Financial Reporting After The Subprime Crisis:New Challenges For Audit Committees - Part II

Monday, August 2, 2010 - 01:00

The first part of this article appeared in the July issue of The Metropolitan Corporate Counsel. In it the author describes how the subprime crisis ushered in a new era of financial reporting. Please see our website at www.metrocorpcounsel.com.

Challenges For Audit Committees (cont'd)

Faster Financial Reporting - The subprime crisis illustrates all too clearly what is sure to be a fundamental tension in financial reporting going forward. That is the tension between the desire to provide sufficiently reliable financial information to investors but at the same time to increase the speed of financial reports, particularly when the news is bad.

This desire for more rapid information is driven largely by investors. They have made plain their impatience with a "periodic" system of financial reporting that was initially designed only to present information once a year or, more recently, once a quarter. Trying to be responsive, those responsible for the design of financial reporting systems have worked hard to make improvements. Hence, the deadlines for periodic reports - Forms 10-K being the most prominent - have been shrunk. Sarbanes-Oxley contains new "real time" provisions seeking to increase the speed of information. Increased emphasis has been placed on internal control over financial reporting with one of the objectives being more reliable and efficient information collection and transmittal.

Still, capturing and processing the requisite data takes time. That was particularly evident in the subprime crisis where the analysis often started with companies trying to figure out exactly where within their various business units mortgage-related assets were being held. The overnight evaporation of markets, moreover, meant the numbers were that much harder to figure out. All the while investors were clamoring to know what was going on.

This investor demand for more rapid information is unlikely to change. Indeed, such is the desire for updated information that at times investors have almost seemed willing to trade reliability for speed, arguing "a rough number is better than no number." And one consequence is to place the audit committee between a rock and a hard place. On the one hand, it wants to be responsive to the desires of investors who are, after all, the main customers for public company financial information. On the other hand, it wants to be satisfied that the financial reporting system is producing information that is sufficiently reliable to be reported to the public. Striking the right balance between the two competing considerations can be a perilous undertaking. And, again, the downsides can include SEC or Department of Justice investigations.

There is no easy solution to this one. Therefore, one of the most important things is for the audit committee to simply appreciate that the tension between reliability and speed exists. Another important reaction is to understand the significant benefits of improved financial reporting systems and, in particular, enhancement of the systems by which fair values can be derived. Just as it's easier to fix the roof when the sun is shining, the time for improvement is when markets are calm. When volatility strikes, it can be difficult to play catch up.

From Rules to Principles - The evolution to fair value accounting - and the resulting need for sometimes-difficult judgments in fulfillment of the principle of reporting asset "exit price" - illustrates a broader trend in financial reporting. That is the trend from a system that relies more on technical rules, which is how many would characterize U.S. GAAP, to a system that relies more on broader principles, which is how many would characterize International Financial Reporting Standards or "IFRS." The general trend even in the U.S. is from a rules-based to a more principles-based system.

Here, too, the evolution is not without controversy. Described as a debate of "principles versus rules," the discussion often focuses on which is actually better for U.S. financial reporting given U.S. cultural inclinations and the way financial reporting in the U.S. actually works. Adherents of rules say that rules can be clearer, offer brighter lines, be easier to apply in the field, and thereby make accounting less susceptible to manipulation. Beyond that, the application of rules can be - a critical concern for some - more difficult to second guess (the SEC is often mentioned). On the other side, adherents of principles argue that the application of principles requires more thought about the broad objective of the accounting standard, is less vulnerable to abuse through accounting engineering, and thereby allows for a truer financial picture of what is actually happening. Those arguing for a more principles-based approach also point to the occasional ridiculousness of some aspects of U.S. GAAP. The 1000+ pages of interpretive data on derivative accounting under FAS 133 is often the poster child.

In truth, the notion of a debate of "principles versus rules" is largely artificial. Financial reporting needs both. At the same time, there is a general consensus that the emphasis on bright-line rules in the U.S. has gotten out of hand. Accordingly, as FASB in the U.S. and the IASB in London continue to work toward convergence, one outcome is almost certain: There will be much more emphasis on principles.

For the accounting systems that U.S. audit committees oversee, this will represent a cultural change. For whatever reason (and lawyers may have played a role), U.S. accountants tend to express greater comfort with the application of rules. A shift to principles will require less of a focus on rule compliance and more of a focus on the objective of a particular accounting standard and whether a particular application furthers that objective. In the end, such a change away from a "compliance mindset" may be healthy. But the comfort of being on the right side of a rule may be lost.

For audit committees, as in the oversight of fair value accounting, an important consideration will be the increasing prominence of judgment in a principles-based system. The watchword for audit committee oversight in such a system may increasingly become "informed objectivity." In a more principles-based system, the audit committee will want to be informed as to the basic judgment calls. But more than that, the audit committee will want to keep in mind that influence on those judgment calls can come from a variety of directions. An important goal, therefore, will be to protect the "objectivity" of the system.

If everyone is trying to do the right thing, a more principles-based system can serve to enhance financial reporting and the usefulness of reported results. But that assumes everyone is trying to do the right thing.

"Accounting Engineering" - An implication of the evolution to a more principles-based system, briefly mentioned above, may be a further trend away from that which some refer to as "accounting engineering."

