Category: Legislative & Regulatory

Alphabet Soup: A Director’s Guide to Financial Literacy and the ABCs of Accounting and Auditing

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On June 13, 1958, my last day as a second-grader at Chesterbrook Elementary School in McLean, Va., I rushed home, got a book of matches, went outside, and ceremoniously burned my Jolly Numbers book.

Yes, I hated math. (Making 8s look like snowmen didn’t fool me; this was work!) Today, for myriad reasons I have grown to love math. But I can’t say that I love accounting and auditing (A&A). Now, I’m not angry enough at A&A to burn ledgers, but I do have a complaint: A&A today involves not only jolly numbers—but ever-changing ones, along with ever-multiplying acronyms. This can make serving on not only the audit committee, but also the board of directors, extremely challenging.

As we all know, all audit committee members serving on the boards of companies listed on the New York Stock Exchange (NYSE) or NASDAQ must be (or become) financially literate. The NYSE leaves the definition of literacy up to the board. NASDAQ, however, has defined this as the ability to read and understand fundamental financial statements. At NACD, we believe that all directors should be financially literate—and, consistent with NASDAQ, define this as the ability to read and interpret financial statements.

To effectively interpret financial statements, it is obviously helpful to know the standards that apply to them. This means not only understanding the financial numbers, but also some idea of how to account for and audit those numbers.  Given the complexity of auditing and accounting standards today, this is not easy—not even for the “audit committee financial expert” that Sarbanes-Oxley rules first required for all audit committees almost a decade ago.

Yet A&A literacy is achievable—just ask! That’s what I’ve been doing for the past few decades while working with accountants and auditors on a number of projects—most recently a collaboration of the Center for Audit Quality (CAQ), the Financial Executives International, and The Institute for Internal Auditors with the NACD to find innovative ways to combat financial reporting fraud. As a group, I find these A&As typical of the profession: full of diligence and integrity—and governed by a growing number of standards.

Complex Challenges, Simple Solutions

Over time, I’ve identified at least seven complex challenges that thwart understanding of A&A:

  1. Similar or identical A&A acronyms.
  2. Overlap between A&A professions, and shared use of the word “auditor” for both internal controls and external reviews.
  3. Shared turf between A&A standard setters.
  4. Periodic changes of the names/numbers of A&A standards.
  5. Growth in the number of mandatory A&A standards and standard-setters.
  6. Growth in the number of voluntary A&A standards and standard setters.
  7. Global convergence of A&A standards.

This blog will define these challenges and propose simple tips that all directors can use. At the end of this article, there is a list of the 20 most crucial acronyms for A&A standards and standard setters. As a director, you will want to learn these terms. But before you do, consider my advice on how to keep it simple.

Complex Challenge 1: Similar or identical A&A acronyms.  At a board meeting, hearing about A&A standards, just to start with the beginning of the alphabet, you may hear the letters AS, ASB, ASU, AT, AU, followed by numbers. Do you really know which are accounting standards, and which are audit standards, and what they mean? (See the handy glossary below.) Getting to the letter I in the alphabet of A&A, the soup thickens. Recently, I learned that there was an IAASB as well as two different IASBs. I had the same second-grade impulse to strike a match! I calmed down when I learned that whereas the IASB is the International Accounting Standards Board, the other IASB is the Internal Auditing Standards Board, and the IAASB is the International Auditing and Assurance Standards Board. Might some nonexperts serving on audit committees drown in the alphabet soup?

Simple Tip 1: Call things by name. When you are in a board or committee meeting, whether you are a director or an advisor, don’t just use an acronym and number—and don’t let anyone get away with one. Use or insist upon the name of the standard. For example, instead of Topic 820 (or worse yet FAS 157, in the pre’99 parlance), call it “fair value accounting.”

 

 

Complex Challenge 2: Overlap between “accounting” and “auditing” professions—and use of the term “auditor” for both external and internal auditors. Auditing and accounting are different yet intertwined. It’s notable that the main U.S. standard setter for audit standards does not have audit in its name. It is called the Public Company Accounting Standards Board—even though it sets standards for auditing, not accounting! Similarly the IAASB (for “Audit” standards) is run by the International Federation of Accountants.

