Sunday, March 20, 2011 0 comments

Opinion: Should auditors provide interpretation in the accounting statements?

The way the accounting profession is going, it may very well end up like the legal profession. What I mean is that, once upon a time—say a hundread years ago—lawyers were respected individuals; Abraham Lincoln was one and many were held in high regard. Right now, the public has a very negative perception of lawyers. Some even claim they are not helping society very much. If you are a lawyer, you still earn above-average (relative to the whole economy) compensation but the respect you get is nothing like it used to be.

My feeling is that the accounting profession may head in that direction. There have been quite a number of crises of late—the recent accounting by financial firms and the fraud at companies like Enron and Worldcom a decade ago come to mind—which the auditors didn't catch. The auditors are well-paid professionals that earn above-average compensation but if they are incapable of flagging serious accounting problems then why are shareholders paying them so much?

Writing for Barron's, Jim McTague summarizes the investigation being undertaken by the Public Company Accounting Oversight Board with respect to the auditing of accounting statements of financial companies before the financial crisis. I found one of the suggestions interesting (bold by me):

The advisory group suggested enhancing auditor reports to provide investors with the equivalent of color commentary. For example, close to 80% of the survey respondents would like auditors to assess the accuracy of significant estimates and judgments by management; and 67% would like an auditor to discuss unusual transactions by management. One possible problem: Auditors, who are fond of boilerplate language, simply might add more boilerplate, says Anne Simpson, senior portfolio manager for global equities at Calpers.

Turner [forensic accountant Lynn Turner] said auditors would be flirting with obsolescence if they played boilerplate games. If data in SEC reports were electronically tagged, he asserted, computers could be programmed to analyze the adequacy of a filing firm's accounting at far less cost to the company than an auditing firm. And since auditors uncover few miscreants among managers, sites like WikiLeaks might usurp them as watchdogs.

That's definitely an interesting idea: should the auditors provide "colour commentary?" For those not familiar with the sports allusion, colour commentary refers to interpretation of some event. Instead of a commentator simply reading out that, 'player A ran up the field from X to Y and avoided a tackle,' a colour commentator would suggest why the player ran up the field and how it helps the team. Right now, accounting statements just state the facts, if you will. As anyone who has looked at facts knows, facts may imply different things depending on the context. Should auditors try to add some interpretation (and possibly a limited, narrow, opinion) along with the facts?

It's a revolutionary thought but it's not clear if the accounting profession will pursue it. First of all, it's not clear if the auditors have much insight into the business they are auditing. Secondly, it'll be difficult to separate 'interpretation' from 'opinion.' I am pretty sure the auditors don't want to go into the 'opinion' business—such a move would drastically alter the accounting profession. However, if the auditors don't provide much value then they will play a lesser role going forward.

Whatever happens, I do think inserting more interpretation would help. Investors, whether pro or amateur, would likely find additional commentary highly valuable. Those that don't like the interpretation can obviously skip it or form their own opinion. For instance, if the auditors notice that, say, Lehman Brothers' repo-105 transactions followed accounting requirements but were highly unusual—I'm making this up; I have no idea if they are unusual or not—then it would have been very benefitial to investors, rating agencies, and regulators. If management pursues unusual accounting tactics, outsiders can investigate that as they see fit. Right now, if repo-105 was legal and met accounting standards, it wouldn't raise any flag.

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