How directors and auditors can improve corporate governance.

Early in 1994, chief accountant of the Securities and Exchange Commission Walter Schuetze criticized independent auditors for not measuring up to their profession's high standards for integrity, objectivity and independence. His criticisms were similar to those also aimed at corporate directors--failure to act as guardians of the corporation and its stockholders and being passive supporters of management. In the view of Schuetze, auditors were at times being "cheerleaders," not just passive supporters. This article covers the response of the profession to those charges and its recommendations for improving financial reporting.

The Public Oversight Board (POB) of the SEC practice section (SECPS) of the American Institute of CPAs appointed a three-member advisory panel on auditor independence, charging it to determine whether "the SECPS, the accounting profession or the SEC should take steps to better assure the independence of auditors and the integrity and objectivity of their judgments."

The advisory panel in its report, Strengthening the Professionalism of the Independent Auditor, suggested ways to enhance the value of the audit and better serve the auditing profession's principal client: the investing public. The POB had identified a similar need in its 1993 special report, In the Public Interest, commenting, "In too many cases [of alleged audit failure], the preference of client management...prevailed over the preference of the auditing or consulting partner."

A NEW FOCUS IS NECESSARY

The panel said the time was now for the profession to expand existing "best practices," by shifting its focus from a compliance and rule-oriented audit to one recognizing the board of directors as its client and by becoming part of what is called a "corporate governance" approach to improved financial reporting. The major topic in the report was "strengthening the relationship between the board of directors and the independent auditor."

The panel's central suggestion was that corporate boards and audit committees should expect independent auditors to forthrightly communicate in a timely fashion their views on the quality--not just the acceptability--of a company's financial reporting. That quality assessment should encompass judgments about the appropriateness, aggressiveness or conservatism of estimates and elective accounting principles or methods and judgments about the clarity of disclosures.

The intended result is an informed audit committee and board that will understand the quality of a company's financial reporting and thus be better equipped to fulfill their corporate governance responsibilities.

THE RESPONSES OF THE POB AND THE SECPS

The POB recently published a booklet, Directors, Management, and Auditors--Allies in Protecting Shareholder Interests, that urges the adoption of, and describes ways for audit committees to implement, the panel's major suggestions affecting the corporate community. The POB sent it to some 34,000 directors, chief executives and chief financial officers of companies listed on the New York Stock Exchange and other publicly held companies with revenues greater than $250 million. It also was sent to every member firm of the SECPS, in many cases in sufficient quantity to distribute to all audit partners and professional staff, as well as to the CEOs, CFOs and directors of publicly held companies not included in the POB distribution.

The SECPS executive committee endorsed the panel's view by saying that the SECPS believed it was in both the public interest and the interest of the accounting profession for auditors to discuss with directors the auditor's judgments about the quality of a client's financial reporting.

PERSONAL JUDGMENT, NOT PROFESSIONAL RULES

The advisory panel, the POB and the SECPS executive committee agreed that establishing standards and authoritative definitions for commonly used terms, such as "appropriate" and "aggressive" would place emphasis on the form rather than the content of the communication and would overlook the key driver: personal judgment.

It is important to recognize that the individual partners, both engagement and concurring, best understand the practices of particular industries, the corporate culture and the motives of their client companies. The circumstances surrounding the accounting and disclosure choices made by a particular client may at times be unique and differ subtly from circumstances of other companies. It is the experience, competence and judgment of the individual auditor that need to be applied in assessing the quality of the client's financial reporting--not a set of rules or "bright lines." In addition, it is just not practical for a firm as a whole to take a position on each client's set of judgments, and directors and officers should understand that.

The engagement partner's view, however, should reflect the input of the concurring partner and if they disagree (which is possible, considering the subjective nature of the conclusions), that should be communicated as well.

It should be obvious from the above that the quality or appropriateness of financial reporting is not synonymous with "generally accepted." The panel's report makes that point by stating that "under the panel's approach, the auditor would not only evaluate the company's compliance with generally accepted accounting principles but also express, to the audit committee and the board of directors, a qualitative judgment about the company's choice of principles, disclosures and estimates. For years, the auditing standards have required the auditor to judge whether the acCounting principles selected and applied are 'appropriate in the circumstances.' The standard to which the auditor has been held in making that judgment has been whether the selected principle falls in the range of acceptable practice. The panel would hold the auditor to a different standard in communicating with the board of directors."

High-quality financial reporting does not result from mere compliance with the rules. While compliance may be good enough to earn an unqualified opinion from the auditor, it is not necessarily the best result for the users of those financial reports or for the boards of directors in meeting their corporate governance responsibilities.

