Part III: Auditing Accounting Statements and Enterprise Resource Planning Records
Chapter 13: The Framework of Accounting, Financial Reporting, and Auditing
13.4 Both Quantitative and Qualitative Features of Accounting and ERP Are Vital to Business
Accounting sets out to record events that have taken place, rather than to discover them. This is true even if accountants, to some extent, may have to discover facts to be able to record them. This discovery process is not concerned with the creation of data pertaining to events or transactions that have to be registered, but with the mapping into accounting books of what has taken place but might be hidden at first look.
If one looks at organizational issues, one notices (as emphasized in Chapter 13.1) that not only is accounting in direct contact with the business infrastructure, but it literally rests on it. Therefore, the accountant must have considerable knowledge of how commerce and industry operate, as well as of the laws and regulations, before attempting to audit events and financial transactions in the books. An example is the issue of materiality; an expense of $20,000 has no effect on General Motors, but it may have a large impact on a small family firm.
A person who is not familiar with the interpretative metalayer as explained in Chapter 13.2, may fail to recognize significant facts from non-significant, or even become confused or frustrated by reading accounting statements. As another example, a very common source of confusion, both with accounting and with ERP, is the word cost. There are direct costs, indirect costs, variable costs, historical costs, standard costs, differential costs, net costs, residual costs, incremental costs, marginal costs,
opportunity costs, and estimated costs. Some of these terms are synonymous. Others are almost, but not quite the same. Still others are used by some people as if they were synonymous.
Therefore, accounting figures should always be discussed and interpreted in terms of the particular problem that they are intended to help solve, rather than in an abstract sense. A useful procedure to follow in approaching a specific problem is to define, as carefully as possible, the purpose for which accounting data is to be used in a given problem, and then consider how appropriate figures should be collected, assembled, processed, and presented for that specific purpose.
A different way of making this statement is that the first step in understanding accounting — and by extension of ERP and CRM — principles and figures is to gain knowledge both of the general principles on which the business world rests and the interpretive complexities associated with this world. As Exhibit 13.5 suggests, facts, events, and financial transactions must primarily depend for their existence upon the principles on which the world conducts its business. The data accounting collects must be specific:
The fact that commerce booms in no way means that every company prospers.
"This" or "that" company, or an entire sector of the economy, may suffer because of the law of unintended consequences.
Exhibit 13.5: The Principles of Data Colllection, Storage, and Interpretation Are Similar from One Company to Another, but Data Must Be Accurate, Timely, and Specific
Here is a practical example. Internet commerce booms, but after the late March 2000 stock market shakedown, the capitalization of business-to-business (B2B) companies has collapsed. The advent of Internet commerce led to a surge in the value of companies dedicated to B2B trades. During 1999, and the first three months of 2000, investors could not have enough of them. Then, at the end of first quarter 2000, a major correction in technology stocks turned their glamour on its head.
Accounting must capture, record, and report changes that happen both in-the-big and in-the-small. An example of big-picture change is that of March/April 2000 when the 18-percent drop in the NASDAQ Composite Index wiped $1 trillion from investors' portfolios. While that major correction was the result of an overvalued technology sector that suddenly confronted reality, the connection that exists tick-by-tick with accounting should not be missed. The current way of rather backward-looking financial statements used by business and industry does not capture the volatility in crucial assets, effects of innovative processes, or wealth effect of accumulated groundbreaking patents.
These and other assets are tracked a long way after the facts. Yet these are the assets underpinning New Economy companies. Leaving them out of current statements sees to it that investors looking for tomorrow's sources of wealth are flying blind. They are condemned to use substandard information and to suffer wild market mood swings. First-class accounting, MIS, ERP, CPM, and other software cannot
cure the market's volatility, but they can provide investors with a better picture of a company's true worth.
The connection between the restructuring of accounts and financial statements to reflect strengths and weaknesses of the New Economy, and their recording through orderly accounting procedure, is evident.
Auditing should not focus only on errors in accounting books and traditional financial statements. It should help in foresight. This will not likely happen when accountants and implementers of ERP systems take a near-sighted view of the work they should be doing, or follow a policy characterized by lukewarm analysis and too many files kept secret.
Exhibit 13.6 maps this process of successive ups and downs as I have seen them happening in the auditing of many processes and projects, particularly in IT. Given management support, the auditors start their work diligently. As difficulties in pinning down errors and malfunctions come along, and political plots mount, management support wanes and the auditors fall into a state of depression. Only pressure by regulators gets management going again, and auditing is back on track toward a valid solution.
Exhibit 13.6: The Auditing of Any Major Process or Project Tends to Go Through Successive Ups and Downs
Regulators need to grasp the technical complexities of globalization, its tools, instruments, techniques, and differences characterizing major segments. The Basle Committee on Banking Supervision has performed in the most commendable way along this line of reference, showing that it comprehends very well the broader significance of the globalized financial system — all the way to evaluating systemic risks and taking measures to avoid them.[7]
Accurate accounting records and financial reports are vital because a great deal can be learned from the analysis of differences characterizing major segments of the global market. For example, in October 1999, stock market capitalization in the euro countries, as a percentage of GDP, was 71.1 percent. This compared poorly with the securitized structure of the United States economy where, as a percentage of GDP, financing through the issuance of domestic securities has been 163.3 percent, dwarfing the 48.4 percent of GDP for loans by banks.
Exhibit 13.7 contrasts statistics from the United States, euroland, and Japan. This is a case where the business infrastructure is practically the same, involving commercial banking and securities (debt and equity), but the rules underpinning the economic and financial information being reported differ — and these differences help in estimating the way credit works in each major area, as well as the possible aftermath of assumed exposure.
Reporting
Period United
States Euroland Japan
Bank deposits June
1999 55.2 77.8 111.7
Bank loans June
1999 48.4 100.4 107.0
Outstanding domestic
debt securities June
1999 164.6 88.8 126.5
Value: Sum of Debt Instruments
213.0 189.2 233.5
Stock market
capitalization October
1999 163.3 71.1 137.7
Debt and equity 376.3 260.3 370.2
Reporting
Period United
States Euroland Japan financing
Note:Statistics selected from ECB Monthly Bulletin, January 2000.
Exhibit 13.7: Critical Financial Statistics of Mid- to Late 1999 as Percent of GDP in the United States, Euroland, and Japan
An interesting observation, based on accounting data, is that in the United States, bank loans are about 15 percent less than the banks' intake; America is not a nation of savers. In contract, in euroland, bank loans are some 40 percent above deposits. Another interesting divergence is in the amount of stock capitalization. In this case, however, given prevailing differences in reporting rules and in calculation methods, these figures are not 100 percent comparable.
Significant are the differences that exist when one sums up debt and equity financing. The message given by the total of debt and equity is how far investors go in providing or cutting off funding to companies by, respectively, buying or declining to buy their assets and liabilities. Investors base their decisions on financial reports that must be reliable and based on international accounting standards.
Because they certify the accounting information on which such reports are based, internal and external auditors play a key role in making the financial system tick.
[7]D.N. Chorafas, The 1996 Market Risk Amendment. Understanding the Marking-to-Model and Value-at- Risk, McGraw-Hill, Burr Ridge, IL, 1998; and D.N. Chorafas, Risk and the New Economy, New York Institute of Finance, New York, 2001.