Tuesday, August 4, 2020

Integrated Reporting and Risk: A Helix and a Spring

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Michael Kraten, Professor of Accounting at Houston Baptist University. Please contact Michael.Kraten@SaveTheBlueFrog.com with questions, comments, or suggestions about our blog, or to express interest in our organization.

This post has also appeared on the blogs of the Sustainability Investment Leadership Council, and on Dr. Kraten's own blog Save The Blue Frog. I encourage you to use these links to peruse these outstanding online publications.

Three years ago, COSO updated its Integrated Framework for Enterprise Risk Management (ERM). It was a noteworthy event in the business community, given that the Committee of Sponsoring Organizations of the Treadway Commission (COSO) is the leading authority that promulgates guidance about internal control and enterprise risk management systems.

Prior to this update, organizations utilized a cubic ERM framework that COSO first promulgated in 2004, following a scandal plagued era that featured the collapses of Enron, Arthur Andersen, and WorldCom. The original cubic ERM model emphasized the practices of event identification, risk assessment, control practices, and response capabilities.

After years of widespread use, the 2004 COSO Cube became synonymous with the practice of ERM. In its 2017 update, though, COSO presented a new “Focused Framework” with five components: (a) Governance and Culture, (b) Strategy and Objective Setting, (c) Performance, (d) Review and Revision, and (e) Information, Communication, and Reporting. To emphasize the “interrelated” nature of these five components, COSO designed a visual framework that weaves the five together in the form of a multi-colored Helix.

The designers of the Integrated Reporting <IR> Framework may have taken this Helix into account when they defined their own framework development goals earlier this year. Since 2013, issuers of integrated reports have used the International Integrated Reporting Council’s (IIRC’s) colorful Six Capitals model to structure their presentations. Some even referred to the framework as the Octopus Model, given its vaguely mollusk-like shape.

Like COSO, the IIRC felt the need to update this original framework. Its design project remains in progress, but the organization recently issued a model entitled “From String to Spring” that features an extension of the Six Capitals model.

Each of the six capitals of the <IR> Framework, like each of the five components of the ERM framework, is represented by a colorful String. Whereas the five “interrelated” Strings of the ERM framework are woven into a colorful Helix, the six “integrated” Strings of the <IR> Framework are woven into a colorful Spring.

Given the obvious similarities between the Helix and the Spring, it is hard to believe that the two design teams were oblivious to each other’s efforts to update their original Frameworks. Indeed, by presenting such similar models, COSO and the IIRC remind us of the significant “interrelationships” and “integrations” that link the functions of enterprise risk management and integrated reporting.

Thursday, July 2, 2020

The Case For Delisting Chinese Companies From U.S. Stock Exchanges

Editorial Note: We are delighted to present this essay by contributing columnist Steve Mintz, Professor Emeritus, Cal Poly, San Luis Obispo. When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

The Trump administration is considering whether to step into the controversy over whether foreign companies listing their stock on U.S. exchanges should be subject to the same accounting and audit regulations as U.S. companies. The problem is some foreign companies are reluctant to provide access to the Public Company Accounting Oversight Board to enable it to conduct audit inspections of registered public accounting firms. Absent equal access, there is a disconnect between regulatory oversight of U.S. companies and foreign firms.

According to the SEC, 224 U.S.-listed companies representing more than $1.8 trillion in combined market capitalization are located in countries where there are obstacles to PCAOB inspections of the kind. About 95 percent of firms whose financial statements cannot be reviewed use Chinese auditors.

The Public Interest

The public interest demands that foreign governments provide such access to level the playing field and protect investors. U.S. investors need to know that foreign companies are following the same rules that U.S. companies follow. Effective audits and regulatory oversight provide the foundation of trust in foreign companies listed on U.S. exchanges.

The world’s capital markets are global, as are the world’s largest companies. It is important that capital investment continue to flow internationally and U.S. stock markets are a major player in that process. In return for free access to foreign companies listed on U.S. exchanges, foreign companies must abide by market rules. One such requirement is for the PCAOB to have access to audits conducted by registered firms in order to inspect audits and make sure the financial information is of high quality and reliable.

U.S. Regulations

In order for the securities to be traded in U.S. capital markets, public companies, whether located in the U.S. or abroad, must comply with certain U.S. legal requirements, including the requirement to periodically file financial statements with the U.S. Securities and Exchange Commission. Sarbanes-Oxley requires that the auditor of these statements—whether a U.S. auditor or a non-U.S. auditor— must be registered with and be subject to the jurisdiction of the PCAOB. This includes undergoing regular PCAOB inspections to assess the auditor’s compliance with U.S. law and professional standards in connection with its audits of public companies.

According to the SEC, the PCAOB has conducted inspections of registered audit firms in 50 different non-U.S. jurisdictions (https://www.bloomberg.com/news/articles/2020-05-20/senate-passes-bill-to-delist-chinese-companies-from-exchanges). For the most part, regulators from foreign jurisdictions have cooperated with the PCAOB and allowed U.S. auditors to have access to the audit information of foreign companies. Still, this level of interconnectedness creates challenges, including regulatory oversight with respect to U.S.-listed companies with international operations.

Chinese Companies

Chinese companies that list their shares in the U.S. have long fought with the PCAOB over audit inspections. In some cases, the government either prohibits it or is not interested in cooperating with U.S. regulators. The Chinese typically explain it by saying the financial information may contain state secrets. More likely, it is a cultural issue in that by examining the audits already conducted by Chinese audit firms, a message is sent that those firms and, indeed, the Chinese system cannot be trusted  

President Trump and U.S. lawmakers have decided to get involved. Back in May, the President said that regulators are looking to see whether Chinese companies should be forced to comply with American accounting rules. Senators Chris Van Hollen (D-Md.) and John Kennedy (R-La.) have sponsored bipartisan legislation (Holding Foreign Companies Accountable Act) that would kick Chinese companies off U.S. stock exchanges if they continue to deny the PCAOB to access their audits (https://www.congress.gov/bill/116th-congress/senate-bill/945).

The U.S. Senate overwhelmingly approved the Act (S.945) on May 20, 2020, that would bar Chinese companies such as Alibaba Group Holding Ltd. and Baidu Inc. if they do not certify that they are not owned or controlled by a foreign government. Moreover, if the board is unable to inspect the issuer’s public accounting firm for three years, the issuer’s securities are banned from trade on a U.S. exchange or through other methods.

Costs and Benefits of Delisting

The costs of delisting Chinese companies should not be ignored. Indeed, the Trump administration may back off if it means delisting Chinese companies that do not comply with U.S. regulations when that motivates Chinese firms to flee to a competing foreign stock exchange. There may not be the appetite to deprive Americans of the chance to invest in Chinese companies. The stock exchanges may be reluctant to lose the presence of an important emerging market.

The benefits of removal from the exchanges are many. It starts with being able to verify that the audits were conducted in accordance with U.S. standards, which may be part of the reason Chinese authorities are reluctant to open up the books of Chinese companies. In China, most of the enterprises are state-owned and the standards for auditing are set by the government. Most important, holding both U.S.-based and foreign-based audit firms to the same PCAOB oversight rules enhances trust, a key element of transparency.

Chinese companies benefit by having access to American markets but they do not play by the same rules. A lack of transparency into the ownership and finances of Chinese companies has been criticized by American businesses. In particular, China has classified some auditor reports on company finances as state secrets, thereby prohibiting cross-border transfers of audit documentation.


U.S. audit firms suffer when Chinese authorities place barriers to access audit reports including those of Chinese affiliates of the Big Four accounting firms. Recently, each paid $500,000 to the SEC to settle a dispute about their refusal to provide documentation on Chinese companies, which an American judge ruled was a violation of U.S. law.

Recent examples of delisting illustrate why it is so important for the PCAOB to be able to audit Chinese affiliates of U.S. Big 4 audit firms. Failing to open up the books so that the PCAOB can conduct an audit inspection can mask a financial fraud that would otherwise be detected. A good example is Chinese company Luckin Coffee Inc., which recently disclosed it had an accounting fraud.  Luckin’s shares were sold on the exchange for just one year. It was touted as a Chinese rival to Starbucks. But trading was halted in April 2020 after an internal investigation found about $310 million in fabricated transactions.

Chinese companies should be held to the same standards as other foreign companies that list their stock on U.S. exchanges. There is no sound basis to give preferential treatment to Chinese companies simply because they are reluctant to open their books and audits for inspection by U.S. regulators.

Steven Mintz, professor emeritus Cal Poly San Luis Obispo

Tuesday, June 23, 2020

The Historical (And Yet Contemporary) Importance of Behavioral Accounting

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Michael Kraten, Professor of Accounting at Houston Baptist University. Please contact Michael.Kraten@SaveTheBlueFrog.com with questions, comments, or suggestions about our blog, or to express interest in our organization.

