but what happens after two years when you have to start expensing for advertising? Is that really conservative? [Also included in 2(b)] [TI 3/17, p. 31]
[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, a comment was made on audit reports.
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(b)] [TC 12/8, p. 74]
[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
Are you interested in seeing a report on internal controls? A long form report that explains what the auditors did and what they found, or would you just prefer that they looked at it and are comfortable, and as long as they don't say anything, that's enough? [TC 3/11, p. 3]
Participant C-5
Any of this, when you're forced to come down to a final opinion, it's a plus-minus test. And we'd like the flexibility of applying our own judgments. The creditor always wants the raw data, and then wants to make their own decisions as to how that impacts their thinking. [TC 3/11, p. 3]
Committee/Staff/Observer
I'm talking about a separate opinion on internal controls. [TC 3/11, p. 3]
Participant C-5
We consider the management letter to be that, although we'd like more depth to it, as opposed to just the opinion, we'd rather have the detail of the findings. Much more of a factual interpretation, less of an opinion. Something typical of what we get by our internal examiners that we would use on a more middle-market, marginal case. [TC 3/11, p. 3]
Committee/Staff/Observer
So you're really talking about a down and dirty examination of internal controls and where auditors report on the problems that they found and identified? [TC 3/11, p. 4]
Participant C-5
That's right. [TC 3/11, p. 4]
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(a), 18(b), and 19] [TC 3/11, p. 4]
Participant C-8
We generally request and often get the management letter prepared by the auditor at the time of the audit, but we can not always get it. So to have something like that incorporated into the financial statements might not be all bad. The second point is that we deal with the construction industry, and quite often the auditors really don't understand the construction business, and it shows in their financial presentation. I guess the point is, something that describes what procedures were undertaken, especially with respect to the work in progress, might be of some benefit. [TC 3/11, p. 4]
Participant C-10
As creditors, we're looking for the debt, overall, of the company. But we're still trying to understand just in general whether you folks have said that there's a company here, and it's reasonable. Whereas if you get securitization of assets or hedging, as [participant C-11] mentioned, I think it's a different thing. And I think perhaps there's two levels of types of reports needed here. [TC 3/11, p. 4-5]
__________
Participant C-5
. . . 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(b)] [TC 3/11, p. 12]
__________
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(b)] [TC 3/11, p. 14-15]
__________
Committee/Staff/Observer
The problem is they [the auditors] don't tell you what they do [in respect of the MD&A]. [Also included in 17(b)] [TC 3/11, p. 25]
__________
Committee/Staff/Observer
Question number 6 is: should all audit reports be highly standardized, or alternatively, should they be more tailored? For example, should it give more detail about what was done in that particular audit on that particular company, either in terms of the scope of the work or the results of the work? But those are just examples, the question really is fundamentally should the report speak more specifically about the company in a less standardized way, even if nothing is wrong? [TC 3/11, p. 29]
Participant C-5
I would agree that it should be more flexible although being in the business of evaluation there is a need to come back to sort of an overall opinion at one point. But the remainder of it, the structure of the opinion statement, is clearly something that I think is too rigid and doesn't allow for that. So I would say yes, it should be flexible but there should be a standard as to requirement for a final opinion and that typically should stick with the words. But the more disclosure I can get on the auditor's findings -- similar to a management letter but actually with more detail-- that is always helpful. And I'd even be willing to take those without assurances about them but just statements of what was found and not. [TC 3/11, p. 29-30]
Participant C-14
There's really just two opinions, you're either clean or you're not clean. And I'm not sure how that's done but if I could add one sentence to the opinion it would be: the major risks to the reported net worth of the company are the following... And there's three blanks and you guys fill in the blanks. And that would give you an opportunity to highlight whether it's an off balance sheet item, whether it's inventory controls, whatever it is. And if every statement had that, auditors would have the leverage with management to fill in those blanks. [Also included in 10(d)] [TC 3/11, p. 30]
