In September 1998, Securities Exchange Commission Chairman Arthur Levitt announced his plan to fight "accounting hocus-pocus" and curb some of the major abuses and fraudulent reporting that have occurred in public companies. The SEC plans to accomplish this by attacking the use of accounting techniques used to manage earnings and taking steps to improve the effectiveness of auditing and the oversight of financial reporting.

In December 1999 and January 2000, the SEC, NYSE, AMEX, NASD, and Auditing Standards Board (ASB) issued new rules (see Portfolio, "Policy Watch," July/August 1999). These new rules significantly change the responsibilities and requirements of audit committees. In addition, during the second half of 1999, the SEC issued new Staff Accounting Bulletins (SAB) aimed at cracking down on aggressive and sometimes abusive accounting practices.

One of the most important of these new rules—and the rule with the least guidance—is the ASB's amendment to Statement of Auditing Standards ("SAS") 61 which now states: "In connection with each SEC engagement, the auditor should discuss with the audit committee the auditor's judgments about the quality, not just the acceptability, of the entity's accounting principles as applied in its financial reporting."

This "quality" rule, which has been somewhat overlooked since it was finalized, does not provide much guidance on how to have that auditor-audit committee discussion. Auditors and audit committees are left to determine, largely on their own, what "quality" financial reporting is and how it is to be evaluated.

Until more guidance is provided, it is essential that companies develop their own framework for assessing reporting quality, one that promotes a common vocabulary and understanding about quality among audit committee members, senior management, and auditors. At Arthur Andersen, we believe that this framework should be defined by the needs of those who actually use the financial reporting—the company's investors and creditors and their advisors. In other words, the people who make or influence decisions about capital allocation.

With this starting point, we have created a framework—which is still a work in progress—to help those involved in the financial reporting process look beyond the requirements of mere rule compliance to the needs and expectations of the customer of financial reporting. The goal is to improve financial reporting and the information reported to the company's financial reporting users, and thus reduce the likelihood of public company financial reporting abuses.

The Paths to Quality

Arthur Andersen agrees with the Financial Accounting Standards Board that any framework for reporting quality should focus on four dimensions: relevance, reliability, comparability, and clarity. Beneath these four, we have added other elements based on academic and regulator theories of reporting quality. For example, in order for financial reporting to be relevant it has to be timely and predictive both with respect to earnings persistence and with respect to business segments. It also needs to offer feedback value. To be reliable, financial reporting must be both verifiable and complete. And, it must be neutral (i.e., unbiased). Lastly, we believe it needs to be comparable and clear.

The various dimensions of quality within the framework diagram are actually just a matter of common sense. Let's look at each dimension and some of the issues these dimensions suggest auditors and audit committees might want to discuss:

Relevance

Users must find the information useful in making decisions. For this to happen, the information should have predictive value, i.e. it should allow the reader to predict to some degree future operating results. In our framework there are two major elements of predictive value. First, earnings persistence, i.e., the information should be useful in assessing the likely levels of recurring earnings, and the company's sustainable earnings potential. For example: To what extent was the timing of a transaction managed in order to occur (or not occur) in the reported period? What was the purpose of managing the timing? How did that decision affect the predictive value of the reported results? Second, is the extent to which information is disaggregated. Disaggregated information permits users to identify and assess the different opportunities and risks contained within a company's various businesses. Next, relevance requires that the financial reporting should provide feedback value, i.e., the information should allow investors to understand how management's past actions and decisions have affected a company's current financial position and accomplishments. Feedback in this sense confirms (or corrects) prior expectations. And lastly, to be relevant, financial reporting requires timeliness. The auditor and audit committee must be able to answer "no" to the question: Would the information have been more useful had it been available earlier? For example: How does the company ensure that it provides the same information to all interested users at the same time?

Reliability

The information must faithfully represent what it purports to represent. Three elements help to assess whether information is reliable. First, verifiability: A knowledgeable third party should be able to look at the underlying data and derive a similar result. Second, neutra qlity: The information should convey facts in an unbiased manner, i.e., without an intent to influence the investor's opinion or behavior. Third, representational faithfulness. The financial information should be consistent with the facts, reflect the substance of events, and portray the underlying economics of the transaction. A subset of this dimension of quality is completeness: The information must honestly and clearly tell the whole story. For example: When a company enters into a complex transaction for which the accounting literature is gray, how does it assess whether the accounting is appropriate? How does it apply accounting principles in these circumstances? In order for the financial reporting to be complete, you should ask what are the most significant events of the past year and how those events are communicated to investors. Is the information presented even-handed? And what specific elements in a company's 10-K illustrate this?

Financial Reporting Framework [Click for larger image]

Comparability

The user should be able to compare the information from one company to another, and from one time period to another, to identify trends. It should also be consistent. A shorthand way of thinking about consistency is to ask whether the information is prepared in a way that lends itself to appropriate comparisons of a company's business performance over a period of time.

Clarity

The information should be presented in an organized, concise, and clear fashion so that it can be understood by competent users. Is the language used in the financial reports easily understandable by non-accountants? For example: auditors and audit committees might want to ask themselves whether the reporting truly complies with the spirit of "plain English."

It is vital that public companies focus now and in the future on improving the quality of their financial reporting to protect themselves and their financial reporting customers. Any company that makes a good faith effort to address all the dimensions of quality we have discussed here should be able to respond to the new requirement of the Auditing Standards Board with confidence.

Richard M. Jeanneret is a partner in Arthur Andersen's Washington, D.C. Real Estate and Hospitality Services Group and specializes in serving the REIT industry.