PREFERABILITY REVISITED?

Questions have been raised as to whether the panel's suggestions, particularly the determination of "most appropriate" financial reporting, are a reopening of that contentious issue--the determination of "preferable" accounting principles--that in the opinion of most in the profession has been satisfactorily resolved. It is not a reopening of that issue. The quality assessment goes beyond it because it also deals with estimates, disclosures and judgments about existing practices. The determination of "most appropriate," however, is in many ways consistent with the determination of "preferable." Foremost among the similarities are that the determination of the preferability of a change from one generally accepted accounting principle to another and the assessment of the quality of financial reporting are both value judgments based on particular circumstances, but are not based on a belief that one acceptable method is always preferable to another.

Unlike preferability determinations, however, the quality assessment does not involve public reporting; it is informed input to help management and directors meet their corporate governance responsibilities. Some managements will welcome the opportunity to reassess practices, but others will have little interest in improving their financial reporting or justifying continuing practices when circumstances have changed. In the latter case, it is hoped independent directors will help create an environment receptive to such a reassessment.

While corporate management should strive for the best financial reporting, auditors are well acquainted with the real-world pressures that cause managers to search for principles, or methods of applying them, and disclosure practices that, in the circumstances, barely pass the test of being "generally accepted." An auditor normally recognizes those situations and, usually, the motives for them. When those pressures exist the auditor knows the resulting financial reporting may not be of the highest quality. While no standard can supplant the auditor's judgment in these situations, it is valid to ask what guidance is available to identify what would be the "best" or "better" financial reporting, and there is more about that below.

FASB STATEMENTS OF CONCEPTS

The Financial Accounting Standards Board's statements of concepts offer some guidance in deciding what accounting or reporting alternative might be the most appropriate in the circumstances.

The FASB describes its conceptual framework as "a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function and limits of financial accounting and reporting." However, other benefits are also expected from the careful use of the framework "in resolving new or emerging problems of financial accounting and reporting in the absence of applicable authoritative pronouncements."

CONCEPTS STATEMENT NO. 2

Most significant for purposes of this article is Statement of Financial Accounting Concepts no. 2, Qualitative Characteristics of Accounting Information. The statement identifies characteristics that "distinguish more useful accounting information from less useful information." One way to think of "most appropriate in the circumstances" is to equate it with the "most useful" information.

Relevance and reliability are the qualities that "distinguish 'better' (more useful) information from 'inferior' (less useful) information." Relevance is defined as "the capacity of information to make a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct prior expectations." Reliability is defined as "the quality of information that assures that information is reasonably free from error and bias and faithfully represents what it purports to represent."

Also helpful are the discussion in the statement of conservatism, meaning a prudent reaction to uncertainty, and the conclusion that "prudent reporting based on healthy skepticism builds confidence in the results and in the long run best serves all of the divergent interests that are represented by the [FASB's] constituents."

Another way to judge the quality of an entity's financial reporting is to imagine what other parties--for example, another auditor, a prudent independent corporate director or a knowledgeable investigative reporter or investor--would, conclude about the accounting or disclosure choice made. If the auditor thinks other such experts, knowing what the appointed auditor knows, would probably favor a "more prudent" accounting choice or forthright disclosure, then the auditor at least has a talking point, if not the basis for deciding what other choice would be of the highest quality.

A STEP BEYOND THE TREADWAY COMMISSION'S RECOMMENDATIONS

The POB's letter accompanying the advisory panel's report said it was a call for the "completion of a process that has long been developing and that has been presaged in reports of the Cohen commission (1978) and the Treadway commission (1987) among others."

Improving the quality of financial reporting is a continuous process, and the authors view the panel's focus on the "tone" of a corporation's financial reporting as an extension of--a step beyond--the recommendations of the Treadway commission, in particular.

The panel's suggestions are, of course, not focusing on what the Treadway commission defined as fraudulent financial reporting--intentional or reckless conduct that results in materially misleading financial statements. While it is true that aggressive application of principles or excessive optimism in determining estimates and disclosure practices is a signal about the "tone" set by top management, such practices do not always lead down the slippery slope to "misleading" presentations.

Calling attention to such an aggressive practice, even though believed at the time to be immaterial or marginally in accordance with GAAP, and advocating what the auditor believes is a more appropriate accounting choice, at least offers the opportunity for second thoughts and possible avoidance of fraudulent reporting. While the auditor may not always be persuasive, he or she will still have given the board of directors his or her timely, forth-right, frank advice and informal, subjective opinions--the hallmark of a true professional.

