a © 2001 Arthur Andersen. All rights reserved. The Accountants Role in the New Economy Robert A. Johnson February 5, 2001

1 © 2001 Arthur Andersen. All rights reserved. Agenda Characteristics of the New Economy New Economy Impact on Management New Economy Impact on Accounting and Auditing New Economy Accounting Issues

2 © 2001 Arthur Andersen. All rights reserved. The External Context Has Changed Convergence Consolidation Globalization Privatization Emerging markets/trade shifts Deregulation Currency Crises Technology innovation Strategic alliances Recession? Core competence focus Knowledge Intellectual capital Intangible economy Supply chain integration Communications infrastructure e-Business Brand Corporate governance Investor pressures Change in social/cultural patterns Generation X

3 © 2001 Arthur Andersen. All rights reserved. Implications for Companies and Accountants New competitors Complex transactions Premium upon knowledge Political/ economic instability New skill needs Cross border sales Rising cost of labor Accelerating product cycles Core competencies focus Volatility of value New distribution channels Pricing pressure New business opportunities

4 © 2001 Arthur Andersen. All rights reserved. The Risk Gap is Growing Unacceptable Risk Gap Business Risks Ability to Manage Risks

5 © 2001 Arthur Andersen. All rights reserved. Business Risk Managers Worry They Cant Keep Up Does your company have a formal risk management process? Yes 30% Yes, But Inadequate 31% Dont Know 6% No 33% Source: 1997 EIU Study

6 © 2001 Arthur Andersen. All rights reserved. The New Economy Requires A New Management Paradigm

7 © 2001 Arthur Andersen. All rights reserved. Exploding Risks

8 © 2001 Arthur Andersen. All rights reserved. The Old Audit Paradigm Business Environment, Processes and Decisions Business Data Accounting and Management Information Financial Statements and Management Reports RealityInformation About Reality

9 © 2001 Arthur Andersen. All rights reserved. The New Audit Paradigm Financial Statements and Management Reports Accounting and Management Information Business Data Business Environment, Processes and Decisions RealityInformation About Reality

10 © 2001 Arthur Andersen. All rights reserved. New Audit Paradigm

11 © 2001 Arthur Andersen. All rights reserved. Understand the Business Assess Client Risk Controls Determine Residual Audit Risk Manage Residual Audit Risk The Business Audit Better audit Helps clients manage better Risk focus Control reliance Plank #1: A New Audit Paradigm: the Business Audit

12 © 2001 Arthur Andersen. All rights reserved. Understand the Business Assess Client Risk Controls Determine Residual Audit Risk Manage Residual Audit Risk UNDERSTAND THE BUSINESS In depth business analysis to address: What are the key business and financial reporting risks the company is facing? How does business information flow through the company, and what are the related risks? How do key risks impact the companys financial reporting? How effective is the company in identifying, sourcing, and measuring these risks?

13 © 2001 Arthur Andersen. All rights reserved. Assess Client Risk Controls Understand the Business Determine Residual Audit Risk Manage Residual Audit Risk ASSESS CLIENT RISK CONTROLS How does the company control key risks? How does the company know its risk control processes are operating effectively?

14 © 2001 Arthur Andersen. All rights reserved. Determine Residual Audit Risk Understand the Business Assess Client Risk Controls Determine Residual Audit Risk Manage Residual Audit Risk DETERMINE RESIDUAL AUDIT RISK Are there any risks not reduced to an acceptable level? If so, what elements of the business risk management process and risk control processes are not operating effectively?

15 © 2001 Arthur Andersen. All rights reserved. Manage Residual Audit Risk Understand the Business Assess Client Risk Controls Determine Residual Audit Risk Manage Residual Audit Risk MANAGE RESIDUAL RISK What additional company actions or audit procedures will reduce the specific risk to an acceptable level for purposes of the financial statement audit? What recommendations will we make to the company to improve its business risk management process and risk control processes?

16 © 2001 Arthur Andersen. All rights reserved. New Economy Accounting Issues New Economy Drives Accounting Issues/Risk –Rapid rate of change –Lack of traditional audit trail –Mix of high volume of relatively uniform transactions and limited number of unique complex transactions –Capital market volatility and nontraditional value measures

17 © 2001 Arthur Andersen. All rights reserved. New Economy Accounting Issues Proactive SEC Drives Accounting Issues/Risk –October 1999 New Economy letter –SAB 101 –SAB 99 –Blue Ribbon Commission –APB 20 Interpretation

18 © 2001 Arthur Andersen. All rights reserved. New Economy Accounting Issues Business models are changing rapidly –Software ASP Hosting Complex arrangements –Multiple elements –Strategic partnerships Each party may provide products/services to the other May involve equity instruments –Cash may pass back and forth Cash may not be indicator of fair value

19 © 2001 Arthur Andersen. All rights reserved. New Economy Accounting Issues Back to back transactions –May not be contractually linked –May not occur at the same time Swaps or exchanges are common –Product for products –Product for technology –Product for services

20 © 2001 Arthur Andersen. All rights reserved. New Economy Accounting Issues Various Accounting Literature May Apply –SOP 97-2 (software) –EITF 00-3 (hosting) –EITF (barter transactions) –EITF (gross vs. net) –SAB 101 (SEC revenue recognition) –EITF 00-8 (equity received for services) –EITF (multiple element arrangements) –SOP 81-1 (contract accounting) –FASB 68 (funded development) –EITF (equity issued for services) –APB No. 29 (nonmonetary transaction) –EITF (magnitude of boot)

21 © 2001 Arthur Andersen. All rights reserved. New Economy Accounting Issues Key Risks –Software accounting or some other model? –Identifying back-to-back transactions Documents may not link them May not occur at the same time –How to value various elements VSOE/fair value not established Residual method/undelivered elements

22 © 2001 Arthur Andersen. All rights reserved. New Economy Accounting Issues Valuation of equity instruments –Private company issues –Future accounting/impairment Valuation of other nonmonetary assets Impairment of nonmonetary assets received Is the earnings process complete? What is the business purpose of the transaction/transactions?

23 © 2001 Arthur Andersen. All rights reserved. The Accountants Role in the New Economy There is an increased need for accountants in the New Economy, but with new skills: –Better understanding of business processes –Deeper technology skills –Technical research capability –A solid analytical framework