Committee/Staff/Observer
This would be an assertion the auditor would make as opposed to the management saying the three risks we believe the company is at risk in? [Also included in 10(d)] [TC 3/11, p. 30]
Participant C-14
You would fill in those blanks. It would be the three major risks on the stated net worth based on our opinion of the reliability of the accounting or validity of the values in the accounts are the following: ... But it's got to be practiced industry-wide or you'd have no leverage over management to get them in your opinion. That's an ideal world. But that's the kind of quality of information that could be in an opinion. [Also included in 10(d)] [TC 3/11, p. 30]
Participant C-5
Would they be sized? [Also included in 10(d)] [TC 3/11, p. 30]
Participant C-17
And then you start getting into what's the probability and so on. [Also included in 10(d)] [TC 3/11, p. 30]
Participant C-15
What type of information do the auditors generally provide to the board of directors? It's very different than the letter that you sign off for the shareholder reports. [TC 3/11, p. 31]
Committee/Staff/Observer
I would say no; in fact, what you see that goes to the public is just about what goes to the board in terms of formal reporting. With the exception of management letter comments that are given to the audit committee. Do you see it differently? [TC 3/11, p. 31]
Committee/Staff/Observer
Quite differently. Significantly differently. The level of depth is far greater. [TC 3/11, p. 31]
Participant C-15
Obviously, companies wouldn't want a lot of the negative stuff disclosed but to the extent that the board of directors has access to that, why shouldn't the investors in the company have access to the same information? The creditors and investors. [TC 3/11, p. 31]
Participant C-14
Right. It's not to go and say that these negative things are going to occur, it's just to highlight them as large potential areas for concern; maybe they are areas where you couldn't come up with a hard value. You can't come up with a hard value on legal liabilities or environmental liabilities. But you may in your audit work determine that the degree of variation of potential outcomes is so great that it should be mentioned as a very viable risk. I don't know about size threshold. I'm just throwing out a very idealistic concept. [Also included in 10(d)] [TC 3/11, p. 31]
Participant C-12
Being more of a cynic than an idealist, I throw out the idea that advocating a less standardized approach, given the business and legal environments in which we all work and the realities of the marketplace, it's going to be difficult to say certain things, both in terms of what management will accept in terms of the business relationship and particularly in terms of what the lawyers are going to allow to be said. And I fear that in the end it's a good idea. What we get is boilerplate; we think we have information but what we have is boilerplate. [Also included in 10(d) and 18(b)] [TC 3/11, p. 31-32]
Committee/Staff/Observer
With that cynical view, then would you just advocate staying where we are? [Also included in 10(d) and 18(b)] [TC 3/11, p. 32]
Participant C-12
I would tend to, yes, because I think in the end if we try to broaden what we get, the lawyers and the business relationship is going to give us boilerplate. [Also included in 10(d) and 18(b)] [TC 3/11, p. 32]
Participant C-14
Why would it necessarily be boilerplate? Are you saying that every opinion would have the same three issues? Or that because of pressure from management they'd pick issues that aren't truly significant? [Also included in 10(d) and 18(b)] [TC 3/11, p. 32]
Participant C-12
I tend to think we'd get the three easy ones raised in a way that waters them down a lot. We've been through this with merger letters and we've seen them expanded greatly. But there's no additional information there. There's more stuff but there's no useful information in this greatly expanded letter. Because the lawyers get hold of it. [Also included in 10(d) and 18(b)] [TC 3/11, p. 32]
Participant C-17
It tends to violate the two things I hold dear. One is the independence issue and the other's the consistency. When you start trying to do the hit list for the year and you have some kind of predetermined format, it just becomes subject to all kinds of constraints from the legal end or boilerplate; it tends to have very little value when it comes out. [Also included in 10(d) and 18(b)] [TC 3/11, p. 32]
Participant C-6
Considering the market that I deal with, I think standardization is very important because I'm afraid to think of what we'd get if we didn't have standardization. Right now we always fight for more information and if we didn't have a standardized situation I think we would get less than we get now. [TC 3/11, p. 32-33]
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(b)] [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(b)] [TC 3/11, p. 33]
Participant C-5