To make matters more complicated, the word “auditor” by itself means someone who works for an audit firm. However, the term “internal auditor” means someone who works for a company that gets audited by such a firm. The work of these two types of auditors is entirely different. The external auditor, as mentioned earlier, reviews the work of accountants. The internal auditor is responsible for what are called internal controls—the system of checks and balances that ensures an environment conducive to proper accounting and reduces the chance of error or fraud. Standards for each of these groups—accountants, auditors, and internal auditors, are set by three different authorities.

Simple Tip 2: Keep the As straight.  Think of it this way. Accountants apply accounting standards to create financial statements, internal auditors set internal controls, and auditors audit the results. All three are necessary for good financial reporting and each needs separate professional standards.

 

Complex Challenge 3: Shared turf between accounting- and audit-standard setters. Because auditors essentially check the work of accountants, and both accountants and auditors must be CPAs, it is not surprising that there is some overlap between the turf of standard setters. An example of this would be the overlap between the American Institute of Certified Public Accountants (AICPA) and the Public Company Accounting Standards Board (PCAOB).  The AICPA sets standards for private company auditors, and the PCAOB sets standards for public company auditors. However, unlike the AICPA, which has been in existence since 1897, the PCAOB is relatively young (10 years old) and has set only 15 Audit Standards so far (this is not counting other types of documents produced by the PCAOB such as concept releases). Where the PCAOB has not set an audit standard, called an AS, and where the AICPA has not set a statement of audit standard, called an SAS, companies are expected to follow by default the applicable audit standard set by the AICPA, called an AU.

Simple Tip 3: Give it to the committee “expert.” This is a particularly complex area. To maintain simplicity, the designated audit committee financial expert can shoulder this burden, assisted perhaps by an occasional educational session for the full board. Directors can take comfort in knowing that public company auditors are overseen by an independent board—the PCAOB. The AICPA has overseen private company auditors for more than 100 years.

 

Complex Challenge 4: Periodic changes of the names and content of accounting and audit standardsBy now all audit committee members know about the FASB Codification project that renamed the GAAP standards definitively in July 2009. A few years back, I was writing a long treatise on U.S. accounting standards under the Financial Accounting Standards Board (FASB), such as the famous FAS 157 and its sequel 157R on fair value accounting. But along came a change that renamed and renumbered all of the standards.  FAS 157 is now Topic 820. The global landscape has also shifted nomenclature. From 2004 to 2009, the Clarity Project of the International Accounting Standards Board improved International Standards for Accounting (ISAs), which are now referred to as International Financial Reporting Standards (IFRS).

Simple Tip 4: Learn the code! As mentioned earlier, it’s a good idea to use descriptive words rather than numbers when referring to a standard. In addition, if you are going to learn any numbers, the FASB Codification scheme is worth learning. Being only a few years old, and very well organized, it’s not likely to change in our generation.

 

Complex Challenge 5: Growth in the number of mandatory A&A standard-setters and standards. Currently, there are at least eight separate entities that are responsible for accounting and/or audit standards, more than 1,000 accounting standards, and dozens of audit standards—domestic and international. Thanks to monumental efforts by standard setters and the professionals helping them, the standards are logically ordered and clearly labeled. The main problem is the sheer amount. No single human brain can possibly know them all. Certainly an experienced accountant and/or auditor can help familiarize the board and the audit committee with the most important standard setters and standards.

Simple Tip 5: Make a list.  Make your own list of the important acronyms.  For a one-page guide to the 10 main standard setters and the 10 main acronyms they use, see the lists at the end of this blog.

 

Complex Challenge 6: Growth in the number of groups setting voluntary standards to supplement the mandatory standards. I was recently given an excellent guide to A&A organizations and their acronyms from a colleague in the standard-setting profession. In addition to the eight standard setters listed below in this blog, the list had 10 more, including the above-mentioned organizations (CAQ, FEI, IIA) and the longstanding Committee of Sponsoring Organizations of the Treadway Commission (COSO), which has suggested voluntary standards for internal controls for a quarter century.

