Susan Schmidt Bies: Challenges facing the accounting profession today
Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, to the Cincinnati Chapter of the Ohio Society of Certified Public Accountants, Cincinnati,
Ohio, 28 September 2004.
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Introduction
Good evening. Thank you for the invitation to speak to you during your annual CPA Recognition Night.
Those of you who are new to the profession no doubt realize, just as your more experienced
colleagues do, that you are entering into this noble area of service during a dynamic and crucial time
in its existence. You are entering the profession just as new rules, greater responsibility and increased
scrutiny are being imposed on accountants and auditors alike in response to the discovery of
accounting and auditing improprieties in the recent past. In addition, as the world of commerce and
business continues to change, it is vital that the accounting profession responds to meet the
challenges of auditing new innovations.
This evening, I will share some of my views on the challenges that the profession faces today,
particularly with regard to accounting and auditing in service industries and model-based accounting.
Accounting in a service based economy
I think it is fair to say that nearly all of us, including those of you who are new to the profession, first
learned about accounting from the "old economy" perspective of retail and manufacturing. Our
accounting text books gave us examples and exercises that pertained to the XYZ Corporation that
sold widgets. In this context, we learned that assets and liabilities were valued on a historical cost
basis and that the earnings cycle was completed when sales occurred. Indeed, we learned the
fundamental concept that revenue was recognized only when it was earned.
Today, our economy is becoming more and more service-based. Unlike in manufacturing and retail
trade, where the sale marks the end of the earnings process, in most services the sale of the service
marks the beginning of the earnings process. In the case of services, once the sale has closed,
revenues are earned over the ensuing period in which such services are rendered. If earnings are
recorded at the time of the sale, that is at the beginning of the service process or before risks are
transferred, the financial statements may not be reflecting the earnings process. You may recall that
the practice of recognizing revenue "up front" was used by some high-tech firms a few years ago,
sometimes in inappropriate circumstances. The Securities and Exchange Commission issued
guidance at that time to clarify that revenue should be deferred until it is earned.
One major industry affected by these concepts is the financial services industry. While a small amount
of revenue is received for transactions, most is generated by sales that lead to future revenue
streams, such as that when a checking account is opened. In the context of the financial services
industry, the accounting practice used today is sometimes called the "mixed attribute" approach. This
means that some assets and liabilities continue to be recorded on a historical cost basis, while others
are reported at fair value or at lower-of-cost-or-market (LOCOM). In some instances in the mixed
attribute approach, changes in fair value are reported in earnings, while in other cases they are
excluded from earnings but affect the equity portion of the balance sheet. For example, assets that are
included in the trading account are carried at fair value and changes in fair value are reported in
earnings during the period. However, securities that are intended to be held until maturity are reported
at amortized cost with no change in fair value recognized in earnings unless permanent impairment
has occurred. Loans that are held-for-sale are separately reported on the balance sheet and recorded
at LOCOM, while loans that a bank intends to hold for the long-term are reported at amortized cost.
The mixed attribute accounting model is effective for financial services because it reflects differences
in the earnings process. Thus, when profits are generated through the trading account, earnings are
driven by the activity of buying and selling securities. Traders make decisions about what to buy, and
the market timing of the purchases and sales rest on comparisons of relative returns on the alternative
securities. The success of a trading account as a business reflects management's ability to identify
unusual valuations in the market and quickly act upon them. In this case, a fair value framework is
appropriate for accounting since it is similar to the information and decision process that management
is using.
An example of a different business model is a floating rate loan that is made and held on the balance
sheet with the intent to service the loan until it is paid off. Here, the floating rate means that changes in
market interest rates will not affect the fair value of the loan. Rather, credit quality and the cost to
service the loan are the two major drivers of profitability. Management's ability to underwrite the credit
initially, manage changes in credit risk over the life of the loan, and limit losses of principal and interest
and collection costs should a default occur, are key drivers of credit costs. In addition, the costs to
receive and post payments and service the loan over its life are important drivers of the operating
costs of making the loan.
