The Accounting Onion

Initial Reactions to the SEC Moving IFRS from the Fast Lane

I recently recorded a podcast for Compliance Week with editor Matt Kelly, who interviewed me on the SEC's most recent statement on IFRS—a clear detour from the original Roadmap by any reasonable estimation.

Matt gave me some sample questions in advance, so I could organize my thoughts, and this blog post is an edited and somewhat more elaborate version of the notes I wrote down while preparing for those questions. The last third or so of the podcast took a different tack, so if you want to listen to for yourself, click here.

What do you think of the SEC's most recent IFRS actions, re-affirming interest but stalling on adoption?

I get a number of mixed messages from the Commission's statement. Even its title, "Commission Statement in Support of Convergence and Global Accounting Standards" confuses me somewhat. On the one hand, the endgame of the initial Roadmap release is adoption of IFRS.  But the title of the Commission's statement only mentions "convergence" and leaves out "adoption."

You certainly can work toward achieving convergence with IFRS without necessarily sun setting GAAP and adopting IFRS; and perhaps that is factoring into the SEC's current thinking. I have a different view: we in the U.S. should be working toward providing investors in the U.S. capital markets with the highest quality and most transparent financial information available anywhere in the world. I don't believe that working on convergence with the IASB will get U.S. GAAP to where investors should expect our regulators to be.

Getting deeper into the document, the Commission appears to be willing to accept at face value the benefits of IFRS adoption that have been most frequently cited by convergence proponents: they mention enhanced comparability, savings for multinationals, and lowering the cost of capital worldwide. Yet, there is nothing in the Staff's work plan that indicates there will be any attempt to validate those benefits. I suspect that's because there doesn't appear to be any sort of reliable methods for validating them. The Commission has committed itself to evaluate research on the IFRS question, so academics can make a significant contribution in this regard. They can either: (1) explain to the SEC which propositions regarding the benefits of IFRS adoption/convergence are (or are not) subject to rigorous and reliable estimation; and (2) undertake studies allowing reliable quantification of benefits—if that is indeed possible. The studies themselves must not be directly funded or influenced by the accounting profession, or any other group that clearly has a 'dog in the hunt.'

Although the benefits part of the IFRS adoption/convergence narrative are given short shrift in their statement, I think the SEC has done a pretty thorough job of laying out the issues that will determine whether IFRS adoption is even feasible or can be accomplished at a reasonable and predictable cost. I'm very happy that the SEC acknowledges that serious thought has to be given to figuring out what the ongoing role of the FASB would be, assuming we were to take in some or all of IFRS in some manner shape or form.

So, I guess the answer to the question of whether the SEC is pushing for IFRS adoption, or pulling back, cannot be answered by me with a great degree of confidence—except to say that I am sticking with the prediction I made the day before the Commission's statement was published. I predicted that the ultimate decision maker will be the EU; the most likely scenario being that the EU will state that more convergence is not something they are interested in, especially if it means more bright-line rules. The EU is going to eventually tell the IASB that they will want a divorce if the IASB continues to court the US while everybody else has to sit around and twiddle their thumbs.

So, in the end, I expect that a no-go decision will be made for the SEC by the EU. If the EU doesn't bail the SEC out, then Mary Schapiro or her successor will be in a big pickle.

Any final decision really hinges on FASB and IASB converging their standards, whether it's by June 2011 or any other date. How do you see that effort coming along?

I see two fundamental problems,with the the "doubling and re-doubling" of convergence efforts. First, is the short-timeframe. The initial reaction of Denny Beresford, former FASB chair, to the convergence aspect of the work plan, which I read on the AECM listserv, was that many of the convergence projects that are now supposed to be fast-tracked and completed in the next 16 months have been on the agenda since he was at the FASB; and, he departed over 13 years ago! The consolidation project has been on the agenda since 1982 and the FASB still has not been able to develop a fully satisfactory definition of control. Just a couple of the scores of specific issues that will be addressed in the convergence projects are the direct method of reporting operating cash flows and reporting all financial instruments (including loans) at fair value. Those are highly controversial.

Another person whose comments I've been reading are those of retired professor Bob Jensen of Trinity University; one of his points should be a deal breaker, but somehow the Commission doesn't see it that way--yet. Bob says that high quality accounting standards can only occur if there is a reasonable opportunity for consultation with constituents. This would include exposure drafts, field visits, field tests, and other ways of communication that the FASB has developed over many years of experience. It's virtually unthinkable, he says, that seven or so highly technical and highly complicated projects can be compressed into a 16-month period and still maintain a reasonable opportunity for input and, more important, for the Boards to learn from that input and be willing to make changes.

