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provided to analysts and rating agencies.

30
Ganesh Krishnamoorthy, Arnie Wright, and Jeffrey Cohen. “Auditors™ Views on Audit Committees
and Financial Reporting Quality,” CPA Journal 75, No. 10, (October 2002), p. 56.
The Investors 111


6. Review and discuss with management, the Internal Auditors and the Outside
Auditor:
(a) Significant financial reporting issues and judgments made in connection with
the preparation of the Company™s financial statements;
(b) The clarity of the financial disclosures made by the Company;
(c) The development, selection, and disclosure of critical accounting estimates
and the analyses of alternative assumptions or estimates, and the effect of
such estimates on the Company™s financial statements;
(d) Potential changes in GAAP and the effect such changes would have on the
Company™s financial statements;
(e) Significant changes in accounting principles, financial reporting policies and
internal controls implemented by the Company;
(f) Significant litigation, contingencies and claims against the Company and
material accounting issues that require disclosure in the Company™s financial
statements;
(g) Information regarding any “second” opinions sought by management from
an independent auditor with respect to the accounting treatment of a particu-
lar event or transaction;
(h) Management™s compliance with the company™s internal accounting and fi-
nancial controls and the recommendations of management, the Internal Au-
ditors and the Outside Auditor for the improvement of accounting practices
and internal controls; and
(i) The adequacy and effectiveness of the Company™s internal accounting nd fi-
nancial controls and the recommendations of management, the Internal Au-
ditors and the Outside Auditor for the improvement of accounting practices
and internal controls; and
(j) Any difficulties encountered by the Outside Auditor or the Internal Auditors
in the course of their audit work, including any restrictions on the scope of
activities or access to requested information, and any significant disagree-
ments with management.
7. Discuss with management and the Outside Auditor the effect of regulatory and
accounting initiatives as well as off-balance sheet structures and aggregate con-
tractual obligations on the Company™s financial statements.
8. Discuss with management the company™s major financial risk exposures and the
steps management has taken to monitor and control such exposures, including the
Company™s risk assessment and risk management policies.
9. Discuss with the Outside Auditor the matters required to be discussed by State-
ment on Auditing Standards (“SAS”) No. 61 relating to the conduct of the audit.
In particular, discuss:
(a) The adoption of, or changes to, the Company™s significant internal auditing
and accounting principles and practices as suggested by the Outside Auditor,
Internal Auditors or management; and
(b) The management letter provided by the Outside Auditor and the Company™s
response to that letter
10. Receive and review disclosures made to the Audit Committee by the Company™s
Chief Executive Officer and Chief Financial Officer during their certification
process for the Company™s Form 10-K and Form 10-Q about (a) any significant
112 The External Users of Accounting Information


deficiencies in the design or operation of internal controls or material weakness
therein, (b) any fraud involving management or other associates who have a sig-
nificant role in the Company™s internal controls and (c) any ignificant changes in
internal controls or in other factors that could significantly affect internal controls
subsequent to the date of their evaluation. 31



CREDIT GRANTORS
Importance of the Credit Grantors
Obviously, credit grantors are a significant group since they are a source of funds
to the enterprise. The group consists of both short-term and long-term lenders of
credit, such as banks, insurance companies, trade creditors, and bondholders.
Short-term creditors are concerned principally with the corporation™s ability to
maintain an adequate cash position because they expect to be paid in a short pe-
riod of time. Hence they focus their attention on the working capital position of the
enterprise, which represents the relationship between cash and near-cash assets,
such as short-term securities, receivables, inventories, and short-term liabilities.
Such information is central to this group™s decision-making process because the
particular assets may be converted readily into cash. Conversely, long-term credi-
tors are concerned not only with the corporation™s ability to generate cash but also
with its potential profitability. For example, they are interested in the ability of the
enterprise to secure a loan with the necessary assets in relationship to its commit-
ments and contingencies, such as a pending lawsuit. Thus credit grantors are pri-
marily interested in the current solvency position of the corporation and its
adherence to the loan covenants. In short, the major objective of the creditors is not
only to safeguard their claim against the assets of the enterprise but also to obtain
assurance with respect to the debt-paying ability of the corporation.