In this case of loans made to be held in portfolio, amortized cost is appropriate accounting. The
interest received over the life of the loan supports the operating costs to service the loan that are
incurred while it is outstanding, as well as credit losses that occur, and the cost to acquire funding for
the loan. To the user of financial statements, amortized yield, operating costs, funding costs, and
credit quality each need to be visible to the user of financial statements, and be reflected in the period
in which they are earned or incurred.
Fair value accounting and auditing
While historical cost accounting methods have well-developed auditing techniques, fair value
accounting relies on key assumptions, modeling techniques and judgment. For example, modeling
techniques are commonly used in valuing mortgage loan servicing assets. The present value of the
estimated future net cash flows of servicing assets attempts to anticipate prepayments of mortgages
due to changing interest rates, fees earned from late payments, cost to receive payments and remit
funds to investors, costs to handle delinquent and charged-off loans and other factors. Changes in the
assumptions used in the modeling approach for any instrument or product will change the resulting
values. Further, the models used for financial statements look to what the market would expect these
revenues and costs to be, rather than the firm's specific information. Since sales of servicing assets,
especially for seasoned loans, is so irregular, it is often difficult to validate the model against actual
values seen in the market.
Thus, auditing model-based accounting requires a high level of specialized knowledge. The auditor
must fully understand how modeling or other sophisticated techniques are used to determine fair
value, and whether the assumptions used in the models are appropriate, and that the data has
integrity. Furthermore, "fair value" is not always clearly defined or easily determined for some products
or instruments. Certainly, a non-complex instrument that is highly liquid with an observable market
price is easier to value with more precision than a highly complex, illiquid instrument. Accountants are
being asked to know more than just the proper classification of assets and liabilities, but also the
appropriate way to value assets and liabilities.
Let me mention that the Federal Reserve supports a fair value-based measurement for assets and
liabilities used in the business of short-term trading for profit, such as the trading account for banks.
And we support enhanced disclosures of fair value-based information. However, we believe that the
accounting industry should be very careful before moving toward a comprehensive fair value
approach, where all assets and liabilities are recorded on the balance sheet at fair value and changes
in fair value are recorded in earnings, whether or not realized.
In today's world, with the myriad of complex financial instruments that exist and are constantly being
created, developing verifiable and auditable fair value estimates is a major concern. The lack of
observable market prices, differences in modeling assumptions, expectations of future events and
market conditions, as well as customer behavior make the task of assigning appropriate valuations
very difficult. And because fair value models are forward looking, the auditor has an additional
challenge of determining the line between normal variability in expectations that surrounds any
forecast and earnings manipulation.
To its credit, the Financial Accounting Standards Board (FASB) has recently issued an exposure draft
on fair value measurement. The proposal was developed to provide a framework for fair value
measurement objectives, and it is just the initial phase of a long-term fair value project. The initial
phase is generally intended to apply to financial and nonfinancial assets and liabilities that are
currently subject to fair value measurement and disclosure. It is not intended to expand the use of fair
value measurements in financial statements at the present time.
In our view, the proposal is a good first step in enhancing fair value measurement guidance, but we
believe additional guidance is warranted. Reliability issues should be addressed more
comprehensively in the proposal. Most important, the FASB should develop further guidance and
conduct further research and testing to enhance the reliability of fair value measurements before the
use of fair value is significantly expanded in the primary financial statements. Furthermore, we believe
that the FASB should work with other organizations including the Public Company Accounting
Oversight Board (PCAOB), American Institute of Certified Public Accountants (AICPA), and
accounting firms to enable the development of robust guidance that ensures fair value estimates can
be verified and audited.
Transparent disclosure
These concerns, among others, also raise the importance of disclosures in the financial statements
that assist readers in understanding how the financial statements reflect the business strategy, risk
management, and operating effectiveness of the enterprise. As organizations have grown in size and
scope, innovative financing techniques have made it more difficult for outside investors to understand
a particular firm's risk profile and the performance of its various lines of business.