I'm not losing that much in that standard letter; it's boilerplate to the max with the exception of your qualification of the opinion and then the listing of the items that are material in your qualification. As to the issue that [participant C-14] raised about business risks, I want the company's specific risks or those that are unique or different from that which someone would expect for the industry it's in. If I'm in the dry cleaning business and I run 500 laundries, we all know they've got environmental risks and now it's up to me to make a determination of how much they are. I really would only want it if it's a unique risk for that particular company. It may not be the largest risk, in fact, it may be the one that's least risky where I've already assumed there's high risk because of the industry component that it's in. I don't need an auditor to take publicly available information and long perspectives and opinions that are published through analysts and industry watchers and so forth and give that back to me again. In some cases, you have to assume you have no idea who the user is because there's broad distribution of financial statements, but there are other cases where you can be very specific as to what the issues are for the user of the financial information. [Also included in 10(d)] [TC 3/11, p. 33-34]
Participant C-12
In general I like [participant C-14]'s idea although if it's going to work we've got to be closer to the ideal than the cynic's view. I'm basically a cynic and I think the risk is that we end up with something extra that looks like more information but isn't. I like the boilerplate we have now which comes down to basically a very important binary decision, qualified or unqualified. One change I would like to see in the letter though is just a listing of how important the business relationship is. You're telling me you've done the work, tell me how biased or unbiased you are. [Also included in 10(d)] [TC 3/11, p. 34]
Committee/Staff/Observer
[Participant C-17], when most auditors prepare a management letter, they do so with the supposition that this is a rather internal document to management, in many ways designed to be helpful in assisting somebody to operate a company better and more efficiently in some way and certainly deals with controls. If we made those types of letters part of the publicly available reporting package that is routinely disseminated without restriction or limitation, do you think those letters would become less helpful, that they would become more rigid and encrusted with boilerplate? [TC 3/11, p. 34]
Participant C-17
I use the management letter as a source, I mean that as a direct relationship between me and management. Just for the reasons you've mentioned. Because if it became a publicly available document, especially for a publicly-held company, it would be useless. Very quickly. [TC 3/11, p. 35]
Committee/Staff/Observer
I understand. It's troubling because it's only useful if we prepare it for a purpose other than that for which it's used. [TC 3/11, p. 35]
Participant C-17
I understand that. The difficulty that we have as lenders sometimes is the level of cooperation. There are managements that don't want to release it. But then we have to ask ourselves the question as to why. I have seen management letters that spell out the difficulties in extreme detail and had I not asked for it, I would have gotten into a situation that would be extremely unprofitable. [TC 3/11, p. 35]
Participant C-5
I have traditionally used the management letter as a report of management. The management letter that gets prepared for our company is really a board letter. We start with 58 items and it ends up with a list of 12. The management letter is the 58 item list. If you're thinking management means user then that's not the management letter to me; it's already so scrubbed. [TC 3/11, p. 35]
Committee/Staff/Observer
There are other communications that are directed to lower levels of management as well but not that frequently. [TC 3/11, p. 35]
Participant C-5
Which is the draft management letter, yes? [TC 3/11, p. 35]
Committee/Staff/Observer
The point is that it is considered a rather internal document and not something that's going to be disseminated completely to the public, at least as I understand the mindset of most auditors. [TC 3/11, p. 36]
[Context] Responses to the postmeeting questionnaire to the March 17, 1993 Investor Discussion Group meeting.
QUESTION 4
Independent audits related to external reporting usually cover only a company's annual financial statements and related notes. Audits currently do not cover other areas of external reporting. Nevertheless, auditors are frequently involved in "checking" other areas, such as the MD&A and historical financial data, that may accompany the audited financial statements and footnotes; the auditors just don't report on their procedures regarding these areas.
a. Would you find it useful for auditors to report on any procedures they performed with respect to other areas that accompany audited financial statements and footnotes?
