Accounting in Crisis?

Financial Reporting at a Crossroads

Laws of Accounting

Trial Balances don’t

Bank reconciliations never do

Working capital does not

Return on investments never will

The “New” Pledge of Allegiance

One nation, under greed, with stock options and tax shelters for all.

Proposed following a June 26, 2002 U.S. court decision that the present version is unconstitutional.

Consider Three Quotations

Quotation #1

Transparent accounting plays an important role in maintaining the vibrancy of our financial markets.

Alan Greenspan Chairman, Board of Governors of

The Federal Reserve Board

Quotation #2

The single most important innovation shaping the (American capital) market was the idea of generally accepted accounting principles. We need something similar internationally.

Lawrence H. Summers Former Secretary of the Treasury.

Quotation #3

The quality of information we now receive from companies in the U.S. is about the best we have ever seen and exceeds that of almost any other nation.

Abby Joseph Cohen Chair, Investment Policy Committee Goldman,

Sachs & Co.

What is the “purpose” of Accounting?

Objective #1

Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.

Objective 1 continued

The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.

Objective #2

Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash flows.

Objective #3

Financial reporting should provide information about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners’ equity), and

Objective #3 continued

The effects of transactions, events, and circumstances that change its resources and claims to those resources.

First-Order Feedback System

ProcessInputs Outputs

SensorControl

Feedback Loop

EnvironmentBoundary

Source documents

Recording & posting

Trial balanceReporting

Transaction or event

Analysis

The Accounting Process

Ongoing events in world

Recording Data Bank

ClassifyingInformation

Accounting Information System

Boundary

First . . . Consider this

Accounting is all about accuracy.

Accounting is all about hard numbers.

Accounting is all about accountability.

Accounting is a time-honored tool for making hard decisions about dollars and cents, about profits and losses.

First . . . Consider this

Accounting is the land of bean counters, of number crunchers – men and women with green eyeshades and calculators.

Accounting says Baruch Lev, Professor of Accounting and Business at New York University’s Stern School of Business is increasingly irrelevant.

First . . . Consider this

The problem, says Lev, is that the systems of accounting and financial reporting that are being used today date back more than 500 years.

These systems are not only part of the old economy, they’re part of the old, old economy.

First . . . Consider this

Luca Pacioli, an Italian mathematician who lived in Venice in the 1400s developed double-entry bookkeeping in order to offer business people a simple method for keeping track of their transactions – and even more important, for making sense of the way they did business.

First . . . Consider this

“If you cannot be a good accountant,” Pacioli wrote, “you will grope your way forward like a blind man and may meet great losses.”

The Evolution of the Knowledge Professional

Robert K. Elliott and Peter D. Jacobson Accounting Horizons, March 2002

Introduction

Wealth creation depends on knowledge work as never before, a change full of implications for those who provide information services.

We argue that a new economic model has created a need for a new type of information professional.

Four Economic Paradigms

Hunting and Gathering

Agriculture

Industry

The Information Economy

Your Questions

Is it possible that the role of the new information professional will never be fully defined? Since technology is now advancing at such a rapid rate, could the role of the new information technology professional be a moving target?

Your Questions

Is the new paradigm really coming, or is this simply a case of divergent specialties resulting from an increasingly complex world?

Your Questions

Is it possible for a profession to consciously “reinvent” itself? If so, what are some examples of professions who have succeeded (or tried and failed)?

Your Questions

The author argues that the accounting profession should take the initiative to expand its role in the information economy and serve as the foundation of the new information professional. Are there other professional disciplines that might serve as well or better as a foundation for the new information professional?

Your Questions

In light of the scandals that occurred after the commentary was written, do accountants have an opportunity to fulfill the role of the knowledge professional in the new economy.

Aren’t there other professions that have just as much claim to lead the “information economy?”

Your Questions

As the “information economy” continues to improve making information more easily and readily available to each individual, will there not be fewer positions for these trusted knowledge professionals since their efficiency will be greater than those of today? Conversely, would each individual then become responsible for being their own knowledge professional?

Your Questions

Is it possible that the evolution of the accountant/auditor profession will end in a merger with the finance profession? Or will software replace them both?

Your Questions

Is this field moving so fast that when teaching new methods, they will be outdated by the end of the semester? Does the teaching professional need to be revolutionized as well?

Financial Reporting at a Crossroads

Michael H. Sutton Accounting Horizons December 2002

Some Challenging Questions

Can we believe in and rely on the independent audit?

Can we believe that our accounting and disclosure standards provide the transparency that is essential to investors and the public?

Some Challenging Questions

Can we rely on self-regulatory systems to ensure audit quality and to root out and discipline substandard performance?

No one wants Congressional Required Accounting Principles (CRAP makes a pretty lousy acronym!)