The concept of "accounting engineering" by its terms carries an almost sinister tone, but it is useful to keep in mind that attentiveness to accounting consequences in structuring transactions has historically been commonplace. Not that long ago, financial executives would explicitly seek to structure a business combination to attain "pooling" accounting treatment and candidly describe that they were doing just that. More recently, structures to place assets and liabilities "off balance sheet" have been ubiquitous. Just as it seemed perfectly natural to lawfully structure transactions to minimize taxes, structuring transactions toward a particular accounting result had historically seemed fine.

But things have gotten a bit more dicey of late. The SEC has expressed growing frustration at corporate structures driven by the accounting rather than what makes sense for the business. More than that, accounting-driven structures are being second-guessed in accounting investigations (think of Lehman Brothers), in litigation, and by the financial press. In all of this, the line between legitimate profit maximization and improper manipulation of accounting can be hazy, unlawfulness is often far from clear, and the discussion can end up focusing on such imprecise concepts as the adequacy of disclosure and "economic substance." If nothing else, the reputational damage from suspicious accounting structures can be considerable.

For audit committees, it may be good news that accounting engineering will in some respects be more difficult in a principles-based system. While counterintuitive to some, the fact is that the lack of sharp edges to bright-line rules can make it more difficult to know precisely the point at which accounting treatment changes. Rather than aim for the edges, those seeking to determine accounting consequences under a more principles-based system may be more drawn to "aim for the center," that is, to fulfill the objective of the principle at issue. For audit committees worried about technical compliance lacking economic substance, a greater focus on the underlying principles may help.

Nonetheless, continued attentiveness to this area may be useful. The distinction between acceptable and unacceptable approaches can be difficult to pin down, and it can be difficult for an executive to know exactly when he or she is stepping over the line. Beyond that, a preoccupation with profit maximization through accounting devices can suggest a nonoptimal environment. In this area, audit committees will want to stay on their toes.

Auditor Interaction - In some ways, the subprime crisis put to the test the strength of relationships between audit committees and their auditors. The increased need for judgment calls, the pressure-cooker environment in which accounting judgments needed to be made, the difficulties in finding observable market data - all of these understandably created stress even as everyone was trying to figure out the right things to do.

Unfortunately, factors giving rise to that stress will to some extent continue. Tough judgment calls will continue to be needed. Financial reporting will continue to get faster. Objective market data will come and go. It will be more important than ever, therefore, for audit committees to cultivate excellent auditor relationships.

The hallmarks of an excellent relationship will include candor and transparency both in providing objective information and in making objective judgments. The concept of audit committee "informed objectivity" again comes to mind. A natural outgrowth may be increased audit committee interaction with internal audit so that the committee can learn more about, and improve, system frailties even before the outside auditors get started. A healthy and candid dialogue among all three participants - the audit committee, the outside auditor, and internal audit - should improve the workings of the system overall.

Responsibility for Risk Management - A particular challenge for audit committees coming out of the subprime crisis will be the need to address increased expectations for risk management. Those increased expectations are perfectly understandable. However, it is far from clear that the audit committee members are the best ones to address them.

The reason is that the risk emerging as the principal culprit in the subprime crisis did not involve falsely reported financial results but, rather, the liquidity of reporting entities. In a nutshell, they ran out of cash. A typical audit committee may, as a result of legal requirements and practical need, possess significant experience in debits, credits, and GAAP. But enterprise liquidity, and the intricacies of the financial markets underlying it, are a different thing altogether. Add in the other risks gaining prominence in the subprime crisis - credit risk and market risk to name two - and it is far from clear that the audit committee's accounting expertise makes it the best committee to take them on.

And this is before getting to the fact that, with all of the new demands on financial reporting systems, the audit committee will have enough to do just staying on top of financial reporting. Rather than placing on the audit committee additional responsibilities for risk management, boards of directors may want to approach it from another direction. It may make sense, for example, for boards to consider the establishment of a separate "risk management committee" as the central board-level committee responsible for risk.

The Reemergence Of Fraud?

As we continue to emerge from the recession, audit committees may understandably think they've earned the right to take a sigh of relief. The prevailing view seems to be that the worst is behind us and that, while it may take awhile, things are gradually going to get better. That is obviously good news for the economy.

But, ironically, an economic recovery may carry with it a new challenge for financial reporting. The fact is that, during the depths of the recession, some of the toughest pressures on the accounting system had been removed. Foremost among these was the quarterly earnings expectations of outside analysts. During a time when everyone was fighting for cash flow and survival, a failure to meet earnings estimates was a complete nonevent.

That can be expected to change as companies again start making money. And an ominous sign, as we emerge from the recession, is that companies are being perceived as stepping back onto growth curves and analyst expectations are again starting to matter. Financial fraud rarely starts with dishonesty; it starts with pressure of the sort put in place by quarterly analyst expectations. With the increased prominence of fair value accounting, and the increased need for judgment calls in a principles-based system, the opportunities for the nonobjective application of accounting standards by those under pressure will in some ways increase.

All this means that audit committees will want to stay on guard against the influence of business pressures on accounting determinations and that an approach of "informed objectivity" may be more important than ever. The subprime crisis created significant challenges for audit committees and financial reporting systems. An economic recovery will create new ones.

Michael R. Young is a Partner of Willkie Farr & Gallagher LLP in New York.He served on the main advisory council of the Financial Accounting Standards Board during its development of the "fair value" accounting principles at issue in the subprime crisis.His publications include The Financial Reporting Handbook (2003) and Accounting Irregularities and Financial Fraud (3d ed. 2006).

Please email the author at myoung@willkie.com with questions about this article.