Accounting in Crisis? Financial Reporting at a Crossroads

Laws of Accounting Trial Balances don’t Bank reconciliations never do Working capital does not Return on investments never will

The “New” Pledge of Allegiance One nation, under greed, with stock options and tax shelters for all.

Consider Five Quotations

Quotation #1 Transparent accounting plays an important role in maintaining the vibrancy of our financial markets. Alan Greenspan Chairman, Board of Governors of The Federal Reserve Board

Quotation #2 The single most important innovation shaping the (American capital) market was the idea of generally accepted accounting principles. We need something similar internationally. Lawrence H. Summers Former Deputy Secretary of the Treasury March 9, 1998 Remarks before the IMF

Quotation #3 The quality of information we now receive from companies in the U.S. is about the best we have ever seen and exceeds that of almost any other nation. Abby Joseph Cohen Chair, Investment Policy Committee Goldman, Sachs & Co.

Quotation #4 We are in a situation now in our society where the temptations to provide “bad” financial reporting are probably greater than they used to be. The need to get the stock price up, or to keep it up, is intense. Floyd Norris, Reporter 2001 Annual Report of the Financial Accounting Foundation

Quotation #5 While the U.S. accounting is generally recognized as the best in the world, the Enron collapse that unfolded in 2001 has reminded us all that there is still room for improvement. Manuel H. Johnson, FAF Chairman 2001 Annual Report of the Financial Accounting Foundation

What is the “purpose” of Accounting?

Objective #1 Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.

Objective 1 continued The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.

Objective #2 Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash flows.

Objective #3 Financial reporting should provide information about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners’ equity), and

Objective #3 continued The effects of transactions, events, and circumstances that change its resources and claims to those resources.

First-Order Feedback System Process InputsOutputs SensorControl Feedback Loop EnvironmentBoundary

General Purpose Financial Statements GPFS means that Information is... Not exactly what the investors need, Not exactly what the creditors need, Not exactly what the managers need, Not exactly what the regulators need, Not exactly what the tax man needs. It’s not exactly what anybody needs IT’S A COMPROMISE!!!

New Math for a New Economy Allan Webber FastCompany, Issue 31, p. 214 January/February 2000

New Math for a New Economy Accounting is all about accuracy. Accounting is all about hard numbers. Accounting is all about accountability. Accounting is a time-honored tool for making hard decisions about dollars and cents, about profits and losses.

New Math for a New Economy Accounting is the land of bean counters, of number crunchers – men and women with green eyeshades and calculators. Accounting says Baruch Lev, Professor of Accounting and Business at New York University’s Stern School of Business is increasingly irrelevant.

New Math for a New Economy The problem, says Lev, is that the systems of accounting and financial reporting that are being used today date back more than 500 years. These systems are not only part of the old economy, they’re part of the old, old economy.

New Math for a New Economy Luca Pacioli, an Italian mathematician who lived in Venice in the 1400s developed double-entry bookkeeping in order to offer business people a simple method for keeping track of their transactions – and even more important, for making sense of the way they did business.

New Math for a New Economy “If you cannot be a good accountant,” Pacioli wrote, “you will grope your way forward like a blind man and may meet great losses.”

The Evolution of the Knowledge Professional Robert K. Elliott and Peter D. Jacobson Accounting Horizons, March 2002

Introduction Wealth creation depends on knowledge work as never before, a change full of implications for those who provide information services. We argue that a new economic model has created a need for a new type of information professional.

Four Economic Paradigms Hunting and Gathering Agriculture Industry The Information Economy

Questions Is it possible that the role of the new information professional will never be fully defined? Since technology is now advancing at such a rapid rate, could the role of the new information technology professional be a moving target?

Questions Is it possible for a profession to consciously “reinvent” itself? Is the accounting profession attempting to “reinvent” itself, or what?

Questions The author argues that the accounting profession should take the initiative to expand its role in the information economy and serve as the foundation of the new information professional. Are there other professional disciplines that might serve as well or better as a foundation for the new information professional?

Financial Reporting at a Crossroads Michael H. Sutton Accounting Horizons December 2002

Challenging Questions Can we believe in and rely on the independent audit? Can we believe that our accounting and disclosure standards provide the transparency that is essential to investors and the public?

Challenging Questions Can we rely on self-regulatory systems to ensure audit quality and to root out and discipline substandard performance? No one wants Congressional Required Accounting Principles (CRAP makes a pretty lousy acronym!)

Challenging Questions Can we rely on corporate governance processes – oversight by boards of directors and audit committees – to ride herd on management and to see to it that auditors do their job?

