Peeling away financial reporting issues one layer at a time

One Shouldn’t Have to be an Auditor to Understand an Audit Report

The PCAOB* has proposed a new standard to make the auditor’s report more informative.  If finalized in its present form, it would provide more and/or better information concerning the following:

  • Critical audit matters (as determined by the auditor).
  • Auditor independence and tenure.
  • The auditor’s responsibilities for, and the results of, its evaluation of other information outside the financial statements (think MD&A).
  • The auditor’s responsibilities for fraud and notes to the financial statements.

I heartily support the initiative to make the auditor’s report on a public company amount to something more than merely a stamp of approval.  But, I would also like the PCAOB to use the momentum of this project to look closely at the surviving standardized language; to consider what it actually means — or doesn’t — as compared to what the words should convey to someone who is not a member of the accounting cognoscenti.

Specifically, and in light of recent significant developments in financial reporting rules, I hope the PCAOB will take the opportunity to look closely at the meaning of, “fairly presented … in accordance with Generally Accepted Accounting Principles.”   It is a phrase as familiar and dear to CPAs as the lyrics to The Star Spangled Banner.  Yet, if you were to ask 100 CPAs what “fairly presented…” means for an audit engagement, you might get 100 different answers.

The PCAOB should be concerned about the present state of affairs for at least two reasons:

  1. Truth in labeling — As I’ll describe below, “fairly presented …” never amounted to much more than vague aspirations in search of a cure to the accounting abuses that played a role in the Wall Street Crash of 1929.
  2. The Wild West of nonauthoritative GAAP — Even though the FASB has crystallized “authoritative” GAAP in its Accounting Standards Codification (ASC) the vaguely specified methods set forth by the FASB for applying “non-authoritative” GAAP should be of great concern to the PCAOB.

I’ll be focusing on the first reason herein.  I hope to come up with a post on the second one in about a week.

A Very Brief History of “Fairly presented…”

It seems (i.e., I disclaim any expertise as an accounting historian) that the phrase “fairly presented …” had its genesis in a series of meetings between the American Institute of Accountants — now the AICPA — and the NYSE, in the early 1930s.  Ultimately, the Institute’s membership approved a set of six “broad principles of accounting which have won fairly general acceptance”; and it introduced the phrase ‘… fairly presented, in accordance with accepted principles of accounting …’ for use as standard auditor’s report language.

The precise term “GAAP” made its debut in 1936, which was the same year that the AICPA’s Committee on Accounting Procedure (CAP) was formed.  In the spirit of the phrase, accounting pronouncements to emanate from the CAP did not dictate mandatory practice; rather, they were authoritative only to the extent that they documented (hence, the nomenclature as “Accounting Research Bulletins”) accounting treatments that appeared to be generally accepted in practice.  There can be little question that “fair presentation in accordance with GAAP” was open to interpretation, but the goals of the system — like them or not — were clear at that time.

The practical meaning of “GAAP” changed abruptly soon after the CAP was replaced in 1959 by the Accounting Principles Board. All pretense of support for high quality financial statements by the Accounting Establishment evaporated when some of the “Big Eight” firms advised their clients that the new APB pronouncement (APB Opinion No. 2) — to spread the benefits of an investment tax credit over the life of the asset to which it related — was literally just an “opinion,” which didn’t have to be followed to produce GAAP-compliant financial statements.  To stem the tide, the AICPA issued its “ethics” Rule 203:

“A member shall not (1) express an opinion … that the financial statements … are presented in conformity with generally accepted accounting principles … if such statements or data contain any [material] departure from an accounting principle promulgated by … [the FASB] …. If, however, the statements or data contain such a departure and the member can demonstrate that due to unusual circumstances the financial statements or data would otherwise have been misleading, the member can comply with the rule by describing the departure, its approximate effects, if practicable, and the reasons why compliance with the principle would result in a misleading statement.  [emphasis supplied]

I have never seen an auditor report for a public company that justified a departure from GAAP based on the “unusual circumstances” referred to in Rule 203. (Have you?)  But, I have seen this hilarious bit from Dumb and Dumber:

Lloyd: “What are the chances of a guy like you and a girl like me… ending up together?”
Mary: “Well, that’s pretty difficult to say.”
Lloyd: “Hit me with it! I’ve come a long way to see you, Mary. The least you can do is level with me. What are my chances?”
Mary: “Not good.”
Lloyd: “You mean, not good like one out of a hundred?”
Mary: “I’d say more like one out of a million.”
Lloyd: “So you’re telling me there’s a chance.”

