Preparation of financial statements Part 1

Part I – Responsibility for the FS preparation

This is the maiden issue of our column, From Where We Sit, which The Manila Times has graciously permitted us, Partners of P&A Grant Thornton, to write on a weekly basis. We consider this privilege a great honor.

This first issue will cover accounting and will dwell on an ongoing controversy relating to the enforcement of business management’s responsibility in preparing the company’s financial statements (FS) before these are audited by external auditors.

I have written on this subject some years back elsewhere to emphasize that the responsibility for the FS preparation rests solely with the entity’s management, and to help remove the long-held belief that the external auditor is responsible for preparing such FS. The external auditor’s responsibility is to audit the FS prepared by management and accordingly issues his report thereon. The reason for this distinction is clear – if the external auditor prepares the FS himself, then he will be auditing his own work and this condition might lead to material misstatements in the FS.

Over the last few years, this division of responsibility has gained much recognition in the Philippines, but additional work has to be done for this work distinction to gain universal compliance.

Very recently, the Philippine Board of Accountancy (BOA), the entity that regulates the CPA profession, passed a resolution to compel compliance with this division of work and to apply the requirements immediately on practically all FS for 2015, which are now under various stages of completion. This effectivity date was subsequently moved to a later date in response to serious objections.

The solution being provided by BOA is to shift the burden of compliance to the person who prepares the FS who, in this role, is clearly distinguished from management.

To enforce the foregoing solution, the resolution requires the preparer of the FS to submit a “Certificate of Compilation Services” and that such certificate be attached to the audited FS filed with the Securities and Exchange Commission (SEC) and the Bureau of Internal Revenue (BIR). In this certificate, the FS preparer is required primarily to “certify” that, in effect, the FS were prepared in accordance with accounting and auditing standards. The language is vague, but it seems to indicate a level of assurance. Secondarily, the FS preparer is required to express that he was not assisted by the entity’s external auditor in preparing the FS, which is the part that deals directly with what I thought is the primary issue.

In addition, the preparer needs to apply for accreditation with the BOA for doing such work.

I have great respect for the current chairman and members of the BOA. They have shown aggressiveness and activism in the exercise of their responsibilities, which have not been seen for a long time.

However, I believe that the said BOA resolution was unduly rushed and, therefore, might not have been properly conceived. Its promulgation did not follow the usual processes in the formulation of professional requirements. For example, formulation of accounting and auditing standards by the respective standard-setting bodies takes a few years to conclude as a result of providing adequate time for exposure of the draft professional standard, evaluation of comments received and finalization for adoption. Requirements by other regulatory bodies (SEC, BSP and IC) also generally follow a similar, even though shorter, time process. The issue may be urgent, but certainly a period of less than two months for comments and final adoption is too short.

Moreover, it is normal practice that any exposure draft of professional requirements is also circulated to other stakeholders who may be affected by such requirements. The draft BOA resolution was not circulated to business entities, which surely would be affected by such a resolution in terms of time, cost and the accreditation requirements for their CPA personnel. Also, the SEC, which requires in its own rules that companies registered with it must themselves prepare the entity’s FS, appeared not to have been consulted.

Let me move to specifics. It has now been clearly established that the entity’s management is responsible for the preparation of the entity’s FS before these are audited by external auditors. I believe it follows that it is the management’s prerogative to deal with this responsibility in the ways it knows best. It has hired CPAs to do the entity’s finance and accounting functions, which include the preparation of all sorts of accounting information, including the FS. Now, BOA wants these FS preparers to be BOA-accredited. Why? These CPAs are employees who work under the direction of management and are not rendering independent outside professional services.

On the other side of the fence, as a reaction to the BOA resolution, practically all CPAs (there are tens of thousands of them here) would want to be accredited as FS preparers because it is their livelihood. So, in effect, the regulator is placing another qualification level for a CPA to enable him to exercise his profession, but not if we assume that most CPAs would rather just become clerks and would not seek accreditation as an FS preparer. This raises the issue of what the CPA title is if the regulator itself cannot trust the qualified CPAs to prepare the FS without being accredited. Moreover, this additional level of accreditation will necessarily entail much additional time and cost for all those concerned.

