Recently members of the U.S.-based Financial Accounting Standards Board (FASB) and the U.K.’s International Accounting Standards Board (IASB) huddled in FASB’s Connecticut office, laying out the game plan for an ambitious goal: harmonizing U.S. and European accounting standards by 2005. (That year also happens to be the deadline for all publicly traded companies in the European Union to adopt international accounting standards, or IAS.) Simultaneously, FASB is moving forward with a project whose goals include “improving the quality of information displayed in financial statements so that investors, creditors, and others can better evaluate an enterprise’s financial performance.”
What’s going on? Is the accounting profession finally making headway in introducing some much-needed changes or will it be business as usual? These questions will figure prominently at an October 18 conference at Wharton titled, “New American Rules for Business? Post-Scandal Directions for Policy and Governance.” The conference, which is being co-sponsored by two Wharton research centers – the Reginald H. Jones Center for Management Policy, Strategy, and Organization and the Financial Institutions Center – will provide a forum to discuss critical questions companies now face, given the many issues of policy and governance that recent financial scandals have placed on the table.
In the wake of a flurry of business scandals and failures that have helped drive record losses in the stock market, politicians and regulators have, fairly or otherwise, pointed accusing fingers at accountants. Their claim is that the guardians of financial statements were complacent or worse when it came to massive corporate fraud at companies like Enron and Worldcom. Now, the very independence of the profession is being questioned, as demonstrated by legislation passed this summer calling for a new, five-member board to oversee and discipline accountants. The law requires the Securities and Exchange Commission to pick the board members by Oct. 28.
One of the panels at the October 18 conference will explore the role of accounting standards and audit practices and how they may be affected in the post-Enron environment. The panel, titled “What Rules, Who Enforces? Accounting Standards and Auditing Practice,” will feature Wharton accounting professor David Larcker; James J. Leisenring, a member of the board of the International Accounting Standards Board, and liaison board member to the United States; Gunther Gebhardt, a professor in the accounting department at the Johann Wolfgang Goethe – Universität Frankfurt am Main; and Robert G. Eccles, president of Advisory Capital Partners and senior fellow with PricewaterhouseCoopers.
“Given the recent controversies involving the accounting and auditing profession, almost any thoughtful discussion among international accounting experts is likely to produce important new ideas about the future direction of accounting,” says Larcker. One such concern is international accounting standards, which may vary from U.S. Generally Accepted Accounting Principles (GAAP). “American standards are more specific, and rule oriented, while the International Accounting Standards Board (IASB) pronouncements tend to consist of general guidance,” he says. “Although FASB and the London-based IASB have tried to harmonize their standards for years, there is still a debate over just how much integration between the sets of standards is really necessary.”
A paper by Christian Leuz, a professor of accounting at Wharton, investigates this question, and he concludes that IAS and GAAP are comparable in their ability to deliver information. Leuz notes, however, that his study was limited to a sample of firms that trade on Germany’s New Market, where companies must choose between IAS and GAAP for financial reporting purposes. “While confining attention to New Market firms is one of the key advantages (of the study), it is also a limitation,” he cautions. “The sample choice could reduce test power and the results need not extend to other firms and settings. Finally, it should be noted that the paper does not directly address policy questions faced by national standard setters.”
The IASB’s Leisenring acknowledges that there are currently significant differences between international accounting standards and GAAP. He notes that companies are incurring significant costs to first comply with their domestic requirements, and to then reconcile to GAAP in order to access the U.S. market. “But it is investors who pay the greatest price, trying to compare investment alternatives while using financial information that is not comparable,” he says.
Gebhardt points out that when European companies are listed in the U.S., they either apply GAAP or provide reconciliation statements that do not provide much information. “The production of this information comes with a cost,” he says. “There are better uses of the resources consumed in these exercises. In addition, there are costs on the side of the users of financial statements.”
Gebhardt believes that the International Financial Reporting Standards, which will be required in Europe and in other parts of the world beginning in 2005, will provide a greater incentive for U.S.-based international companies to press for convergence between GAAP and international audit standards. “Such a request might also come from U.S. investors that are diversified internationally,” he notes. “Hopefully, the problem of differing U.S. GAAP and IFRS will disappear. The IASB and the FASB are cooperating closely and have designed an agenda of convergence.”