The second fundamental problem I see is that some critical differences between IFRS and U.S. GAAP aren't even on the agenda. R&D is only one example of an abandoned project; the so-called "convergence" of business combinations standards was half-baked.  And with the recently breaking news of the abuses of repo accounting that have come closer to the foreground with the publication of the Lehman bankruptcy report, the FASB may have to divert some of their resources to fix those offending portions of U.S. GAAP—and do it fast, a la FIN 46 on variable interest entities while the Enron debacle was still simmering.

But, the elephant in the room is the accounting for impairment of long-lived assets, including goodwill. I don't think you could get the EU to agree with the US approach, and I don't think you'll get US issuers to accept the IFRS standard. The fact is that both impairment standards leave a great deal to be desired—neither are what the SEC should be willing to abide.  I don't see how you can end up with a so-called "stable, high-quality platform" unless this issue, among numerous others, is resolved. Yet, so far, it's being ignored.

Part of the delay in the Roadmap timetable is so the SEC staff can devise a work plan examining implementation obstacles. What are some of the practical adoption and implementation problems—stuff the chief accounting officers of the world will need to deal with— that are going to cause everyone headaches?

Supposedly, IFRS and GAAP will be sufficiently converged so that if the US does adopt IFRS in some manner, the switchover shouldn't be a big deal. A big question is whether college educators will be able to keep up with all the changes. I'm not a faculty member any more, but I've had some interesting indirect experiences through my son, who is an accounting major with plans to take the CPA exam.

Rick is currently taking "intermediate accounting." His teacher covers one chapter every two days—like clockwork. It doesn't matter how difficult or detailed the concept is, it's one chapter every two class days.

That's certainly not the way I would teach intermediate accounting. But, I suspect that Rick's teacher is close to the mode, if not right there. The one-chapter-per-two-days approach is a lot of breadth, with extremely little depth. So, given what is already being crammed into curricula now, I'm not sure how any more breadth in the form of significant knowledge of IFRS can fit in. I prefer to stress depth when I teach, and not to cram as many topics as possible into a semester, but the structure of the current CPA exam and the importance to an accounting program of its students' pass rates goes a long way toward explaining why Rick's professor does what she does.

Even though I am an IFRS adoption skeptic, I am fully aware that there is a huge amount to be learned from comparing IFRS with GAAP in class (I co-authored a textbook on comparative accounting for gosh sakes). Yet, something in college curricula has got to give.

But, based on my experience in universities, curriculum change is almost invariably a political football. Even forgetting about every other thorny issue regarding IFRS adoption/convergence, it's an odds-on bet that changes to the education sector will bump up against turf issues galore, and make widespread significant progress in that area a practical impossibility. The fundament problem is that there is only 24 hours in a day, and about 150 semester hours in a 5-year accounting major's curriculum. Something (or some academic discipline) will have to give up a portion of their fiefdom for nothing.

I wish accounting departments much good fortune as they try to convince their colleagues in marketing, finance, economics, statistics, psychology, English, foreign languages, math, science, history, gender studies and sociology that teven more time should be given over for teaching 'bean counting.'

Could Lehman's Audit Committee Have Done Better?

I am, and have always been, a very reluctant user of pen and paper. Even on the rare occasion where I am sufficiently moved to take handwritten notes, they frequently end up to be little more than random doodling. Soon thereafter, I transfer them to the recycling bin.

But a few months ago, as I was culling about a tree's worth of papers from the piles I absolutely did not want to transfer to my newly renovated office, I unearthed a rare anomaly—a useful page of notes. The precious artifact was my scribbles during the annual meeting of the Association of Audit Committee Members Inc. (AACMI.org), which I attended as a speaker. My presentation from two or three years ago was on the changing accounting standards for business combinations, and especially what audit committee members should be asking management about them. Not exactly scintillating I know, but such has become my lot—to play the geek at meetings of big picture guys. As usual for such a meeting, the agenda for the afternoon had been set in descending order of turgidity, which clearly made me and my topic the last thing standing between everyone else and the cocktail hour.