This post has also appeared on the blogs of Econvue and the Sustainability Investment Leadership Council, and on Dr. Kraten's own blog Save The Blue Frog. I encourage you to use these links to peruse these outstanding online publications.

The field of behavioral finance studies the behavior of the investment markets. Similarly, the field of behavioral economics studies the behavior of the global economy and the numerous national, regional, and local economies.

But what of the field of behavioral accounting? How does it resemble the fields of behavioral finance and economics? And how does it differ?

Behavioral accountants, like their colleagues in the other financial professions, focus on elements of human characteristics that can be identified in aggregate data sets. They recognize that organizations, like markets and societies, are composed of individuals who make personal decisions in often-predictable ways. Thus, because behavioral researchers can understand and predict individual decisions in various situations, they are also able to understand and predict the impact of aggregate decisions.

Accountants, though, specialize in the development of organizational reports that describe the conditions of organizations. Internal and external users of their reports rely on them to make important decisions that impact the well-being of those organizations. Thus, at times, accountants feel inherent tensions between the goals of “measuring and reporting data accurately and objectively” versus “measuring and reporting data that persuades the user to make decisions that help the organization.”

Individuals study to become public accountants to learn how to implement measurement and assurance procedures in support of the first goal. Separately, they study to become behavioral accountants to learn how to support the second goal. These goals overlap, but they are not mutually exclusive. In certain situations, they are perfectly aligned. In other situations, though, they have little in common, and they may even conflict.

A Controversial Example of Behavioral Accounting

A prime example of controversial behavioral accounting is commonly known as “greenwashing” in sustainability circles. Organizations cherry-pick data that appear to portray them as responsible guardians of the environment, and then present that data to persuade readers that they are responsible stewards of the natural world.

Volkswagen’s notorious collection of falsified emissions testing data is an obvious and egregious illustration of greenwashing behavior. Other illustrations are more subtle in nature, generating healthy debates over whether the content is misleading at all.

Consider, for instance, the pledge that was made by E. Neville Isdell, Chairman and CEO of The Coca-Cola Company. In 2007, he declared that “Our goal is to replace every drop of water we use in our beverages and their production.

On the one hand, the firm produced data that indicated the successful achievement of that goal. But on the other hand, investigative reporters have noted that “… ‘every drop’ includes only what goes into the bottle. The company does not count water in its supply chain — including the water-guzzling sugar crop — in its ‘every drop’ math.

Indeed, a public accountant may be able to provide assurance that the “drop for drop” phrase is (technically speaking) an accurate description of Coca-Cola’s water utilization patterns. But a behavioral accountant may protest that the vaguely defined phrase invites selective interpretation.

A Universally Admired Example of Behavioral Accounting

Ben & Jerry’s provides a contrasting illustration to the controversial food and beverage example of Coca-Cola’s environmental accounting practices. The ice cream manufacturer is often credited with producing the world’s first Corporate Stakeholder report (i.e. Integrated Report) more than two decades ago.

Using an internally developed proprietary format that the firm called Social & Environmental Assessment Reports (SEARs), Ben & Jerry’s published sustainability data on its web site for many years until concluding the practice in 2018. The reports employed colorful graphic imagery to express its core values, its focus on its social mission, its multiple year planning processes, its goal setting practices, and its outcomes. It also hired an independent public accounting firm to prepare annual independent review reports on the information.

The playful graphics, the earnest social messaging, and the metrics all served to reinforce the impression of Ben & Jerry’s as a socially conscious firm that made business decisions in support of the public interest. The behavioral impressions that were produced by the SEAR Reports undoubtedly supported the decision by Unilever to purchase the firm on friendly terms.

From The Past To The Future

Why did Abraham Lincoln begin his 1863 Gettysburg Address by noting an event that occurred “four score and seven years ago,” instead of simply beginning with the phrase “in 1776”? He must have known that his audience would have leaned into the arithmetic calisthenics of computing the year, thereby placing them in an appropriate frame of mind to focus on his intellectual argument about the war’s threat to democracy.

And why did he end his Address by vowing to protect the “government of the people, by the people, for the people”? Why didn’t he simply vow to protect “democracy”? Once again, he must have anticipated that the repetitive rhythmic triadic cadence would be more memorable to his audience. It’s also why Martin Luther King repeated “I Have A Dream” nine times in his immortal address, and “Free At Last” three times at the very end of the speech.

Lincoln and King both knew that the levels of the persuasiveness of the information that they conveyed to their audiences were just as important as the objective validity of their logical arguments. Such knowledge continually inspires today’s behavioral accountants to redefine traditional profitability measurements into more esoteric metrics like Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and Adjusted Consolidated Segment Operating Income (ACSOI).

From Abraham Lincoln to the Chief Financial Officer of Groupon, the principles of behavioral accounting have been widely used to influence the decisions of stakeholders. Indeed, it is not sufficient for an accountant to simply “get the numbers right.” It is also important for an accountant to “persuade the user of the numbers to behave in a desirable manner.”

Saturday, May 23, 2020

Once Again, A Lost Generation

Editorial Note: We are delighted to present this essay by contributing columnist Michael Kraten, Professor of Accounting, Houston Baptist University. The piece has also been published on the Blog of the Sustainability Investment Leadership Council (see silcmedia.blogspot.com) and Dr. Kraten's personal blog (see SaveTheBlueFrog.com).

When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

Precisely one century ago, Ernest Hemingway was living in Chicago and attempting to readjust to civilian life after experiencing the horrors of service as an ambulance driver for the Italian Army in World War I. F Scott Fitzgerald was drinking excessively and wooing his future wife Zelda while attempting to transition from an unsuccessful career in advertising to a lucrative one in writing novels and short stories. And the United States, as a nation, was struggling to recover from its loss of human life during the Spanish Flu pandemic, its failure to permanently “make the world safe for democracy” in World War I, and its inability to prevent the economic collapse of the 1920 Depression.

Hemingway’s and Fitzgerald’s subsequent tales illustrated the plight of The Lost Generation, the demographic cohort that came of age at a time when national leaders and the general public were asking serious questions about the sustainability of American society and its capitalist economy. Although the 1920s are now remembered as a time of prosperity, the decade also represented a time of escalating income inequality, debt-fueled business transactions, racial and religious bigotry, and political turmoil.

Today, much praise is bestowed on America’s Greatest Generation, the demographic group that came of age during the Great Depression and World War II. Much less attention is paid to the Lost Generation, though, the preceding generation that (according to Hemingway) believed that “if you have a success you have it for the wrong reasons. If you become popular it is always because of the worst aspects of your work.”

What caused such a pessimistic, fatalistic, and almost nihilistic perception of American business and society to be adopted by an entire generation? It could not have been a mere single catastrophic event; after all, many American generations experience such events. Perhaps, instead, it was the impact of a wide variety of catastrophic events that generated such cynicism, catastrophes that affected many different types of institutions that supported American society.

And what of today’s youthful generation? What of Gen Z, the demographic cohort that was born after 1996 and is now entering the work force? Their collective memories encompass the national security failure of 9/11, the military quagmire of the Middle Eastern wars, the economic collapse of the Great Recession, the radicalization of contemporary political movements, and the social and medical convulsions of the coronavirus pandemic.

Today, some citizens are calling for dramatic new investments in national programs, arguing that the failure to make such investments will result in severe economic losses. Others reply that massive increases in federal debt will be required to finance such investments, and that excessive spending will impose even more severe economic losses in the long term. 

But neither side is factoring the risk of the emergence of a new Lost Generation into its Return On Investment analyses. If we believe that the potential cost of a climate collapse must be factored into analyses of proposed environmental sustainability investments, perhaps we should likewise conclude that the potential cost of producing another Lost Generation must be factored into analyses of proposed social sustainability investments.

After all, a century ago, the Spanish Flu pandemic helped to produce a group of “Lost” authors who shaped the generation that stumbled into the Great Depression. What will the Coronavirus pandemic do today?

Wednesday, April 8, 2020

Accounting For Coronavirus Risk

Editorial Note: We are delighted to present this essay by contributing columnist Michael Kraten, Professor of Accounting, Houston Baptist University. The piece has also been published on the Blog of the Sustainability Investment Leadership Council. See SILCNY.com.

When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

As Queen Elizabeth makes her emergency address to the British people from her safe zone in Windsor Castle, and as the U.S. Surgeon General Jerome Adams warns the American people of an impending “Pearl Harbor Moment,” is it reasonable to ask why governments and businesses were caught blindsided by the coronavirus catastrophe?

Perhaps it’s unfair to expect foresight in the face of such a menace. But why weren’t health care providers and other organizations prepared to respond promptly? Why the shortages of such basic items as face masks and nasal swabs? Where was the contingency plan to increase production of such essentials at a time of dire need?

