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Some Puzzling Developments in Financial Reporting and Auditing

Scott Taub | September 30, 2014

Normally, I have no problem deciding what I want to write about, but this month, it was difficult.

It’s not because there’s nothing interesting going on in financial reporting and auditing—there is plenty happening. But I usually like to give some insight into why things are happening the way they are, and I can usually do that. Recently, though, there have been repeated instances in which I can’t figure out why what is happening is happening.

So, rather than try to explain to you that which I’ve been unable to explain to myself, I’ll instead describe a few things that have me puzzled. Perhaps the fact that so many recent developments are leaving us scratching our heads says something about the current state of affairs. Hopefully, these riddles will eventually unravel themselves, but for the time being, confusion reigns.

Name That Auditor

Based on public reports and discussions, it seems that the Public Company Accounting Oversight Board is close to finishing its “transparency” project, pursuant to which the most significant development would be making public the name of the lead audit partner.

Possible ways to do this include having the partner actually sign the audit opinion with his or her own name in addition to the name of the firm, leaving the signature the same but naming the audit partner in the body of the audit report, or having the firm supply the name of the partner in a report to the Public Company Accounting Oversight Board that would be publicly available.

Some believe that the PCAOB wants to go the “signature” route, while audit firms, the Securities and Exchange Commission, and others prefer one of the other solutions. Some suggest that the SEC wants to leave things as they currently are, with the name of the audit partner not being made widely available (although the information is by no means secret).

I really don’t see why it’s so hard to finish this up. It seems to me that there is general agreement that, first, a substantive portion (at least) of investors believe this information would be useful, and, second, the intent is not in any way to increase the personal liability of the audit partner. With those things agreed upon, and input from hundreds of intelligent people, there must be a way to get this done.

I can’t figure out why it’s taking this long, why the SEC would lay in the road to stop it (or why people think the SEC is doing that if it isn’t), and why this is generating as much argument as it apparently is. If a small change in the auditor’s report like this one generates so much hand-wringing, my hopes are not high for the PCAOB’s more significant project that could ask the auditor to communicate more substance in the report than in the past.

The Leasing Split

The Financial Accounting Standards Board and International Accounting Standards Board have been working on the lease project for a long time. Originally, they proposed a single model for lessee accounting, which would roughly apply current capital lease accounting to all leases. Then they proposed a “dual model” in which all leases would look like capital leases on the balance sheet, but many would look like current operating leases on the income statement, with straight line “lease expense” instead of a generally accelerated combination of interest expense and depreciation expense.

Again, my head spins. If there are only minimal differences in the approaches for major lessees, why are we complicating things by having different approaches?

Now it appears that FASB will stick with a dual model, although with a more familiar cut between the two models than in the latest exposure draft, while IASB will go with a single model, comparable to the original proposal.

This split seems like nothing new, as the boards have disagreed on many things recently. But the comments leading up to and following the split are what has my head spinning. Back in March, at a joint meeting, IASB Chairman Hans Hoogervorst said: “I agree with all those who say there is no simple answer.” If that’s true, it seems like a good idea for the boards to at least choose the same “non-simple” answer.

While IASB thought the move back to a single model was important enough to justify divergence from FASB and the most recent joint proposal, it nonetheless stated in an August release that “In practice, the difference in the IASB and FASB positions is expected to result in little difference for many lessees for portfolios of leases.” Again, my head spins. If there are only minimal differences in the approaches for major lessees, why are we complicating things by having different approaches?

When IASB decided to return to the original single model, it claimed that an important reason for doing so was that the single model approach is simpler. On the other hand, Jim Kroeker of FASB has reportedly stated that the dual approach is simpler (although I’m having a difficult time figuring out why). They can’t both be right, can they?

Either FASB is sacrificing convergence to satisfy those who are focused on having a predictable income statement or IASB is sacrificing it in the name of being able to say “one model,” because that sounds better. Of course IASB then complicates its one model by offering a scope out for “small-ticket leases,” whatever that means. But whichever board’s model you’re reading, don’t worry, it’s simpler than the other one—just ask them.

It’s All Simplification, I Guess

Continuing on with the theme, apparently, that standard-setting decisions should be explained as being “simpler” than whatever the alternative was, I was confused at FASB’s exposure draft on accounting by the purchaser of cloud computing services.

The question here was whether a company that commits to buy several years of cloud computing services (prepaying or not) should account for that arrangement in a similar way as a purchase software licenses, by capitalizing the cost as an intangible asset and amortizing it, or instead like a service arrangement, in which the expense would go through some line item other than amortization expense.

First, I thought this answer was clear already—if there’s no software license, it’s a service contract. Also, the main reason that people care about this issue is its effect on EBITDA, because, by and large, net income is not affected. I’m surprised that FASB decided to weigh in given that EBITDA is a made-up measure. That said, FASB is proposing what I believe is the right answer, so I’m happy there.

What confused me, though, is the headline indicating that this exposure draft was issued “to simplify accounting for cloud computing fees paid by customers,” and that the project is part of its simplification initiative. I don’t see how adding new requirements is “simplification,” and the project was proposed to FASB before the simplification initiative even existed. It’s an improvement that will eliminate diversity in practice, and that’s a good thing. It is also consistent with principles already laid down for the seller in these arrangements—that too is a good thing. It doesn’t also have to be justified as being simpler. Doing so just gives those who don’t like the answer another angle to push back on it.

The Auditor Failed to Do What?

One more source of confusion for me is a comment repeatedly found in several PCAOB inspection reports, including those of the U.S. firms of EY and PwC, which were issued over the summer. Those reports included repeated criticisms related to the work to assess the effectiveness of internal controls, with the PCAOB noting at least 10 times in each that the firm failed in testing a particular internal control by not “evaluating whether the control operated at a level of precision that would prevent or detect material mis-statements.”

The words themselves seem understandable, but the comment shows up in regard to evaluation of all kinds of controls over unusual or infrequent items, like business combinations, valuation of deferred tax assets, presentation of discontinued operations, and other areas. There is so little description in the reports that I can’t understand just what the firm was supposed to do. Companies generally have no trouble figuring out when they have entered into a business combination and remember to test the valuation of deferred tax assets every quarter. As long as the control is applied each time, what “level of precision” is missing?

I can only hope that this is clearer to the firms themselves than it is to knowledgeable readers of the report, like me, who are interested but not directly affected. Of course, the firms have not helped to provide any clarity, responding to the PCAOB’s reports with what amount to form letters indicating that changes will be made to address the concerns expressed. I’d love to know what changes were made, if only because that would help me understand what was missing in the first place. But nobody seems to want to explain that.

Which gets me back to my trouble in writing this column. Normally, I like to explain things, but on the matters here, I can’t figure them out. Perhaps my brain just took the summer off. Perhaps we need a little more transparency from the organizations involved. Or perhaps I can’t understand what’s going on because these things really don’t make sense. If it’s the latter, here’s hoping that fall brings some changes in more than just the color of the leaves.