Global capital markets and the global economy: analysis and commentary on the vision from the CEOs of the international audit networks.

The leaders of the six largest accounting firms (PricewaterhouseCoopers, KPMG, Deloitte, Ernst & Young, Grant Thornton, and BDO, which we will refer to as the "Big Six") recently published a vision of the future of the accounting profession. Specifically, the vision examines how financial reporting and public company auditing procedures must adapt to better serve global capital markets.

Satisfying the needs of an increasingly international business environment, characterized by linkages among countries in trade capital flows and movements of people, requires changes in current accounting reporting and auditing practices. While these changes may be difficult to accomplish, they should benefit investors and accounting professionals worldwide. The following provides an overview and evaluation of this vision, including a discussion of its implications for CPAs.

The accounting profession and the health of capital markets

The vision cites several requirements to maintain stability, efficiency, and growth in these markets:

* Satisfy investors' need for clear information

* Align and support the roles of the various stakeholders in these markets--preparers, regulators, investors, standards-setters and auditors--by appropriate forums

* Ensure the auditing profession is vibrant and sustainable, providing sufficient choice for all stakeholders in these markets

* Develop a new business reporting model to furnish relevant and reliable information in a timely manner

* Make sure large collusive frauds seldom occur

* Report and audit information based on globally consistent standards.

While these requirements are appealing, clearly defining attributes and measuring progress towards fulfilling them will be a difficult task. For example, specifying the information needs of diverse investors is a complicated charge. It is not clear how the auditing community can accommodate the varied interests of the different stakeholders. Although there has been progress on the convergence of accounting standards, a significant divergence in auditing standards and in enforcement of accounting and auditing standards exists internationally.

Investor information needs in today's economy

Changes in the business environment in recent years have had significant implications for the nature of the information investors will need in financial reporting--in particular:

* Various intangible assets, since the value of many enterprises is based on such assets

* Access to financial reporting information on a real time basis

* Customization of data, such as that produced using Extensible Business Reporting Language (XBRL)

To improve financial reporting of intangible assets, the accounting profession needs to develop better techniques to value intangible assets. Access to financial reporting on a real-time basis requires an even greater emphasis on the profession's ability to audit accounting processes and systems in order to ensure that information provided so expeditiously is reliable.

An interactive data system such as XBRL allows financial statement users to easily gather and compare information from different companies. XBRL tags individual data elements of business reports so that financial statement data can be instantly searchable and retrievable. By doing so, XBRL can assist users in analyzing data in their preferred formats, including different currencies and different accounting principles. Potentially, computer-tagged data would provide real-time, operational information for business managers. Its instant availability would dramatically streamline and accelerate the distribution of financial information to the public.

Barriers to implementation

The vision considers three major barriers to implementing significant changes in the nature of global financial reporting:

1. Expectations gap

The expectations gap represents a misalignment of expectations from both stakeholders and the public on auditors' ability to discover fraud. The vision suggests that clearer communication of the specific role of an audit is necessary. The vision also offers suggestions on fraud detection, including subjecting all public companies to a forensic audit on a regular or random basis to deter fraud. A forensic audit would require examination of all records, e-mails, and interviews of personnel under oath.

2. Attracting talent to the audit profession

An important factor in attracting and retaining staff of skill and integrity is reform of the legal and regulatory system to protect investors without putting the well-being of audit firms at risk.

3. International variation in legal and regulatory environments

The degree to which legal and regulatory environments differ from country to country can discourage reporting future-oriented information. To achieve the goals of the vision, there must be at least some global convergence in the legal and regulatory environment.

Implementation

The vision recommends convergence of accounting and auditing standards as a short-term measure to improve global financial reporting and analysis. Consistency among accounting and auditing standards, along with enforcement of these standards is imperative for global commerce to function at the lowest cost of capital. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been converging their accounting standards, and in doing so generating more understandable, principles-based standards rather than complex, technical rules. Nevertheless, this is hardly the short-term endeavor the Big Six refers to in the vision.

Convergence of accounting standards has implications for both large and small accounting firms, not to mention public companies. Changes in accounting standards are often difficult to implement for practicing accountants. The current convergence of the FASB and IASB standards will continue to cause significant changes in financial reporting for the foreseeable future, which will be especially difficult to apply because many of the forthcoming standards will be principles-based. Such standards place increased reliance on practitioner judgment. As such, new standards will require management accountants and independent auditors to change their mindset. No longer will standards be checklists of bright lines to follow.

Additionally, there is no significant convergence of national audit standards relative to the standards of the International Federation of Accountants (IFAC). Since audit standards are incorporated into national legislation in many countries, such convergence is especially problematic. Complicated as well is the international variation in definitions of terms such as "audit independence."

Nevertheless, the U.S. Public Company Accounting Oversight Board (PCAOB) has proposed convergence. The goal is to reduce national differences in auditor oversight and in enforcement of audit standards through participation in the Independent Forum of International Audit Regulators. However, it is one matter to converge standards and quite another to converge interpretations, especially their enforcement from one country to another.

