by Glenn Cheney

New York - Financial reporting is suffering an abysmal credibility gap, and the problem is serious, systemic and global, according to the author of a report just issued by the International Federation of Accountants.

“We have confirmed that this is serious,” said John Crow, chair of IFAC’s task force on rebuilding confidence in financial reporting, and a former governor of the Bank of Canada. “We looked into each other’s eyes, thought about our experiences around the world, and decided that the U.S. isn’t unique even though the size of its cases dwarfs everyone else’s. We also decided that the problem of credibility, which is a problem with perception, is serious.”

Crow said that lack of confidence in financial information is leading to market volatility and an increase in the cost of capital. Unfortunately, he said, the overall increase cannot be measured because of myriad complicating and counterbalancing factors.

Low interest rates offset the heightened cost of capital by supporting market growth. The true cost of the credibility gap is therefore unknowable.

In individual cases, however, where distorted reports result in restatements - Crow calls them “uncontrolled experiments” - the market quickly demonstrates the cost of inaccurate financial statements.

The report, “Rebuilding Public Confidence in Financial Reporting: An International Perspective,” was researched and compiled by a multinational group of seven authors, including Olivia Kirtley, former chair of the American Institute of CPAs; Guylaine Saucier, former chair of the Canadian Institute of Chartered Accountants; Kosuke Nakahira, former controller of the Tokyo Stock Exchange; Christian Aubin, former French inspector general of finance; Graham Ward, a senior partner at PricewaterhouseCoopers; and Ian Ramsay, dean of the University of Melbourne Law School.

Crow said that it’s important to read the whole report, not just part, because the causes of the problem are interlinked through the entire “information supply chain” that stretches from company management to the potential investor or other final user of the information. Along this chain are CPA firms, lawyers, bankers, financial analysts, credit rating agencies, regulators, standard-setters, internal auditors, boards of directors and the media.

All of these participants operate under continuous pressure, the report said. Management wants to report profit and performance that meets expectations. Standards-setters face “political pressures” from industry and government. Auditors and rating agencies face the pressure of producing opinions on the companies that hire them.

The report suggests that some of the pressure can be relieved if audit committees hold tighter reins on auditors.

“The audit committee has to be much more conscious of its responsibilities vis-a-vis the auditor,” Crow said. “The audit committee shouldn’t leave the company’s relationship with the auditor so much to management. The audit committee has to take it over, [and] remember that the auditor reports to the shareholders, and management is there to help them, not to run the show. That change is taking place, but not everyone has gotten the message.”

The report found several weak points where these forms of pressure can cause a failure in the flow of information. Remuneration and share options, for example, are incentives for management to distort information. Internal controls are often poorly designed and implemented. Auditors are expected to produce objective opinions on the companies that select and pay them. Boards of directors and chief executive officers may not set the right “tone at the top.”

The report concludes that these and other points of weakness need to be reinforced. Ethics codes must be established in all sectors of the chain of financial information. Corporate management must emphasize financial management and controls. Boards of directors must improve their oversight of management and the audit function. Auditors must be more transparent about possible conflicts of interest. Audit standards, regulations and accounting practices must be strengthened.

And a little legislation wouldn’t hurt.

“You can’t legislate morality, but you can make it clear to people how they are supposed to behave,” Crow said. “We shouldn’t have to go through the situation where someone is saying, ‘Oh, I didn’t understand. I didn’t know’...the Enron kind of situation.”

The overall problem gets worse, the report said, as it goes global. The regulations of national jurisdictions are primarily concerned with national issues, so there are international inconsistencies and, inevitably, conflicts. The report falls short of offering a solution beyond noting a few best practices.

“We didn’t get much further than pointing out the conflicts,” he said. “This is not something you’d want to turn over to the United Nations. It would go in and never come out.”

Crow believes that any resolution of these conflicts would come about in discussions of financial reports based on principles rather than rules - a concept widely accepted outside the United States. He recognizes, however, the difficulty of drawing a line that distinguishes between principles and rules. He sees reliance on rules failing as people work around the rules. But principles, he said, fail too, if auditors lack integrity or are not supported by the preparers of financial information.

Janet Seefried, chair of the ethics committee of the Institute of Management Accountants and president of Seefried and Associates, a corporate governance consultancy, agreed with the report’s conclusion that principles are more adept at producing the truth, but she sees problems with the abandoning of rules.

“This report has a lot of teeth to it, and the concept of moving toward principles is admirable, but I think that in practice there needs to be a blend between principles and rules,” she said.

Seefried emphasized the importance of financial reports “telling the true story,” a responsibility that falls on all the people in the information supply line. This, she said, calls for not only integrity but reports expressed in “plain English” that all users of financial information can understand. Her IMA committee will be reviewing and commenting on the IFAC report.

Olivia Kirtley, a board member and audit committee chairperson for three public companies, reiterated that the report is international in scope, and that many of the identified problems and consequent recommendations do not generally apply in the United States. She herself considered the call for greater auditor independence to apply more overseas than in the United States.

As former AICPA chair and current chair of its Board of Examiners, Kirtley saw poignant significance in the message that the “tone at the top” applies not only to companies but to audit firms.

“CPA firms need to constantly reassess the process by which they accept and retain clients and do ongoing reviews on the retention process to make sure that the controls and the management at client companies are the ones they want to be associated with,” Kirtley said.

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