If we review the reporting standards of the Global Reporting Institute (GRI), we can find disclosure requirements that address these readiness considerations. GRI Standard 204 on Procurement Practices, for instance, states that:

“When reporting its management approach for procurement practices, the reporting organization can … describe actions taken to identify and adjust the organization’s procurement practices that cause or contribute to negative impacts in the supply chain … (these) can include stability or length of relationships with suppliers, lead times, ordering and payment routines, purchasing prices, changing or cancelling orders.”

Consider the many health care providers that rely on unstable Asian suppliers to provide face masks under terms that permit long lead times, uncertain ordering routines, and the imposition of extreme price increases when products are scarce. If they are required to disclose these procurement relationships under GRI Standard 204, we would be aware of the resulting social risk.

Likewise, GRI Standard 403 on Occupational Health and Safety states that:

“The reporting organization shall report … whether the (occupational health and safety management) system has been implemented based on recognized risk management and/or management system standards / guidelines and, if so, a list of the standard guidelines.”

Consider the employees of our food and delivery companies who are now protesting that their employers are not providing satisfactory protections against the coronavirus. If the employers are required to disclose the standards and systems that they utilize to keep their employees healthy and safe, we would be aware of the extent of their preparedness (or lack thereof) in the face of pandemic threat.

There are other GRI Standards that come close to addressing pandemic concerns, but that fall just short of the mark. GRI Standard 201 on Economic Performance, for instance, states that:

“The reporting organization shall report … risks and opportunities posed by climate change that have the potential to generate substantive changes in operations, revenue, or expenditure, including a description of the risk … a description of the impact associated with the risk … the financial implications of the risk … the methods used to manage the risk … (and) the costs of actions taken to manage the risk.”

Although Standard 201 refers to climate change, it would represent an ideal disclosure requirement for pandemic preparedness if the GRI simply adds the words “and pandemics” to “climate change.”

It may be comforting to know that disclosure defining entities like the GRI have issued standards that address our readiness to fight the current pandemic. But we cannot reap the benefits of these disclosure requirements if organizations simply ignore their reporting responsibilities.

Thursday, March 26, 2020

Economic Consequences of Relaxing the Rule for Small Companies to Audit ICFR

Editorial Note: We are delighted to present this essay by contributing columnist Steve Mintz, Professor Emeritus, Cal Poly, San Luis Obispo. When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

When economic and political considerations enter into accounting standard setting, a whole new range of public interest issues arise. The SEC just announced that it is relaxing its requirement for small companies to have an auditor examine their internal control systems and issue a report on their findings. This requirement has been in place since the Enron and WorldCom scandals of the early 2000s.

Why Relax the Rules?

The reason given for relaxing the rules for companies with annual revenue below $100 million and public shares worth less than $700 million is concerning to say the least. According to SEC Commissioner Hester Pierce, with this change a company trying to develop a vaccine for the fast-spreading coronavirus “will be able to pour resources and – importantly – management’s time and attention into that effort rather than into obtaining an internal-controls audit.” This is a knee-jerk reaction to the current spread of the virus and unworthy of being a goal of standard setting.

The Commission also rationalizes its decision by saying it is consistent with the practice of scaling disclosure and other requirements for smaller issuers. The problem is small businesses have more challenges with respect to fraud than larger ones. Writing in the Journal of Accountancy, “Report Finds Big Fraud Problems for Small Businesses,” Jeff Drew reviews the 2018 Report to the Nations on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners (ACFE) and concludes that the “lack of a control makes small businesses more vulnerable to fraud.”

The findings in the ACFE Report include the following.

  • 25% of frauds at larger companies were due to a lack of controls compared to 42% at smaller businesses.
  • Owner/executives committed 16% of frauds at larger companies compared to 29% at smaller businesses.
  • Some frauds occurred more frequently at smaller companies versus larger ones including check and payment tampering (22% vs 8%) and skimming and payroll fraud (20% vs 8%).

In the past, the SEC relaxed some regulations, especially in the finance and banking world, to send a signal to Wall Street that regulatory requirements will be lessened and these firms should look to use the money saved to expand economic development and the investment in new plant and equipment. The purpose of SEC regulations should not be to stimulate the economy.

It also seems that the SEC believes more companies will be able to raise money in public markets by easing regulations. The SEC may be on to something here but standards should not be set or relaxed based on a desire to stimulate the financial markets.

Costs of Relaxing the Rules

Four accounting professors reviewed the comment letters sent to the SEC about the initial proposal to ease the rules for internal control audits. They found that at least a dozen companies that wrote letters of support to relax the rule had disclosed accounting problems of their own. Some had to restate earnings reports due to errors, while other company auditors flagged “material weaknesses” in their internal controls over financial reporting (ICFR).

The authors did a preliminary analysis of earnings restatements in 2018 of 11 companies that the Commission proposed to exempt from internal control audits and found they restated over $65 million in net income that destroyed more than $294 million in shareholder wealth. They concluded that this destruction in wealth, caused by only a handful of restatements, dwarfs the proposal’s total cost savings of $75 million across all 358 affected companies.

Furthermore, a MarketWatch analysis of SEC filing data provided by research firm Audit Analytics shows that of 100 initial public offering filings in 2019 year-to-date, companies that use a Big 4 audit firm found 20 that have voluntarily disclosed serious issues with internal controls. So, by easing the rules fewer red flags will be raised on deficiencies in internal controls making it, presumably, easier to go public. How does this protect the public interest?

PCAOB Inspections

The problem is more pronounced when we look at deficiencies cited in ICFR as a result of the annual inspection of audits by PCAOB. Writing in The CPA Journal, Thomas Calderon, Hakjoon Song and Li Wang investigated 1,025 PCAOB inspection reports for years 2002 through 2012 and found about 50 percent had audit deficiencies, 131 of which were due to ICFR-related deficiencies. This is greater than a 25 percent deficiency rate in ICFR.

Deficiencies in ICFR can indicate there are errors in the financial reports that went undetected or material misstatements of the financial statements. Now that certain small companies are exempt from auditing the controls, it is possible that fraud will go undetected. As a result, a firm may give reasonable assurance about the accuracy and reliability of financial statements when a modified opinion should have been issued. In such cases, the public interest is at stake and the reputation of the accounting profession hangs in the balance.

By allowing economic consequences to influence whether certain companies must audit ICFR, the SEC has introduced bias in the PCAOB inspection process. The rationalization given that it will help companies invest in research and human capital makes no sense. How do they know companies will use the funds saved to develop a vaccine for the coronavirus or any other health-saving activity? What prevents these companies from using the funds to buy back stock or increase executive compensation?

What is the Public Interest?

The accounting profession exists because of the 1933 SEC requirement for public company audits that can only be conducted by independent CPAs. The franchise given to the profession is designed to best serve the public interest through independent audits that provide reasonable assurance that the financial statements are free from material misstatements including fraud. Given the important role of ICFR to prevent and detect fraud, the loosening of the rules for audits of the controls can only serve the interests of those companies affected by the rule change.

The SEC should not set rules designed to be an engine for economic development. The rule change is nothing less than a crack in the ethics wall that protects the public interest. Issues such as objectivity, representational faithfulness, due care and reliability are at stake. Changes in the rules to serve a particular political or economic interest has no place in accounting standards.

Friday, February 28, 2020

Peer Review: Stepping Forward!

In our continuing efforts to better serve our existing stakeholders and to expand our audience, the Public Interest Section of the American Accounting Association is delighted to announce its new peer review practice for contributors to its professional blog.

Upon request by a contributing author, two blind reviewers will be asked to review a submission and to reply with comments within three weeks. Given that a blog post is a much “lighter” document than a journal article, a three week review period should prove to be a manageable task.

After this original review, the finalization of a blog post should not require more than three additional weeks. Thus, blog posts are expected to require no more than six weeks “from submission to publication” in most circumstances. Submissions that address breaking news stories and other extremely topical events may be published much more quickly.

We expect that the publication of peer reviewed blog submissions will result in more submissions from a wider array of authors. Although a peer reviewed blog post is clearly not equivalent to a traditional journal publication, it is nevertheless recognized as a valid second tier intellectual contribution by many academic institutions.

Please contact Michael Kraten at Houston Baptist University if you wish to contribute a post, to discuss a topic for a potential blog post, or to volunteer to serve as a reviewer. Most importantly, thank you for your continuing interest in our section!

Wednesday, January 1, 2020

A Little Optimism For The Upcoming Decade

Editor’s Note: We are pleased to begin the new decade by publishing the following editorial piece by Michael Kraten, Professor of Accounting at Houston Baptist University. It is the third of a series of three columns that address the theme of The Evolution of the Public Interest in Accounting.