Simple Tip 6: Prioritize your attention. As valuable as suggested practices are, mandatory standards come first. So, for example, a PCAOB standard on risk oversight would have more weight than a COSO standard, no matter how valuable the latter may be.

 

Complex Challenge 7: Convergence of accounting and audit standards globally. For years we have been hearing that accounting standards are converging into a global standard. The FASB and the IASB are currently holding meetings, slowly but surely creating joint standards. So far, the IASB has either completed or is working on more than 30 International Financial Reporting Standards (IFRS). That’s only about 3 percent of the way through the 1,000 we have in the United States.—and some may remain forever American—but it’s a trend worth watching.

Simple Tip 7: Request a “short list” of global A&A standards. It is beyond the call of duty for directors to master convergence by themselves. Here is a good area for professional assistance. Ask your external audit firm to provide a short list of the global accounting and audit standards that impact your operations most critically—along with notes about what they mean for the company. Given the slow progress of convergence, this is not an impossible task—and can broaden your A&A horizons.    

Conclusion

Don’t get me wrong. I have profound respect for the accounting profession and the various professionals who hold the title of certified public accountant (CPA). They rival corporate directors as a group endowed with a keen sense of integrity and service on behalf of the enterprises they serve.  Personally, however, I wouldn’t want to do their work. They deserve every penny they make, precisely because of all the names and numbers they must learn and remember to do their jobs.

In closing, here are the acronyms I have collected as must-knows for all of us. Good luck, and please keep all matches away from me!

20 MUST-KNOW ACRONYMS FOR A&A STANDARD SETTERS AND STANDARDS

These lists only include mandatory or unique standards and the bodies that set them. It does not include the many organizations that support this fundamental work through additional voluntary standards.  (See No. 7)

Acronyms for Standard-Setters

AICPA – American Institute of Certified Public Accountants – standard-setter for accounting and auditing of private companies.

ASB – Audit Standards Board of the AICPA – standard setter for private company audits. This board oversees the AU standards of the AICPA.  The AU standards are numbered from 110 to 901. They are interim standards unless they are superseded by an SAS. There are 121 of the SAS standards (SAS 1-SAS 121).

FASB—Financial Accounting Standards Board—standard-setter for U.S. accounting rules. The FASB, along with its predecessor the Accounting Principles Board, has set standards in Topic Areas, as well Exposure Drafts to test ideas. Topics, which are authoritative, cover nine areas numbered 105 (General Principles) through 995 (Industry Standards). Each Topic has drop downs with one to 10 further topics, each of which in turn has several more topics. All in all, counting all three levels of topics, there are some 1,000 topics. 

IASB—International Accounting Standards Board—This group has either completed or is currently working on more than 30 standards, called IFRSs.  See also the IASB below

IAASB—The International Auditing and Assurance Standards Board—part of IFAC. The IAASB has issued 36 standards for auditing and assurance numbered 200 through 810.

IASB—Internal Auditing Standards Board—This group sets standards for internal auditing internationally. It is part of The IIA.

IFAC—International Federation of Accountants—standard setter for international standards of audit and assurance (via IAASB). See IAASB.

IFRS Foundation—With the IASB, sets international accounting standards. See IASB.

The IIA—The Institute of Internal Auditors—sets global standards for internal auditing. The long name of these are International Standards for the Professional Practice of Internal Auditing, globally nicknamed IPPF. These Standards are numbered 1000 through 2600. Standards vary in length and complexity, but some are many pages long, containing numerous subtopics.

PCAOB—Public Company Accounting Oversight Board—setter of U.S. auditing rules. The PCAOB has set 15 Audit Standards (AS1-AS15). It also has posted 18 professional standards, called Rule 3100 through Rule 3700. It also has posted the AICPA’s AUs (see AICPA). The PCAOB also publishes Concept Releases to text ideas before they become proposed standards.

