Standard-setters’ guiding principles: time for a makeover?

The principles underlying today’s financial reporting frameworks and auditing standards may no longer be relevant in today’s financial reporting climate.

A downpour of regulation in response to an increasingly complex business environment, seemingly ever-multiplying professional standards and technology that would have been unthinkable a decade ago is our reality today. And in the face of this change, the complexity and rate of change in financial reporting has kept pace.

Financial reporting frameworks for listed companies are more complex than anyone could have imagined a few years ago. All a user has to do is to compare the length and detail in a company’s 2004 annual financial statements with that of its 2014 statements to see the difference. In many cases, it has more than doubled.

At the same time, auditing standards have also had to keep pace with financial reporting framework changes. And a number of principles underlying both financial reporting frameworks and auditing standards have been a fundamental part of formulating our standards over the past half-century.

But these principles may no longer be relevant in today’s financial reporting climate. If they are not, then how might that affect our current standard-setting environment? Or are these assumptions so ingrained in our standards today that we cannot afford to question them?

Are these principles the elephants in our room?

Elephant #1 – The inappropriate assumption of an understanding user

A fundamental tenant of auditing standards is that:

It is reasonable for the auditor to assume that users:

(a) have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information in the financial statements with reasonable diligence; …; and

(d) make reasonable economic decisions on the basis of the information in the financial statements. [CAS 320.04]

The question is whether this assumption is valid in today’s complex reporting world.

For example, download the annual report of any major Canadian bank to see the increase in complexity. Notes in the CIBC annual consolidated financial statements blossomed from 46 pages in 2002 to 93 pages in 2012. Sophisticated analysts and regulators may understand the disclosures in the statements, but to the general user — even one with an understanding of accounting — the statements can be a mystery.

Even if users have the knowledge to interpret the statements, they will bring their all-too-human inherent and unconscious biases to the table. Users with differing pre-conceived points of view give disproportionate weight to evidence that supports their views.

The assumption that users can get what they need from the study of complex financial statements alone may no longer be enough. Their study of the statements must be coupled with the skeptical attitude required to make impartial decisions, but even professional auditors have trouble being skeptical in today’s world.

The implications of departing from the "knowledgeable general user" assumption are significant. Acknowledging that statements are prepared for sophisticated users only will likely result in setting a different bar for disclosure and detail in the statements. This then brings into question what information would be appropriate for the general user, who would prepare it, whether it needs independent assurance, and to what standards it should be prepared.

The impact of complex financial reporting on users today is truly an elephant in the room. It’s time to take a closer look at the appropriateness of today’s accounting standards for general purpose financial statements.

Elephant #2 - Management of small and micro-entities can prepare financial statements

Small and micro-entities need reliable financial statements to give users an understanding of the entity’s performance in the preceding year and its financial position. Having an independent professional give an opinion on the statements adds important credibility.

Under the current assurance model, the assurance provider requires that management take full responsibility for statement preparation. Many see this requirement as essential to maintaining the assurance provider’s independence. It has become increasingly difficult for management to keep on top of financial reporting standards changes as they become more and more complex.

Because auditors are financial reporting experts, management of a small or micro-entity is understandably placing increasing reliance on these professionals to assist with year-end reporting, especially in the area of disclosures. With today’s audit software, the most efficient model is often for the auditor to prepare the annual statements and for management to then take responsibility for them.

But perhaps too much weight is being given to independence given that disclosures in financial statements of small and micro-entities often do not require significant judgments, and too little weight is given to efficient preparation of high-quality statements.

The level of assistance provided to management by an auditor during the course of an audit engagement can vary greatly. As the actual nature of meaningful responsibility is rarely addressed in today’s standards, there is no bright line as to what is acceptable in today’s environment. For example:

  • Management can give the auditor a copy of last year’s financial statements with this year’s numbers handwritten and ask for them to be typed.
  • Management can give the auditor this year’s trial balance, knowing the auditor has a preprogrammed template from last year to automatically generate statements.
  • Management can give the auditor what it considers a complete financial statement. If the auditor notices that a required note (or two or three or four) is either missing or incomplete, then the auditor can suggest wording and type it into the auditor’s template.
  • If management is unfamiliar with the disclosure requirements, it could ask the auditor to draft the financial statements. Management can then acknowledge its responsibility in a letter of management representations. This responsibility is, however, often largely based on trust in the professional.

All of these scenarios are commonplace in jurisdictions where small and micro-entities are either required to, or choose to, have a review or an audit. Often management understandably does not have the expertise to prepare a complete set of financial statements. It makes sense for a professional with a detailed knowledge of both the business and the industry to assist management with statement drafting. At the small and micro-entity level it rarely makes economic sense for a second professional to get involved in the process.

Auditor assistance to management is invaluable in practice and certainly very much a value-add for small and micro-entity assurance engagements. The assurance provider’s role in statement drafting is yet another elephant rarely addressed head on by the profession.

Elephant #3 – Users take only the level of assurance that practitioners intend to provide

The gap between what users believe assurance professionals provide versus what assurance professionals believe they deliver is significant, has always existed and appears to be widening.

Standard-setters’ attempts to reduce the expectation gap by a combination of user education and report wording to clarify complex assurance concepts appear to have largely fallen on deaf ears. Users have said that they take more comfort from a compilation report than from an audit report on the basis that a professional accountant did all the work – despite the fact that there was no intention to provide any assurance. It is clear that even when professional accountants give no assurance, users are comforted by their involvement in the process. This is value added.

The expectation gap is evidently here to stay, notwithstanding standard-setters’ valiant attempts to close it. Instead of bemoaning the gap, professional accountants should take pride in it. Consider the implications of the reverse: if users thought the level of assurance provided was less than the professionals thought they were providing, the profession would truly be in crisis.

Elephant #4 - Small and medium sized enterprises (SMEs) are not the engine of economic growth

Politicians, chambers of commerce and many others around the world trumpet the statement that SMEs, specifically companies with less than 100 employees, are the engine of economic growth and as such need to be treated with much more public respect and reverence than they currently are.

A February 2012 empirical study by the Institute of Competitiveness & Prosperity shows that this is not the case in Canada and the United States. According to the study, it seems true that SMEs in these countries are the backbone of both economies, accounting for 97.8% of total firms, and employing 48% of workers in Canada and 35.8% in the US. However, less than 1% of these firms are high growth, defined as having a 20% annual increase in employees or sales over a three year period. Plus, the vast majority of SMEs just do not have significant growth ambitions.

It appears to be a myth that SMEs are the engine of job growth. However, they do provide a very stabilizing influence on our economy. This would indicate that development of accounting and assurance standards affecting these entities’ financial reporting should focus on financial position and less on earnings measurement, with perhaps an added focus on applicability of the going concern assumption. It is encouraging to see that Canada’s Accounting Standards for Private Enterprises were initially developed with this goal in mind.

Time to start talking about our elephants

The rate of change in the complexity of our economy brings into question a number of assumptions that have been fundamental to the profession for ages. If we are to remain relevant in today’s world, it is time we started to talk about the elephants in our room.

Technical editor: Greg Shields, CPA, CA, director of auditing and assurance standards, CPA Canada.

About the Author

Phil Cowperthwaite


Phil Cowperthwaite, FCPA, FCA, is a partner of Cowperthwaite Mehta and a member of the IFAC’s Small and Medium Practices committee.

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