Companies whose earnings are out of sync with the rest of their industry are more likely to misreport them.
Based on research by Stephen A. Zeff
Splitting Audits Into Two Opinions Could Improve Accounting And Professionalize Auditors
- The debate about whether accounting should be based on principles or rules should focus on auditors rather than on standard-setting institutions.
- Interpreting the phrase “present fairly” just to mean fulfilling Generally Accepted Accounting Principles, or GAAP, can lead in misleading accounting.
- Letting auditors themselves evaluate fair presentation, independent of GAAP, would allow them to judge accounting practice by principles rather than by checking off boxes stating rules.
Is good accounting based on principles or on rules? It’s an ongoing debate within the industry, with most skirmishes taking place over the standards set by the Financial Accounting Standards Board. But Stephen A. Zeff, an accounting professor at Rice Business, argues it makes more sense to focus on external auditors. In a recent historical/opinion paper, Zeff proposes altering the current language describing their duties.
Currently, auditors assessing a company’s financial position must opine whether the firm’s financial statements “present fairly…in conformity with generally accepted accounting principles,” or GAAP. The problem, Zeff argues, is that there are often several options to choose from among those included in GAAP. Under certain circumstances, those choices or the prescribed GAAP procedure itself can create misleading financial statements.
Instead, Zeff calls for a requirement that auditors provide separate opinions, first on whether the information in the financial statements is presented fairly, and second, whether all accounting choices are in accordance with GAAP. He contends this would foster professional judgment in the accounting profession and lead to a greater reliance on principles rather than rules. Zeff’s proposal is by no means without precedent in the United States. In his article, he carefully outlines the history of the phrase “present fairly": from its introduction by an American Institute of Accountants’ special committee in 1934, to its widespread adoption by 95 percent of auditors by 1937, to its 1939 linking with GAAP. Zeff also points out that from 1946 to 1962, auditing firm Arthur Andersen & Co. actually provided dual opinions in their audits of financial statements, decoupling their opinion “present fairly” from their opinion on whether the company’s financial statements complied with GAAP.
Zeff outlines three variations on how the dual opinion could work today. First, a “fairness” opinion would evaluate the company’s choice to use a non-GAAP accounting choice, in cases where a company and auditor believe a GAAP method is unacceptable. There has been a history of such practice already, and, as Zeff points out, “Somehow, corporate financial reporting was not thrown into chaos because of these announced departures from GAAP measures.”
Second, the auditor would offer an opinion on a company’s choice of among many GAAP methods, assessing whether the company’s pick was appropriate.
And third, the audit report would include a “fairness” opinion on whether a company’s non-GAAP accounting method over a GAAP method was in fact superior. Zeff concedes this last option would cause the most difficulty, because it represents the auditor recommending that the company depart from GAAP in order to present financial information fairly. But, he suggests, this is also an example of how an auditor would build a reputation for professionalism.
In recent years, Zeff argues, complaints over diminished meaning in financial reporting have spiked. At the same time, so have expectations for financial reporting. Separating the auditor’s opinion into two portions, Zeff proposes, would provide shareholders and the market with truly useful information.
Stephen A. Zeff is the Keith Anderson Professor of Accounting at Jones Graduate School of Business at Rice University.
To learn more, please see: Zeff, S. A. (2007). The primacy of “present fairly” in the auditor's report. Accounting Perspectives, 6(1), 1-20.