Acronyms for Standards

AS—Audit Standards—standards set by the PCAOB

ASU-—Accounting Standard Update—Updates to accompany the Topics in FASB. (Ever since Sept.15, 2009, Topics replaced SFASs name and numbers.)

AT—Interim Attestation Standard—adopted by the PCAOB as an interim standard for an aspect of auditing; based on AICPA audit attestation standards.

AU—Interim Audit Standards of the PCAOB and shared by the AICPA. (The “A” and “U” do not stand for words.) Each AU is authoritative unless and until it is superseded by an SAS.  Each AU is consistent with and draws from one or more SASs.

GAAP—Generally Accepted Accounting Principles—standards set by FASB.

GAAS—Generally Accepted Auditing Standards—standards set by the ASB of the AICPA.

IFRS—International Financial Reporting Standards—set by the IASB and IFRS Foundation; supersede IAS standards.

ISA—International Standards on Auditing—from IAASB.

SAS—Statement on Auditing Standard—an authoritative standards from AICPA.

Topics—the new name given to accounting standards under FASB’s Codification.

The following acronyms are superseded (or waning) but still being referenced by those who have not learned the new nomenclature.

FAS—Financial Accounting Standard—old name for standards issued by the FASB—also called SFAS (for Statement of Financial Accounting Standard).

IAS—International Accounting Standards—currently being superseded by IFRS.

 

PCAOB’s Proposed Mandatory Audit Firm Rotation Misses the Point

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Last year, when the Public Company Accounting Oversight Board began soliciting comments on ways that auditor independence, objectivity and professional skepticism could be enhanced through mandatory audit firm rotation, NACD felt obligated to share our perspective. While NACD agrees with the PCAOB’s initiative to improve company audits, instituting a term-limit system may be the wrong approach. View NACD’s comment letter at www.NACDonline.org/CommentLetter2011.

As the only organization serving as the voice of the director, NACD is aware of the burdens that mandatory audit firm rotation places on boards and businesses alike. The turnover of audit firms could undermine the board’s duty to evaluate the firm’s work as required under the Sarbanes-Oxley Act of 2002.

Auditor rotation may accomplish the PCAOB’s intended goals but it has not yet shown this process to be cost effective nor has it shown that it would enhance financial reporting. On behalf of NACD’s nearly 12,000 members, we’ve submitted a comment letter to the PCAOB on this issue, outlining our five major issues with the proposal as drafted.

1. The board and audit committee are uniquely qualified to evaluate the work of an audit firm.

The board of directors, and more specifically the audit committee, is best positioned to judge the effectiveness of an auditor. An audit committee will possess the necessary objectivity to make this judgment. Furthermore, the committee will understand the most important aspects of a company’s strategy, financial reporting and internal controls. As such, along with the board, the audit committee is uniquely qualified to evaluate the work of an auditor and, if appropriate, to renew the auditor’s contract of engagement. Limiting the tenure of an auditor through mandatory firm rotation would infringe upon the committee.

2. The board and audit committee have a statutory responsibility for the oversight of auditors. Mandatory audit firm rotation supplants this authority.

Reducing the board’s options to keep an existing auditor runs counter to the spirit of existing law. Audit committees are directed to appoint, compensate and oversee the external auditor. These requirements came from the implementation of SOX. The act established qualifications for audit committee members and delegated specific responsibilities to protect the shareholders’ interest in accurate financial reporting.

Mandatory audit firm rotation would supplant the statutory responsibility and authority of audit committees to select the best auditor for a company and oversee its work. The authority of the board and its committees is at the heart of the corporate governance framework, and reducing that authority would result in weakened oversight and guidance directors provide for U.S. companies.

NACD believes change should occur based on the performance of the auditors—not an arbitrary timeline. Boards of directors should constantly assess the value an outside auditor is bringing to the company. When performance is lacking, a board of directors must step in and make a change. This type of assessment takes time and effort, but boards and audit committees are dedicated to the task.

3. Audit firm rotation is unnecessary for objectivity, since there is already a requirement for mandatory audit partner rotation —as well as rules for auditor independence.