But, at least I was on the undercard for a luminary. The first speaker of the afternoon was the one and only Harvey Pitt, securities lawyer extraordinaire and former SEC chair. I don't remember the formal title of his talk, but the gist of it was 15 suggestions for audit committees. Memorializing them in a blog post had been my intention as a follow-up to my previous post on Koss. There, I noted that the effectiveness of Koss's audit committee appeared dubious, to say the least—if not moribund and incompetent. I had thought that Pitt's words of advice were so self-evident (once he made them evident) that they could help any smaller company set up, or perform a pretty thorough evaluation of their own audit committee.

But, this past Thursday, another potential use of "Pitt's Tips" came to mind. The bankruptcy examiner for Lehman Brothers issued his 2200-page report. So far, I have read only a few pages of that report, put many sources already strongly suggest that Lehman's auditor, Ernst & Young, and its management may have some explaining to do. As regards the involvement of Lehman's audit committee, the report apparently finds that the directors of Lehman did not breach any of their duties, but that doesn't really address whether the board, and the audit committee in particular, could have done more to prevent the bankruptcy.

So, I am presenting my notes from Harvey Pitt's talk with these two cases as reference points—and one important caveat. The caveat is that I do not claim that anything in my notes were Harvey Pitt's exact words. The 15-the item list I am presenting is nothing more or less than a transcription of my notes with some minor rewrites for clarity, based on my memory of a cogent and engaging presentation.

Pitt's Tips

1. Audit committee member should limit themselves to two or three boards.
2. The committee should strive to maintain the appropriate "tone at the top."
3. A culture of compliance should continually be taught.
4. Continually evaluate how best to meet one's duties.
5. The corporation should have a compliance committee.
6. Stay current with legal and financial reporting requirements affecting the company.
7. Strive for collegiality and "play nice" together.
8. Develop a formal policy for financial statement disclosure.
9. Access to both internal and external experts should be easy.
10. Develop effective relationships with management
11. Keep communications paths open and objective. The audit committee should have separate meetings with the internal and external auditors.
12. Keep in mind that the IRS looks at public company disclosures.
13. Consult an outside expert for tax issues
14. Ask tough questions – make sure all of the questions raised are answered by the auditor to your satisfaction.
15. Be able to prove what you did; make sure that the minutes of your meetings reflect your actual diligence.

A 16^th Tip from Yours Truly

I'm willing to bet that Lehman's audit committee might say that they complied with each one of Pitt's guidelines.  So what, if anything is missing from his list? Maybe nothing, depending on how one reads them, but I might put things a little more bluntly than I recall Harvey Pitt having done.

My own Tip 16 is a variation on a theme that pops up in many of my posts: audit the auditor. Yes, the PCAOB inspects audit firms and may select audits to review; and there are new PCAOB audit standards for concuring partner review of the work of the audit team, but this is clearly not enough.

Tip 16 is, "The auditor should be concerned that the audit committee might, at any moment directly examine some of its work." Just as management's assertions should be subject to verification by the auditors, the assertions made to the audit committee by the auditors should be subject to verification. If the audit committee tells the auditor to do something, verify it was done. If the auditor stakes out a position on a sensitive issue, and if you are not an expert yourself on that issue, hire an expert to verify that the auditor's conclusion is the correct one.

In Lehman's case, it appears that the audit committee was aware of the whistleblower's letter, but it did not even read it! Instead, they instructed E&Y, in no uncertain terms they thought, to investigate and report on each of the allegations. Yet, the bankruptcy administrator concludes that E&Y omitted mention of certain critical allegations, pertaining to the accounting for a series of repurchase agreements ("repos") in its communications with the audit committee. The repo transactions may have lacked any valid business purpose other than to make Lehman's capitalization ratios look better to the naked eye; and, as the whistleblower pointed out, the accounting treatment itself may have been questionable.

A straightforward application of Tip 16 would require that the audit committee should have at least considered hiring an outside expert to provide assurance to the committee that each one of the whistleblower's allegations had been thoroughly investigated. If the audit committee would not even read the allegations for themselves, then hiring an investigator should have been a no brainer at a company the size of Lehman, especially given the perilous situation they were in.  Even if they had read the whistleblower's letter and did not consider themselves sufficiently qualified to evaluate the auditor's conclusions regarding the accounting treatment for the repo transactions, then maybe that was another reason to hire an expert.

Maybe Lehman's audit committee did enough to satisfy its legal obligtions, but I am sure that each member inidvidually holds themselves to standards of integrity that far exceed the minimum established by law.  If there are lessons to be learned from Lehman, one of them could come from asking whether audit committees, as presently constructed, are as effecive as they should be.  Would simple changes on the order of Tip 16 result in fewer audit failures?  It seems to me that the answer is clearly 'yes.'