The piece was also published on the Blog of the Sustainability Investment Leadership Council. See SILCNY.com.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

As the calendar flips from 2019 to 2020, it’s easy to feel a bit depressed about the metrics that have challenged us during the past decade. The aggregate debt of the United States federal government, for instance, has exploded from $13 trillion to $24 trillion. Wealth inequality has also grown, and the number of American citizens without health insurance has resumed its climb after years of decline. Meanwhile, increases in sea levels, meteorological instability, and ocean temperatures are threatening our natural environment.

It’s a grim set of trends, isn’t it? But if we choose to focus on these dismal metrics, we’ll lose sight of the broader picture. There were, after all, many events that occurred during the 2010s that should encourage optimism among those who support the public interest.

At the start of the decade, for instance, the standards of the Global Reporting Initiative (GRI) merely provided a voluntary framework of reporting guidelines. But they would not remain a purely voluntary framework for long! In 2013 and 2014, the European Union issued a pair of directives on non-financial reporting. They required many of the world’s largest corporations to begin to include a wide variety of non-financial information in their annual reports, starting in 2018.

Furthermore, at the start of the decade, the Sustainability Accounting Standards Board (SASB) didn’t even exist. Launched in 2011, the SASB now promulgates detailed sets of standards for 77 industries, including sample disclosure language for inclusion in corporate annual reports. The SASB’s framework and standards, like the European Union’s directives on non-financial reporting, have served to impose sustainability reporting requirements and expectations on the world’s largest for-profit entities.

Meanwhile, the Task Force on Climate-related Financial Disclosures (TCFD) was launched by the Financial Stability Board in 2016 to recommend voluntary practices. Chaired by Michael Bloomberg, the Task Force presented its final recommendations the following year, and then remained in place to launch a Knowledge Hub, a pair of annual Status Reports, and a Consortium. The TCFD, like the GRI and the SASB, now focuses on developing and supporting private and public initiatives to enhance financial reporting practices.

The most startling development during the past decade, though, may have been the dramatic growth of the ESG investment industry. According to Fidelity, Socially Responsible Investing assets in the United States have quadrupled since 2010, rising roughly from $3 trillion to $12 trillion; the size of this asset market now exceeds $30 trillion worldwide (see fidelity.com/viewpoints/active-investor/strategies-for-sustainable-investing).

If you believe in the power of money, this final metric may be the most impressive one of all. After all, government entities and standard setting bodies may be able to protect the public interest against public apathy and private sector opposition. However, the re-direction of billions of dollars in investment funds can only occur if public opinion and the private sector support the movement.

So let’s try to maintain an optimistic perspective as we enter the next decade of the 21st Century. After all, the decade of the 2010s have produced an impressive array of positive occurrences. It is entirely possible that the upcoming decade of the 2020s will likewise give birth to many new trends that support the public interest.

Thursday, December 26, 2019

Stop the Madness: We Need a New Approach to Split-Off Nonaudit ServicesFor Audit Clients

Editorial Note: We are delighted to present this essay by contributing columnist Steve Mintz, Professor Emeritus, Cal Poly, San Luis Obispo. It is the second of a series of three columns that address the theme of The Evolution of the Public Interest in Accounting. 

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

The time has come to revisit the issue whether all nonaudit services should be prohibited for audit clients. The accounting profession continues to struggle with independence issues when both services are provided. The threats and safeguards approach in the AICPA Code does not seem to have reduced the instances of independence violations. Deficiencies in CPA firm quality controls and the failure to communicate independence issues with audit committees have exacerbated the problem.

Recent examples, just in 2019, illustrate a decline in basic ethics and the failure to protect the public interest.

  • On September 23, 2019, PwC agreed to pay $7.9 million to settle charges that the firm violated the SEC’s auditor independence rules by performing prohibited nonaudit services during an audit engagement, including exercising decision-making authority in the design and implementation of software relating to an audit client’s financial reporting, and engaging in management functions thereby creating a self-review threat to independence.

  • On September 10, 2019, Marcum LLP, one of the largest independent public accounting and advisory services firms in the nation, settled disciplinary proceedings with the PCAOB over advocating numerous issuer auditor clients in connection with the firm’s annual MicroCap Conference. As the host, Marcum praised the presenting companies, which included many of the firm’s auditing clients, as high-quality companies that were selected via a vetting process thereby creating an advocacy threat to independence.

  • On August 27, 2019, the SEC charged RSM US LLP (formerly known as McGladrey LLP), which is the fifth largest accounting firm in the U.S., with violating SEC independence rules in connection with more than 100 audit reports involving at least 15 audit clients for which they provided prohibited nonaudit services including corporate secretarial services, payment facilitation, payroll outsourcing, loaned staff, financial information system design or implementation, bookkeeping, internal audit outsourcing, and investment adviser services. A partner also had a prohibited employment relationship in serving as a non-discretionary member of the board of an affiliate of an RSM US issuer audit client, a management participation threat to independence.

  • On February 13, 2019, the SEC announced an agreement with Deloitte Touche Tohmatsu LLC (Deloitte Japan) to pay $2 million to settle charges that the firm issued audit reports for an audit client at a time when dozens of its employees maintained bank accounts with the client’s subsidiary thereby creating a self-interest threat to independence. An investigation by the firm revealed that 88 other Deloitte Japan employees had financial relationships with the audit client that compromised their independence.

This is just the tip of the iceberg. During the past few years we’ve witnessed the KPMG-PCAOB cheating scandal whereby the firm received inside information about audits to be inspected by the PCAOB from staffers who went to work for the firm. A partner at Ernst & Young tipped off a friend about non-public actions to be taken by an audit client that had the potential of moving the stock price.

It seems the United Kingdom is taking the matter of a conflict of interests seriously. The Financial Reporting Council (FRC), the United Kingdom’s accounting watchdog, has been examining the question of whether the performance of all nonaudit services should be prohibited for audit clients in the aftermath of the liquidation of two large companies, Carillion and BHS. The impetus for the review is FRC’s claims that auditors from KPMG in both instances did not do enough to challenge management and did not maintain their professional skepticism. KPMG, for its part, indicated it would not continue to provide nonaudit services to audit clients but had some qualifiers, such as continuing to provide nonaudit services, such as consultancy, to smaller UK-listed clients, as well as private firms of all sizes. It also failed to give an end date for the changes.

Other firms, including PwC and EY, also said they would stop offering non-essential consulting services to its largest British public audit clients by 2020. The firms stated their goal is to eliminate any perception of conflict between selling audit and consulting work to the same client. The key here is what is a “non-essential consulting service?” Perhaps the firms purposefully left it vague.

Enter the UK Competition and Markets Authority, a government department in the UK, that issued a report on April 18, 2019 recommending an operational split of audit and nonaudit services. The large firms would be split into separate operating entities with respect to auditing and consultancy functions to reduce the influence of consulting practices upon auditing divisions. The split would help to prevent potential conflicts of interest from impairing audit independence and increasing the public trust in the quality of financial statements. However, the watchdog stopped short of recommending a full break-up based on firm services.

A study group chaired by Prem Sikka, a professor of Accounting and Finance at the University of Sheffield, prepared a report on behalf of the UK Parliamentary Labour Party, that concluded an operational split would not go far enough, calling instead for two legally separate organizations. In essence, it calls for a structural break-up of large firms saying that it would be more effective than other options in dealing with conflicts of interest and providing professional skepticism needed to deliver high-quality audits.

The SEC and PCAOB should closely monitor the events in the UK as regulators deal with the issue of how best to eliminate threats to independence that might occur when nonaudit services are provided for audit clients. Regardless of the method chosen, the time has come to split off nonaudit services as a separate unit, at a minimum, and study the issue of legal separation much as is being done in the UK. Nothing short of these remedies is necessary to protect the public interest.

Thursday, November 28, 2019

Entering Uncharted Waters

Editorial Note: We are delighted to present this essay by contributing columnist Rick Kravitz. It is the first of a series of three columns that address the theme of The Evolution of the Public Interest in Accounting. 

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

Disclaimer by author Rick Kravitz: The comments and opinions expressed in this article represent the writers’ own personal views and not necessarily those of his employer, or of other organizations that are affiliated with the author. The opinions of this author do not reflect the opinions of the CPA Journal, the New York State Society of CPAs, its board, its executives or its membership.


Over the past two years, the PCAOB, a nonprofit corporation established by Congress, has replaced all five of its board members. Its new chairman, William Duhnke [a former Republican Senate Aide, according to Fortune Magazine], will receive a salary of $673,000 a year.

As a result of the changing of the guard, the PCAOB is now in a perfect position to look back at its accomplishments over its past seventeen years [in 2010, funding was established through annual accounting support fees assessed on public corporations and broker-dealers] and determine its correct path going forward.