However, while fraud prevention might in some cases be a side-benefit of the panel's suggestions, it was not among the objectives. Improved financial reporting for the benefit of investors and enhancement of the value of the independent audit as a means to assist directors in fulfilling their corporate governance responsibilities were the primary objectives. It should not be overlooked that management and members of audit committees may also have views on what constitutes high-quality financial reporting, and in those cases candid dialogue among those parties will give directors a better basis for understanding and influencing corporate practices.

IMPLEMENTATION ISSUES 

Advance discussions. Best practices, and prudence, suggest that the auditor's preliminary judgments about the quality of a client's financial reporting be thoroughly discussed with appropriate client officials before meeting with the audit committee and board of directors. Client officials are entitled to advance knowledge of the auditor's views, and the auditor should understand the views of client officials. Advance discussions also give management the opportunity to decide which, if any, of the auditor's suggestions it chooses to adopt even before the meeting with the audit committee.

Advance discussion with the chair of the audit committee is also highly desirable. This gives the auditor an opportunity to explain any issues in a less-pressured environment, clarify motivations and objectives, learn what other issues might be on the mind of the audit committee chair and help create the right environment at the meeting.

Cooperation, not confrontation. The practices suggested in the panel report are already employed at many companies. In these companies, management accepts the corporate governance role Of the board of directors, and the directors welcome the auditor's candor. Extending this best practice will work if all the parties involved see it as an opportunity to learn about the auditor's judgments of the quality of the company's financial reporting--after the auditor has concluded that present or proposed practices conform to GAAP. The resulting discussions will enhance the auditor's stature, improve understanding and, over time, the quality of financial reporting. This should not and need not be confrontational if the right tone is set by the key players: the chair of the audit committee, key corporate officers and the auditor. On the other hand, if the issues become contentious, the auditor should consider whether he or she is communicating the objectives effectively, whether he or she has developed the right relationship with client officials and directors, and, if particularly difficult, even whether he or she should reevaluate the desirability of continuing with the client.

Form of communication. The panel and POB reports advocate oral reporting to avoid professionwide standards and the boilerplate language that frequently permeates written communications. There may be reasons, however, for the auditor to put his or her views in writing: to use language that says exactly what is intended and to avoid having different people at the same meeting leave with varying impressions of what the auditor said. There is no one answer to the question of oral versus written report--it depends on how comfortable the auditor is with each, what the particular audit committee and board of directors are used to receiving and the importance of what is being said.

Most appropriate. Auditors may find it much easier to identify better accounting principles, more appropriate estimates and more informative disclosures--compared with what the client is currently using--than to reach the conclusion that a single approach is most appropriate. In fact, in some cases, more than one alternative presentation or explanation may be better than what the client proposes or uses, and the auditor may be indifferent as to which of the alternatives is best. When, in the auditor's view, there is not a most appropriate choice, more appropriate is a reasonable guideline.

In the authors' opinion, the objectives of the panel report will be achieved if auditors inform directors that there are several better alternatives to the accounting and disclosure choices made by management. The authors believe that the impact of these discussions will be improvements in the quality of financial reporting over time.

The slippery slope. In some situations the quality of a company's accounting practices and estimates deteriorates over time, but not by so much in any one year to conclude that the practices violate GAAP or to raise a consistency question. In 1987, the Treadway commission described this situation as follows: "The commission's studies revealed that while the perpetrators of fraudulent financial reporting may use many different means, the effect of their actions is almost always to inflate or 'smooth' earnings or to overstate the company's assets. In addition, fraudulent financial reporting usually does not begin with an overt intentional act to distort the financial statements. In many cases, fraudulent financial reporting is the culmination of a series of acts designed to respond to operational difficulties. Initially, the activities may not be fraudulent, but in time they become increasingly questionable. When the tone set by top management permits or encourages such activities, eventually the resuit may be fraudulent financial reporting." [Emphasis added]

While the auditor may not believe there is fraudulent intent, recognizing the trend of a deteriorating quality of financial reporting and calling it to the attention of both management and directors is a proper function of the auditor. In fact, in hindsight, directors could well question why such trends were not identified and discussed. Filling this role requires thinking more broadly about the financial reporting of the client, but it is well within the auditor's competence, and it is in the client's and the public's interest.

