The purpose of this document is to provide those with a role in high-quality financial reporting with information relevant to the current financial reporting environment. It includes an assessment of risk factors that may be important for financial statement prepares, auditors, and audit committees to consider during the current reporting cycle. It also offers suggestions as to how each of these major constituencies can contribute to enhancing financial reporting for the benefit of investors.

The current economic downturn, the unprecedented events of September 11, and recent business failures have combined to create a financial reporting environment unlike any in recent memory. Investor confidence, already shaken by significant volatility in the capital markets, has been further unsettled by highly publicized restatements of financial statements, which have generated questions about the quality of financial reporting, the effectiveness of the independent audit process, and the efficacy of corporate governance. This environment is creating significant challenges for U.S. businesses and their management, boards of directors, audit committees, and auditors.

Always fundamental to the well-being of our capital markets, reliable and transparent financial reporting is particularly important in this troubled environment. Financial reporting cannot forecast the strengths and weaknesses of the economy. However, financial statements and related information, such as Management’s Discussion and Analysis (MD&A) can provide useful information that allows users to make informed decisions and facilitates the continued efficient functioning of our capital markets. This requires the attention of management, auditors, and audit committees, who not only must carry out their unique responsibilities in their respective areas, but also must work together to produce the high-quality financial reporting that is vital to our capital markets.

We have summarized the particularly challenging factors affecting financial reporting today, and have identified some of the financial reporting issues that are especially relevant in this difficult business environment. We also have highlighted the actions that management, auditors, and audit committees can take to effectively address these risks and produce reliable financial reporting.



 

The economic slowdown began with a decline in business capital spending and investment. With the burst of the dot.com bubble, businesses took a more pessimistic view of the economic future and curtailed spending on equipment, software, real estate, inventories, and other investments. One of the first sectors to suffer the effects of the reduction in capital spending was the high-tech industry, where earnings and share prices nose-dived.

As the effects of cutbacks in corporate spending rippled through the economy, temporarily soaring energy prices took money out of consumers’ pockets and ate into corporate revenues. Earnings sank, borrowing capacity dwindled, growth slowed, energy prices dropped, and the stock market tumbled. Investor wealth declined by trillions of dollars. Layoffs followed, and with the unemployment rate rising (although still historically low), the surprisingly hardy consumer spending finally started to wane. Companies initiated restructurings, inventory liquidations, and write-offs. The events of September 11 and their aftermath only worsened already deteriorating economic conditions.

These factors put downward pressure on earnings and other performance measures that, for most of the previous decade, had been on an upward trend. This change in direction has created a growing sensitivity in the capital markets to bad news.



Pressures to Perform



Businesses deal with pressures that arise from a variety of sources, both internal and external. External pressures come primarily from the capital markets, with many believing that Wall Street’s expectations too often drive inappropriate management behaviour. Management often is under pressure to meet short-term performance indicators, such as earnings or revenue growth, financial ratios tied to debt covenants, or other measures. Most often the intentions of management are to follow sound and ethical practices, but pressure may build when analysts and shareholders demand short-term performance and when competitors move closer to the edge of the range of acceptable behaviour.



Members of top management also may be pressured to demonstrate that shareholder value has grown as a consequence of their leadership. Boards of directors often create pressure on management to meet financial and other goals. There also is a well-established practice of motivating management with stock options and other equity instruments that attempt to align management and shareholder interests. With their own performance and compensation tied to operating or financial targets, management can in turn push hard on personnel throughout the company, including those in operating business units, to meet what may be overly optimistic goals. This high-pressure environment can create an incentive to adopt practices that may be too aggressive or inconsistently applied in an effort to meet perceived expectations of the capital markets, creditors, or potential investors. At some point, the motivation behind earnings management can become strong enough for individuals with the right opportunity to move beyond acceptable practices, even though they are otherwise honest individuals. The greater the pressures, the more likely individuals will rationalize the acceptability of their actions.



Complexity and Sophistication of Business Structures and Transactions



The increasing sophistication of the capital markets and the creativity of investment bankers and other financial advisers have fostered a wide variety of complex financial instruments and structured financial transactions. Many companies now use complex transactions involving transactions with one another in the form of purchases/sales of assets, derivative transactions, and intricate operating agreements designed to meet a specific reporting objective as well as an economic objective. Some companies have transferred assets off-balance-sheet or arranged for units to be acquired by special purpose entities, joint ventures, limited liability corporations, or partnerships, retaining substantially all the risks and rewards of ownership but without “control.” Recent business failures, including the boom-bust cycle of dot.com enterprises, have focused attention on the potential risks of these business structures and transactions and the challenge of reporting them in a way that is easily understood by financial statement users.

Many companies have adopted rapid and innovative forms of business expansion, either through acquisitions and mergers, or internal development. Such rapid expansion may have been necessary to support high price-to-earnings multiples. However, it also creates many challenges, including integrating disparate operations, melding internal control processes, and meeting expanded financing needs. Liquidity crises or financial reporting failures may result.



Complex and Voluminous Standards

Adding to the challenges businesses face are the number of accounting standards, interpretations, SEC staff positions, task force consensuses, statements of position, and so on, that continue to expand the body of technical material that must be understood and applied in the financial reporting process. Understanding this vast body of literature can be a daunting task, even for large sophisticated companies. Furthermore, as transactions become more complex, the accounting rules for them become highly technical and detailed, such as Statements of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities; No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities; No. 141, Business Combinations; No. 142, Goodwill and Other Intangible Assets; and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Complex and detailed rules become self-perpetuating, promising that their complexity will continue to increase. Every new regulation specifying how a certain transaction should be accounted for presents an opportunity for someone to find a way around it by creating an even more complex transaction. This, in turn, creates the need for a new rule to tighten the loophole, and so on. These rules have become so complex that management struggles increasingly to comprehend and apply them. Proper application often requires the attention and involvement of senior financial management and senior technical people in the auditing firms, and even then the decisions are subject to alternative interpretations.

The SEC recently has announced its desire to help registrants “get it right the first time” by discussing and pre-clearing registrants’ proposed accounting for anticipated events, planned transactions, or other unusual accounting matters prior to their inclusion in registrants’ financial information. The pre-clearance process should help registrants apply complex accounting standards to unusual situations, helping to ensure that financial statements reflect appropriate accounting policies and disclosures and reducing the risk of subsequent restatements.