Business advisors: That is what auditors wanted to be before Enron and the collapse of Arthur Andersen. Auditors were routinely advising their clients on new business ventures and transactions on a real-time basis, including advice on the accounting for such transactions.The scenario would go something along the lines of the following: A registrant planning on closing on a transaction in the near term would want to make sure there weren't going to be any unintended accounting consequences. This allowed auditors to better understand the registrant's business, transactions and results, while allowing the registrant to avoid any last-minute adjustments or earnings restatements. It appeared to be the trend of the future - real-time auditing.
That is not the way things turned out, as we all know.
The public outcry over the audit failures of the Enron case in particular resulted in Congress passing the Sarbanes-Oxley Act. The biggest impact of Sarbanes-Oxley has been on the relationship between registrants and their auditors.
Some auditors are taking a conservative approach, that any uncertainty by registrants with respect to accounting treatment over transactions, and the corresponding need to discuss these transactions with the auditors, is proof of a material weakness of the internal controls over financial reporting, and could result in a qualified opinion related to the effectiveness of management's controls.
In addition, there is a question within the auditing community as to whether advising registrants with respect to accounting conclusions impairs independence on the audit of the registrants' annual reports. Some auditors have taken the position that continuous dialogue with registrants on accounting issues runs counter to the Securities and Exchange Commission's position that an accounting firm cannot be deemed independent with regard to auditing financial statements of a client if it has participated closely in maintenance of basic accounting records and preparation of financial statements, or if the firm performs other accounting services through which it participates with management in operational decisions.
This is the question that is confounding auditors: Does ongoing dialogue between registrants and auditors over the proper accounting treatment of transactions, or events on a real-time basis, create an impairment of independence or prove the existence of a material weakness over internal controls ... or both?
Lost connection
Because business failures seem to have somehow become synonymous with audit failures, some of today's auditors have begun taking ultraconservative attitudes with regard to the application of accounting and auditing standards. The rationale is that the conservative approach will help shield firms from second-guessing of their audit approach and conclusions in the case of a business failure and, eventually, lawsuits.
Part of that conservative attitude that is being employed may have resulted in some unintended consequences, such as the loss of an informal dialogue on accounting issues that previously existed. That informal dialogue between registrants and auditors was often integral to the identification of accounting and audit issues, and for assisting in the auditors' overall understanding of the registrants' business.
It is still too early to analyze the rate of audit failures pre-Sarbanes-Oxley versus post-Sarbanes-Oxley over an extended period, but it's not hard to imagine the audit breakdowns that could result from an inadequate understanding of business transactions and events. Communication is the key to a healthy audit relationship.
One of the main goals of Sarbanes-Oxley was to force registrants to identify and document formal and informal control processes. Auditors are expected to test the effectiveness of those controls and, in the process, increase their awareness of how that company operates. Without an open dialogue, do we not, in effect, defeat the purpose of Sarbanes-Oxley?
Open communication
There clearly is a lack of understanding regarding the application and intent of SOX over registrant and independent auditor communication. The SEC was compelled to address the issue last year in its May 16, 2005, Statement on Management's Report on Internal Controls over Financial Reporting. In short, the SEC said, "The auditor's discussing and exchanging views with management does not in itself violate the independence principles, nor does it fall into one of the nine prohibited categories of service ... . The SEC staff supports a strong audit profession where a hallmark of its professionalism is to exercise sound judgment in both the audit and in ongoing dialogue with management."
The American Institute of CPAs Code of Professional Conduct also addresses the issue of providing advisory-related service to audit clients. It says independence would not be considered to be impaired if a member attends board meetings; interprets financial statements, forecasts and other analyses; or counsels on potential expansion plans or on banking relationships, so long as the member's role is advisory in nature.
Although this scenario discussed by the AICPA is not directly related to the questions of discussions between registrants and auditors regarding technical accounting matters, it does reiterate the point that as long as auditors are not making decisions that put them in the position of management, independence is not impaired.
Corporate executives need to make a connection
As the SEC staff and AICPA make clear, real-time communication in relation to accounting treatment for transactions is not prohibited. There are, however, several ways a corporate registrant can alleviate the concerns of the company's independent auditors if they still feel that that they could become too close to the decision-making process:
* Retain a strong chief accounting officer. The key to managing the audit relationship from a corporate perspective is the presence of a strong chief accounting officer. This person needs to have a significant technical accounting background and an understanding of SEC rules and regulations. They also must be willing to take the ultimate responsibility for making accounting decisions. Prior to discussing any issues with auditors, a strong chief accounting officer should be prepared to research the issues and develop well-formed conclusions.
* Discuss issues with a third-party consultant. Obtaining a perspective from a third-party (nonattest) technical accounting expert can be advantageous. The expert assessment can help identify issues that were not previously recognized or corroborate the initial thought process. This is important, because when the time comes to present an analysis to the independent auditors, it will appear that the transactions or issues have been thoroughly researched and thought-out, and potential outcomes have been investigated.
* Incorporate key controls. If the chief accounting officer was held responsible for the researching and conclusions of complex accounting transactions, it would be a key control over the financial reporting process. These transactions would be thoroughly analyzed prior to review or examination by the independent auditor. In addition, this analysis should be provided to the auditors on at least a quarterly basis as part of the SAS 71 quarterly review procedures.
* Frequent dialogue with auditors. Frequent discussions with the independent auditors with regard to complex accounting issues and transactions is still important. Although the registrant should take responsibility for analysis and conclusions, frequent dialogue will help engage the auditors in the understanding of the business and transactions and help avoid year-end audit adjustments or quarterly restatements. In addition, with the registrant taking the lead on researching and concluding on complex issues, the auditors will feel that they are not impairing their independence by making accounting decisions, but simply concluding on the company's own analysis.
Communication is the basis for all good working relationships. The auditor and registrant relationship is no different. It's that basic.
Joseph E. Spinella Jr., CPA, is a manager in the Washington, D.C., office of FTI Ten Eyck, a provider of investigative accounting and consulting services to counsel, audit committees and corporate financial officers. Reach him at jay.spinella@fticonsulting.com. Reprinted with permission from the Pennsylvania CPA Journal.
