Accounting in Crisis?

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. • Proposed following a June 26, 2002 U.S. court decision that the present version is unconstitutional.

Consider Three 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 Secretary of the Treasury.

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.

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 Boundary Environment Process Inputs Outputs Feedback Loop Control Sensor

Source documents Transaction or event Analysis Reporting Trial balance Recording & posting The Accounting Process

Boundary Data Bank Information Classifying Accounting Information System Ongoing events in world Recording

First . . . Consider this • 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.

First . . . Consider this • 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.

First . . . Consider this • 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.

First . . . Consider this • 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.

First . . . Consider this • “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

Your 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?

Your Questions • Is the new paradigm really coming, or is this simply a case of divergent specialties resulting from an increasingly complex world?

Your Questions • Is it possible for a profession to consciously “reinvent” itself? If so, what are some examples of professions who have succeeded (or tried and failed)?

Your 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?

Your Questions • In light of the scandals that occurred after the commentary was written, do accountants have an opportunity to fulfill the role of the knowledge professional in the new economy. • Aren’t there other professions that have just as much claim to lead the “information economy?”

Your Questions • As the “information economy” continues to improve making information more easily and readily available to each individual, will there not be fewer positions for these trusted knowledge professionals since their efficiency will be greater than those of today? Conversely, would each individual then become responsible for being their own knowledge professional?

Your Questions • Is it possible that the evolution of the accountant/auditor profession will end in a merger with the finance profession? Or will software replace them both?

Your Questions • Is this field moving so fast that when teaching new methods, they will be outdated by the end of the semester? Does the teaching professional need to be revolutionized as well?

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

Some 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?

Some 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!)

Some 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.

Your Questions • The words “in a timely manner” were used throughout the article in reference to auditors reporting information. What would be considered “timely” in the eyes of the law.

Your Questions • How were auditors ever entrusted to fulfill their duties when they reported to top management of the firm they audited?

Your Questions • The author points to information asymmetry between insiders and the investing public as a source of inefficiency in capital markets and asserts that auditors can “balance the scales” by providing accurate and trustworthy information about business entities. How far do you believe the auditing function can reduce this asymmetry and level the playing field between insiders and the investing public?

Your Questions • Is there a way to redefine the accounting system to ensure that a “single financial reporting failure” is not a disaster that wipes out “decades of hard work, planning, and saving?”

Your Questions • How can the bonds between managers and independent auditors be entirely broken when large amounts of money from corporations fund the independent auditors?

Your Questions • Why did the Enron and WorldCom failures demand meaningful reforms, but past failures did not?

Your Questions • Were the financial reporting of Enron and WorldCom legal or within the rules of accounting authorities?

Your Questions • The FASB rules currently permit distorting financial reporting of Special Purpose Entities. Why?

So . . . What is “wrong” with Accounting? Accounting in the 21st Century Testimonies Before the U.S. Senate Banking Committee

The Traditional View of Accounting • “Transaction” oriented • Narrow focus on financial data • Reporting is periodic and not real-time • Limited accessibility of information • Too high a level of aggregation

The Traditional View of Accounting • Limited flexibility which prevents answering queries that cross functional boundaries.

Accounting in Crisis?