Peeling away financial reporting issues one layer at a time

On the Use of “Fair” in the Auditor’s Report: A Conversation with David Damant

My previous post addressed three aspects of the auditor’s report:

  1. The PCAOB* proposal to require a discussion of “critical audit matters”;
  2. Whether use of non-authoritative GAAP should be given special mention by the auditors; and
  3. The opinion language that financial statements are “fairly presented in accordance with  GAAP.”

This post is a continuation of #3, above.  It is derived from the thoughtful and insightful comments I received from David Damant.  David’s professional background (more on his education, later) is in financial analysis and accounting standards.  Among his many high profile roles, for six years (2004 – 2010) he served as the first independent chair of the Consultative Advisory Group (CAG) of the International Auditing and Assurance Standards Board (IAASB); and was a member of the former IASC board (1986 – 2000).

I have structured this post as a dialogue between David and me, based on our series of email exchanges.

David — After those six years on the IAASB CAG I have a few ideas. Central to those is that it is the job of the auditor to say that the accounts are in accordance with the accounting framework, which is made up of the accounting standards and the relevant laws and regulations.

Tom — We agree.  I prefer to strike references to “fair presentation” (or “true and fair” in the EU) from the auditor’s report.  Two years ago, I wrote a letter to PCAOB Chief Auditor Marty Baumann to suggest the following language would be more appropriate for the opinion paragraph:

‘In our opinion, the financial statements referred to above conform, in all material respects, to the following authoritative sources: the provisions of the Financial Accounting Standards Board (FASB) Accounting Standards Codification™; the rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of the federal securities laws; and the administrative views of the SEC staff on accounting and disclosure issues.’

Only if called for, a sentence would be inserted at the end of the paragraph to state as follows:

‘In addition, the financial statements also conform to the nonauthoritative sources listed and described in Note xx.’

David — I am also hostile to the proposals that the auditors should say that the company is in good health etc. (which they are not trained to do anyway).  If a company goes bust a few months after giving a clean audit opinion that is not a contradiction.

Tom — Again, we agree. From my perspective, the origin of requirements for auditors to evaluate the ability of an entity to continue as a going concern was to merely serve as a Band-Aid for historic cost accounting, which would be even more misleading than usual when a company is confronting the distinct possibility of bankruptcy. The requirement in the U.S. for a going concern qualification was instituted long before the existence of any formal impairment standards or the idea that at least some assets, like financial instruments, should be measured at market value.  In 1995, lawmakers added a statutory requirement for the auditor to provide a going concern qualification when warranted (see section 10A(a)(3) of the Securities Exchange Act).

But, it doesn’t work.  If anything, auditors are embarrassing themselves in the eyes of the general public.  A Bloomberg study found that auditors failed to provide a going concern qualification for 54% of the 673 largest bankruptcies during the period studied.  From my own personal experience at the SEC as the S&Ls were unraveling, I documented for the chief accountant a very high frequency of auditors’ omissions of going concern language in reports on banks, even when the book value of net assets was substantially above market values.

David — But the pressures are the other way.  There is a mistaken view that auditors are there to warn investors if things are going in the wrong direction. That is the job of the regulators (who were asleep in the run up to 2007/8).

I am also hostile to all these suggestions about sustainability, the environment, ethics etc. By all means have separate reports on these important matters (I have cooperated on some), but do not cloud the picture. If all companies published perfectly complete and transparent accounts, how wonderful it would be. And we do not need more extended audit reports — one line is all that is needed to state the opinion that the accounts are in line with the accounting framework.

Tom — I agree about trying to cram too much into double entry accounting. However, the notion of “complete” is a little more complicated.  In point of fact, it is impossible to take account of all of the economic events affecting an entity’s financial position. But that doesn’t mean we can’t come a lot closer than we do.  We could easily be moving in the right direction of both transparency and completeness by simply providing roll-forwards of all balance sheet accounts. No matter what the basis of accounting — historic cost or current value — these are essential. You are probably aware of a draft proposal from the IASB and the FASB to do just that, but it was quashed by special interests some years ago. Although the project is still technically on the agenda of the FASB at least, we haven’t heard a peep from them about it for years.

David — I am in favour however of some comment on uncertain valuations etc. (Emphasis of Matter). Maybe some improvement in the methods of valuation could be found at the International Valuation Standards Council, where David Tweedie is Chair of the Trustees.

Tom — This is an area that has been getting more attention lately. I gave a presentation to the PCAOB a couple of years ago on the impossibility of effective audits when management estimates pervade the financial statements.  Basically, competent auditors should be capable of verifying. But for all sorts of reasons it is too much to expect that they can reliably assess the reasonableness of management’s (often biased) judgments.

I have proposed that we should, incrementally over time, transfer the responsibility for financial statement judgments to independent appraisers.  Auditing would become solely a verification service, and financial statements would better serve investors and the public interest.  If you are interested in the details, the shorter of the two articles I wrote is in the May 2015 issue of The CPA Journal.

David —The British did a bad thing in promoting “true and fair.” The idea was to look carefully at accounting standards to see whether they gave a view which was fair as well as true.

There is a wonderful cake shop in Cambridge, which on Saturdays has a long queue from households buying the cakes for the weekend — and they also sell bread. A soviet professor in the 1960s took a photograph of the queue and had it published in Russia under the heading “Queuing for Bread.” That was true but not fair. But what does the phrase mean in practice, in accounting? Legal opinion was taken and the opinion was that it meant that the accounts were in line with the accounting framework. OK, good.