The Koss Fraud: Do Smaller Companies Need New Regulations or Better Old Regulations?

The Koss Corp. fraud case has been in the news since the end of December, so why am I just getting around to writing about it now? Because, that's the way I roll, man.

I don't know if anyone has noticed that a great many of my blog posts are based on not-so-current events. My style, if you can call it that, has been to keep a low profile initially (my father would have called it "procrastinating"), and eventually attempt to provide a new slant on a more mature topic. That's why, for example, you shouldn't expect much from me on the SEC's latest IFRS missive for the next few weeks. In the meantime, you'll have these thoughts on Koss to chew on, plus a related post to come on the role of audit committees.

What Can We Learn from the Fraud at Koss?

According to Koss's SEC filings, it has only 73 employees, and 79% of the shares of this small company are owned by its directors and executive officers. I certainly don't want to minimize the losses of the passive investors in Koss (although it must be said that Koss's stock price is holding pretty steady), but methinks the legs of this case as a national story has less to do with a internal control deficiencies and/or a busted audit than with the entertainment value of a story fit for reality TV; to wit, the comeuppance of a two-bit embezzler cum pillar of the community, who also happens to be a world-class shopaholic.

The fraud at Koss was allegedly committed by the company's vice president of finance, Sujata Sachdeva, who is accused of siphoning off about $31 million of the company's cash over a five-year period. That's almost one year's worth of the company's revenues, which she allegedly spent on vast quantities of designer clothing and other high-priced tchotchkes.

Incredibly, the fraud might have continued for much longer than five years had American Express not called to the attention of Koss's CEO two large wire transfers made from its bank account to Sachdeva's personal credit card. Sachdeva allegedly did her best to conceal the wire transfers by falsifying the bank account balance.

So, at first blush, the Koss fraud appears to be little more than a sad tale of listless second-generation family management getting fleeced, along with a few passive dabblers in Koss shares. But, others apparently see it differently. For example, the headline of a CFO.com article, "Fraud Case Feeds Sarbox-Exemption Critics" from early January strongly implies that some believe that if smaller reporting companies had not been exempted from the requirement to obtain an audit of internal controls over financial reporting (ICFR), tragedies like this could be prevented.

The Lesson:  Fix That Which is Broken

I actually do agree that there are important lessons to be learned from the Koss case, despite its modest parameters; but that lesson is not that smaller reporting companies should have to obtain an audit of their ICFR. The lesson is more like, 'simple problems have simple solutions.' There are two sorts of reasons for this.

The first sort is related to the costs and benefits of the ICFR audit. These are discussed at length elsewhere, including previous posts of my own, so I won't bore you by repeating them here. But the second kind of reasoning is where the path to improved financial reporting lies. Not to put too sharp a point on it, but there are much more efficient options available than to simply award the audit industry a new franchise.

To see what those alternatives could be from the perspective of the Koss case, I will enumerate (in no particular order) the major overlapping systems that together serve as the barrier to financial reporting abuses. I'll demonstrate that each of them could be easily improved in ways that would significantly affect the likelihood of a fraud, like the one at Koss, from occurring.

An issuer's board of directors has a fiduciary duty to shareholders to ensure that the issuer is led by competent individuals who are motivated to achieve appropriate operational and financial objectives.

If I were a consultant to Koss, the first thing to be evaluated would be its planning and budgeting processes. Indeed, I would be surprised if Koss actually did very much beyond, say, set sales goals. But, if Koss had a profit plan, and the discipline to rigorously evaluate itself periodically against that plan, the unauthorized expenditures on clothes and tchotchkes would have become self-evident; the improper expenditures would have been too significant to ignore. 

The larger lesson is that boards of even small companies have to exercise a degree of oversight that ensures that management sets goals for itself, and that management is evaluated against those goals. 

An ICFR audit won't fix that. 

The issuer's principal executive and financial officers certify that, to the best of their knowledge and after taking the appropriate steps to become informed, the financial statements are free of material errors.

Sachdeva's official title was "vice president of finance and secretary," and Michael Koss, who has served as "president, chief operating officer and chief financial officer" for over 20 years, signed the certifications required S-OX as both head honcho and head finance guy. Thusly, Sachdeva, who must have had free reign over the company's finances, was able to escape signing off on financial statements that she must have known were materially misstated.

