Posted: May 25th, 2022

Restoring Investor Confidence in Financial Statements

Public Confidence in Accounting

Restoring Investor Confidence in Audits and Financial Statements

Scandals in the accounting profession have led to a sense of mistrust among the public. Investors depend on the accuracy of accounting statements to make key financial decisions. They must feel that they can trust the information on the accounting reports in order to make the best decisions with their money. Restoring public trust has been a key focus of the accounting profession and regulators for the past decade.

Attempts to restore public trust in the accounting profession can be divided into two general categories. The first are legislative actions that impose stricter regulation on the accounting profession. The PCAOB is one of these measures. The PCAOB serves as an oversight board for public accountants who are working for publicly owned companies. However, there are many loopholes and misunderstandings that must still be worked out in order for the PCAOB to be an effective regulatory force.

The second type of action that is designed to restore public confidence in the accounting profession are actions that are designed to allow the accounting profession to police itself, as it has done in the past. The creation of a system of rotating third-party audits and the creation of an oversight committee are two of these measures.

This research will explore the merits and deficiencies of each of these regulatory approaches. It will examine which of these will be the most likely to result in the restoration of public trust. It will support the thesis that none of these efforts will be effective alone, and that it will take a combination of self-regulation and legislation to equate the maximum restoration of public trust.

Introduction / Summary

Scandals in the accounting departments have become the corporate plague of the 21st century. The negative effects of accounting scandals can be felt throughout the financial sector. Accounting scandals make investors hesitant to place their hard-earned money in companies, for fear of being cheated. Accounting scandal has an overall effect on trust in the accounting profession. The public does not know if the information that they are receiving is a true representation of the company. Accounting scandal might also have a negative effect on the desire of customers to purchase a company’s goods or to use their services. Distrust in the accountants might be reflected in distrust in the company as a whole, or perhaps in some cases, an entire business sector.

Financial statements are a key factor in the decision making process of investors. Investors depend on these statements to be accurate and a good representation of the company of interest. Currently, accountants in the United States must comply with a set of rules called the Generally Accepted Accounting Practices (GAAP). Many have the perception that the GAAP is a set of concrete rules that result in uniform reporting of the facts about the company’s financial position. However, the GAAP is not a set of absolutes, but a set of guidelines. Within these guidelines, various differences can exist that are specific to certain industries or situations. The consumer is often not aware of these differences and how they can affect the financial outlook of the company. Recently, there has been a public outcry to fix the system so that financial reporting is uniform across various sectors and among different companies. Often management has a motive to make their company appear as good as possible so that they can attract investors.

The negative effects of scandals on the accounting profession and the companies that they represent have led to the need to find ways to restore integrity to the profession and to the companies that they represent. Increasing accountability among accountants has been the key focus of debate and proposed actions designed to increase accountability in the profession. Many different suggestions have been proposed to accomplish this task. They range from legislative measures, oversight measures, audit committees, and accountant switching measures. All of these proposed suggestions have advantages and disadvantages. The following will explore the suggestions that have been proposed and will evaluate them in terms of their likely effectiveness in increasing honesty in the accounting profession and increased public trust in them.

Analysis of Proposed Methods

Legislative Measures

Regardless of the effectiveness of the other methods that are employed to help increase accountant honesty and public trust in them, these measures must have a strong underpinning of legislative and legal support. Without a strong base upon which to build, any measure will be weakened due to the inability to enforce it. Several new legal approaches have been suggested that will serve as the base for other actions to help increase accountability and trust in the accounting profession.

The Sarbanes-Oxley act was the first of many new standards to be introduced on the tail of corporate scandal. The act led to the establishment of the Public Company Accounting Oversight Board (PCAOB). The accounting profession is becoming one of the most highly regulated industries in the economy. However, despite an ever-tightening legislative atmosphere, public trust still remains low as far as the accounting profession is concerned. The accounting profession is the foundation of the economy and a lack of trust in the accounting profession translates into a lack of trust in the economy itself.

The PCAOB was one of the most far-reaching reforms in the accounting profession since Roosevelt (Thomason, 2009). The PCAOB has the authority to dictate rules, governing standards, issue audit reports and conduct inspections of public accounting firms. They also have the right to impose monetary sanctions on firms that are registered for noncompliance. The establishment of the PCAOB was supposed to promote public confidence by creating oversight and regulation to an industry that had been largely self-regulating in the past (Thomason, 2009).

Regulations were set up within the PCAOB to assure that they remained free from political influence. However, it was not long before the constitutionality of the establishment came under question. Currently, this debate is unresolved (Thomason, 2009). The PCAOB was established as a nonprofit corporation that is assigned to carry out the provision of the Sarbanes-Oxley Act (SOX). This allows them to operate independently and free from political influence or lobbyists. As a nonprofit company, the individuals within the organization cannot be removed by outside influences unless there is evidence that they have not performed their job in accordance with set standards. However, many of the decisions of the PCAOB are limited by certain provisions and powers by entities such as the President or the SEC.