Tom — Great story!   I do agree that it was a mistake for the EU to adopt the UK concept of true and fair in the 7th Directive.  However, your story presumes a very narrow definition for “true” — not one that corresponds to what I thought a philosopher would regard as “truth.” But if one accepts that narrow definition, then “true and fair” should mean that the totality of information provided is reasonably complete, so as not to create a misleading picture of economic substance.  I have come to see a middle ground alternative for the auditor’s opinion paragraph:

‘In our opinion, the financial statements referred to above are fairly presented and [see my reference to Steve Zeff’s paper in my blog post] conform, in all material respects, to the following authoritative sources: …’

Under this second alternative, the term “fairly presented” would be declared accounting-speak for Securities Exchange Act Rule 12b-20.  This is the general requirement of the SEC to add information that may not be specifically called for by its rules, if omitting such information would result in misleading disclosures.

But, why would we need “fairly presented” as a separate term of art if there is already Rule 12b-20?  Actually, I don’t think we would; but it stresses the idea that if there is anything misleading about GAAP, the financial statements and notes should contain additional disclosures to prevent them from being misleading.

David — But there are quite a few large investors in the UK who when the law was revised had the “true and fair” rule put in as a freestanding clause.  A delusion in my view but the argument for it appeals to the politicians and civil servants. And as they listen to large investors my arguments got nowhere. I tried taking the example of when derivatives were for the first time revalued in the balance sheet. Were the auditors who signed the accounts before the rule about revaluing derivatives came in in error?   If so, that would amount to asking the auditors to write accounting standards on the hoof.  It is better that the accounts are in accordance with the accounting framework, period, especially as standards are now tying up every loophole possible.

Tom — I think that argument is very compelling.  But in challenging the language of the audit opinion, I have a larger goal in mind that I hope would resolve our shared concerns. I would like for financial statements to hew strictly to language that readers can understand without (or with minimal) reference to terms of art. U.S. GAAP and IFRS are but two bases of accounting that actually do mislead by mischaracterizing its product with countless terms of art that masquerade as plain language.  “Statement of financial position” is a misrepresentation of the balance sheet.  It is in fact nothing but a list of items determined by rule to be assets or liabilities (whether or not they really are) paired with arbitrary currency amounts.  An “income statement” is no different; it is nothing more than a statement of items recognized to be revenues/gains/expenses/losses.  The result is not “income” (or even a subset of “income”), but only the sum of these categories of items.

If truth in labeling were required, the question of fair presentation would become moot.  But I don’t foresee truth in labeling of financial statements happening for a long, long time.  Though far short of our ideal, I would prefer the “and” version of the opinion paragraph over the status quo.  For example, if the issuers applies a non-authoritative version of GAAP, it should alert the auditor to the possibility that might additional note disclosure could be necessary in order to prevent the financial statements from being (even further) misleading.

David — And I have to add that the auditors at least sometimes do a dreadful job. Have you read the inspector’s report on the failure of Lehman? 2000 pages but 500 are the heart of the matter, and the number of pages is increased by having many pages with just a graph etc. It is beautifully written — a pleasure to read (I wrote to the inspector to congratulate him on the English). The directors of Lehmann did a really super job of fiddling the results by maneuvers in the relevant derivatives. These were large sums, moving around at crucial dates; brilliantly and secretly done. Outsiders could not see at all what was going on. E & Y failed to notice.

I also noted the amateurish nature of the press and public comment. Lots of attention was given to the question of arbitrage between US and UK standards. Had they read the inspector’s report (some hope) they would have seen that he said explicitly that he did not examine the question of whether the accounting standards employed were the right ones. Whatever they were, it was a fiddle. Only the auditor could have dug into that.

It is that sort thing which makes one despair, and it is not much to do with auditing or accounting standards. It just requires auditors of the right intellectual and moral quality and those qualities are not easy to legislate for.  Maybe we should go back and revise the outcome in the Garden of Eden.

Tom — Auditors are not priests, immune to the temptations of the material world.  (Many of us have come to realize that even priests are not priests.) We do ask a lot of auditors that we would not ask of any other economic actor. I don’t think we should do that.  This feeds back into my argument that audit services should be limited to verification — physical existence, documentation, confirmation, etc.

David — Not priests maybe, but high standards of intellectual and ethical behaviour should be the norm for auditors, and indeed I met quite a few of those in my professional career (I am not an accountant or auditor).  It is when the standards get to their implementation that the problems occur. That is, (1) even the best standards can be “worked around” by clever investment bankers (I have heard them say so), or simply incompetently applied by auditors who are not up to speed; (2) all sorts of misrepresentations can take place regardless of the quality of the auditing standards (for example Lehmann); and (3) there are cultural differences around the world, which reflect different ways of judging accounting and therefore auditing standards (related parties for example).

As it happens I am a philosopher — at least I have a degree in philosophical logic from the University of Cambridge England. I do not think that there is very much of a problem with “truth” despite Pontius Pilate’s comment (St John 18.38) and I will spare you 20 pages on Tarski’s Correspondence Theory of Truth. But “fair” is another matter. Whishy washy.  I would like to banish the term — and also “fairly presented.” Why not just “in accordance with”  or ” conform to…” etc?

The problem with allowing a company to change  (and its auditor to agree) or to set aside a standard because it does not give a “fair view” in their opinion is that by doing that the floodgates will open. (You may have heard the banks screaming that the accounting standard setters did not understand their business — they never sold their mortgage books of course — this was shortly before many of them went bust). It is better to require companies, if a standard appears inappropriate, nevertheless to apply it, and then have a note setting out the reasons why it is inappropriate and how the company’s approach reconciles with the standard deemed not to be appropriate.

Tom — Thank you, David!


* I am a member of the Standing Advisory Group of the PCAOB.  All of the opinion I express in this post are my own.

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