This unusual statement of affairs presumably occurred with the blessing of Koss's legal counsel, who would have provided a very liberal interpretation of the applicable provisions of S-OX and SEC regulations. But, who benefited from that liberal interpretation other than Sachdeva, the only named executive officer in the executive compensation disclosures described as having a finance function? A clear lesson from this case for the SEC is that it should issue additional guidance for determining when one person at a company can sign a S-OX certification as both CEO and CFO. In my experience, the strong tendency of securities lawyers is to recommend that a company should avoid if at all possible doing more than is minimally required.disclosure regulations.

An ICFR audit isn't needed to fix that, but a more watchful securities lawyer could have come in handy.

The "independent" auditors certify the financial statements

CFO.com reported that Koss:

"… fired its accounting firm, Grant Thornton, on New Year's Eve. The auditor's response has been to highlight the fact that Koss is one of the companies that are not yet subject to Sarbox's Section 404(b), which requires an auditor sign-off of internal controls. 'The company did not engage Grant Thornton to conduct an audit or evaluation of internal controls over financial reporting,' says a spokesperson for the accounting firm. 'Establishing and maintaining effective internal control is management's and the board's responsibility.'"

Nothwithstanding anything that Grant Thornton has put out there for public consumption in their own defense, who among us has not asked themselves how GT could have missed a falsified bank balance? Few details are available, but it must be noted that the alleged fraud took place over five years, and consequently, five audits. I can't resist speculating that the bank reconciliation portions of the audit work papers were produced by the most junior person on the engagement, who failed to perceive that the large transfers to American Express (a non-vendor) for $382,000 and $1.4 million were very large red flags that something was amiss. 

And, just for good measure, I'll mention yet one more time my support for mandatory audit firm rotation.  Merely the fear of a fresh set of eyes every few years could have given the edge the auditors and needed to catch the alleged fraud before the numbers became as ridiculously high as they did.

An ICFR audit shouldn't be needed to do a bank reconciliation properly.

The issuer's audit committee, which is composed of "independent" board members and has unfettered access to its own outside experts, oversees the work of the "independent" auditors.

Three of the four members of Koss's audit committee had been serving on the board for more than two decades, and none of them list any direct experience whatsoever in accounting or auditing matters.

The audit committee financial expert was, and is still, 77-year old John Mattson. The only qualification listed for him is that he is the retired president of Oster Company, a division of Sunbeam Corporation. I don't want to cast unwarranted aspersions, but the shareholders of Sunbeam were the victims of an infamous and massive accounting fraud perpetrated by one Albert (Chainsaw Al) Dunlap in the late 1990s. I don't know whether Mr. Mattson was involved with Oster at the time, but the irony of a former Sunbeam executive at Koss while a fraud occurred is inescapable. 

An ICFR audit of Koss could have easily devolved into a mere compliance exercise with nothing to show for it is left to be overseen by an evidently disinterested, uninformed, and moribund audit committee.

The threat of enforcement of the securities laws and SEC regulations by the SEC itself and private parties discourage intentional misstatements.

Although I have nothing specifically with respect to Koss in this regard, I do want to point out a very interesting op-ed piece from Joel Seligman that recently appeared in the New York Times. Among the points he made was that the rate of financial fraud at various points in time is negatively correlated with the size of the SEC staff.

The SEC and analysts review issuers' financial statements

A fraud that siphoned about 20% of revenue each year could not possibly escape detection by analysts of any stripe (or the auditors for that matter) if detailed reconciliations of the beginning and ending balances of all balance sheet accounts were required in the financial statement notes. There would simply be no place to hide the fancy clothes and the overpriced tchotchkes.

An audit of internal controls does not obviate the need for appropriate external controls over financial reporting.

If the SEC is looking for demonstrable improvement in the quality of financial reporting through convergence with IFRS, they should unambiguously state to both Boards that they regard full transparency of changes to balance sheet accounts as the most effective measure for discouraging fraud and earnings management.

 

Winding Up

The point of this post is to show that strengthening elements of the financial reporting system that are already in place for all public companies would be more effective than adding a new element, such as an audit of ICFR.

We should require increased transparency through comprehensive reconciliations of balance sheet accounts, strengthen auditor independence through mandatory audit firm rotation; and strengthen board and audit committee independence through enhanced disclosure requirements and regulatory oversight. Any of these, singly or in combination, are logical next steps before considering the imposition of ICFR audits on smaller reporting companies.