YES 3 NO 2
COMMENTS
Participant I-16: Shareholders have paid for auditors' work and should receive the full benefit of their insight and knowledge.
Participant I-7: Especially if auditor found notes or MD&A, etc. particularly lacking in usefulness.
Participant I-9: In most cases.
b. With respect to Management's Discussion and Analysis (MD&A), please indicate your degree of agreement or disagreement with the following observations:
SA - Strongly Agree
A - Agree
N - Neutral
D - Disagree
SD - Strongly Disagree
Strongly Agree Neutral Disagree Strongly
Agree Disagree
1. Presently, auditors are 1 2 1 1
significantly involved with
review of some MD&A's, but
they don't report on their
procedures. Users would like
to know to what extent an
auditor was involved in a
particular MD&A.
2. Regardless of auditor 1 3 1
involvement in MD&A review,
auditor reporting on MD&A
should be discouraged,
because it would inhibit
management's willingness to
"discuss" matters not subject
to verification.
3. Auditor reporting on MD&A 2 3
could be helpful to users if
the nature of the reporting
was limited to giving comfort
to disclosed amounts and not
addressing the "analysis"
language.
[PMQI 3/17, p. 6-8]
QUESTION 6
Professional standards currently require highly standardized audit reports on financial statements. Auditors have little flexibility to customize their reports. Thus, audit reports are generally the same from company to company.
Should audit reports be highly standardized or should they be tailored to the specific company and circumstances? Please indicate whether you AGREE or DISAGREE with each of the following:
Agree Disagree
a. Auditors' reports should remain 3 2
highly standardized.
b. Auditors' reports should be 4 1
expanded to discuss in more detail
the scope of the auditors' work on
the specific audit engagement.
Participant I-9: Boring to
outsiders.
c. Auditors' reports should be 3
expanded to discuss in more detail
the results of the audit work on
the specific audit engagement.
Participant I-9: In some cases
this could be useful.
Participant I-11: What does this
mean?
d. The auditors should grade, or 2 3
otherwise offer some view of the
relative quality of a company's
reporting (including the
reasonableness of management's
assumptions and estimates), in
addition to the opinion about
whether the financial statements
are free from material
misstatement.
Participant I-9: Can you be
objective in doing this?
Agree Disagree
e.Something else. Please describe: 1
Participant I-16: Auditors should
express a judgement on the role of
management's estimates and their
record of past accuracy and the
effect of specific accounting
principles chosen when alternatives
were available.
[PMQI 3/17, p. 9-10]
QUESTION 7
Currently, auditors report on management's representations; they make no representations themselves unless they detect a material fairness problem in the financial statements.
Would you find it useful in your work if we expanded the auditors' role and reporting to include auditors' analysis and commentary about the following topics? (Please indicate your agreement or disagreement with each item.)
Agree Disagree
a. Ability of the company to 4 1
continue as a going concern
Participant I-16: Auditors should
express any doubts.
b. Risks and uncertainties facing 2 3
the company
Participant I-16: Not the
auditors' area of expertise - they
might list all conceivable risks to
avoid legal liability.
c. Prospects of illiquidity 5
d. Significant change-sensitive 4 1
estimates used in preparing the
financial statements, including
major assumptions used in those
estimates
Participant I-9: In computing
pension liabilities.
e. Quality and effectiveness of 5
the company's system of internal
financial control
Participant I-9: Only if usual or
poor.
Agree Disagree
f. Quality and effectiveness of 3 1
the company's system of internal
business control
Participant I-9: Yes- then we can
sue the auditors if the company's
controls are lousy!
g. Auditors' discussion and 3
analysis of the company's
operations
h. Something else. Please 1
describe:
Participant I-16: Auditors should
stick to their areas of expertise
(controls, tests, and going-concern
risks).
Participant I-11: These all would
be useful- but I'm not sure they
are practical either from the
standpoint of liability in
litigation or from the standpoint
of auditor/client relations.