This article examines whether the PCAOB, in its 17 year history, has achieved its objectives. Has it improved investor protection? Has it improved financial reporting by auditing auditor work papers? Has it been open, honest and transparent in the reporting of its results? Or was PCAOB’s establishment as a nonprofit corporation, designed to shelter its activities from the public and from FOIA requests?

Other questions need to be answered. Are the deliberations by the PCAOB open to the public or held behind closed doors? Does the public know how much has been collected in penalties or settlements and even the criteria for distributing penalty funds to their merit scholarship program [students in accredited accounting programs]?

The mission of the PCAOB is noble:

“… Oversee the audits of public companies, protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports…”

But, over the last nine years, the PCAOB has spent over 2 ½ billion dollars. Has this money been spent wisely in service to the public in support of its mission?

(1) The PCAOB Inspection Process

PCAOB inspections [2016 of auditors and brokers] observed deficiencies in 97% of the firms inspected in 2016, compared against 96% in 2015. PCAOB inspectors publicized these deficiencies online and in the press. This nonprofit also reported a 48 % deficiency rate in attestation engagements in 2016, compared against a 55% deficiency rate in 2015. [Fact Sheet: Annual Report on the 2016 Inspections of Broker-Dealer Auditors, August 18, 2017]. For non-broker audits, Audit deficiencies rates [particularly internal control deficiencies] averaged from 32% to around 35% over a five year period [Summary of Inspection Findings of the Big Four and Next Six, August, 2017, the CPA Journal, page 54].

So, let’s go back to the mission of the PCAOB and ask the following; how, exactly, do these findings inspire confidence in the capital markets…and in addition, how do these findings improve investor protection? Were there follow up inspections on these work paper audits -to demonstrate to the inspectors that these error rates could be reduced substantially now that they were identified? I think not. Also, what did the inspectors do to ensure that the auditors corrected these deficiencies? Did they report these to the senior execs of the company, the board of directors, internal auditors and audit committees? If they did, why is it that we don’t see public responses, auditor changes, and responses by the board in public statements regarding these critical audit deficiencies? Were they not told or is there something else in play?

The critical question is whether the work of CPAs is so poor, so inferior, so incompetent, that in its 100 years of audit history and seventeen thousand pages of audit guidance [including the use of specialized audit and risk assessment programs, compliance software, proven statistical and cumulative monetary sampling techniques], that CPA audits are deficient from 30% to almost 100% of the time? Do we actually believe that this 147 billion dollar global industry has product defects in excess of 50%? That licensed practitioners with master's degrees and specialized training and education failed 1/3 to ½ of the time? Can you imagine if PCAOB extended their review to the AMA, ABA or Society of Mechanical or Electrical Engineers and generated failing grades at this level? What rational organization would accept this? Is this in any way credible, believable – or even make any sense --- so 2.5 billion dollars reveals tens of thousands of critical audit deficiencies ---will a ten time higher budget of 25 billion dollars then reveal hundreds of thousands more deficiencies? I think not.

I would argue that an accounting firm[s] should be allowed to inspect the inspection reports. I suggest that they would find that most of the identified deficiencies were of little or no material value.

Suggestion: allow an outside accounting firm to audit the PCAOB audits based on GAAS and to determine whether the identified deficiencies have any impact or material effect on the financial statements or whether they were "gotcha" items to justify the $2.5 billion in expenditures.

(2) Should A Public Agency Make Its Information Public?

Should the new board now disclose the names of companies that they review; make the information public? Clearly, the reputation of an auditing firm impacts a company’s decision to choose an outside auditor. If an outside auditor behaves badly, shouldn’t the company’s investors know this? Shouldn’t the public who invests in these companies and the institutional investors and the 401k plan participants know this? Clearly, reputation has a critical impact on auditor choice - The significant number of changes in auditors in South Africa informs us of this --bad audits have significant consequences.

Suggestion: provide the names of the companies whose work papers were audited to the public in the spirit of free and open capital markets.

(3) The Connection Between PCAOB Inspections And The Detection/Prevention Of Fraud

Can we connect the PCAOB audits of auditor work papers to the accuracy of the company’s financial reports? Can we correlate PCAOB inspections to financial restatements? Why do we not know what impact PCAOB audits have on financial restatements and the behavior of the reporting entity? Is there any? Is this not of critical importance to the public that should be made public?

The greatest corporate failures in global history occurred during the existence of the PCAOB. So if their risk assessment techniques were valid, then PCAOB audits ought to have selected many of these failed or failing enterprises [ERM risk assessments, internal control risk, materiality risk, independence risk and others]. In fact, there should be a close relationship between the PCAOB’s ‘picks” of failed companies such as AIG [arguably one of the largest global failure in corporate history], Lehman Brothers, Merrill Lynch, MF Global, Countrywide, GE, Chipotle Grill, Wells Fargo, Steinhoff, Satyam, Mattel and others.

So, public disclosure of these work papers would affirm that PCAOB selection criteria was correct; their methodology for picking companies was valid; their risk assessment programs were accurate and it was auditor failure that allowed fraudulent financials….that PCAOB audits of auditor work papers had been ignored.

And if PCAOB audited the audit work papers of say Toshiba, Colonial Bank, Clayton Homes, and Miller Energy, or looked at internal control and Enterprise risk of Carillon, how could they have failed to uncover audit deficiencies that led to audit failures of these failed institutions who falsified their financials?

The public should know where the multibillions of dollars were spent. And that in their reviews, PCAOB uncovered weaknesses in internal controls at Wells Fargo, cyber risk failures at Equifax and fraud at the top at Colonial Bank. If PCAOB methodology was of great value, shouldn’t investors know this, in order to make more informed investment decisions? Why is this information not public?

Suggestion: make this information public.

(4) Regulation In Perspective

Perhaps, with the new board, it is time to look for a better regulatory model other than self-regulation or government oversight by PCAOB. John Coffee, Corporate Governance Law Professor at Columbia University Law School [Gatekeepers, Oxford University Press, page 365], argues that “the SEC’s experience with both attorneys and accountants suggests that it is difficult for a regulatory agency to supervise a profession for long…as scandals subside, a return to normalcy becomes predictable, and professional autonomy return is re-established. “

Is there a blended form of regulation that might work? Might a process similar to that in the UK of supervised self-regulation be looked at more closely in the States to improve outcomes? Especially if the findings of the PCAOB were made public and the judgment was that PCAOB’s audits of the auditor’s work papers failed miserably in their mission to protect the public interest and uncover defective or fraudulent financial statements of public corporations?

Suggestion: look at other governance and oversight models at other international stock exchanges and determine whether any are of greater value to the investing public.

(5) Board Compensation: Does This Make Sense?

But let’s go further into this self-regulatory body and ask what else does not make sense. If we were recruiting for the board, would we look for competency in auditing? Would we then pay each former board member an average of $540,000 a year in salary – more than the SEC Chair, more than the president of the United States? Would we compensate an attorney, a Senate and White House aid with little or no auditing experience over $672,000 a year? Does this make sense? Should public accounting firms, who pay their salaries, have no input whatsoever on who governs the governed or is presided over other than by their peers.

Suggestion: align compensation with the expertise and qualifications of the candidate.

(6) Board Composition: Does This Make Sense?

What else does not make sense? The composition of the new board, three attorneys and two CPAs stills leaves voting control in the hands of attorneys. This is remarkably similar to the composition of the last board. In the current Board, two members had audit experience and none had recent audit experience. Only one Board member has any recent experience in auditing public companies. Another was controller of a corporation. The Director of Inspections, with 14 years of institutional memory resigned effective May, 2018.

Suggestion: in a democratic society, the board should reflect its constituency. Their prior decisions should be the principle indicator of the ethical decisions they would be making in the future.

(7) Cost Of Inspections

Does this make sense? The PCAOB spent over 2 ½ billion dollars on audit inspections between 2010 and 2019. The big four handle public audits of U.S. issuers, accounting for more than 98% of global market capitalization [August 2017, CPA Journal, pg. 52, Boland, Daugherty, Dickins and Johns-Snyder].” A result of strong quality control and peer review at all large firms, has PCAOB determined whether it is actually the standardized audit programs and uniform work papers within the firm that are deficient according to their audit manual and the audits themselves

Suggestion: open the PCAOB audit inspection manual and examine the inspection steps to determine whether their manual actually is in accordance with generally accepted auditing standards and generally accepted accounting principles and conforms with standards and practice promulgated by the global standard setters.

