Far too often (like here), I have been compelled to point out that "presented fairly" is much more sizzle than steak. I, myself, am sizzled over the fact that convergence with IFRS seems to be pushing financial reporting further from "fair," and more toward "arbitrary." Witness the ludicrous methodology for loan measurement that the IASB proposes in place of fair value; or the simplistic procedures the Boards have proposed for measuring leased assets and the related obligations; or the lame approach taken to revenue recognition.
Thus, I take a great deal of pleasure in telling you that, for whatever reason, the FASB did consciously pass on adopting "present fairly" when it took responsibility for the GAAP hierarchy from the AICPA. I'll describe how that happened in a moment. But first, you should know that my primary motivation for this post is the PCAOB's plan to consider re-writing the standard audit report. Reportedly, the PCAOB staff is preparing a report on that topic, which it plans to present to the Standards Advisory Group (SAG) in early April. This post is my two cents.
FASB Throws "Present Fairly" Under the Bus
Let's first talk about what the FASB did to "present fairly." SFAS 168 established the FASB's Accounting Standards Codification as the principle source of authoritative GAAP; and essentially compressed the "GAAP hierarchy" into a dichotomy: "authoritative" (to which SEC literature is added for public companies) and everything else — although in rare circumstances, one might apply a "grandfathered" accounting standard not included in the Codification.
In tandem with the Codification going live, the AICPA excised AU Section 411, The Meaning of "Present Fairly in Accordance with Generally Accepted Accounting Principles" from its own codification of auditing standards (which the PCAOB took into its own home, so to speak). So, the situation we now have is this: while the phrase "presented fairly" survives in the standard auditor's report language (see AU Section 508), there is nothing anymore to tell auditors, much less financial statement users, what "presented fairly" is supposed to mean. Weird, but true.
Also quite weird is the Codification's guidance for determining an accounting treatment when, as is very often the case, no authoritative GAAP exists that is directly on point:
"If the guidance for a transaction or event is not specified within a source of authoritative GAAP for that entity, an entity shall first consider accounting principles for similar transactions or events within a source of GAAP for that entity and then consider nonauthoritative guidance from other sources. … The appropriateness of other sources of accounting guidance depends on its relevance to particular circumstances, the specificity of the guidance, the general recognition of the issuer or author as an authority, and the extent of its use in practice." [ASC 105-10-05-2,3 – italics supplied]
In other words, the Codification deals with when it would be appropriate to employ analogy to other guidance (or to use non-authoritative guidance), but not how to do it, merely stating that any accounting treatment is legit so long as it emanates from an "appropriate" source. I smile to myself every time I read that an appropriate source could even include "practice" — that classic safety-in-numbers ploy. If there were a role for the concept of fair presentation in GAAP, it would be in determining the most appropriate guidance. But, if the FASB wants to throw fair presentation under the bus, then the PCAOB should follow suit by taking the term out of the auditor's report.
An Audit Report that Actually Provides Useful Information
The content of an auditor's report is, quite obviously, a function of that which is being reported upon. So, as you continue reading, kindly remember that I am holding everything else except for the auditor's report constant (and also holding my nose). I also want to note before proceeding that Section 302 of Sarbanes-Oxley requires the CEO and CFO to certify that the information contained in the entire SEC filing is fairly presented. Although S-OX 302 may or may not require some rethinking, I'm not proposing here that we need to change that.
With that, here is a stab at "opinion" language that could actually provide useful information to investors:
The financial statements were prepared in accordance with the specifications of the Financial Accounting Standards Board as set forth in its Accounting Standards Codification, [name any grandfathered pronouncements that were applicable], and the applicable rules and regulations of the Securities and Exchange Commission, with the following exceptions: ….[here, auditors should list transactions not specifically provided for in the Codification, and how the accounting treatment elected was determined to be appropriate: i.e., analogy to other guidance in the ASC and/or reference to non-authoritative sources – and perhaps even whether the SEC staff was consulted].