Public accounting firms must register with the PCAOB in order to be allowed to prepare reports on a public company. The purpose of the PCAOB was to restore the faith of the public in the accounting profession. However, their limited powers and the questionability of their authority create doubt in their ability to carry out their intended functions effectively. Therefore, the success of the PCAOB in restoring the faith of the American people is questionable.

Another approach to accounting regulation is mark-to market accounting. This is also referred to as “Fair Value” accounting. Accountants have received a great deal of blame in the most recent banking collapses. However, the accountant is only the messenger. Their job is to tell the story as accurately as possible. They must give an accurate picture of the real risks associated with financial decisions. It is the banks themselves that actually make the decisions upon which the accountant base their reports. The accountant could be considered the messenger in this case, they are not the ones who are responsible for the actions themselves (Seay & Ford, 2010). This is something that many people tend to forget.

As the messenger, accountants are concerned with transparency and the accuracy of their statements. Fair value reporting enhanced increases transparency and in doing so, is expected to enhance public trust in the accounting profession. Fair value came about as a result of the need to change traditional accounting valuation of assets. Under the current practice, some assets and liabilities are accounted for at a historical cost and some must be reported at fair value. A lack of consistency and framework regarding which method is to be used for which assets creates areas of inconsistency in the accounting statements.

The SFAS No. 157 was adopted to improve consistency and the ability to compare fair value measurements (Seay & Ford, 2010). The existing mark-to-market requirements were developed in response to be applied to select market instruments, such as derivatives and other financial instruments. Mark-to-Market assets do not have an effect on a majority of assets (Seay & Ford, 2010). However, for those assets that do fall under this initiative, the rules are said to be too objective and inconsistent. Once again, leaving the opportunity open for less transparency. Therefore, SFAS No. 157 will be likely to be ineffective at restoring public confidence in the accounting profession.

Concerns over SFAS No. 157 center around four main concerns. The first concern is that fair value accounting measurements are unreliable when there are no quoted market prices. This leads to the inability to compare financial statements reliably with each other (Seay & Ford, 2010). A second concern is that the income statement will reflect increased volatility due to fair market writeups or writedowns. The third concern is the inconsistency in valuing some assets and liabilities at the current exit price. The fourth concern is whether price reflects the intrinsic value of the asset. It is suspected that price and value will differ, particularly in a downward trending market (Seay & Ford, 2010).

These concerns will affect the acceptance of fair value accounting and its ability to restore trust in the transparency and accuracy of accounting statements. According to Seay & Ford, many blamed fair value accounting for the collapse of the banking industry. However, they remind readers that the accountant only reports the information and that they were not to blame in the banking industry collapse.

As one can see, legislative actions such as the establishment of the PCAOB and fair value accounting are limited in their ability to restore public trust in the accounting profession. This research suggests that the public does not have confidence in the ability of the legislation to provide the transparency for which they ask. They also do not feel that the proposed actions will result in consistency in the accounting statements. These measures are not being viewed as the answer to the dilemma.

Self-Policing Efforts by Accountants

Accountants realize the importance of their need to restore the confidence of the public in their profession. They also realize that the public is not entirely trusting of the methods being proposed to help restore their confidence by the government. Therefore, the accounting profession has developed several methods to help increase accountability, transparency and the faith of the public in their profession. These methods are being developed out of a feeling that that the government efforts will not be enough. The first of these methods is the establishment of audit committees. The second to be discussed is third=party audits and rotating auditing methods.

The concept of audit committees is not new. Audit committees have been around for nearly 40 years. However, recently recommendations and regulations propose extending their use and their responsibilities. The proposed measures are intended to strengthen their ability to restore public confidence (Bedard & Gendron, 2010).

The effectiveness of the audit committee is determined by their composition, authority and the resources that they are granted. These three elements have the greatest impact on investor’s perceptions of their capabilities and ability to effectively police the accounting profession (Bedard & Gendron, 2010). Another factor the significantly influences confidence in the audit committee is independence. The committee must be free of any relationship that could be construed as having any association with the business that is being audited. Bedard and Gendron state that even if the relationship is not important to the committee member, it can still result in mistrust among the public.

Another characteristic that is important in the effectiveness of the audit committee to establish public trust is member competency. They must be familiar with best practices and regulations. They must have demonstrated ability in performing their job. Audit committees are not always composed of accountants. Having at least one or more committee members who is a financial expert can go a long way in building the trust of the public (Bedard & Gendron, 2010). The final recommendation for the audit committee is that it must have a minimum of three members. This number is considered important in discouraging unscrupulous decision making. The chance for misconduct is decreased as committee members police themselves (Bedard & Gendron, 2010).