(8) PCAOB Budget Creep

If we were overseeing the budget of the PCAOB, we would notice that their budget grew by over 18% during between 2010 and 2018. Their staff grew by over 30% [to over 851 staff members]. In contrast, auditor concentration increased during this time and the number of registered firms with PCAOB declined by almost 20%, while the number of listed publicly traded US companies decreased by the same amount. Moreover, during PCAOB’s existence, publicly traded firms declined by almost 50%. How can this then be justified in terms of workload and staffing

Regarding staff, on the other hand, might we conclude that there is a correlation between the number of PCAOB staffers, the number of audits and the increasing number of deficiencies? Do staff auditors at PCAOB have to fill a quota of auditor dings?

A crucially important outside of the box question, however, is whether the public interest is served by PCAOB when, the explosive growth of non-public enterprises [out of the regulatory system in what my former corporate securities attorney/author, Larry Ribstein calls ‘going dark’] owned/managed by hedge funds, private equity, and other institutional investors remain unregulated and uninspected? Does this make any sense at all from a regulatory perspective?

Suggestion: expand PCAOB reach to the unregulated but audited private investment sector similar to the CMA in London. If it touches the shareholder investor over a certain dollar amount it requires auditor oversight.

(9) Auditing Internal Control

Internal control audit deficiencies were the highest in the top three areas in PCAOB’s Staff Inspection Brief [Previewing 2016 Inspection Findings, PCAOB November, 10, 2017] from 2016 inspections and other years.

Internal control over financial reporting deficiencies were in the 30% plus range [Auditing the Auditor: Insights from PCAOB Inspection Reports/GAAP Dynamics, 6/9/2015]. Studies regarding public expectation is that auditors uncover fraud, principally through an examination of internal control. Perhaps it is worth noting Lee Seidler’s comments from the classic forensic and fraud text [Crumbly, Heitger, page 405, Forensic and Investigative Accounting, 4th edition]. “…Much of the auditor’s work and examination time is based on a faulty assumption that separation of duties within the corporation prevents fraud…an albeit unsupportable assumption.” So was the time spent by PCAOB in finding deficiencies in the audits of internal controls, money well spent – spent wisely? To what end? Does it make sense, when uncovering fraud is a principal obligation no longer assumed by auditors? And if PCAOB identified weaknesses, did they uncover the fraud that impacted investors in the insolvent or bankrupt companies mentioned earlier?

(10) Giving Voice To Consequence

PCAOB levies fines against auditors for audit failures. But in its 16 year history, has bad behavior ever been deterred by the PCAOB, especially when the largest corporations self-insure and use offshore captives and receive special tax breaks? Just a cost of doing business? What if there were additional consequences to bad behavior? Might the PCAOB consider other penalties other than civil fines? Is jail time an option? Certainly other regulatory bodies in the UK, Germany and South Africa apply this?

Many years ago, around the time of the Public Oversight Board, it was suggested that an NTSB type board of experts could be assembled to look at each audit failure; report on what exactly occurred, determine the causes of failure, call out the violators and make this information public –put the issue before a tribunal who would adjudicate on a case by case basis, which would, as well, provide guidance on future audits….Would this not provide better guidance on prevention than secret inspections drawn from a secret inspection manual?

Another suggestion is that a new Board might be comprised of auditors, government overseers and outside investor representatives. Would a trial board review audit failures, base its decisions on precedent, adjudicate fairly and impartially in a public forum, and have the ability to apply civil and criminal provisions from an expanded tool bag? Might this improve audit quality? All in the public domain?

Might a modified form of self-regulation then work? Would Colonial Carter, former president of the NYSSCPA, [who was the only CPA to testify before Congress and the SEC in support of our grant of a monopoly to audit public companies] once more provide the right answer as to who audits the auditor? Would we all be morally and ethically correct if we responded in unison “Our conscience” as did Colonel Carter unabashedly before Congress in 1933?

Tuesday, October 29, 2019

From Gatekeepers to Gateway Constructors – the social role of creditrating agencies

Editorial Note: We are delighted to "go global” and welcome the following contribution by Dr Stewart Smyth of the University of Sheffield, UK. 

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

Over the summer Critical Perspectives on Accounting published a paper I co-authored on the role of credit rating agencies in the process of financialising social housing providers in London. In the style of the TV show, Jeopardy!, the paper is the answer to the question – What is the research outcome when a geography, a housing studies and an accounting academic collaborate?

During our initial discussions credit rating agencies (CRAs) barely warranted a mention, we were more focused on the impact that large amounts of debt finance was having on the provision of below market-rents accommodation in a city that has become a location to store excess capital for the global billionaire class. However, two UK-based colleagues – Thomas Wainwright and Graham Manville - beat us to the punch, publishing an excellent article on innovation in the social housing bond market.

Rating agencies hone into view

The innovation Wainwright and Manville explore is the manner in which not-for-profit organisations, often with a charitable heritage, are increasingly turning to the capital debt markets for finance and issuing their own corporate bonds. In England, up to the turn of the century a social housing provider issuing a corporate bond was almost unheard of – by 2017 there was a cumulative total of 84 bond issues by 58 housing providers, worth £17.1 billion.

The increased activity in this form of finance comes from a combination of severe cuts in government grants during the austerity years and a reluctance by the traditional financers of this sector, banks, to fund over the long term (i.e. a 30-year business plan) after the financial crash of 2008.

Of course, every bond issued by a social housing provider requires at least one credit rating and an ongoing relationship with a rating agency afterwards. However, my co-authors and I were aware that credit rating agencies had been implicated in the 2007/08 credit crunch and following financial crash, and we wondered what impact their rating methodologies have had on the operation of social housing providers.

Rating agencies – a history

For much of their history CRAs have been considered peripheral to the operation of business, often having a quasi-academic image. With roots in the commercialisation of emergent business financial information during the nineteenth century, CRAs started to become key actors in capital and financial markets from the 1970s, in the main due to changes in regulation by the SEC and subsequently under the Basel capital adequacy rules for banks.

In that decade CRAs also changed their business model by securing fees from those issuing financial instruments, (rather than those buying them). This change created similar relations to those in the auditing industry with related conflicts, such as being paid by those you are forming an opinion on and the opportunity to sell ancillary services.

However, it is in recent decades, with the increasing financialisation of the world economy, that CRAs’ revenue and power has grown substantially. For example, in the fifteen years to 2015 Moody’s global revenue grew by US$ 602 million to total US$ 3.5 billion. Further, Moody’s describes themselves as “… an essential component of the global capital markets” which contributes to transparent and integrated financial markets.

Yet, CRAs have been criticised not just in relation to the 2008 global financial crisis but also for not being able to predict the 1997 Asian currency crisis or the collapse of Enron. For example, in the wake of the Enron bankruptcy, Senator Joe Liberman said,

The credit-rating agencies were dismally lax in their coverage of Enron. They didn’t ask probing questions and generally accepted at face value whatever Enron’s officials chose to tell them. And while they claim to rely primarily on public filings with the SEC, analysts from Standard and Poor’s not only did not read Enron’s proxy statement, they didn’t even know what information it might contain.

Not only gatekeepers …

Despite this history and the central role now afforded to CRAs in the operation of the capital markets we know very little about their operation in general and specifically with regards to the impact their work has on the operation of those they rate. Much of the research completed to date places CRAs in a principle-agent relationship, where they act as a reputational intermediary to reassure financial investors.

In this way CRAs are seen as gatekeepers for those entering the capital markets to secure bond (or other) finance.

In our paper we seek to understand the role of CRAs by drawing on the smaller stream of work that utilises a political economy understanding. In this understanding credit ratings are, as Timothy Sinclair has argued, a surveillance system for secure capital mobility across geographical and cultural space.

This idea of capital’s mobility across cultural space is particularly relevant in our case study with ratings being provided for not-for-profit organisations delivering a public service. The idea of movement also allowed us to flip the gatekeeper metaphor round and look at the rating activity from the perspective of the finance providers.

but gateway constructors

Hence, we were able to theorise, and show empirically in the paper, that credit rating agencies also construct gateways that enable private capital’s movement into a new space, i.e. social housing.

The gateway construction occurs through a number of activities but a central one is that through the process of securing a rating the debt issuer learns to speak the same language as the finance provider. As one of our interviewees stated,
I mean it does educate us when we go out to investors ... [to] do a road show. So, we would have had the experience of a credit rating before one of them and when you go into the investors you’re talking the same language.

Alongside, the new language we show how the social housing providers internalise the priorities of finance capital, through the rating process by changing their internal reporting and decision-making activities. For example, taking key accounting ratios that are preferred by the CRAs into their new build and development decisions.

The financialisation of everything

Since the turn of the century, research on financialisation has tended towards either macro studies of changes in the global processes of capital accumulation or a micro-level focus on individual companies where the short-termism of the shareholder value revolution pre-dominates. Our study focuses on a fine-grained analysis of financialisation processes at a meso-level (i.e. the social housing sector), where credit rating agencies play a crucial, even decisive role.

