Part III: Auditing Accounting Statements and Enterprise Resource Planning Records
Chapter 13: The Framework of Accounting, Financial Reporting, and Auditing
13.2 Understanding the Role of Accounting in the Financial System
The role of accounting and financial reporting, as well as the auditing of accounting data, will be better appreciated if one thinks in terms of the decision space of an executive, manager, or other professional.
Typically, in every organization this decision space is applications oriented; its main three axes of reference are those shown in Exhibit 13.1.
Exhibit 13.1: An Applications-Oriented Decision Space for Self-Service Banking
Anything happening within this frame of reference must be measured; That is accounting's role.
The economic aftermath of these decisions must be reported; that is what financial reporting is all about.
The information contained both in the books of account and in financial reports must be reliable; that is the mission of auditing.
A person who wants to make intelligent use of accounting information, whether this comes from ERP and CRM software or any other sources, must understand what a given accounting figure probably means, what its limitations are, and under what circumstances it may mean something different than what seems to be apparent or even self-evident. The user of accounting information does not need to know how to design or construct an accounting system from scratch, but he or she must appreciate the reason for and meaning of numbers and the qualitative aspects underpinning these numbers.
Because the uses of accounting are so broad, knowledge of the concepts underpinning accounting reports is vital. Recall that ERP is only an instrument of information technology. Many people think its conceptual understanding is all that the user needs to know. This is necessary, but it's not enough. In addition, the person using ERP or CRM information and accounting data must know:
How to employ this knowledge to solve problems that arise in the management of the enterprise
What the goal of the company is, with the environment defined by the industry and the market in which it operates
This is written in appreciation of the fact that there is much more to the art of management than the use of quantitative information that comes from classical accounting reports or ERP products. Qualitative information is also important, whether it relates to general accounting, cost accounting, principles underlying the construction of financial statements, evolution of the company's financial position at a given moment in time, or business performance over consecutive years.
The best way to look at qualitative information is that, above the quantitative presentation of business data, there is an interpretative metalayer (see Chapter 7) that can be instrumental in ensuring that resources are obtained and used effectively in the accomplishment of the organization's objectives. As Exhibit 13.2 suggests, below the quantitative accounting data there is another layer — that of the specific business infrastructure. The importance of an interpretative layer is dramatized by the fact that few, if any, business problems can be solved solely by the collection and analysis of figures. Usually, there are important questions connected to the business environment and infrastructural factors that cannot be, or have not been, reduced to numbers — yet they impact on accounting information.
Interpretative Metalayer Accounting Data Business Infrastructure
Exhibit 13.2: The Three-Layered Structure into Which Fits Accounting Information
The business infrastructure can change because of many reasons. Some have to do with the evolution of the line of business one is in; others with ways and means used to conduct one's business; still others, with the technology that is available, the way one approaches the market, and the manner in which the market behaves. The market that characterizes the globalized Internet economy has different characteristics from those of a static market with local appeal.
A key component of the three-layered structure presented in Exhibit 13.2, particularly of the
interpretative metalayer, is prognostication. Its goal is less that of an estimate of what might happen in the future and much more an evaluation of future effect(s) of current decisions. This evaluation can be facilitated or limited by the data one uses. In daily business practice, however, facilitation and limitation are relative, not absolute terms; they change over time because the market environment itself evolves.
Prognostication is a prerequisite to the planning function that must be performed at all levels in the organization and in all organizations. Budgeting, for example, is a systematic form of planning that uses accounting data, while the balance sheet is a means of control. Neither budgets nor balance sheets are fully objective ways of passing on data, even if many people act as if financial problems need only be presented in numerical form.
At the basis of this limited, quantitative approach is the erroneous idea that a rational decision can be made solely from knowledge of numbers. People with experience appreciate that it is wrong to forego figures, concepts, prognostications, deliverables, and their interaction in the solution of problems.
Concepts include ideas and use rules that lead to interpretations. They may make reference to matters of precedence or jurisprudence that impact on accounting figures and, sometimes, change their meaning. While the inference one does is largely based on figures, concepts may lead to a totally different path than the one originally projected on numerical data alone.
Inference based on accounting and other financial information is vital because business people can obtain considerable insight from these statements. To do so, they need information about their own company and about their competitors, as well as about their business partners in the Internet supply chain. At the same time, there are inherent limitations in financial and accounting information — and by consequence, in ERP reports — that prevent these statements from providing answers to some of the most important questions raised about an enterprise.
The principle is that the accounts and statistics must be right. Interpretation of them is the manager's own privilege and risk. When talking about auditing the book of accounts or ERP information, what one is principally after is accuracy, precision, and documentation of the figures. This leads the auditor to question both the data and certain aspects of the process — or all of it. This questioning aims to respond to two queries:
1. Whether the accounting process functions in an effective and efficient manner 2. Whether the accounting process operates in compliance with rules and regulations Expert auditors know that, for any practical reason, compliance with rules and regulations is, to a significant extent, a matter of interpretation. It is therefore part of the metalayer of accounting depicted in Exhibit 13.2. To the contrary, the rules and regulations themselves are part of the established business infrastructure. In this sense, at the middle layer, accounting does not prove; its mission is to announce and reveal. But the reading of accounting statements leads to induction, which goes beyond the simple enumeration of data.
Take as an example the accounting rules for software depreciation, which evidently apply to ERP and CRM. In March 1998, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 98-1: "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." Its objective is to provide guidance on accounting for the costs of computer software developed or bought by entities for their own employment.
Because it introduces the concept of depreciation, the implementation of SOP 98-1 decreases costs and expenses the first fiscal year, but thereafter it increases year-over-year costs and expenses as the capitalized amounts are amortized. Because bought software such as ERP adds functionality to the existing information system, its depreciation must follow SOP 98-1. In contrast, the cost of software that does not add functionality to the present IT routines will continue being expensed as incurred.
SOP 98-1 identifies the characteristics of internal-use software, providing guidance on new cost recognition principles. This is significant because it changes past practices. Certain costs that were previously expensed as incurred will now have to be capitalized and amortized on a straight-line basis over three years. Accounting rules, such as those concerning depreciation, are not cast once and forever.