Some Challenging Questions

Can we rely on corporate governance processes – oversight by boards of directors and audit committees – to ride herd on management and to see to it that auditors do their job?

Some Recommended Changes

Regulatory Processes

Timely and thorough investigations of circumstances that may involve fraudulent financial reporting.

Objective and fair assessments of the role and performance of auditors.

Timely and meaningful discipline of auditors and firms that violate acceptable norms of conduct.

Regulatory Processes

Regular oversight and periodic examinations of the policies and performance of independent auditors.

Timely and responsive changes in professional standards and guidance when a need for improvements is identified.

Your Questions

The words “in a timely manner” were used throughout the article in reference to auditors reporting information. What would be considered “timely” in the eyes of the law.

Your Questions

How were auditors ever entrusted to fulfill their duties when they reported to top management of the firm they audited?

Your Questions The author points to information asymmetry

between insiders and the investing public as a source of inefficiency in capital markets and asserts that auditors can “balance the scales” by providing accurate and trustworthy information about business entities. How far do you believe the auditing function can reduce this asymmetry and level the playing field between insiders and the investing public?

Your Questions

Is there a way to redefine the accounting system to ensure that a “single financial reporting failure” is not a disaster that wipes out “decades of hard work, planning, and saving?”

Your Questions

How can the bonds between managers and independent auditors be entirely broken when large amounts of money from corporations fund the independent auditors?

Your Questions

Why did the Enron and WorldCom failures demand meaningful reforms, but past failures did not?

Your Questions

Were the financial reporting of Enron and WorldCom legal or within the rules of accounting authorities?

Your Questions

The FASB rules currently permit distorting financial reporting of Special Purpose Entities. Why?

So . . . What is “wrong” with Accounting?

Accounting in the 21st Century

Testimonies Before the U.S. Senate Banking Committee

The Traditional View of Accounting

“Transaction” oriented

Narrow focus on financial data

Reporting is periodic and not real-time

Limited accessibility of information

Too high a level of aggregation

The Traditional View of Accounting

Limited flexibility which prevents answering queries that cross functional boundaries.

The Fundamental Accounting Problem

Fundamental Accounting Problem

We are using a 500-year-old system to make decisions in a complex business environment in which the essential assets that create value have fundamentally changed.

Baruch Lev Professor of Accounting NYU Stern School of Business

New Math for a New Economy www.fastcompany.com

Intangible Assets

Assets associated with product innovation (R&D)

Assets associated with a company’s brand

Structural assets – better, smarter, different ways of doing business.

Monopolies (barriers to entry).

Intangible Assets

Expensive to acquire and to develop.

Extremely difficult to manage

Property rights are fuzzy

Violation of Matching Principle

Accounting is based on the matching principle.

Good matching = good income number.

Knowledge assets = mismatch.

The Sarbanes-Oxley Act of 2002

Public Companies Accounting Reform and Investor Protection Act of 2002

Sarbanes-Oxley Act of 2002

Directly impact these groups:CPAs and CPA firms auditing public

companies.

Publicly traded companies, their employees, officers, and owners. (Includes CPAs employed by publicly traded companies as CFOs or in their finance department)

Sarbanes-Oxley Act of 2002

Directly impact these groups:Attorneys who work for or have as clients

publicly traded companies; and

Brokers, dealers, investment bankers and financial analysts who work for these companies.

PCAOB

Establishes a new Public Company Accounting Oversight Board (PCAOB).

Board compositionTwo must be or must have been CPAs

Three must not be and cannot have been CPAs

PCAOB

Board composition – continuedChair may be CPA, but must not have

practiced accounting during the five years preceding appointment.

Appointed by the SEC.

Subject to SEC oversight

PCAOB - Funding

The Board will be funded by public companies through mandatory fees.

Accounting firms that audit public companies must register with the Board and pay registration and annual fees.

PCAOB – Standard Setting

The Board will issue standards or adopt standards set by other groups or organizations, for audit firm quality controls for the audits of public companies.

PCAOB – Standard Setting

These standards include: auditing and related attestation, quality control, ethics, independence and “other standards necessary to protect the public interest.”

The Board has the authority to set and enforce audit and quality control standards for public company audits.

PCAOB – Other Powers

Investigative and Disciplinary authority

International authority

The Sarbanes-Oxley Act of 2002

New Roles for Audit Committees and Auditors

Audit Committees & Auditors

Auditors report to audit committee

Audit committees must approve all services

Auditor must report new information to audit committee

Offering specified non-audit services prohibited

Audit Committees & Auditors

Audit partner rotation

Employment implications.

The Sarbanes-Oxley Act of 2002

Criminal penalties and protection for whistleblowers.

Criminal penalties

Failure to maintain workpapers

Document destruction

Securities fraud

Fraud discovery

Protection for whistleblowers