The members of this sector have been described as hybrid organisations – as the 2014 front cover of one social housing provider’s annual report proclaimed “Socially hearted, commercially minded”. The policy and funding environment over the past ten-years has increased the commercially-minded activities of the social housing providers by securing finance from the capital markets and is enabled by credit rating agencies.

Ultimately this leads us to conclude that credit rating agencies do not play a neutral or independent role in verifying accounting and commercial information but are active participants in the extension of financial logics and practices to ever more areas of human activity; in other words, CRAs facilitate the financialisation of everything.


Dr Stewart Smyth works at the University of Sheffield, UK where he is director of the Centre for Research into Accounting and Finance in Context (CRAFiC). Stewart is also the chairperson of the Interdisciplinary Perspectives Special Interest Group, of the British Accounting and Finance Association (BAFA).

The paper this blog is based on is freely available under open access rules at the following link:

Smyth, S.; Cole, I. and Fields, D. (2019/forthcoming), “From gatekeepers to gateway constructors: Credit rating agencies and the financialisation of housing associations”, Critical Perspectives on Accounting

Monday, September 30, 2019

A Public Interest Debate!

On March 14, 2019, our Contributing Columnist Rick Kravitz, the Editor In Chief of the CPA Journal, authored a blog post entitled “Reimagining a More Ethical and Sustainable Management Accounting Curriculum.” In that post, he asserted that:

The accounting curriculum, while relevant 40 years ago, has lost much of its relevance today in our post-modern global economy. Accounting education fails to account for the real drivers of enterprise growth in the digital economy.

That drew a rebuttal from Dr. Lawrence Murphy Smith, CPA, a Professor of Accounting at Texas A&M University-Corpus Christi. According to Murphy:

Since I was an accounting student more than 40 years ago, people within and outside the profession have lamented that accounting and financial reporting isn't doing a good job of providing useful information.

In the editorial column, "Reimagining a More Ethical and Sustainable Management Accounting Curriculum" by Richard Kravitz, this complaint appears once again. On the upside, accountants should be constantly working to ensure the usefulness of accounting and financial reporting. On the downside, this article way overstates the lack of value of accounting information.

The most important piece of accounting information, I would argue, is net income/profit. That number is still calculated, just as it has been through the centuries. To a very large extent the current value and future projected value of net income/profit drives the market value of virtually every modern-day company, whether that market value is 100 times the book value or one times the book value. So, accounting/financial reporting is still relevant; it always has been.

Of course, there will always be exceptions to the predictive power of financial reports. Exceptions result from new technologies, innovative new products, economic cycles, fraudulent financial reporting, brilliant and dismal company leadership, politics, and unexpected events. For example, before the Internet, few people could predict its massive impact on business, which enabled Amazon to become the second largest retail store in the U.S., second only to Walmart. After reading about a very profitable airline company in the summer of 2001, I invested. There was no public awareness that Islamic terrorists were plotting the attack on the World Trade Center. Not long after September 11, 2001, my airline stock was worthless.

The past cannot always predict the future, and by their nature, financial reports are about the past. So, while financial reports are extremely helpful, they cannot guarantee future outcomes. I would argue that financial reports provide a critical part, if not the majority, of information supporting investment decisions. When people are willing to buy stock in a company with giant losses, those people are taking the risk that the company will turn around and make profits in the future. In effect, the future projected value of net income is driving the company’s market value. Sometimes a company turns things around and sometimes it doesn’t. While financial reports are still very relevant in predicting future prospects of most companies, in the final analysis, only God knows the future with absolute certainty.

In conclusion, I have the highest regard for Rick Kravitz and Baruch Lev but I respectfully disagree with their negative assessment of the value of financial statements.

That, in turn, drew a rebuttal to the rebuttal from Rick! He noted:

I would ask the good professor how he can conclude this when Uber, Tesla, Lyft, and dozens of other cash burning companies now have losses in the trillions of dollars and yet possess positive share value. Bad reporting by accountants caused 55 billion dollars of shareholder losses last year, the highest since the Great Recession. And according to Baruch Lev, the information content of the financial statements only constitutes 3% to 4% of information that supports investment decision. What a lack of relevance!

The debate clearly rages on. It clearly will not be resolved in the near future. Nevertheless, our Public Interest Section is delighted to host a professional forum for this lively conversation.

Sunday, August 25, 2019

Using the PLUS Ethical Decision Making Model to Teach Ethics toAccounting Students

Editorial Note: It’s time to go “back to school” as we begin the traditional academic year! In the spirit of the season, we’re pleased to feature the following piece by Contributing Columnist Steve Mintz on accounting education.

Steve is one of three regular columnists who have agreed to author a blog post every quarter. All posts are distributed via email, and are published online at AAAPublicInterest.org.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

It’s time now for accounting educators to rethink the scope of decision-making models used to teach accounting ethics. If ethical issues that arise in the context of organizational culture are not dealt with properly then it is less likely ethical conflicts can be resolved. Consideration of the internal systems within organizations is what’s missing from traditional decision-making models and should be given a more prominent role.

Ethical Decision Making

Accounting educators typically use an ethical decision-making model to teach ethics to accounting students. Ethical decision models provide a systematic way to think through ethical issues, identify alternative courses of action, evaluate the ethics of each alternative and decide what to do.

Traditionally, the decision-making models used to teach ethics to accounting students have focused on applying philosophical reasoning methods to the analysis of what should be done. These models tend to downplay or ignore the importance of organizational culture in the decision-making process including internal policies and practices, the code of ethics and individuals in the organization who might serve as supporters to help resolve conflicts.

Given the added focus on organizational ethics since passage of the Sarbanes-Oxley Act and the profession’s recognition of the importance of the control environment, accounting educators should look for new ways to incorporate organizational factors to make the ethics curriculum more relevant. Moreover, the AICPA Code of Professional Conduct now addresses ethical conflicts and describes the process to resolve them including internal steps.

The PLUS Ethical Decision Making Model

The PLUS Ethical Decision Making Model was developed through The Ethics Resource Center, the research arm of the Ethics & Compliance Initiative (ECI). The ECI is a community of organizations that are committed to creating and sustaining high quality ethics and compliance programs to assist organizations in building strong cultures. The mission of ECI is to assist its members across the globe to operate their businesses at the highest levels of integrity.

The PLUS Model is based on a seven-step process described below. The word PLUS refers to ethics filters that facilitate the analysis of ethics considerations and implications of the decision at hand. The filters ensure that ethical issues rise to the forefront in ethical decision making. The mnemonic PLUS refers to four considerations that apply to the analysis in steps 1, 4 and 7 of the decision-making model as follows.

P = Policies
L = Legal
U = Universal
S = Self

A description of each filter and its role in decision-making follows (Ethics Resource Center of the Ethics & Compliance Initiative, The PLUS Decision Making Model, https://www.ethics.org/resources/free-toolkit/decision-making-model/).

Policies. Is it consistent with organizational policies, procedures and guidelines?
Legal. Is it acceptable under applicable laws and regulations?
Universal. Does it conform to universal principles and the values of the organization?
Self. Does it satisfy my personal definition of right, good and fair?

The advantage of the PLUS model is it relies heavily on organizational ethics. This is important because no matter how good one’s ethical judgment may be, ethical decision-making is not likely to occur unless support for the position exists in the organization. A summary of the seven-step model follows.

Step 1: Define the problem. Determine why a decision is necessary and identify the desired outcome(s). This helps to clearly state the problem and where to look for alternatives to resolve it. Consider the PLUS factors to ensure the existing situation does not violate any of them.

Step 2: Seek out relevant assistance, guidance and support. Identify the available resources within the organization to help resolve the problem. This helps to define the guidelines and individuals within the organization that may help to resolve the problem.

Step 3: Identify available alternative solutions to the problem. Consider all relevant solutions to avoid the dichotomy of one choice versus another (i.e., either this or that).

Step 4: Evaluate the identified alternatives. This step in the model uses a decidedly consequence-based criteria. Positive and negative consequences are evaluated with fact-based consequences weighed more heavily because the expected outcome is more likely to occur. The PLUS factors are an integral part of the evaluation to supplement outcomes-oriented considerations, which are teleologically based, with universal principles (deontology) and virtue ethics as represented by organizational values.

Step 5. Make the decision. After evaluating all the alternatives, it’s time to decide on a course of action. The reasons for choosing one alternative over the others should be explained especially if the decision is by a work team that recommends a solution to higher-ups.

Step 6. Implement the decision. Putting the decision into effect is essential to change the situation and resolve the problem identified.

