Financial reporting: recommendations from the Committee on the Future of California's Professional Accountants.
Confidence in financial reports and the work of auditors has been shaken, which has carried consequences for the future of the accounting profession in terms of its status, reputation and attractiveness as a career.
In 2002, CalCPA assembled an independent committee to recommend changes that could be made in California to improve financial reports and the process involved in preparing and auditing those reports. To that end, the Committee on the Future of California's Professional Accountants--a group of California civic, business and professional leaders--was formed to prepare a report recommending changes.
The report (available at www.calcpa.org/futures.htm) represents the committee's recommendations and does not necessarily represent the views of CalCPA or the view of every individual member on each issue.
The committee's report recommends actions to improve (1) the financial reporting process, (2) published financial statements and (3) the conduct of audits.
These recommendations apply to the conduct of professional accountants and auditors, and the financial statements with which they are associated, for both SEC registrants and for nonpublic companies and organizations with substantial outside capital or public trust. It's expected that such nonpublic companies and organizations would engage a CPA firm to conduct an audit of their financial statements. Some of the recommendations also may be of interest to accountants employed by or serving companies and organizations that do not prepare audited financial statements.
Federal securities laws have changed in the past three years, most notably through passage of the Sarbanes-Oxley Act. These changes, however, apply only to public entities subject to federal securities laws.
The committee's report addresses all entities with substantial outside capital or public trust. Some of the recommendations broaden the reach of some provisions of the federal securities laws to other entities to which they do not currently apply.
Other recommendations go beyond what is included in the federal securities laws and would apply to all companies, including those subject to the federal securities laws.
The committee believes that these recommendations will help restore confidence in published financial statements, the financial reporting process and the work of independent auditors. The committee further believes that leaders of the profession must clearly communicate to California's professional accountants their duty to the public trust and the types of behavior that will not be tolerated.
RECOMMENDED BEST PRACTICES: FINANCIAL REPORTING PROCESS
Financial reports reflect the company management's performance and there always will be a basic incentive for management to report favorable results. The financial reporting system should be designed to provide unbiased financial statements in which financial statement users can have confidence. The independent audit committee provides oversight of the financial reporting process while the independent auditor provides an outside opinion on the fairness of the financial statements.
The corporate financial reporting system includes everyone from the CFO to the employee who performs daily data entry. The relationships between the financial reporting team members are critical to the quality of the financial reports.
The following best practices should help to improve confidence in the financial reporting process. Not all companies should necessarily follow all the recommendations, but this provides a menu of possibilities.
Chief Accounting Officer (CAO)--Financial reporting personnel are the most critical element of the financial reporting process for public or nonpublic companies. The quality of the company's financial reports depends upon the competence, dedication, objectivity and integrity of the chief accounting officer and the financial reporting staff. The company should identify a CAO with adequate experience and education to perform the function, and the person also should possess some objective evidence of competence through licensure or certification of accounting competence and continuing education in accounting.
Employing a licensed CPA as the CAO assures that the function is being performed by someone with a certain level of education in accounting and financial reporting and has demonstrated at least a minimum level of competence by passing a rigorous nationally recognized exam.
Licensing regulations in California and many other states allow CPAs not in public practice to convert their licenses to inactive status, which does not require continuing professional education. The California Board of Accountancy and other state boards should expand the requirement to maintain active licensure to CPAs involved in the financial reporting process within a company, as well as those employed at CPA firms.
At a minimum, this would include the CAO, but also may include other members of the staff with significant decision-making authority. The National Association of State Boards of Accountancy may be the appropriate organization to spearhead such an effort on a national level.
CAOs of public companies have a special responsibility that requires additional knowledge and experience beyond what is required to become a CPA in most states. To assure that CAOs have the knowledge and experience to fulfill their roles, the AICPA and Financial Executives International should collaborate to establish an additional credential tailored to their duties and responsibilities.
The credential would serve a similar role and have similar standing to a board certification in a medical specialty. It would not be a state license or tied to any particular state, but instead would focus on the competencies required to be CAO at a company subject to the federal securities laws. Such a designation could require passage of an additional exam focused on disclosure requirements for public companies and ethical issues faced by CAOs. It also may require some experience in the public company financial reporting arena and specialized continuing education.