As an investor, this is precisely what I would want the auditors to tell me: "these were the rules followed, and when there were no specific rules to follow, this is what we did, and why we did it." Instead of vacuous platitudes, we can actually provide investors with useful statements regarding the quality of earnings.
Changing the Auditor's Report Changes Their Attitude
In addition, to providing information about the quality of earnings, precisely citing the rules followed in the auditor's report could also induce more effective audits. As an example of how well this could work, let's take the revenue recognition practices of the Apollo Group, which the SEC is now investigating. As I stated in an earlier post, there appears to be no specific rule that allows for revenue recognition before cash realization if the probability of collection from the customer were as high as 30%.
Now, imagine if Apollo's auditors were required to state that they were aware that Apollo determined its accounting for tuition revenues by, say, analogizing to the accounting for warranty costs. To my way of thinking, it's a tenuous analogy, which the auditor might have a lot less tolerance for if they had to explicitly associate themselves with it. It's one thing for an auditor to put a note in a working paper that may never see the light of day and quite another to publish those same words for all to see. Weird, but true.
Throwing "Appears Reasonable" Under the Bus with "Present Fairly"
As they say on the infomercials, "But wait, there's more! For the same price plus shipping and handling, we'll take the bias out of management's estimates!"
If we can finally acknowledge that fair presentation has become a bogus criteria for financial statements, we can re-state the auditor's role in financial reporting more robustly: to provide a high level of assurance that the rules were applied "impartially" or in an unbiased manner.
In other words, no more squishy "fair" should also mean no more squishy "reasonable." For example, auditors can easily test for bias, or lack of impartiality to much greater effect than simply taking a pass on management's estimation of the allowance for bad debts because it "appears reasonable."
Here is some preliminary thinking as to how an auditor could test for impartiality:
Let's say that the auditor identified 'overstatement of current period's earnings' to be a significant audit risk, and that the auditor further identified 21 key estimates such that if they were not made impartially, net income could be materially overstated.
The auditor independently replicates the 21 estimates made by management; and let's assume the auditor finds that for 17 of them, its own estimate was more conservative than management's.
The chances of that happening at random is slightly less than one in 250 (here's a link to the spreadsheet with the calculation); therefore, the auditor would have to conclude that, for whatever reason, the estimates were not made impartially.
As I stated, this is a first stab, but the point is that taking "presented fairly" out of the auditors report and inserting a focus on adherence to the rules, could change the focus of the audit itself to information investors are entitled to expect.
Under the Bus with Rule 203
Finally, there is this annoying and never-used rule in the audit literature, the gist of which states that if the auditor finds that strictly following the rules of GAAP would make the financial statements misleading, the auditor has permission to bless financial statements that do not comply with GAAP. That would be Rule 203 of the Code of Professional Conduct.
But, if the audit report were focused solely on whether the client followed the rules, then we can throw Rule 203 under the bus with "fairly present." If the financial statements actually were misleading Exchange Act Rule 12b-20 places responsibility on the issuer to provide information somewhere in the filing to cure the problem. Thus, the focus need not be on the auditor.
Requiem æternam dona eis
If you are interested in how "presented fairly" was birthed and interpreted in the past, I highly recommend an article by accounting historian Stephen Zeff, entitled The Primacy of "Present Fairly" in the Auditor's Report. My own reading of Steve's article indicates he believes that accounting alternatives ultimately selected from nonauthoritative sources should not be a free choice, but should be constrained by fair presentation. Accordingly, Steve's proposal for changing the audit report would also focus on whether the rules of GAAP were followed; but, in addition, he would have the auditor provide a separate opinion as to whether the financial statements were presented fairly.
As for me, I would say, 'eternal rest grant unto" what has utlimately come to be, at best, a noble sentiment. If there ever was a practical use for "presented fairly," it's ancient history by now.