Audit committee versus board of directors. The POB booklet calls for the auditor to meet occasionally with the full board of directors, in addition to regular meetings with the audit committee, "particularly when there are independent directors who are not members of the audit committee." The authors agree this is a desirable practice, to provide the auditor with the opportunity to demonstrate the value of the audit to the full board and to further ensure that all board members understand any existing issues. It is the responsibility of the board, however, to determine how it will discharge its responsibilities, and the fact that the auditor is not invited to board meetings should not, in the absence of other evidence, be considered a red flag or warning sign.

Liability concerns. Both the POB and the SECPS believe that implementation of the panel's recommendations should not increase auditor or director liability. The candid discussion of better practices can be expected to enhance understanding and, it is hoped, to improve financial reporting without raising liability concerns, provided the auditor is satisfied and makes clear that the financial statements under discussion already conform to GAAP. If the auditor has concerns about the acceptability of the financial statements, that is a different discussion. The authors agree that a record of full discussion of "most" or "more" appropriate accounting and disclosure practices shows due diligence on the part of directors, auditors and management, even if they are not adopted. In the event of litigation, the fact that some might believe there are "better" practices will be apparent to plaintiffs from their own evaluations, and it should be helpful to the defense to have a record of thoughtful consideration of those alternatives before the financial statements were issued. Auditors are encouraged, however, to make clear that their suggestions are to move from acceptable to what in their judgment is better, so the recommendations are put into the proper context.

ACTIONS NEED TO BE TAKEN

This article offers some insights into the intent of the advisory panel on auditor independence. Now actions need to be taken to achieve what the POB described as a "low-cost, non-regulatory step toward more credible financial reporting." The SECPS is working with the POB in developing an appropriate plan of action. Those actions began with the directive of the executive committee of the section to its peer review committee to identify and report to members on the improved or best practices in communications in the corporate governance and financial reporting processes. The POB also is meeting with other groups, including regulators and director organizations, to gain their support for the panel's report.

The SECPS's commitment to encourage its members to accept responsibility to assess and report to corporate directors on the quality of their clients' financial reporting is an important step in meeting the profession's responsibility. It should enhance the value of the independent audit and, with the right environment created by corporate management and directors, it should result in significant, long-term benefits to investors.

The three recent documents cited in this article are available. Strengthening the Professionalism of the Independent Auditor (1994) and Directors, Management, and Auditors--Allies in Protecting Shareholder Interests (1995), both published by the POB, are available at no charge from the Public Oversight Board, One Station Place, Stamford, Connecticut 06902; telephone: [phone].

SEC Practice Section Response to the Public Oversight Board Advisory panel on Auditor Independence, published by the American Institute of CPAs in 1995, is available at no charge by calling the AICPA order department at [phone], menu #1; fax no. [phone]; and asking for product no. G00111JA.

EXECUTIVE SUMMARY

* RESPONDING TO CRITICISMS expressed in 1994 by the chief accountant of the Securities and Exchange Commission, the Public Oversight Board appointed a panel to address issues of auditor independence, charging it to determine whether steps should be taken to better assure the independence of auditors and the objectivity of their judgments.

* THE POB SAID IT WAS TIME for the profession to expand existing best practices by shifting its focus from a compliance and rule-oriented audit to one in which auditors took part in what it called a corporate governance approach. The intended result would be an informed audit committee and board that would understand the quality of a company's financial reporting.

* RECENTLY, THE POB PUBLISHED, with the endorsement of the SEC practice section executive committee, a booklet that urged the adoption and implementation of the panel's major recommendations.

* THE RECOMMENDATIONS EMPHASIZE that high-quality financial reporting does not result from mere compliance with the rules, but that instead the key driver is the auditor's personal judgment.

* AMONG THE IMPLEMENTATION ISSUES are advance discussions, nonconfrontational exchange with corporate leadership, form of communication, choice of appropriate accounting principles and reaction to the slow deterioration of a company's accounting practices.

* THE POB ADVISORY PANEL hopes its recommendations ultimately will achieve a "low-cost, nonregulatory step toward more credible financial reporting."

DONALD J. KIRK was chair of the advisory panel on auditor independence appointed by the Public Oversight Board and subsequently was elected a member of the POB. He was a founding member and former chair of the Financial Accounting Standards Board and is currently an executive-in-residence at the Columbia University Graduate School of Business and a director and audit committee member of several companies. ARTHUR SIEGEL is a partner of Price Waterhouse in Stamford, Connecticut, and from 1988 to 1995 served as vice-chairman-audit and business advisory services for his firm. He is chair of the AICPA SEC practice section executive committee.