Step 7. Evaluate the decision. A determination has to be made whether the decision fixes the problem identified. Questions to ask are: Did it go away? Did it change appreciably? Is it better now, or worse, or the same? What new problems did the solution create? In making these determinations it’s important to incorporate the PLUS factors to ensure the solution conforms to organizational policies, laws and regulations, universal principles and values adopted by the organization.

Advantages of the PLUS Model

The “S” component of the PLUS factor is a feature of the decision-making process that requires explanation because it’s not recognized explicitly in traditional decision-making models although virtue considerations come close. To implement the “self” factor, the decision maker should consider whether the solution satisfies one’s personal definition of right, good and fair. It means that individuals should understand how their values influence decision making to ensure the decision reflects those values. For ethical decision-making to occur in an accounting situation those values should include independence, integrity, objectivity and due care, which are the principles of professional behavior.

Ethical decision making is a complicated process that relies on organizational variables to ensure the ultimate decision is supported by those who have to carry it out. The PLUS model incorporates those factors and should be used in accounting ethics education to make it more relevant given the increased focus on organizational ethics in the post Sarbanes-Oxley era.

The advantage of using the PLUS model to teach ethics to accounting students is it increases student awareness of organizational factors that influence ethical decision making. In reality, regardless of the ethical justification for one’s position it’s unlikely to be implemented unless individuals within the organization support resolution of the ethical problem. Knowing how the internal systems work can help to make that determination early on and influence ethical decision making in a positive way.

Wednesday, July 31, 2019

Sustainability Reports and the Limitations of ‘Limited’ Assurance

Editorial Note: We are delighted to publish the following article by Professor Michael Kraten of Houston Baptist University. It was originally published in this month’s issue of The CPA Journal; we thank Journal Editor-In-Chief Rick Kravitz (who is himself a frequent contributor to our blog) for permitting us to transmit the article to our Section members. We encourage our members to peruse the contents of this month’s issue at CPAJournal.com.

How many standards can a sustainability accountant possibly follow? Three dozen comprehensive standards are published by the Global Reporting Initiative (GRI), and 77 industry-specific standards are issued by the Sustainability Accounting Standards Board (SASB). In addition, 17 sets of metrics are promulgated within the Sustainability Development Goals (SDG) of the United Nations, 15 components of integrated reporting are defined by the International Integrated Reporting Council (IIRC), and the AICPA, not to be outdone, chimed in earlier this year with its new guide, Attestation Engagements on Sustainability Information.

Sustainability standards are growing in length and complexity; as a result, the length and complexity of corporate sustainability reports are growing as well. The 2018 sustainability report of Volkswagen (VW), for instance, runs at 108 pages. The report of its European rival Fiat Chrysler Automobiles (FCA) is much lengthier, at 148 pages.

Some analysts complain that such reports are filled with “green-washed” public relations content. Others disagree, claiming that the European Union’s Directive on nonfinancial reporting ensures that the sustainability content is meaningful on an individual report basis and comparable across multiple reports.

To be fair, the latter group of analysts can cite examples of meaningful and comparable data. VW’s report, for instance, includes a section entitled “GRI Content Index”; it cross-references its published data to the standards of the Global Reporting Initiative. FCA’s equivalent section, the “GRI Standards Content Index,” serves the same purpose.

But are readers of sustainability reports missing out if they only pay attention to the sustainability report data and the underlying standards? Should they also pay attention to the assurance letters issued by public accounting firms and printed in the reports? After all, if the assurance letters are not sufficient, then all of the information in the reports, greenwashed or substantive, is of dubious value.

Consider, in comparison, the annual financial statements of business entities. They would obviously be less useful if public accounting firms were to use extremely limited assurance procedures during their annual audits. Their assurance procedures would be even less useful if auditing firms could offer different levels of assurance to different clients.

Indeed, spending a little less time worrying about the data in the sustainability reports and a bit more time considering the limited assurance letters may lead to the conclusion that confidence in the validity of any of the report data may not be warranted.


Consider, for instance, Volkswagen’s 2018 report. The table of contents lists a two-page “Independent Assurance Report” on pages 104 and 105. That assurance letter, issued by PricewaterhouseCoopers, is called “Independent Practitioner’s Report On A Limited Assurance Engagement On Non-Financial Reporting.” How much assurance does it actually convey?

The letter notes that PricewaterhouseCoopers is required to “plan and perform the assurance engagement to allow us [i.e., the CPA] to conclude with limited assurance that nothing has come to our attention that causes us to believe that the Company’s Non-financial Report … has not been prepared, in all material aspects, in accordance with” the relevant standards.”

This double-negative structure raises some flags. In essence, the CPA is only required to conclude that nothing came to his attention to cause a belief that something is not right. Metaphorically speaking, an ostrich that buries its head in the sand during a desert storm could satisfy that level of assurance about the weather.

The letter continues by listing eight assurance procedures that were performed by the CPA. It notes that PricewaterhouseCoopers obtained an understanding of the structure of the organization, conducted inquiries regarding the preparation process, analytically evaluated selected disclosures, compared selected disclosures, and so on. There are, however, almost no detailed disclosures of the nature of the inquiries that were made, the disclosures that were selected for analytical evaluation or comparison, or anything else. Interestingly, PricewaterhouseCoopers does list a single specific procedure in its letter; it notes that it performed an “assessment of the aggregation of Scope-3-GHG-emissions (categories 1 and 11) on group level.” That procedure may have been necessitated by Volkswagen’s recent global emissions scandal. (For more on the Volkswagen case, see “The Volkswagen Diesel Emissions Scandal and Accountability” by Daniel Jacobs and Lawrence P. Kalbers, on p. 16 of this issue.). Nevertheless, no other detailed procedure is disclosed in the report.

Finally, the letter concludes with a disclaimer that it “is not intended for any third parties to base any (financial) decision thereon. Our responsibility lies only with the Company. We do not assume any responsibility towards third parties.” Thus, PricewaterhouseCoopers’s letter is not designed to serve the needs of the readers of Volkswagen’s sustainability report, despite being the sole assurance letter that is included in that very report.

Incidentally, although Volkswagen’s 2017 sustainability report is comparable to its 2018 report, one cannot compare these two documents to its 2016 report. Although a synopsis of the 2016 report is posted online, the full 2016 report has been deleted from the Internet. It is left to readers to wonder what was in the full report and why it is no longer available.

Fiat Chrysler Automobiles (FCA)

Fiat Chrysler Automobiles’ table of contents likewise lists a two-page “Independent Auditor’s Report” on pages 139 and 140. That letter, issued by Deloitte, is called “Independent Auditor’s Report on the Sustainability Report.” Deloitte does not explain why it refers to itself as an auditor and not as a practitioner (as PricewaterhouseCoopers does).

Furthermore, Deloitte’s letter contains the same double negative language as PwC’s, concluding that “nothing has come to our attention that causes us to believe that the Sustainability Report … is not prepared, in all material aspects, in accordance with” the relevant standards.

The Deloitte letter lists seven bullet points of assurance procedures. Certain details are excluded from the Deloitte report but are included in the PricewaterhouseCoopers report, and vice versa. For example, PwC’s explicit statement about its GHG emissions assessment procedure is missing from Deloitte’s letter. Conversely, Deloitte’s letter explicitly refers to analyses performed on “minutes of the meetings,” and the receipt of a “representation letter signed by the legal representative” of Fiat Chrysler. Such language is missing from the PricewaterhouseCoopers letter.

Finally, Deloitte’s letter does not contain a warning that it “is not intended for any third parties to base any decision thereon,” or that Deloitte does “not assume any responsibility towards third parties.” PricewaterhouseCoopers’s letter, as noted above, includes these disclaimers.

The Limitations of Limited Assurance

Should stakeholders worry about these facts? On the one hand, it is important to keep in mind that the sustainability movement has succeeded in compelling global corporations to issue more than 100 pages of data each year. Even if significant portions of the reports are filled with green-washed information, the remaining (and perhaps some significant) portions of the reports may contain useful data.

On the other hand, it is also important to keep in mind that the limited assurance of these public accountant’s sustainability letters provides, in certain respects, even less assurance than detailed agreed-upon procedure letters. After all, an agreed-upon procedure letter contains detailed descriptions of the procedures that are performed and the findings that are produced by the procedures. In contrast, the limited assurance letters in these sustainability reports contain very little detailed information and only reach vague, double-negative conclusions regarding the findings.

Furthermore, the descriptions of the procedures in the letters are inconsistent from company to company, and the disclaimers regarding the use of the letters by third parties vary remarkably from firm to firm. Such inconsistencies and variations greatly reduce the value of the assurance reports, and thus of the sustainability data that are included in them.

Clearly, there are significant limitations to the limited assurance letters in the sustainability reports. Perhaps, in addition to lobbying for improvements in sustainability reporting standards, public interest advocates should consider lobbying for the development of more stringent sustainability assurance standards.