Some Recommended Changes

Regulatory Processes Timely and thorough investigations of circumstances that may involve fraudulent financial reporting. Objective and fair assessments of the role and performance of auditors. Timely and meaningful discipline of auditors and firms that violate acceptable norms of conduct.

Regulatory Processes Regular oversight and periodic examinations of the policies and performance of independent auditors. Timely and responsive changes in professional standards and guidance when a need for improvements is identified.

So... What is “wrong” with Accounting?

Fundamental Problems “Transaction” oriented Narrow focus on financial data Reporting is periodic and not real-time Limited accessibility of information Too high a level of aggregation

Fundamental Problems Limited flexibility which prevents answering queries that cross functional boundaries.

THE Fundamental Accounting Problem?

THE Fundamental Problem We are using a 500-year-old system to make decisions in a complex business environment in which the essential assets that create value have fundamentally changed. Baruch Lev Professor of Accounting NYU Stern School of Business New Math for a New Economy

Shifts in Assets... Robert K. Elliott Accounting in the 21 st Century Assets Industrial era Information era Tangible Intangible

Intangible Assets Assets associated with product innovation (R&D) Assets associated with a company’s brand Structural assets – better, smarter, different ways of doing business. Monopolies (barriers to entry). Baruch Lev New Math for a New Economy

Intangible Assets Expensive to acquire and to develop. Extremely difficult to manage Property rights are fuzzy Baruch Lev New Math for a New Economy

Matching Principle Violation? Accounting is based on the matching principle. Good matching = good income number. Knowledge assets = mismatch.

What does all of this have to do with AIS? Subtitle: Are you trying to impress me? Or, are you trying to scare me?

Accounting in 2015 Michael Alles, Alexander Kogan and Miklos A. Vassarhelyi The CPA Journal, November 2000

Relevance of Accounting Central to the future of accounting is the continuing relevance of accounting measurement for corporate management and firm valuation.

Relevance of Accounting The balance sheet and income statement are ceasing to function as relevant measures of a business as underlying processes undergo profound change...

Profound Changes... Many companies only own research and development (R&D) and outsource distribution and manufacturing. Physical possession of inventory becomes meaningless where supply chain management is key.

Profound Changes... Businesses have adopted unorthodox ownership structures emphasizing alliance, tracking stocks, profit sharing agreements, and opportunistic joint ventures.

Profound Changes... Intellectual property is a primary source of a firm’s market valuation, but traditional assessment methods understate its value.

New Technologies Information capture technology Access and monitoring technology Storage Telecommunications and inter- networking Pervasive computing

New Technologies XML standards Automatic workpapers System monitoring architecture Automatic inventory tracking

The Sarbanes-Oxley Act of 2002 Public Companies Accounting Reform and Investor Protection Act of 2002

Sarbanes-Oxley Act of 2002 Directly impact these groups: CPAs and CPA firms auditing public companies. Publicly traded companies, their employees, officers, and owners. (Includes CPAs employed by publicly traded companies as CFOs or in their finance department)

Sarbanes-Oxley Act of 2002 Directly impact these groups: Attorneys who work for or have as clients publicly traded companies; and Brokers, dealers, investment bankers and financial analysts who work for these companies.

PCAOB Establishes a new Public Company Accounting Oversight Board (PCAOB). Board composition Two must be or must have been CPAs Three must not be and cannot have been CPAs

PCAOB Board composition – continued Chair may be CPA, but must not have practiced accounting during the five years preceding appointment. Appointed by the SEC. Subject to SEC oversight

PCAOB - Funding The Board will be funded by public companies through mandatory fees. Accounting firms that audit public companies must register with the Board and pay registration and annual fees.

PCAOB – Standard Setting The Board will issue standards or adopt standards set by other groups or organizations, for audit firm quality controls for the audits of public companies.

PCAOB – Standard Setting These standards include: auditing and related attestation, quality control, ethics, independence and “other standards necessary to protect the public interest.” The Board has the authority to set and enforce audit and quality control standards for public company audits.

PCAOB – Other Powers Investigative and Disciplinary authority International authority

The Sarbanes-Oxley Act of 2002 New Roles for Audit Committees and Auditors

Audit Committees & Auditors Auditors report to audit committee Audit committees must approve all services Auditor must report new information to audit committee Offering specified non-audit services prohibited

Audit Committees & Auditors Audit partner rotation Employment implications.

The Sarbanes-Oxley Act of 2002 Criminal penalties and protection for whistleblowers.

Criminal penalties Failure to maintain workpapers Document destruction Securities fraud Fraud discovery Protection for whistleblowers