Over the last several years, a substantial number of highly complex professional auditing and accounting standards have been issued by numerous standard-setters.
Taken together, these new standards have profoundly affected almost every aspect of performing and documenting an audit. Newly issued audit standards have dramatically increased the auditor's responsibilities with respect to important matters such as detection of material fraud, and understanding of the design and operation of a client's internal controls, including general and application-specific controls that clients maintain over their use of information technology.
This standard-setting trend was not limited to auditing standards. The number of accounting standards and their complexity have also increased exponentially. As those standards have been converging with international standards, they have been transitioning to a more principles-based approach that translates into increased exercise of judgment by both management and the auditor, along with less specific guidance on how to form those judgments.
The trend of increasing the use of fair value for both recurring and nonrecurring measurements has necessitated the acquisition of specialized knowledge on the part of the auditor with respect to the valuation of a wide array of assets and liabilities residing both on and off their clients' balance sheets. What is especially problematic for auditors is that some of the fair value measurements can only be made by using complex, predictive, probability-weighted cash-flow models that are highly subjective in nature.
Increased complexity and subjectivity are not the only problems facing auditors, however. The auditor sometimes faces conflicting guidance in the professional literature that can seem irresolvable. For example, due to current economic conditions, the management of many companies will need to evaluate whether long-lived assets are impaired. The evaluation process prescribed by FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, requires management to estimate future cash flows, over the assets' remaining useful lives, from both using those assets and eventually disposing of them. When those assets have especially long lives, as is the case with real estate, these cash-flow estimates could cover periods extending over 25 or more years, depending on the age of the property. While management is charged with making these estimates, the auditor is responsible for auditing them.
Auditors who are knowledgeable about forecasts and projections are left scratching their heads when they consult the American Institute of CPAs' Audit and Accounting Guide, Prospective Financial Information, which rightly points out that, "It may be difficult to establish that a reasonably objective basis exists for a financial forecast extending beyond three to five years."
IMPLICATIONS FOR FIRMS
Relief from the foregoing conditions does not appear to be imminent, given the turbulence and economic volatility in the current environment. Consequently, in the short term, CPA firm leadership should be asking the following questions as part of monitoring the effectiveness of the quality control system over their attest practice:
1. Does the firm continually devote sufficient time and resources to ensure that auditors are maintaining and enhancing their skills and that, collectively, their audit staff possesses skills aligned with the needs of the firm's client base?
2. Does the firm have sufficiently rigorous client acceptance and continuance policies, and the internal discipline to enforce them, so that the firm is not exposed to legal, regulatory, financial and reputational risk from accepting engagements for which it does not possess the necessary skills and experience?
3. Has the firm implemented a strategy for the timely distribution of newly issued authoritative literature, and proactive communication with clients regarding the effects of that literature on their businesses?
4. Does the firm regularly consult with its clients regarding new and proposed technical developments and the resultant implications to the client in such areas as accounting, information systems, internal control, legal and contractual compliance, risk management, and human capital?
5. Does the firm have access to skilled specialists in the disciplines needed to complete its engagements competently? Examples vary depending on the nature of the practice and the industries it serves, and include expertise in fraud detection, interviewing skills, business and asset valuation, information technology, and internal controls. For smaller firms, access to these skill sets may involve a combination of strategies, including leveraging referrals from network affiliations, or forming joint ventures and strategic alliances with others.
6. Has the firm devised and implemented a systematic, multi-year plan to ensure that it is constantly upgrading the abilities of its audit staff to become more skilled in the emerging areas needed to serve its clients?
FIXING THE PROCESS
Clearly, it is an inherent requirement of any professional to maintain and constantly improve their knowledge and skills. In the longer term, however, our standards-setters must change their mindsets and operating methods to ensure that their standards have a better chance to be skillfully implemented with enough lead-time for all concerned.
To that end, Judy O'Dell, chair of the Private Company Financial Reporting Committee, in a letter dated Feb. 1, 2008, to Robert Herz, the chair of the Financial Accounting Standards Board, submitted the committee's recommendations that FASB consider the merits of:
1. Limiting the issuance of standards to one or two pre-determined dates during the year;
2. Granting automatic effective-date extensions to private companies for every standard issued;
3. Maintaining "blackout periods" during the year during which no new standards or exposure drafts are issued and no standards become newly effective; and,
4. Setting effective-date lead times that take into account the needs of private companies, and establishing a standard minimum lead-time for effective dates of new standards, such as eighteen months.
These recommendations are equally applicable to the work of the Auditing Standards Board and the Public Company Accounting Oversight Board, and those boards should also give them due consideration.
In addition, FASB needs to consider the broader context of its responsibilities to effective capital markets by understanding that if a new accounting standard presents inherent auditing difficulties, it undermines confidence in financial reporting; thus, it is in FASB's best interest to make auditability an important consideration in its deliberative process.
There is a clear need for a coordinated effort to ensure that new standards be both operational and auditable, and provide proper lead-time for all parties involved.
Ralph Nach, CPA, is a senior consultant for AuditWatch, a Thomson Reuters business. He has co-authored several accounting reference books and teaches continuing education courses nationally.
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