Traditional accounting standards have not kept pace with the risk-management tools employed by
sophisticated corporations. Thus, more meaningful disclosures of firms' risk-management positions
and strategies are crucial for improving corporate transparency for market participants. The
improvements in technology, the quick pace of financial innovation, and the evolving risk-management
techniques enable businesses to use almost limitless configurations of products and services and
sophisticated financial structures. Accordingly, outsiders will have ever more difficulty understanding
the risk positions of many large, complex organizations. These developments represent significant
challenges to standard setters and to accounting firms. For market discipline to be effective,
accounting standards and disclosures must evolve to accurately capture these developments.
Challenges for auditors
Auditing firms are facing the growing challenge to build and pass along the knowledge possessed by
their professionals who truly understand the audit and accounting issues around particular business
lines. As companies broaden the range of products, services, and delivery channels they offer, clients
require more specialized knowledge for each operation. As we are all aware, there are fewer large
accounting firms competing in the marketplace today. I understand that many of the larger accounting
firms are no longer accepting audit engagements of some smaller or medium-sized companies. This
opens an opportunity for small to medium-sized auditing firms to become specialists - so-called "niche
players." In this way, smaller auditing firms can develop the expertise of their auditing staff around the
accounting and business practices of the specialized industries or particular types of clients, as
knowledge-sharing can be more successful when it is naturally more targeted.
Perhaps a broader question facing the auditing industry today is how to maintain and instill the
appropriate professional judgment required of auditors as accounting theory moves towards a more
principles-based approach. One impact that the Sarbanes-Oxley Act is having on preparers and
auditors of financial statements is the quest for more "bright line" rules so they can more readily know
when an interpretation comes close to the acceptable limit. But the changing business world,
especially around financial instruments, is making it impossible to write an accounting rule for each
potential nuance of innovation, and so we are turning to more principles-based accounting. Thus,
sound judgment is becoming a more valuable talent to businesses and their auditors. As CPAs, one of
your most important missions is to reinvigorate the profession to successfully address these conflicting
goals.
Other challenges
Let me also mention an area that places increased responsibility on auditors. I mentioned earlier the
PCAOB. The PCAOB was created through the Sarbanes-Oxley Act to oversee the auditors of public
companies. The PCAOB has recently approved Auditing Standard No. 2, An Audit of Internal Control
over Financial Reporting Conducted in Conjunction with an Audit of Financial Statements. The new
standard highlights the benefits of strong internal controls over financial reporting and furthers the
objectives of Sarbanes-Oxley. This standard requires external auditors of public companies to
evaluate the process that management uses to prepare the company's financial statements. External
auditors must gather evidence regarding the design and operations effectiveness of the company's
internal controls and determine whether the evidence supports management's assessment of the
effectiveness of the company's internal controls. While the new standard allows external auditors to
use the work of others, including work performed by internal auditors, it emphasizes that external
auditors must perform enough of the testing themselves so that their own work provides the principal
evidence for making a determination regarding the company's controls. Based on the work performed,
the external auditor must render an opinion as to whether the company's internal control process is
effective, which is a relatively high standard.
In addition, as part of its overall assessment of internal controls, the external auditor is expected to
evaluate the effectiveness of the audit committee. If the audit committee is deemed to be ineffective,
the external auditor is required to report that assessment to the company's board of directors.
This new standard will certainly put more demands on external auditors and public companies alike.
But in the world of business and financial innovation and growing complexity of firms, these standards
should encourage greater reliability of corporate financial statements and therefore, regain the
confidence of the public and the trust of financial markets.
Conclusion
In conclusion, I hope my views will give you an opportunity to think about some of the challenges both
accountants and auditors face in today's business environment. The accounting industry should be
cautious and prudent as it debates the merits of fair value accounting. Accountants and auditors alike
must be knowledgeable of the models and assumptions used in determining the fair value of products
and services. A models-based approach to valuations must produce results that accountants, auditors,
and market participants feel are objective. Standardsetters have the daunting task of balancing the
need to provide accounting principles that keep pace with financial innovation with the need to
promulgate standards that produce accurate, reliable and verifiable results.