The CAO should have direct access to the independent auditors to allow communication of any issues relating to the integrity of the financial statements or the financial reporting environment and for the auditors to quiz them about the state of the financial reporting system and the system of internal control. During the audit process, the auditors should observe the culture in which the CAO operates to see that it does not compromise the honesty and integrity of the reporting process.
If there is no audit committee, access should be to the board of directors. In this case, it may be helpful for the board of directors to designate an outside director as the principal contact with the CAO and auditors.
As part of its oversight function, the audit committee should review the structure and amount of compensation for the CAO and other key members of the financial reporting department to be sure that it is adequate to retain well-qualified employees and that the compensation structure does not create an incentive conflicting with unbiased reporting. The process may include input from the board's compensation committee.
Independent Audit Committee -- The independent audit committee is central to corporate governance regarding the financial reporting process. Companies that have a significant ownership or liability interest not represented within management or on the board of directors should have an audit committee. This also applies to organizations that operate within the public trust, such as companies that are not "public" companies under the federal securities laws and some regulated and not-for-profit organizations.
For nonpublic companies that choose to have an audit committee, SOX guidelines can be helpful in selecting members. To maintain their independence, audit committee members should be selected by a body that is independent of management. They also should be adequately compensated and competent. Auditors should evaluate the competence of the audit committee as part of their evaluation of internal control. The audit committee's authorities and responsibilities must be broad enough to encompass the company's entire financial reporting process.
The frequency and duration of meetings must be adequate to carry out its oversight function, but the committee should not become part of the financial reporting process itself. Its scope should include advanced review of financial statements presented to outsiders, press releases related to financial reporting and financial reporting regulatory filings and any other formal financial presentations. There should be a meeting with the auditors early enough to make any necessary corrections to the financial statements prior to their issuance.
Internal Auditors -- Both companies following and those not electing to follow SOX should establish an internal audit function.
Independent Auditor -- Public and private companies should employ a competent independent auditor who is familiar with the industry in which the company operates. There should be regular and candid communication between the audit committee, where one exists, and the independent auditors. If there is no audit committee, the auditor should have direct access to the board of directors. It may be helpful for the board to designate an outside director as the principal contact with the auditor. It is critical that the auditors of both public and non-public companies meet with the audit committee or a designated independent director outside of the ears and eyes of management. Issues relating to estimates and judgments in the financial reporting process should be discussed.
RECOMMENDED BEST PRACTICES: IMPROVED FINANCIAL REPORTS
Choice of Accounting Policies -- Accounting policies chosen and accounting estimates made can have a significant effect on a company's reported financial statements. It is important for the company to choose policies and make estimates that best reflect its underlying economic results and trends. Where there are alternative accounting policies available, the company should choose the policy that best reflects the underlying economics of the events and transactions upon which the company is reporting.
In those cases where a different, but acceptable, accounting policy would have had a material effect on the financial statements, it would be useful to financial statement readers to know that alternative accounting policies would have resulted in material differences, the reason for and an estimate of the result of using the alternative policy. This disclosure should be included in Note 1 of the financial statement and would enhance financial statement users' ability to compare results among companies.
Estimates and Judgment -- Estimates and judgment are inherent in the process of producing financial statements. Disclosure about the process involved and the judgments made in arriving at important estimates in the financial statements may be particularly useful to investors who are trying to understand the range of possible outcomes for the company in the coming period. If actual results are significantly different than the estimates and assumptions, the methodology for developing them should be reviewed and, if appropriate, revised.
Adequate documentation should be maintained for estimates that have a material effect on the financial statements and disclosure of those estimates should be clear. The process for deciding on the estimates and judgments and disclosures about them should be reviewed in detail with the audit committee. For estimates that are material to the financial statements, disclosure of the range of possible estimates and the effect on the financial statements of those estimates would be useful to financial statement users who are trying to understand the uncertainty the company faces.
While it is not common practice to disclose quantitative information related to the affect of different estimate methodologies, it is possible to undertake that task. In assessing the reasonableness of current estimates, users of financial statements may find information about the company's reliability in making prior estimates useful. Disclosure of material differences from past estimates, including the reason for those differences and management's response in current estimates, would be useful to financial statement users.
MD&A Disclosure -- Non-public companies that have a significant ownership or liability interest not represented within management or on the board of directors and organizations with substantial outside capital or organizations that operate within the public trust should consider including disclosures like the Management Discussion and Analysis discussion required by public companies to supplement their financial statements.