Bedard & Gendron’s review of various characteristics of audit committees and their perceived effectiveness found that all committees are not viewed with the same degree of trust by the public. In order to accomplish their monitoring jobs effectively and in a manner that encourages public confidence, they must be independent, experienced, competent in financial accounting and must be large enough to be considered self-policing.

Bedard & Gendron’s study made an important point about the ability to restore public confidence in the accounting sector. It is not enough to simply establish measures and policies. These measures and policies must have certain characteristics in order to secure the confidence of the public. It is not enough that they exist, they must prove their competence in order to generate confidence. It can be concluded that the effectiveness of oversight committees is only as good as the individual committees themselves.

Audit firm rotation is another method that has been suggested to help restore confidence in the accounting profession. Under this scheme, auditors would be rotated so that each auditor would be held accountable for their decisions. There would be less chance for dishonesty out of fear of being caught by the next auditor. A recent study compared the effects of audit firm rotation and audit partner rotation on confidence in the honesty of the accounting reports. The findings of the study suggest that audit firm rotation increased confidence more than audit partner rotation (Gates, Lowe, & Reckers, 2007).

Familiarity between auditors and their clients can promote the formation of strong bonds and a sense of closeness. This closeness can lead to relationships that are considered too close and can lead to the inability of an auditor to be objective in their assessment of an accounting report (Gates, Lowe, & Reckers, 2007). It is possible for them to have too much inside knowledge about their client and that this can influence their ability to be objective on the accounting report. A key case in point is the Enron auditors who shared in office parties and were given permanent office space within the building. People thought that they were regular Enron employees (Gates, Lowe, & Reckers, 2007). This close relationship was found to be a key factor in their unwillingness to present negative information about their client.

The length of tenure of the auditor-client relationship has been suggested to affect the independence of the auditor. Obviously, having an office inside the client’s building would also have an effect on the auditor. In absence of relationships with their own employees, the auditor would only form bonds with the client. Another scenario that might affect auditor independence is the low-balling of bids in order to get a client. The auditor might have a “need” to retain a client, which could have a negative impact on their impartiality. As one can see, many factors exist that could affect the impartiality of the auditor and their ability to deliver fair and accurate accounting information.

Rotation of audit firm and audit partner rotation were found to have a limited effect due to a lack of legislation requiring it. Mandatory auditor rotation was suggested as a means to increase public confidence in auditors and accountants. However, accountants have not received this notion well (Gates, Lowe, & Reckers, 2007). They have questioned whether the benefits outweigh the costs of such an endeavor. The results of this study indicate that firm relationships are an important factor in achieving greater confidence through auditor rotation. Firm rotation was found to instill greater confidence, as there was less of a chance for a relationship to develop between the auditor and the accountant (Gates, Lowe, & Reckers, 2007).

Conclusion

Accountants do not make the financial decisions that they report, but they are blamed when something goes wrong. When scandals are discovered, it is the auditor who must take the heat. Restoring public confidence in the auditing profession has become a major issue. This research explored several different approaches to restoring public confidence in the auditing profession. Several themes emerged as consistent with the ability to restore public confidence.

The first factor is that the public wants mandatory, not voluntary compliance with programs. The general consensus is that those who volunteer are not the ones to worry about. The second theme that emerged is that the public wants independence and a lack of relationship that could jeopardize the objectivity of the auditor. They also demand competence and knowledge in regards to the auditor.

In order to achieve what the public wants in order to restore public confidence in the accounting profession, a multi-faceted approach is necessary. First, legislation must support the rotation of auditors and the establishment of audit committees. These laws need to set forth the minimum requirements and general operational procedures that must be followed. Third-party auditors must work to gain the confidence of the public. They must be seen as having a certain amount of integrity and concern for what they are doing in order to gain the public trust. Auditor rotation and the establishment of auditing committees can work to restore public trust, but only if these measures are established under clear guidelines and policies to ensure the quality of these programs.

References

Bedard, J. & Gendron, Y. (2010). Can audit committees deliver? CA Magazine; Sep 2010; 143 (7). 50-53.

Gates, S., Lowe, D. & Reckers, P. (2007). Restoring public confidence in capital markets through auditor rotation. Managerial Auditing Journal. 22 (1): 5-17.

Seay, S. & Ford, W. (2010). Fair Presentation — an Ethical Perspective on Fair Value Accounting Pursuant to the SEC Study on Mark-to-Market Accounting. Journal of Legal, Ethical and Regulatory Issues, 13 (1): 53-66.

Thomason, M. (2009). Auditing the PCOAB: A Test to the Accountability of the Uniquely Structured Regulator of Accountants. Vanderbilt Law Review. 62 (6): 1954-1989.

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