Magazine article The CPA Journal

Let's Try to Learn from Our Problems

Magazine article The CPA Journal

Let's Try to Learn from Our Problems

Article excerpt

Standard setters at the FASB and the AICPA and auditing practitioners have come in or a fair measure of criticism recently for either failing to issue adequate professional standards or failing to adhere to the existing standards.

Particularly in the area of audits of financial institutions--banks, savings and loans, finance companies, insurance companies, and other lenders--there has been criticism of the valuation of loan receivables and investments in debt securities. Losses inherent in loan and securities portfolios, it is charged, have not been recognized on a timely basis.

Some observers attribute this problem to defects in the historical cost accounting model and the slowness of the FASB to issue standards that mandate presentation of these assets in all circumstances at current value. These observers point out that current value would be more objective than historical cost because it is based on an estimate of the value of these assets now. On the other hand, so-called historical cost values are largely dependent on similar estimates of value, but, believe it or not, actually depend on projections that sometimes look ahead seven to ten years or more.

This anomaly results from the fact that, under historical cost, measurement and recognition of unrealized losses in portfolios are dependent on management's judgments about what will happen in the future. Both historical cost and current value require estimates. In both cases, the estimating method is the same, but the time horizon is actually further away for historical cost. Based on current value, there is a loss, but management maintains that the value will recover in several years and that the current unrealized loss should not be recognized.

It is the independent auditor's job to evaluate management's valuation of loan and securities portfolios and decide whether the evidence supports management's proposed valuation in the financial statements. In the absence of an accounting standard that mandates current value treatment for all loans and securities, the auditor's job is admittedly more difficult. However, it is still the auditor's job.

The conventional wisdom from almost everyone who has looked at the issue in the last 15 years is that allegations of prominent audit failures, i.e., the failure of a large public company or the revelation of major overstatements of assets and earnings shortly after receiving a clean audit opinion, at most reflect failure in application of the standards. In other words, the auditing guidance was adequate--it was just not followed. In contrast, there have been repeated calls for more explicit accounting guidance and intense criticism of accounting standards setters.

The underlying reason for this conclusion on the adequacy of auditing standards reveals the fallacy in the analysis. It is almost always possible to assert auditing guidance is adequate because the most general principles of auditing are at the top of the hierarchy (rank or ordering) of GAAS while the most general principles of accounting are near the bottom.

The auditor has to evaluate management's application of existing GAAP. That responsibility is increased rather than diminished when GAAP is not as explicit as some would like on a particular issue, e.g., whether debt securities are held for investment, sale, or trading.

Adherence to GAAS requires the auditor either to obtain sufficient, competent evidence to reach a judgment on compliance with GAAP, or state that there is a scope limitation. …

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