RECOMMENDED ATTRIBUTES: CONDUCT OF AUDITS
SOX/non-SOX Audit Report -- To improve audits, the committee recommends that two separate audit reports should be created. One would apply to the financial statements of companies that are governed by and follow SOX requirements and non-public companies that elect to follow SOX, and the other would apply to those non-public companies that choose not to follow SOX.
It will be helpful to readers of audited financial statements to know whether the company has followed SOX guidance. A clear communication by the auditors about whether the company has followed SOX also may encourage companies that are not subject to the provisions to follow them and get the auditors report that says they did.
Internal Controls -- Auditors of public companies are required to report on management assertions on internal controls and procedures for financial reporting, but there is no provision for the auditors of nonpublic companies to do so. Auditors should be required to prepare a report on the internal controls for organizations with substantial outside capital or those that operate within the public trust, just as they do for SEC registrants.
Other Issues -- Auditors should report to the audit committee all critical accounting policies and practices used, all alternative treatments of financial information according to GAAP that have been discussed with management, the ramifications of the use of alternative disclosures and treatments and the preferred treatment. The auditors also should communicate to the audit committee significant accounting estimates, methods and assumptions.
Auditors should assess significant changes in the control environment or the financial reporting procedures, executive compensation and the code of ethics to determine whether the changes were necessary and appropriate.
The CAO's competence is a key element in the financial reporting process that the auditors should evaluate through observation, by reviewing personnel files and interviewing other financial reporting staff. Objectivity also should be evaluated. Auditors should consider interviewing the CAO and reviewing audit committee meeting minutes to obtain evidence about the relationship with the audit committee. Significant deficiencies in competence or performance of the CAO could be considered a reportable event under SAS 60.
The committee believes adherence to these principles by both SEC registrants and nonpublic companies and organizations with substantial outside capital or public trust and their auditors will improve the financial reporting process, published financial statements and the conduct of audits.
Committee on the Future of California's Professional Accountants
John M. Lacey, Chair
Professor of Accountancy and Ernst & Young Research Fellow,
California State University, Long Beach
John A Dodsworth
CAMICO Mutual Ins. Co.
William W. Holder
Ernst & Young Professor of Accounting,
Leventhal School of Accounting,
University of Southern California
Adjunct Professor, West LA College and Pepperdine University
Former President, California Board of Accountancy
Kenneth Leventhal and Company
IndyMac Consumer Bank
Chairman, SEC, 1977-81
Of Counsel, Skadden, Arps, Slate, Meagher & Flom LLP
Chairman and CEO,
Founder and President,
Michael and Edna Josephson Institute of Ethics
RELATED ARTICLE: Financial Reporting Process--Summary of Committee Recommendations
Financial Reporting Process
* Companies employ a Chief Accounting Officer (CAO) who is an actively licensed CPA (or similar), subject to continuing education requirements.
* California Board of Accountancy and the National Association of State Boards of Accountancy (NASB) expand the requirements of "active" licensure to company-employed CPAs involved in the financial reporting process.
* AICPA and FEI develop an additional certification for CAOs of SEC registrants.
* Companies establish an independent audit committee that meets frequently with the internal and the external auditors.
* Companies develop an internal audit function.
Published Financial Statements
* Companies choose accounting policies that best reflect the underlying economics of the events and transactions and that additional disclosures be made about accounting policy choices and the consequences of those choices.
* Companies provide additional disclosure about accounting estimates that have a material effect on the financial statements.
* All companies provide Management Discussion & Analysis (MD&A) disclosures.
Conduct of Audits
* Auditors adopt two separate audit reports, one for companies that follow the Sarbanes-Oxley Act (SOX) and a second for those that do not.
* Auditors report on internal controls for all companies.
* Auditors evaluate annually (a) executive compensation and retirement programs; (b) codes of ethics; and (c) financial reporting processes at the company, including corporate culture, the audit committee and the CAO and staff.
BY JOHN M. LACEY, CPA
John M. Lacey, Ph.D., CPA is professor of accountancy and Ernst & Young Research Fellow at California State University, Long Beach. You can reach him at firstname.lastname@example.org.
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|Title Annotation:||FUTURES REPORT|
|Author:||Lacey, John M.|
|Date:||Dec 1, 2005|
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