William Shakespeare (1564–1616), British dramatist, poet. Friar Francis, in Much Ado About Nothing, act 4, sc. 1, l. 218-22. We do not value at its true worth what we possess, but when we lose a possession, we exaggerate (”rack”) its value; he is thinking of Claudio’s harsh treatment of Hero.
So much discussion about “fair value, ” mark-to-market accounting, and accounting standards such as FAS 157. This blog has never been about discussing or dissecting the technical merits of one accounting standard or another, or even about how accountants and auditors should apply the standards. I know enough to know my limits.
I also know enough to point you to some wonderful discussions of the technical aspects of the rules and the potential for relaxation of them in light of the financial crisis.
On September 30th, the SEC
themselves saw fit to provide additional explanation and interpretation of the standards and how they should be applied given the the ”current market environment”
(the term used three times in the four paragraph introduction to the Q&A.)
The five questions and their short answers, as well as a short conclusion, use the word “judgment” eight (8) times to essentially tell us:
“…because fair value measurements and the assessment of impairment may require significant judgments, clear and transparent disclosures are critical to providing investors with an understanding of the judgments made by management…”
“…the Center for Audit Quality (CAQ), the CFA Institute (an analysts association), the Council of Institutional Investors (CII), and the Consumer Federation of American (CFA) – we’ll call them the Four C’s…October 14 letter to the SEC added, “Investors have a right to know the current value of an investment, even if the investment is falling short of past or future expectations. It, therefore, is imperative at this critical juncture that we not engage in activities that would further obscure reality from investors and do more to damage confidence in the marketplace. We urge the SEC to be clear in rejecting urgings that are contrary to this imperative.”
…The TARP accounting debate centers around a choice among two treatments: (1) purchases/offers by the government are not relevant for valuation of unsold loans; or (2) it is appropriate to use the pricing information from government purchases to measure the fair value of unsold loans.
It seems that the debate exists because a reading of SFAS 157 indicates that both alternatives are within the rules; paragraph 11 of SFAS 157 states as follows:
“The fair value of the asset or liability shall be determined based on the assumptions that market participants would use in pricing the asset or liability. In developing those assumptions, the reporting entity need not [but presumably may] identify specific market participants.” (my additional language is in brackets)
So, instead, I’m going to look at the Big 4 auditors and the review of assumptions used in the models that determined the fair value of assets related to the financial services companies and their most troublesome assets. And we’ll look at the discomfort the Big 4 has whenever the word judgement enters the conversation. It’s the Big 4 auditors’ judgment in determining whether to accept management’s judgment in assigning values to these assets that stood between greed, incompetence, and fraud and the ongoing viability and return to profitability of many of these financial services organizations.
There are several issues that are relevant when the Big 4 uses an outside product or service or develops proprietary software tools to use as part of their methodology for auditing the client. And these issues will become very important as the firms determine how to audit XBRL financial statements (make or buy tools.)
…Given all the concern regarding asset pricing, especially of non-marketable securities, complex derivatives and other exchange traded and OTC products, I found this announcement refreshing and scary at the same time.
It’s refreshing if the firms are reviewing and vetting sophisticated tools, the same ones their clients are using (?) to be better at this…
The key issues are:
1)Having sufficient independent knowledge and expertise to test assumptions and logic used by third party tools to review client models as well as to review the soft IT-type access and change controls over the models.
2) Ensuring staff assigned to these audits are fully trained and up to date, not only in use of the tools but in the underlying accounting standards and principles the tools are built on.
3) Ensuring independence standards are maintained between tool vendors and auditors.
4) If tools used to audit pricing models are developed in house by auditors, ensuring that the Big 4 firms have sufficient staff and budget to maintain the tools functional and technical capabilities at the same pace as their clients’ use of similar tools and models.
My experience with Excel spreadsheets during both the Year 2000 initiatives and Sarbanes-Oxley testing
made me skeptical that audit firms sufficiently scope in complex financial models or address them with enough scrutiny and skepticism. The easy out is there.
The auditor’s role is to pass judgment on management’s judgment. Whenever auditors can rationalize that management knows better than they do and that the cost-benefit of getting smarter than management so they can scrutinize/test something is tipped too far to the cost side, they scope it out, or accept management’s assertions. If they do try to test, it is with one hand tied behind their back given the difficulty of keeping up on the technical aspects of complex models, such as for new and innovative financial instruments.
For another example of this fear of second-guessing management on complex models or assumptions used in estimates take a look at the Big 4 fear of additional disclosure requirements for legal contingencies. The agreement of the Big 4 with corporate management and their lawyers
to maintain or reduce current levels of disclosure under FAS 5 is directly related to their fear of second-guessing management on complex issues that they have no expertise in and of being stuck with the liability if they are wrong. Their comments on FASB’s proposal were, frankly, embarrassing to me as an accountant.
Here’s an excerpt from PwC’s comment:
…the proposal is likely to place undue strain on preparers, the legal community, and the auditing profession due to the fact that maintaining the privity of what is typically highly sensitive information is critical to a company’s successful legal defense. …The nature and subjectivity of the proposed disclosures will create a challenge for auditors to understand management’s assessments and obtain sufficient evidence to support them.
…Mr Quigley said that as the profession moved away from rules “some one’s going to need to exercise judgment to apply those principles”.
“If you want to then make that transition, you have to put in place a framework for actions that a preparer [company] or auditor can take - a layer of guidance that would sit on top of a set of principles-based standards.
“You could then start to build a base for defence if someone challenges your judgement,” he said.
It’s the ability to avoid using their judgment, to even be expected to use their judgment without protection from legal liability, that’s helping them avoid being called to account for their sheer ineptitude, impotence, and uselessness in helping prevent, warn, or mitigate the latest financial catastrophes. Our only solace is that the firms will be hurt financially as their markets consolidate and their clients strain to pay the multimillion dollar fees for a piece of paper
that says to no one in particular anymore, “present fairly…in conformity…”
…In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lehman Brothers Holdings Inc. at November 30, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended November 30, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Lehman Brothers Holdings Inc.’s internal control over financial reporting as of November 30, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated January 28, 2008 expressed an unqualified opinion thereon.
Ernst & Young
New York, New York
January 28, 2008