In previous columns, I have discussed two "IT" topicsinformation technology and identify theft. Today, there is increased focus on yet another ITincreased transparency. The integrity of financial markets and the foundation of the banking system are built on public confidence. Therefore, increased transparency in accounting and disclosure is now a common mantra.
The recent increase in creative accounting, accounting irregularities, creative auditing, and outright fraud has brought accounting issues to the front page of almost every newspaper in America. Although the banking industry has not been in the headlines as much as other industries, there nonetheless have been both high profile and low profile issues that banking supervisors have had to deal with in recent months. A major focus has been on bank failures and losses attributed to improper accounting for securitizations and the treatment of special purpose entities (SPEs). SPEs are financial vehicles used to convert income-producing assets, such as loans, into cash. The debate continues in this area relating to explicit or implicit performance guarantees arising from securitized assets. However, self-disclosure is emerging as a standard.
As businesses have grown more complex, so have the methods of accounting for their transactions. Since its formation in 1973, the Financial Accounting Standards Board (FASB) has issued 144 Financial Accounting Standards. This body of guidance has been supplemented by numerous FASB Interpretations, FASB Technical Bulletins, Emerging Issues Task Force Consensuses, and other authoritative accounting and disclosure guidance. Unfortunately, business complexity always leads accounting change, and in the temporary vacuum of guidance, creative accounting practices may be born.
Invariably, as accounting guidance has become more complex, loopholes are formed. Too often, in a misguided attempt to better serve their clients in today's high pressure competitive marketplace, some accountants look for the loophole in the accounting guidance, squeaking by on technicalities and on the margin, adhering to the letter but not the spirit of the "law." Alternatively, some clients pressure their accountants to turn a blind eye to practices on the margin, asking for the removal of staff who question or resist their requests.
Effective and transparent accounting and disclosure should emphasize the substance of a transaction over the form of accounting. While accountants and economists often debate the "economic value" of a transaction, selecting the accounting and disclosure approach that best describes the economic substance of the transaction but follows GAAP for valuation purposes might best serve all constituents.
The Role of the External
A common misconception is that the financial statements are the auditor's responsibility. The auditor's responsibility is to express an opinion on the financial statements. Accordingly, auditors plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. This requires the auditor to use professional skepticism when considering management's assertions and representations and to obtain sufficient evidential matter to allow the auditor to express an opinion. Sufficient evidential matter is generally a sampling of documents and transactions, since a review of every transaction, document, asset, and liability would be cost and time prohibitive. Therefore, because of the nature of audit evidence and the concealment and/or collusion aspects of fraud, the auditor is able to obtain only reasonable, not absolute, assurance that material misstatements are detected.
The Role of the Bank
Another misconception is that bank supervisors are responsible for detecting all fraud in a financial institution wherever it exists. The examination process is not designed to ferret out fraud; indeed, examinations rely to a significant degree on internal and external auditors to validate the accuracy of the financial data that are the raw material of the examination process.
The key objective of prudential supervision is to ensure that banks operate in a safe and sound manner, thereby maintaining stability and confidence in the financial system and reducing the risk of loss to depositors and the insurance funds. Effective supervision involves the collection and analysis of information about a bank's activities. However, like external auditors, bank supervisors cannot review every document and transaction. Accordingly, they assess whether bank management has established a strong system of internal controls that is consistent with the nature, scope, and scale of their business. It is this system of internal controls that provides assurance that financial reporting is accurate, complete, and timely. Naturally, effective internal controls would also minimize the likelihood of and better ensure the detection of both fraud and error.
To address the risk that fraud places on the banking organizations that we supervise, bank examiners have been trained to identify red flags that might indicate the occurrence of fraudulent activity. Many of our examiners have received training to better enable them to trace financial transactions; recognize public company financial statement misrepresentations; use examination techniques designed to ferret out misrepresentations and distortions in financial statements; understand and be able to recognize indications of money laundering; recognize new types of white collar crime; and assess the adequacy of internal routines and controls to prevent fraud.
When fraud is suspected or detected, bank supervisors have processes to ensure that the fraudulent activity is reported to the proper authorities and that appropriate remedial action is taken. Tools at the examiner's disposal include the Suspicious Activity Reporting (SAR) system, the Board of Governor's Special Investigations Unit, and various levels of enforcement actions.
The Role of Bank
If external auditors and bank examiners are not responsible for the financial statements and are not responsible for detecting all fraud, then who is? Internal controls and the financial statements are management's responsibility. Consistent with the AICPA's Statements on Auditing Standards and Generally Accepted Auditing Standards, management is responsible for adopting sound accounting policies and for establishing and maintaining internal controls that record, process, summarize, and report transactions consistent with management's assertions embodied in the financial statements. Therefore, effective corporate governance is closely linked to accounting transparency.
Recent events surrounding the integrity of financial statements have resulted in increased emphasis on the "responsibility culture." There is a clear recognition that leaders of corporations have a special obligation to shareholders, employees, and the public. In the final analysis, fraud prevention may come down to the character of employees and customers.
and Market Discipline
The Federal Reserve has long supported sound accounting policies and meaningful public disclosure by banking and financial organizations with the objective of improving market discipline and fostering stable financial markets. The most recent proposal to amend the Basel Capital Accord recognizes the importance of market discipline as a supplement to effective bank supervision. Accordingly, the proposal would create three pillars to assess capital adequacyrisk-based capital (pillar 1), risk-focused supervision (pillar 2), and disclosures of risks and capital adequacy to enhance market discipline (pillar 3). This proposed approach to capital regulation signals that sound accounting and disclosure will remain important aspects of bank supervision since, without accounting transparency, market discipline will fail.
Disclosure does not come in a one-size-fits-all package. Prescriptive disclosure would create a statistical nightmare and a false sense of security for financial statement users. Rather, each company should disclose in plain English the information that it believes its stakeholders (whether regulators, supervisors, shareholders, or the general public) would want and need to know to evaluate the company's financial position, internal controls, and risk profile. For in fact, the inability of a company to articulate clearly and transparently the nature and risk of its activities is in itself an indicator that management might be assuming an inappropriate amount of risk.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.