How Good Ideas Still Lead to Bad Reporting

A number of different roles go into financial reporting. The Securities and Exchange Commission sets the rules requiring financial statements to be published and overseas the other parts of the process. The Financial Accounting Standards Board writes the accounting standards. Corporate accountants develop policies and procedures to apply those standards, implement systems to gather necessary information, and prepare the financial statements themselves.

Audit committees oversee the preparation of financial statements and hire auditors to certify them. The Public Company Accounting Oversight Board writes auditing standards. The auditor applies those standards in performing an audit and issues an audit opinion. The PCAOB inspects the audits. The SEC reviews financial statements and makes inquiries in the interests of identifying opportunities for improvement.

It’s a complicated process, and things can go wrong in many ways; sometimes problems happen even when everybody appears to be doing their job right.

One of those situations has been weighing on me lately. This problem doesn’t result in materially incorrect financial statements, but it does add cost and inefficiency to a process already difficult enough as it is. And because it isn’t clear that anybody is doing anything wrong, it isn’t clear how the problem should be fixed.

To illustrate the problem, I’ll walk through the steps I described above, narrowing in on the inefficiency—to wit, spending time and money on known and immaterial departures from Generally Accepted Accounting Principles.

As everybody knows, the SEC requires that financial statements be prepared in accordance with GAAP in all material respects, and the Commission looks to FASB to define GAAP. FASB identifies the correct accounting for a particular transaction or arrangement, noting always that its standards need not be applied to immaterial items.

Companies frequently implement policies and procedures designed to ensure that material items are accounted for in accordance with GAAP, while immaterial items are instead handled in a simpler (and cheaper) way. Some of the more common examples of this are: (1) expensing minor fixed assets instead of capitalizing and depreciating them; (2) expensing some overhead costs instead of capitalizing them into inventory; and (3) using straight-line interest expense instead of the effective interest method. Many other examples abound and everybody agrees that these are appropriate ways to make financial reporting more efficient.

In the not-too-distant past, auditors generally accepted these “simplifying” accounting policies after a qualitative evaluation that the policies were unlikely to lead to material departures from GAAP. Times have changed.

When a company follows an accounting policy that is inconsistent with GAAP, it is, of course, possible for the financial statements to wind up with a material error—something immaterial when a policy was adopted could become material over time. SEC questions have resulted in restatements in circumstances when a public company did not consider this possibility. Little surprise, then, that the PCAOB is interested as well.

PCAOB auditing standards require that an auditor accumulate and evaluate all mis-statements in financial statements that aren’t “clearly trivial.” Since these policies are departures from GAAP, it therefore seems appropriate that auditors propose adjusting entries like they would for any other mis-statement.

Because of that, auditors today want to know the size of the error caused by these non-GAAP policies before concluding that no further evaluation need be done, so that they can decide whether to propose an adjustment. The qualitative evaluation is now just a starting point.

When a company follows an accounting policy that is inconsistent with GAAP, it is, of course, possible for the financial statements to wind up with a material error—something immaterial when a policy was adopted could become material over time.

If an adjustment is proposed because the mis-statement isn’t “clearly trivial,” it then seems reasonable that the proposed adjustment be treated like any other proposed adjustment. Of course, companies generally decide not to record these proposed adjustments, as long the mis-statement isn’t material. This is perfectly understandable. The policy was adopted to save time and money without materially mis-stating the financial statements, and all the subsequent work confirmed that there was no material error.

Auditing standards, however, require that any unrecorded proposed adjustment be communicated to the audit committee. As such, if management doesn’t record the adjustment, the auditor needs to make the audit committee aware of the GAAP departure.

And there’s the rub: These are all logical, understandable positions and actions. And they are leading to wasted time and money.

Quantifying the effects of these policies requires the company to analyze transactions and events that it believes too small to worry about. Even if you can make reasonable estimates, auditors and companies may have difficulty determining what level of internal controls should be applied to information that is being gathered solely to confirm that something is not material, and therefore not important. Regardless, corporate accountants and auditors alike are spending time (and money) on things that everybody believes are not material in the first place—which, of course, undoes some of the benefit of adopting the simpler policy in the first place.

Further inefficiencies occur because audit committees are bothered with things that aren’t the result of anybody making a mistake and have already been determined to have no material effect on the financial statements.

None of this wasted effort can really be traced to anybody failing in their responsibilities. Everybody has acknowledged that GAAP needn’t be applied to immaterial things. The company has designed policies and processes to focus on material items, while allowing immaterial items to be handled more easily. The SEC has only sought to identify situations where management’s processes failed to detect material errors. The PCAOB has only sought to ensure that auditors don’t miss those material errors and that the audit committee is aware of any identified errors. Auditors are simply following professional standards that require them to evaluate departures from GAAP.

Fortunately, many participants in the process have identified this inefficiency and want to do something about it. Unfortunately, it isn’t clear what should be done.

In some cases, FASB is being asked to add guidance that scopes out small items from accounting standards, instead of relying on the general materiality exception. Where such guidance exists, not applying the requirements of the standard to these small items isn’t a deviation from GAAP at all, so no tracking of the effects is necessary.

For example, constituents have asked FASB to scope out “inconsequential” promises to provide goods or services from the requirements of the new revenue recognition standard, amid concern that without such an explicit exception, auditors (and therefore companies) would need to identify and quantify the effects of promises that seem to have little value, such as sending periodic information statements, or answering installation or operational questions by phone. Of course, nobody believes that accounting for such promises would make a material difference in the first place, but the potential need to prove it every year could be a significant undertaking.

Having FASB deal with these matters through the standards might be an elegant solution, if it could work. FASB board members have been receptive to exploring ways to do it. But it puts FASB in the position of trying to write a standard on identifying material items without the benefit of any information on the transactions the standard might be applied to. It also would invite transaction structuring to take advantage of the scope exceptions, and it would only solve the problem one accounting topic at a time. Thus, even if it worked for “inconsequential” revenue items, the problem would continue to exist in myriad other areas.

Since the problem largely resides in the auditing process, a more effective solution ought to be achievable by focusing there. Perhaps the answer is simply focusing on management’s controls for periodically reviewing these “systemic GAAP departures” to ensure they haven’t gotten material. Such controls wouldn’t necessarily need to include quantitative measures in order to be effective. And if the controls are shown to be effective, it seems we should be able to avoid the non-value-added tracking, quantifying, and reporting that is currently going on. Of course, I oversimplify by describing a solution in just a few sentences, but there must be a way to eliminate work that virtually everybody acknowledges is not addressing a significant risk of material mis-statement.

I should cop to my part in this mess. As an SEC official a decade ago, I was asked whether I believed that GAAP departures resulting from policies like these should be considered mis-statements. The answer seemed easy: if you aren’t doing what GAAP requires, you have a mis-statement, even if you were departing from GAAP for a logical reason. I wasn’t terribly concerned when I answered that question way back then, and I still can’t think of a different answer. But the consequences of treating these departures as errors have been far beyond what I had envisioned.