As shown by the Sarbanes-Oxley Act, implementation of new auditing standards can be arduous and costly. To accomplish convergence in auditing standards, an extensive modification of current auditing standards is necessary, which will impact independent auditors in the U.S. and elsewhere.

In the long term, the vision emphasizes the importance of reporting non-financial information, including industry-based, user-customized and readily accessible data. In fact, a new business reporting model is proposed, which would require a clearer specification of the role of the auditor.

The vision identifies the need to attract the best and brightest personnel not only in accounting, but also in information technology, finance and taxation. The Big Six also call for reform in legal and regulatory systems:

Audit firms and their global networks are not insurance companies.

Legal and regulatory systems must reflect this reality. Individual

auditors who engage in wrongdoing must be punished, but without

threatening the financial viability of their firms. (1)

Clearly, the firms are apprehensive about the demise of another Arthur Andersen.

Recapitulation

The vision accentuates the benefits of independent auditing in global markets to:

* Improve capital allocation

* Insulate the global financial system against systemic risk by providing transparent reports

* Promote appropriate corporate governance by furnishing appropriate information for stakeholder decision making

For these purposes, users of financial reports worldwide presumably desire information that is relevant, reliable, timely, understandable and comparable. However, contrary to what the Big Six suggest, it is not at all clear what users specifically want or need in financial reports. Research in this area has not been productive since users may perceive that they need the information they currently receive, or are unsure what information they really need. Moreover, it is not evident how specific users actually apply accounting information in their decision making.

Overall, the vision offers provocative proposals to strengthen global financial reporting and auditing. Such ideas will be hard to implement in light of significant differences in the legal and regulatory environments, including educational and licensing requirements, from country to country. The Big Six themselves, in fact, consist of networks of national firms rather than global operating enterprises.

To implement the principal recommendations in this vision, universities throughout the world would have to expand their accounting curricula to place considerable emphasis on information systems (their design, operations, and assessment), intangible assets and their valuation, and non-financial information to be incorporated into annual reports. (2) The foregoing are subjects that have received short shrift in accounting curricula.

Finally, an important recommendation that the vision does not make is to foster ethical values in accounting and audit practice, a long-neglected area that needs considerable attention to improve the quality of accounting and auditing on a worldwide basis.

ENDNOTES

1 Without much success, the AICPA Jenkins Committee Report (New York, 1994) previously recommended the inclusion of non-financial information in financial reporting.

2 Mainelli and Ronen have proposed audit insurance to enhance the quality of financial reports and to deter audit failures. Insurance companies would insure enterprises against fraud, charging premiums based on careful risk assessment. It is the insurance companies that would pay the audit fees. The premiums would be publicized, and thus would undoubtedly impact the stock prices of the enterprises. Accordingly, firms would have an incentive to lower their risk. See M. Mainelli and J. Ronen, "Put Your Money Where Your Audit Is: Financial Statement Insurance in the UK?" Financial World, May 2006, pp. 36-39.

Robert Bloom, Ph.D., is Professor, Accountancy and Wasmer Fellow in the Boler School of Business at John Carroll University. He is the author and editor of a number of books and many articles in professional and academic journals.

Mark Myring, Ph.D., is Alumni Distinguished Professor, Accounting and Director of Graduate Studies in the Miller College of Business at Ball State University, Muncie, Indiana. He is the author of a number of articles in professional and academic journals.

RELATED ARTICLE: Update on reform debates

This past spring, the U.S. Chamber of Commerce and the U.S. Treasury each released divergent recommendations for modernizing the U.S. legal and regulatory frameworks. Both proposals aim to strengthen the market while ensuring that investors and business interests are protected on the global market.

Recommendations from the U.S. Chamber of Commerce include:

* Renovate the federal government's regulatory approach to financial markets and market participants.

* Allow the Sarbanes-Oxley Act of 2002 to become part of the Securities Exchange Act of 1934, so the SEC will have the flexibility to address issues relating to the implementation of SOX.

* Persuade public companies to stop issuing earnings guidance or to completely abandon quarterly earnings guidance, with one earnings per share (EPS) number instead of annual guidance with a range of EPS numbers.

* Encourage domestic and international policy-makers to consider the risks public audit firms confront from catastrophic litigation, while also allowing national audit firms to raise capital from private shareholders other than audit partners.

* Increase retirement savings plans by implementing a simpler 401(k) program while connecting all employers with 21 or more employees to financial institutions offering retirement arrangements to such employees.

Recommendations from the U.S. Treasury include:

* Reduce financial complexities by moving toward a more principles-based regulatory system.

* Consider the individual and cumulative impact on U.S. public companies arising from the challenges of implementing the Sarbanes-Oxley Act and the growth of overseas and private equity markets

* Analyze the sustainability of the accounting profession's business model as major accounting firms begin to concentrate.

* Consider whether the current system is producing high-quality audits while attracting talented auditors.

* Convince corporate directors that the goal is not mere governance but to produce better managed, more competitive corporations that earn investors' confidence.