Part II – The weight of the FS preparer’s certificate

What about the required certificate to be submitted by the FS preparers? To my mind, the issuance of such certification, just like any similar activity, needs a set of standards and application guidance to be followed to make the expressed assertion in the certificate credible. If such a set of standards and application guidance is not envisioned to be developed, then it implies that the current knowledge and skills of the CPA FS preparer as expressed by his CPA title are sufficient. So what weight does the certificate carry?

As an option, an entity may hire another auditing firm (but not its own external auditors) to prepare the FS. In such a case, the auditing firm and its engagement team are required to follow a whole set of standards that apply to FS compilation (preparation) work (Philippine Standard on Related Services 4410), which is a non-assurance engagement. These standards prescribe what the report must contain and provide several illustrative reports to be sure. Under these circumstances, I believe that it is meaningless to prepare additionally the BOA-prescribed certificate, which indicates some assurance that the PSRS 4410 explicitly avoids. But more than this, I doubt whether a CPA in public practice will sign such a certificate as mandated by BOA. The reporting standards in PSRS4410 clearly prohibit him to do so.

Moreover, BOA in its clarifications indicated that the FS preparer should follow the standards and application guidance provided in PSRS4410. But PSRS4410 was promulgated for CPAs engaged in public practice. Is this standard now being applied to cover CPAs not in public practice? Were the views of the Auditing Standards and Practices Council sought? PSRS 4410 is a complete self-contained document that requires many standards and application guidance to be followed. It now appears that FS preparers who are CPAs not in public practice must follow all these requirements. For example, a CPA FS preparer employed by an entity, if he follows the standards, must submit a letter of engagement to his employer. Would that make sense?

Presently, the SEC requires all companies registered with the SEC to attach to the audited FS filed with the SEC a “Statement of Management’s Responsibility for Financial Statements.” In this statement, among many other things, the entity’s management, which includes the chairman, chief executive officer (CEO) and chief financial officer (CFO), indicates clearly that it is responsible for the preparation and fair presentation of the FS. The BOA subsequently, clarified that it is a separate document and both this statement and the certificate must be prepared as required by the respective regulators. I find this attempt to identify the FS preparer as distinct from management difficult to comprehend.

The certificate is required to be attached to the audited FS when these are filed with the SEC and BIR. This required attachment clearly implies that the final audited FS are exactly the same FS for which the FS preparer issued his certificate. I believe this is practically impossible to happen. External auditors, almost always, make adjustments to the financial statements in terms of numbers, presentation, etc. It will be a lot more so when the division of responsibility for the FS preparation is completely complied with. As the entity’s FS go through the audit process, the final audited FS may be so different from their initial contents and form for which the FS preparer issued his certificate. So what meaning does the certificate convey in relation to the final audited FS? Does the FS preparer carry the same responsibility as the external auditor carries? Is he exposed to the same professional liability risk to which the external auditor is exposed? If the answer is ‘yes’ to both questions, would that be fair?

Those things said, I believe that the BOA resolution was unfortunately not well conceived, and, more importantly, is unnecessary. It is not well conceived primarily because the problem lies on the parts of the external auditor and the entity’s management, while the solution being sought is imposed on another party being differentiated from management. It is unnecessary because the problem will solve itself.

The awareness and acceptance by management of its responsibility for the preparation of the FS before these are audited are accelerating fast and I believe that substantial compliance will be achieved soon. Certainly, the external auditor must do his part by dealing decisively with this issue. Under existing auditing standards, he is required to be vigilant in assessing risks and threats to independence and possible misstatements of FS. Under these standards, he is required to deal with those risks and threats appropriately. The measures available to him include applying suitable appropriate auditing procedures to deal with the risks, mitigating the threats, and withdrawing from the engagement if no solutions are found.

The solution clearly lies with the entity’s management and the external auditor working together to achieve a common objective. There is where the arrow should be pointed.

The author founded Punongbayan & Araullo (P&A) in 1988. Today, P&A Grant Thornton is one of the largest public accounting firms in the Philippines, with 19 partners, over 500 staff members, and four offices around the country.

As published in The Manila Times dated 03 February 2016

If you want to read Part 2 of Preparation of financial statements, please click here.