[PMQI 3/17, p. 9-11]
QUESTION 8
In certain cases, the auditor considers whether to modify the standard auditor's report. One of those cases is when the company faces material uncertainties in the measurement of a liability or asset. If the auditor concludes that the uncertainty is sufficiently important to require emphasis, he or she adds a fourth paragraph to the standard three paragraph audit report.
What follows on the next page is a standard auditor's report (the first three paragraphs) with an example of a fourth paragraph added to emphasize a material contingency.
What would be your reaction if you reviewed the following report related to one of the companies that you analyze? (Please check ONE.)
a. The litigation is obviously 4 important to the company, and you should carefully review Note X and, if necessary, discuss the matter further with management. b. It is likely that the company will lose a very significant amount related to the litigation, otherwise, the auditor would not have taken the unusual step of referring to the matter.
c. The reference in the auditors' report signals that the litigation is so serious that it threatens the company's existence. d. Something else. Please 1 describe: Participant I-16: The litigation might be significant and should merit further investigation. The auditor is protecting himself by warning the user to beware.
Independent Auditor's Report
We have audited the accompanying balance sheets of MLJ Company as of December 31, 19x2 and 19x1, and the related statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of MLJ Company as of December 31, 19x2 and 19x1, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
As discussed in Note X to the financial statements, the Company is a defendant in a lawsuit alleging infringement of patent rights and claiming royalties and punitive damages. The Company has filed a counteraction, and preliminary hearings and discovery proceedings on both actions are in progress. The ultimate outcome of the litigation cannot presently be determined. Accordingly, no provision for any liability that may result upon adjudication has been made in the accompanying financial statements.
[PMQI 3/17, p. 9-13]
QUESTION 22
A group that has studied internal control has recently defined it as a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories:
(a) effectiveness and efficiency of operations
(b) reliability of financial reporting
(c) compliance with laws and regulations.
Do you agree with the above definition of internal control? (Please check one.)
Yes 4 No 1
If not, how would you change the definition? (Please describe.)
Participant I-9: Too many "weasel" words, make it sharper with less modifiers. [Emphasis on "other", "reasonable"]
[PMQI 3/17, p. 40-41]
QUESTION 23
Please indicate in the spaces below whether you would find helpful management or auditor reporting on internal control. In each space please write one of the following:
Yes - I would find helpful management or auditor reporting on the internal control category, or
No - I would not find helpful management or auditor reporting on the internal control category.
Management Reporting Auditor Reporting
Control Category
Yes No Yes No
(a) effectiveness and 3 2 2 3
efficiency of
operations
(b) reliability of 2 3 4 1
financial reporting
(c) compliance with 4 1 4 1
laws and regulations
[PMQI 3/17, p. 41]
QUESTION 24
a. If you responded NO to reporting on internal control for any category, please indicate the reason(s) for your response. (Please check all that apply.)
It is not possible to report on
internal control in the particular
category.
A company's system of internal
control in the particular category
is not a sufficiently important
driver of my investment decision.
Management or auditor reporting on 1
internal control would be
boilerplate and thus not helpful to
my work.
The costs of reporting on internal
control are excessive.
Something else. Please describe. Participant I-16: Auditors lack
expertise to evaluate effectiveness
and efficiency - it is the purview
of management and outside
directors.
Participant I-7: Want the relative
party in these cases to make the
statement.
Participant I-9: It is the
auditor's job to do this as a
routine part of certifying
financials. Nothing special should
be required.
Participant I-11: Asking
management to report on the
effectiveness and reliability of
its controls is, in effect, asking
management to report on its own
competence. Who's going to answer
"no"?
b. If you responded YES to reporting on internal control for any category, please indicate the reason(s) for your response. (Please check all that apply.)
Public reporting on the internal 4 control category will result in improvement in internal control. That improvement will reduce the risk of management fraud and manipulation of financial reporting. Public reporting on the internal 3 control category will cause directors and management to feel more accountable to the company's investors and creditors.
