ACCOUNTING STANDARDS

Although this is a book on auditing, it is useful to briefly review the accounting criteria auditors use in audits of financial statements as these have greatly changed over time and can have an important impact on audit effectiveness. In Chapter 2 we will review the broader suitable criteria concept, but here we review the complexity and issues associated with the traditionally most common criteria in audits: those of the accounting standards. Accounting standards have broadly followed a path of increased standard setting and regulations that parallels that of auditing standards. As noted in the previous section, the first 1917 Bulletin was nominally about accounting standards but was primarily devoted to auditing procedures, indicating perhaps that the most important feature of accounting standards is that they are verifiable by outside independent auditors. Early criticisms of financial reporting in the 1920s were that many of the speculative values used in the financial reporting were not verifiable, in part because there were no Generally Accepted Accounting Principles (GAAP) (Previts and Merino 1998, 263-269). Identifying such principles first began with the practices that had “substantial authoritative support” (A1CPA 1987, 116). The Committee on Accounting Procedures (CAP) of the AICPA began the process by issuing accounting research bulletins. But CAP focused on dealing with specific problem areas. A more conceptual approach to standard setting began in 1959 with the creation of the Accounting Principles Board (APB) with a research division that published Accounting Research Studies (ARSs). In 1964 departures from APB opinion were to be disclosed with a requirement that such departures should have “substantial authoritative support” (AICPA 1987, 118).

Dissatisfaction with the APB’s standard-setting activities led to the creation of two special study groups by the AICPA in 1971. The reports from these groups led to the creation of FASB in 1973. The FASB launched a conceptual framework project to guide its standard setting. An evolving set of concepts statements (1 through 8), informed by extensive accounting research, have been issued with the latest efforts focused on disclosure guidance. These activities parallel and in several instances have converged with international accounting standard setting by the International Accounting Standard Setting Board (IASB), and the two standard-setting groups have worked together closely for the last 15—20 years.

From an audit perspective, a major trend in financial reporting has been toward increasing use of estimates in accounting, including fair value accounting. This has occurred in accounting standards even though in many situations the verification of the information has caused audit problems. The importance of verifiability appears to have been decreasing over time for both sets of accounting standard setters. Some have attributed this to a return to the balance sheet perspective that dominated financial accounting in the 19th century and earlier. The 20th century saw an increased stress on the income statement, realization, and matching concepts (Lev 2018, 471—472). However, a return to the balance sheet perspective and fair value accounting in the 21st century is not considered a good development by at least some accounting researchers (e.g., Lev 2018, 472-488; Barker and Penman 2017; Dichev 2017). To argue that these changes in accounting concepts and theory should have no impact on auditing practice and theory would appear to be simplistic.

Recent books on accounting theory suggest an important role of information economics and tests of theories based on it (e.g., see Scott 2015 and Wolk et al. 2017). There is much conflicting evidence in research and there are issues not addressed by economic theories: how verifiable the reported numbers in the financial statements should be, what a minimal assurance level should be, and the fact that empirical research can only be done on what is practiced and not other possibilities. The first issue is a focus of Chapter 11. Verifiability is an important attribute of all rigorous approaches to knowledge. Reproducibility of research results is the foundation of research in accounting, yet it does not seem to merit the same concern in accounting practice.

There is also the issue of other forms of research not covered in standard accounting theory. We will review these in later chapters and especially in Chapter 2. Finally, it should be noted that although accounting standards have evolved to the point of developing conceptual frameworks in accounting standard setting, there is as yet no comparable framework for auditing standard setting. We feel that this gap will not only hinder broader development of auditing theory but also may prevent accounting practice from fulfilling its appropriate social role. One of Brydon’s (2019, section 6) major recommendations is the creation of a new audit profession firmly based on corporate auditing.

The next section provides a brief overview of audit research not covered in later chapters that could help more fully develop an audit conceptual framework.