If “there’s a chance” of a Rule 203 departure from GAAP, I’d say its more like one out of a billion.  Thus, I take more pity on the thousands of budding CPAs each year than I do on the Lloyd’s of the world who will read Rule 203 and naïvely  think that the boilerplate language tacked to the end of a so-called “ethics rule” actually means something.  It is only that piece of boilerplate, and nothing else about financial reporting,  that lends any credence whatsoever to the myth that “fair” is somehow an operational concept in financial reporting.

The sad reality is that the initial attempts to base a fair — in a real sense — system of financial reporting on a coherent and finite set of principles came to an end decades ago.  In fact, as I will explain shortly, any concept of “fair” no longer exists in professional standards, although it blithely lives on in the standard audit report language.

Moving on, let’s turn our attention to the second part of the phrase, the meaning of “GAAP.”

Prior to the advent of the FASB’s Accounting Standards Codification (ASC), auditors relied on SAS 69, setting forth an official pecking order for the alphabet-soup of sometimes-contradictory sources of  so-called GAAP.  According to SAS 69, the phrase “generally accepted accounting principles” was officially declared void of an meaning in common language; it was “a technical accounting term” essentially meaning a set of rules to be strictly enforced under practically speaking, any and all circumstances:

“Rule 203 implies [even though no other reasonable interpretation is possible] that application of officially established accounting principles almost always [i.e., 1.0 – .0000000000001 = 0.999999999999] results in the fair presentation … in conformity with generally accepted accounting principles. Nevertheless, rule 203 provides for the possibility [There is a chance!] that literal application of such a pronouncement might, in unusual circumstances, result in misleading financial statements. [emphasis supplied]

The bottom line is that unless the reader of an audit report were an accountant, nobody could possible know that “fair” and “GAAP” are labels that meant something totally different than what the words actually said.  Was the AICPA being intentionally misleading?  I’ll let you be the judge.

The Mysterious Disappearance of “Fair”

But wait, there’s more.  After 2009, the responsibility for defining GAAP was transferred (for reasons I won’t belabor here) to the FASB.  There are two things worth noting (in ASC 105).  First, the protocol to follow for determining an accountant treatment when there is no specific or analogous guidance in the ASC is like nailing jell-o to a tree; and more so, even, the guidance in SAS 69 that it replaced.  This should be of equal concern to the PCAOB, and I will address the issue further in my next post.

Second, there no longer any mention of the term “fair” in any authoritative guidance for issuers and auditors.  Even if a user wanted to know what “fair” is now supposed to mean in the context of an audit report, they certainly won’t find it in GAAP or GAAS.  Yet, it still blithely lives on to convey an aura of gravitas that is, to be kind, undeserved.

* * * * * *

The AICPA is a professional organization that is funded by professionals in large part to promote the interests of the profession.  It is understandable that, as promotional and branding strategies, puffery would be preferred to parsimony by some of its members.  But, that’s not the role of the PCAOB; and indeed it was created because the AICPA could no longer be counted on to protect the public interest.  Changing the “fairly presented…” language may not immediately change practice, but it will send the message that words are meant to be read by users of financial statements; and that the words can be counted on to mean what they say.

Something like, “Presented in accordance with the rules of the FASB in addition to the non-authoritative guidance cited in Note xx” would certainly change perceptions.  It must also eventually affect how accounting rules are promulgated, as perceptions must inevitably collide with reality.


*I was recently appointed to the Standing Advisory Group of the PCAOB.  The views expressed herein are my own and do not necessarily reflect the views of the Board or other Board members or staff.



  1. Reply Francis Mendoza April 2, 2014

    Excellent article Tom and congratulations for your appointment to the PCAOB!
    This may be one point in favor of IFRS since the IAS 1 and the IFRS framework include the meaning of fair presentation.
    Fair presentation requires the faithful representation of the effects of transactions, other events, and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework. The application of IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation. [IAS 1.15]
    Faithful representation
    General purpose financial reports represent economic phenomena in words and numbers, To be useful, financial information must not only be relevant, it must also represent faithfully the phenomena it purports to represent. This fundamental characteristic seeks to maximise the underlying characteristics of completeness, neutrality and freedom from error. [F QC12] Information must be both relevant and faithfully represented if it is to be useful. [F QC17]

    • Reply Tom Selling April 3, 2014

      Hi, Francis:

      Thanks very much for the kind words.

      Unfortunately, though, I don’t think that IFRS defines “fair” presentation any differently than U.S. GAAP.
      The first paragraph you quoted is effectively no different than Rule 203 of the AICPA ethics code: i.e., there is rarely justification for not abiding by IFRS as stated. The second paragraph, elaborating on faithful representation, adds nothing to alter the intent of the first paragraph: “faithful representation” is nothing more or less than being what non-accountants would call “truthful.”

      Also, don’t forget that this was the operative language that SocGen, two auditors and one national regulator exploited to depart from the rules as stated in order to avoid recognizing Jerome Kerviel’s large trading losses in the year that they actually occurred.