Under current rules implemented under SOX, there is a requirement to rotate the lead partner in audits every five years, with a cooling off period of another five years. Having a new audit partner in charge ensures objectivity. In addition, the audit profession has spent years defining ever more stringent rules to define auditor independence. It would be difficult in this day and age to find a single auditor or audit firm with conflicts of interest in relation to the audited client. This regulatory framework already ensures the objectivity desired by proposed firm rotation, rendering firm rotation unnecessary. 

4. Developing an understanding of the company may take auditors years to develop and to deliver the maximum benefits.

On a practical level, mandatory rotation may also reduce the quality of an audit. It is common knowledge that quality audits are dependent upon the auditors’ understanding of the company. As an audit firm’s institutional knowledge of a company grows, so does its ability to identify critical issues. This understanding often takes years to develop.

5. Mandatory audit firm rotation is disruptive and costly, particularly in special situations.

Mandatory rotation forces a change that may not only be undesirable, but is disruptive and time-consuming. This is particularly true in times of corporate change. For example, a need to change auditors during M&A transactions, corporate financing or a change in management could prove daunting. A confluence of events such as this would greatly expand the cost and difficulty of the transaction or transition and potentially hamper an effective audit of the company. The time and resources required for management and audit committees to manage all of these transitions would be significant. Moreover, the additional work required for a new firm to get up to speed would add cost and possibly delay to the audit.

Call to action:  Please join me contacting the PCAOB to let your voice be known.

 

NACD Submits Comment Letter to the PCAOB

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Yesterday, NACD submitted a comment letter to the PCAOB regarding its new concept release on audit firm rotation. In an effort to promote professional objectivity and skepticism, the PCAOB believes that more frequent turnover of audit firms may help promote these goals. Proponents of such a proposal argue that changing audit firms would “free the auditor, to a significant degree, from the effects of management pressure and offer an opportunity for a fresh look at the company’s financial reporting.” While the overall intent of increased auditor independence and high quality audits is laudable, NACD believes that this approach is not practical and may have strong negative consequences.

NACD believes that auditor independence, reinforced through the rigorous application of professional objectivity and skepticism, provides the foundation for a quality audit. Further, NACD believes that the audit committee has, and should retain, responsibility for overseeing the work of auditors in an effort to ensure that they perform at a high level of quality. While auditor rotation can be beneficial at times and should periodically be considered by the audit committee, we do not support making this rotation mandatory. 

Our primary concern is that the PCAOB seems to be implying that audit committees, acting on behalf of all shareholders, are not able to determine the best auditor for their companies on an ongoing basis. To that end, the PCAOB seems willing to interfere with private contracts between audit committees and auditors. This interference may constrain the ability of audit committees to select the audit firms that are best able to meet the particular accounting and auditing challenges presented—including an incumbent firm.  

Additionally, mandatory audit firm rotation may engender significant disruption and prohibitive cost for companies without offering substantial benefits. For example, the impact of mandatory firm rotation may be particularly severe if it occurs at a time when a company is going through a significant event such as a corporate financing, merger or acquisition, or change in management. Changing auditors at such a time would greatly expand the cost of the transaction or transition, and potentially affect the ability of the company to execute a transaction.

As an alternative to mandatory rotation, audit committees could employ some of the following practices to improve audit quality:

  • Evaluating the audit plan in a more diligent fashion, taking a close look at the auditor’s risk assessment and the procedures planned to address those risks, as well as milestones for completion.
  • Using the annual evaluation of the audit firm to gauge the firm’s understanding of the business and its helpfulness in the early identification of important issues.
  • Analyzing and discussing the results of the annual evaluation and being responsible for providing feedback to the audit firm.
  • Taking the lead role in interviewing and selecting the lead engagement partner.
  • Monitoring the auditor’s performance by inspecting the firm’s quality and competency.

While NACD supports the PCAOB’s efforts to enhance audit quality, we do not believe that mandatory auditor rotation is the way to do so. We look forward to working with the PCAOB in the future to develop ways of improving the professional objectivity and skepticism of auditors.