The convergence of U.S. and international accounting standards is only one of many changes expected in the accounting and audit fields. Another, according to Larcker, is the audit model, which is likely to shift away from asking, “did the company satisfy the rules,” to a more holistic assessment of how a company may perform in the future. “The audit will possibly evolve from the current ‘checklist’ orientation to a strategic model that will also identify such value drivers as customer loyalty and innovation,” he says. “An approach like this could result in a more relevant engagement.”
Another topic that has been the focus of much discussion concerns an auditor’s responsibility for the accuracy of certified financial statements – an issue that helped to topple the Big Five firm Arthur Andersen. Eccles points out, though, that, “Audits are not designed to detect management fraud. This can be done but it is a more expensive and time-consuming process.” He adds that audits are not “a kind of ‘Good Housekeeping’ seal of approval on the health of the business. That said, it would be desirable to have audits that cover a broader range of issues that do in fact provide a better picture of the underlying health of the business.” Eccles also notes that greater transparency by companies and a broader audit opinion on the information that is reported will require addressing issues of legal liability for both companies and accounting firms.
In Gebhardt’s view, investors and the SEC should be interested in information on the economics of transactions and events. “Often this means that the SEC needs more information on cash flows and on the fair values and changes in fair values that are the basis for decisions by management and are available for management,” he says. “What is needed is more ‘relevant accounting’ and more coincidence of internal and external accounting, though not on the same level of detail.”
Gebhardt notes that at present it is “comfortable for auditors just to state that the rules have been followed. But the expectations of users of financial statements go further and the audit profession needs to be more responsive to these expectations. Compliance with standards should not be an acceptable excuse for misrepresentations of the economics. The Enron special purpose entities structures are an obvious example. Current U.S. accounting rules for executive compensation or for financial instruments would be other areas where misrepresentations occur.”
Larcker points out that while rules and standards are important, the degree to which they are enforced is equally, if not more, important. “It’s a basic issue of incentives,” he says. “When people have something to hide, they are inclined to manipulate numbers to serve their purpose, regardless of accounting standards. So regulators have to ensure that those standards are enforced, so people have a disincentive (fear of punishment) that will keep them from hiding or manipulating information.”
For example, consider Tyco International, in which top executives allegedly looted some $600 million in cash and stock from the company. One of the questions in the case (in which former chairman and CEO Dennis Kozlowski has been indicted on charges of tax evasion, grand larceny, enterprise corruption; falsifying business records, and securities fraud) is whether or not Tyco’s board was aware of excessive pay packages arranged by Kozlowski. Another issue is the degree of independence of the board itself.
With many examples of alleged corporate abuse fresh in the public’s mind, the experts on the conference panel generally agree that there is need for greater transparency of financial statements and for stepped-up regulatory enforcement. However, Eccles and others note that the increased efforts may come at a price. “Initiatives like the Sarbanes-Oxley Act of 2002, which places limits on the ability of an accounting firm to provide non-audit services to an audit client, limits the choices of clients and, along with an increase in the depth of an audit, could result in increased fees,” he observes. “The demise of Andersen may also contribute to a fee hike. But perhaps the more important issue is the future of the industry. If Congress and the media demonize the profession, it may keep students away from accounting, draining the resources we have for future practitioners.”
Some observers have wondered if the scandals, and Andersen’s elimination, will mean more opportunities for the so-called second-tier firms to snatch up “A” class companies that previously would only consider the then-Big Five. Gebhardt, however, doesn’t see that happening. “We now have only the Big Four that can cover the market for the larger global audit clients, and these will not be adequately served by smaller audit companies that do not have an international network,” he comments. “I doubt that even companies that do not need an international accounting firm will switch, since the reputation of the remaining Big Four is valued in the market place.” Looking ahead, however, he does note that new international networks may be formed to challenge the Big Four’s dominance.
The list of companies and top executives involved in recent scandals reads like a Who’s Who of Corporate America. The magnitude of the alleged abuses, coupled with a weak general economy, appears to have spurred soul-searching among accountants and determination among regulators.
But how deep is this commitment to change? Wharton accounting professor Robert E. Verrecchia has his doubts. “I’m not certain how sincere regulators are, given the fact that these moves to change are coincident with a tumble in stock values,” he says. “If values were high, then would anyone care about issues like expensing employee stock options? I wonder. Instead, they might just tinker around the edges.”