      • Reply Francis Mendoza April 3, 2014

        Hello Tom,

        You have shared an interesting point of view.

        My perspective after working with IAS/IFRS for more than 12 years is that SocGen failed in applying IFRS in those financial statements, understanding this is merely an assumption for sake of argument as I did not prepare their statements. But in my experience, this true and fair value provision under IFRS is rarely used.

        However, the AU-C Section 200 defines fair presentation framework as a “financial reporting framework that requires compliance with the requirements of the framework and:
        a. acknowledges explicitly or implicitly that, to achieve fair presentation of the financial statements, it may be necessary for management to provide disclosures beyond those specifically required by the framework; or
        b. acknowledges explicitly that it may be necessary for management to depart from a requirement of the framework to achieve fair presentation of the financial statements. Such departures are expected to be necessary only in extremely rare circumstances.”
        Thus, we may expect companies in the US to have departures from USGAAP in extremely rare circumstances.

        As Louis Brandeis well-known quote says: “Sunlight is the best disinfectant”, I think by the time SocGen financial statements were issued, the capital markets had already ‘punished’ the SocGen’s stock price.

        At the end of the day and please correct me If I am wrong, I think it doesn’t matter what sort of accounting principles or regulations are used, it is about the people who observe them, and that was greatly demonstrated by the accounting scandals in the United States and Europe (Enron, Worldcom, Artur Andersen, Nortel, Lucent, Qwest, Rite Aid, Xerox, Computer Associates, HealthSouth, Hollinger, Fannie Mae, Freddie Mac, AIG, Parmalat, Vivendi Universal, Royal Ahold, Skandia Insurance, etc.)

        Thanks for sharing your knowledge!



  2. Reply Jake Chazan April 10, 2014

    Interesting commentary. I would like to point you towards the IAS’s Conceptual Framework with respect to the preparation of financial statements.


    Classifying, characterising and presenting information clearly and concisely makes it understandable. While some phenomena are inherently complex and cannot be made easy to understand, to exclude such information would make financial reports incomplete and potentially misleading. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information with diligence.

    There is a similar concept that is applied in the law. It’s referred to as the man on the Clapham omnibus: “The man on the Clapham omnibus is a hypothetical reasonable person, used by the courts in English law where it is necessary to decide whether a party has acted as a reasonable person would — for example, in a civil action for negligence. The man on the Clapham omnibus is a reasonably educated and intelligent but nondescript person, against whom the defendant’s conduct can be measured. The concept was used by Greer LJ in the case of Hall v. Brooklands Auto-Racing Club (1933) to define the standard of care a defendant must live up to in order to avoid being found negligent.” (Wikipedia).

    So the question then becomes who is the user of the Auditor’s Report and what standard shhould be brought to bear. Are the users those who (1) have a reasonable knowledge of business and economic activities and who review and analyse the information with diligence or (2) the man on the Clapham omnibus.

    I think one needs to frame the content of the auditor’s report to who the reader is. In the absence of this it does, in my opinion, make it rather difficult to decide content.

    I am with you in that all this has become so complcated that even the individual referred to in (1) will have considerable difficulty understanding the financial report in its totality. Hope you can make some progress in simlifying things!

  3. Reply Christin Thomas October 12, 2014

    As a student whom has just studied IFRS Conceptual Framework in depth, I agree with the two sides of the story given here.

    It is frightening to think that those who read the financial statements will not fully understand the meaning of what is being said, especially since a lot of the company depends on the ‘fairness’ of the financial statements.

    I feel that auditors should expand more on the ‘fairness’ of the statements and what their understanding of ‘fairness’ is within the report. This may help to clear up confusion.

  4. Reply Kefilwe Lehloo October 12, 2014

    Congratulations Tom for your appointment to the PCAOS.
    This is a brilliant article. I also believe, on the other hand, that verification is not enough.
    There are several important points about faithful representation and its relationship to relevance, the other highest-level qualitative characteristic.

    To begin, the boards insist that faithfulness is much more than simple verification. For example, a doublecheck of a depreciation schedule may verify that its calculations are correct, but does nothing to verify the more important proposition that the resulting book values actually provide faithful representations of the assets’ future cash flows.

    In other words, it does no good to validate numbers that do not describe the reporting company’s cash-flow potential. Now that the proposed framework clearly states that relevance is based on helping users evaluate future cash flows, many traditional measures, especially any that involve systematically allocated historical costs, have no real possibility of being faithful representations of that potential. If a measure does not faithfully represent the magnitude of the assets’ and liabilities’ potential cash flows, there can be no usefulness in it, no matter how many people verified the supporting calculations.

    Thanks for sharing your knowledge.

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