Effort to Close the Expectation Gap : CPAs to Propose Changes in Audit Procedures

The accounting profession earlier this month said it will propose changes in the form and substance of auditing standards in an attempt to improve performance while narrowing the gap between what auditors actually do and the public’s expectations.

The move is seen as a response to congressional criticism of the perceived failure of auditors to detect financial troubles at corporations before it is too late. It comes during a period of continued litigation by disgruntled stockholders and creditors resulting in multimillion-dollar judgments against accounting firms that gave clean bills of health to corporations shortly before they went under.

Some of the companies that were given unqualified opinions by their auditors before failing were Penn Square National Bank, Continental Illinois Corp., Financial Corp. of America, Drysdale Government Securities, ESM Government Securities and Baldwin-United.

“The test (of whether the changes will succeed) is whether these proposed rules would have prevented the E. F. Hutton check-kiting scheme,” said Robert Chatov, associate professor of managerial economics and policy at the State University of New York in Buffalo.

In that scandal, Arthur Andersen & Co., one of the Big Eight accounting firms, raised questions about Hutton’s cash-management system. But after receiving a positive legal opinion from a partner at Hutton, Andersen found Hutton’s financial statements to be “in accordance with generally accepted auditing standards.”

The most substantive of the 10 proposals made by the Auditing Standards Board of the American Institute of Certified Public Accountants would require an auditor suspecting illegal acts to notify the internal audit committee of the corporation, the board of trustees or the highest person responsible, rather than just the next person up the chain of command.

Indeed, Hutton officials told federal officials that the overdrafting stopped when it reached the attention of senior management two years after Andersen’s first suspicions.

The most visible change will be in the language of the standard report, language that has not been changed since 1947, according to Dan Guy, AICPA’s vice president of auditing.

The summary at the end of every annual report will be enlarged from two paragraphs to three to tell the public that the statements being examined were prepared by management, not the auditors, although the opinion or interpretation of those documents comes from the auditors.

The words “subject to (adjustments)” included in an auditor’s opinion have always been a red flag that something may be wrong. In an effort to make that red flag even more obvious, the committee has made the language less technical.

For example, when an auditor has doubts about the company’s continued existence, he or she can say so, instead of saying that its existence would be “subject to” adjustments in the bottom line if the company were forced to liquidate at fire sale prices and resulting value of the assets were lower than stated by the company.

“The (new) language is very brave,” said Chatov. “But as a practical matter, I can’t imagine accounting firms will say this and endanger their relationships with their clients.

“What they are not doing is more important than what they are doing. They did not ask the Securities and Exchange Commission (which oversees auditors) for an increased role. As a self-regulatory group, they are trying to maintain the status quo, and that will always present a dilemma.”

Abraham J. Briloff, professor of accountancy at the Bernard M. Baruch College, City University of New York, said: “I believe it makes a good beginning. Yet, if the profession assumes that turning the verbiage into mere platitudes will cause the problem to evaporate, then it is wearing blinders. It won’t distract congressional examination.”

The House Energy and Commerce subcommittee on oversight and investigations, chaired by Rep. John D. Dingell (D-Mich.), held 17 hearings on accounting practices during 1985-86 and plans to resume this year.

The AICPA rules are to be released next month for comment and would become effective, perhaps with modifications, in 1988.