The quality of a company's internal 4
control in the particular category
is an important factor in assessing
the risk and opportunity of an
investment decision.
Something else. Please describe. Participant I-16: Auditors should
have the expertise to evaluate the
reliability of internal financial
reporting and should have some
insight into compliance.
Management to be held responsible
by explicit certifications.
[PMQI 3/17, p. 41-43]
[Context] Responses to the postmeeting questionnaire of the March 11, 1993 Creditor Discussion Group meeting.
QUESTION 4
Independent audits related to external reporting usually cover only a company's annual financial statements and related notes. Audits currently do not cover other areas of external reporting. Nevertheless, auditors are frequently involved in "checking" other areas that may accompany the audited financial statements and footnotes; the auditors just don't report on their procedures regarding these areas.
a. Would you find it useful for auditors to report on any procedures they performed with respect to disclosures that accompany audited financial statements and footnotes?
9 YES 4 NO
COMMENTS:
Participant C-8: Some reporting on MD&A as outlined in #1 & #3 below would be valuable.
Participant C-13: It is unlikely that such a report would provide meaningful information to users; probably would be "boilerplate".
Participant C-20: Audit fees are already too costly. Do not require work that makes U.S. companies less competitive by raising their cost structure.
Participant C-14: Where there are large off-balance sheet contingencies, I would like the auditors to explain why they believe the potential impacts on the company are not significant.
Participant C-12: Bank analysts rely on MD&A disclosure as much, if not more than on financial statements and footnotes. Given the long term trend toward increased disclosure through the MD&A, failure to cover fully the MD&A is a substantial de facto diminution of the scope of the auditor's role in preparing financial reports.
Participant C-11: If auditors had to officially bless comments that will beyond their area of intelligence, the pressure would be to say noting and give boilerplate. Management should have responsibility for their report to owners.
Participant C-4: We'll do.
Participant C-17: Primarily in the area of contingencies - what was done?
b. With respect to Management's Discussion and Analysis ("MD&A"), please indicate your agreement or disagreement with the following observations:
SA - Strongly Agree
A - Agree
N - Neutral
D - Disagree
SD - Strongly Disagree
A-6,N-3,D-2,SD-1
1. Presently, auditors are significantly involved with preparation of some MD&A's, but they don't report on their procedures. Users would like to know to what extent an auditor was involved in a particular MD&A.
SA-2,A-4,N-1,D-5
2. Regardless of auditor involvement in MD&A preparation, auditor reporting on MD&A should be discouraged, because it would inhibit management's willingness to "discuss" matters not subject to verification.
SA-1,A-5,N-4,D-2
3. Auditor reporting on MD&A could be helpful to users if the nature of the reporting was limited to giving comfort to disclosed amounts and not addressing the "analysis" language.
Participant C-11: See above.
[PMQC 3/11, p. 5-7]
QUESTION 6
Professional standards currently require highly standardized audit reports on financial statements. Auditors have little flexibility to customize their reports. Thus, audit reports are generally the same from company to company.
Should audit reports be highly standardized or should they be tailored to the specific company and circumstances? Please indicate whether you AGREE or DISAGREE with each of the following:
Agree Disagree
7 5 a. Auditors' reports should remain highly standardized.
9 4 b. Auditors' reports should be expanded to discuss in more detail the scope of the auditors' work on the specific audit engagement.
Participant C-4: With exception below.
7 6 c. Auditors' reports should be expanded to discuss in more detail the results of the audit work on the specific audit engagement.
8 5 d. The auditors should grade, or otherwise offer some view of the relative quality of a company's reporting, in addition to the opinion about whether the financial statements are free from material misstatement.
3 e. Something Else.
Please Describe:
Participant C-15: Comment on management controls and systems.
Participant C-13: The advantages of highly standardized reporting is that a very visible "red flag" is raised by deviation from one standard report. If reporting became more "fuzzy", this advantage would be lost.
