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The Securities and Exchange Commission (SEC) is well under way with promulgating rules to implement provisions of the Sarbanes-Oxley Act of 2002, and several rules have received much attention due to the perceived additional burdens placed on management. However, one proposed rule has received comparatively little attention, and may have a large impact on how a company operates: the Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies rule (known as the CAP Rule). This rule would affect the way management, outside auditors and audit committees operate in ways that go far beyond any other requirements. With the proposed rule, the SEC, which can regulate public-company disclosure, is attempting to influence how public companies operate in the area of corporate governance. This initiative (some might say “interference”) may not be such a bad thing, particularly in light of key findings of recent internal forensic accounting investigations, including those at Freddie Mac. Section 204 of Sarbanes-Oxley spells out the minimum content of reports from an auditor to the audit committee. They must consist of critical accounting policies and practices, and alternative treatments of financial information within generally accepted accounting principles. Essentially, Congress wanted to encourage a frank discussion between the audit committee and outside auditors regarding the use of accounting principles with material impact that were subject to different interpretations. But the CAP Rule will require greater disclosure than the Section 204 internal report. The CAP Rule focuses on the estimates that are inherent in all accounting data and will require disclosure in the company’s public filings of a complete and thorough discussion of what the SEC expects to be the three to five critical accounting estimates most important to each public company. An accounting estimate is “critical” if the answer is “yes” to both these questions: Did the accounting estimate require assumptions that were highly uncertain at the time they were made? Would different reasonable estimates render a result that would have a material impact on the financial statements? If the estimate is a critical accounting estimate, by inference the related accounting policy is critical as well. The CAP Rule requires the audit committee to assess the adequacy of disclosure of critical accounting estimates or else disclose why the company’s audit committee did not conduct such a review. Since the latter disclosure would not be well received by investors given heightened sensitivity to accounting fraud, it is safe to say that audit committee members will have to inject themselves into the evaluation of critical accounting estimates. To determine which estimates are critical will require management to evaluate a wide range of uncertainties in the accounting data and select the most important. The audit committee will then review the selection for completeness and the accuracy as to the analysis of risk exposure. Section 204 will have auditors weigh in on the same issue, so that the CAP Rule, combined with Sarbanes-Oxley, will create a three-way, detailed discussion process among management, the audit committee and auditors. Preventing fraud We can’t be certain this process will stop fraud before financial statements are published. But from the investigation of accounting and disclosure procedures used at Freddie Mac and other forensic accounting internal investigations, it is clear that better communication among the three parties would result in a more objective and thorough analysis of potential problem areas. At Freddie Mac, for example, management had used a series of meetings and management layers to filter and reduce the amount of information going to board committees. Had the committees seen the original, unfiltered descriptions of questionable transactions, the board likely would have taken appropriate action. The CAP Rule attempts to address lack of candor by involving the audit committee in the accounting process at a deeper level. Under CAP, the audit committee would expect greater discussion of sensitive areas and, if management appears to be holding back, would be required to drill down further, if necessary using internal auditors or outside forensic accountants who would report their findings directly to the audit committee. If forensic accountants are engaged earlier-rather than after fraud is discovered-then the CAP Rule and Section 204 would create a major change in the governance of public companies, providing an important check on management. Charles R. Lundelius Jr. is senior managing director of FTI Consulting’s financial institutions advisory practice. He is the author of Financial Reporting Fraud: A Practical Guide to Detection and Internal Control (AICPA 2003).

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