Participant C-14: Every auditor report should by requirement contain a paragraph on the major risks or uncertainties to the auditors degree of confidence in the financial statements:
- concerns regarding inventory build
- potential asset write-downs
- legal contingencies
- environmental
- lack of internal controls, etc.
Participant C-11: The auditor's opinion should be broadened to include a third option between a "clean" and a qualified opinion. The middle option should require the auditor to state what elements of uncertainty exist to raise some question.
Participant C-4: Auditors should disclose how they arrived at estimates used in F/S, what substantive evidence (hindsight review, comparisons, etc.) supports the estimate? Estimates for allowances, cost to complete %, etc.
Participant C-17: A - By industry (i.e., variations should exist from highly specialized industries - utilities, transportation companies, banks and insurance, etc.) but should be consistent within the industry.
D - Disclosure should explain how the auditor reaches opinions (what test or measurements) but should disclaim liability for management supplied information and should not relieve the client's staff from the need for independent investigation.
[PMQC 3/11, p. 8-10]
QUESTION 7
Currently, auditors report on management's representations; they make no representations themselves unless they detect a material fairness problem in the financial statements.
Would you find useful in your work to expand the auditors' role and reporting to include auditors' analysis and commentary about the following topics? (Please indicate your agreement or disagreement with each item.)
Agree Disagree
6 6 a. Ability of the company to continue as a going concern
Participant C-4: My job.
4 8 b. Risks and uncertainties facing the company
Participant C-14: On the previous page I said risks and uncertainties about the reported figures.
Participant C-4: Report facts, we'll make judgments.
5 7 c. Prospects of illiquidity
11 1 d. Significant change-sensitive estimates used in preparing the financial statements, including major assumptions used in those estimates
11 1 e. Quality and effectiveness of the company's system of internal financial control
9 3 f. Quality and effectiveness of the company's system of internal administrative control
1 g. Something Else.
Please Describe:
Participant C-8: B as it relates to D.
Participant C-11: I do not think this should be a required written report, partly because I do not think auditors are competent by training to analyze these issues. However, auditors have to upgrade these skills in order to do a better job in giving opinions, and the focus of AICPA should be on broadening these skills of auditors - including learning security analysis techniques.
[PMQC 3/11, p. 10-11]
QUESTION 8
In certain cases, the auditor considers whether to modify the standard auditors' report. One of those cases is when the company faces material uncertainties in the measurement of a liability or asset. If the auditor concludes that the uncertainty is sufficiently important to require emphasis, he or she adds a fourth paragraph to the standard three paragraph audit report.
What follows is a standard auditors' report (the first three paragraphs) with an example fourth paragraph added to emphasize a material contingency.
What would be your reaction if you reviewed the following report related to one of the companies that you analyze? (Please check ONE.)
10 a. The litigation is obviously important to the company, and you should carefully review Note X and, if necessary, discuss the matter further with management.
2 b. It is likely that the company will lose a very significant amount related to the litigation, otherwise, the auditor would not have taken the unusual step of referring to the matter.
Participant C-12: My second choice would be "c".
1 c. The reference in the auditors' report signals that the litigation is so serious that it threatens the company's existence.
d. Something Else.
Please Describe:
Participant C-11: As I said on Question 6, we need a recognized middle path so that a question on one aspect of a statement can be differentiated from a going concern question.
Participant C-4: The standard auditors paragraph is a restatement of the footnote, what's the point?
Independent Auditor's Report
We have audited the accompanying balance sheets of MLJ Company as of December 31, 19x2 and 19x1, and the related statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of MLJ Company as of December 31, 19x2 and 19x1, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
As discussed in Note X to the financial statements, the Company is a defendant in a lawsuit alleging infringement of patent rights and claiming royalties and punitive damages. The Company has filed a counteraction, and preliminary hearings and discovery proceedings on both actions are in progress. The ultimate outcome of the litigation cannot presently be determined. Accordingly, no provision for any liability that may result upon adjudication has been made in the accompanying financial statements.
[PMQC 3/11, p. 11-12]