The Need for Accounting Information
Credit grantors need information on the financial and operational conditions of the
enterprise. To judge a credit risk or establish a line of credit, they focus their at-
tention on the financial statements as well as other sources of information, such as
Dun & Bradstreet or National Credit Office credit reports.
In a study of June 1978, Keith G. Stanga and James J. Benjamin concluded that:

1. Bankers assign considerable importance to the basic historical financial state-
ments as information sources for making term loan decisions. The comparative
income statement is ranked as the most important information item.
2. Bankers attribute a fairly high degree of importance to forecast information. This
suggests that accountants should continue striving to improve reporting standards
in this area.
3. In general, bankers assign a fairly high degree of importance to information re-
garding executory contracts. This suggests that the accounting profession should


31
Wal-Mart Stores, Inc., Audit Committee Charter, 2003 (www.walmartstores.com), pp. 3“5.
Credit Grantors 113


concern itself not only with the accounting and reporting problems associated
with leases, but also with other types of executory contracts, such as major pur-
chase commitments, labor contracts, and order backlogs.
4. Bankers consider general purchasing power financial statements as relatively
unimportant. As noted earlier, other studies have found that security analysts also
attribute little, if any, importance to these statements. Given the paramount nature
of user needs in financial accounting, it would seem that the FASB should care-
fully reconsider the usefulness of price-level statements before making this in-
formation mandatory in the future.
5. Bankers assign relatively little value to information on corporate social responsi-
bility and to financial breakdowns of amounts relating to human resources. These
feelings are present despite the tremendous interest shown by many accountants
in these areas in recent years.32

More recently, George Cox and associates report that “the recent spate of corpo-
rate disasters almost defies understanding.” Such companies have “credit lines
with premier lending institutions and yet, disaster struck without much warning to
investors, creditors, or employees.” They believe that “the audit committee should
meet with investment and commercial bankers, as well as rating agency personnel,
about the health of the organization.” For example, “are bank loans and credit lines
competitive, meeting ordinary and customary market terms? Strong oversight and
control are the best prescription for company health.”33

Role of the Audit Committee
Although the finance committee is responsible for the financial policies and pro-
gram, the audit committee should give attention to the financial reporting matters
concerning the credit lenders. The audit committee members are in a unique posi-
tion because they must monitor the accounting information that is related to the
corporation™s financial policies. In approaching the financial reporting task, the
committee should consult with the chairperson of the finance committee as well as
the chief financial officer. For example, the committee™s review of the loan agree-
ments and other commitments should be made in view of the preceding discussion
of the objectives of financial reporting and the information needs of the credit
grantors. Thus the audit committee should be concerned primarily with such mat-
ters as:

• The proper disclosure of the short-term and long-term obligations and any out-
standing commitments of the corporation
• The adherence to the loan covenants regarding the necessary working capital
ratios
• A summary of the sources of creditors™ equity and the related cost of debt

32
Keith G. Stanga and James J. Benjamin, “Information Needs of Bankers,” Management Accounting
59, No. 12 (June 1978), p. 21. FASB No. 33 was rescinded in 1986 by FASB No. 89, which encour-
ages disclosure on a voluntary basis.
33
George Cox, H. Stephen Grace, Jr., John E. Haupert, Peter Howell, and Ronald H. Wilcomes, “A
Prescription for Company Health,” CPA Journal 72, No. 7 (July 2002), pp. 62“63.
114 The External Users of Accounting Information


• A forecast of the proposed debt financing activities and repayment schedule
and its relationship to the stockholders™ equity

As William H. Dougherty, former president of NCNB Corporation, suggests:

The concern of all involved parties should be with the quality of disclosure”not its
quantity, and involved parties should be more vigorous than anyone else in cost/ben-
efit evaluations. . . . The increasing cost of audit and compliance is important be-
cause it raises corporate prices.34

In his article entitled “The Enron Affair from a Lender™s View,” Neville Grusd,
executive vice president of Merchant Factors, points out that “no one has men-
tioned the loss sustained by the creditors of Enron.” He notes that “most credit
grantors, however, rely upon the very financial statements” that the parties in the
public sector (the President, SEC, and Congress) are worrying about.35
Grusd suggests the following to credit grantors:

• “Become more active in accounting rule making through the American Bankers
Association and Commercial Finance Association.”
• “If a lender knows the client is a major account of the CPA firm issuing its fi-
nancials, the lender should take the necessary steps to ensure the quality of the
financial reporting.”
• With respect to review engagements, “lenders and accountants should discuss
the accountant™s procedures, then decide the extent to which the lender™s own
field exam should be extended to cover weak areas.”
• Lenders should insist that the financial statements are prepared by “competent
and independent CPAs.”36

In addition to the issues already discussed, several Financial Accounting Stan-
dards Board Statements are relevant to credit grantors:

SFAS No. 95 “Statement of Cash Flows” (November 1987)
SFAS No. 105 “Disclosure of Information about Financial Instruments with
Off-Balance Sheet Risk and Financial Instruments with Con-
centration of Credit Risk” (March 1990)
SFAS No. 107 “Disclosure About Fair Value of Financial Instruments” (De-
cember 1991)
SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities”
(June 1998)




34
William H. Dougherty, “Financial Reporting”A Banker Looks at the Scene,” Financial Executive
46, No. 12 (December 1978), p. 53.
35
Neville Grusd, “The Enron Affair from a Lender™s View,” CPA Journal 72, No. 12 (December 2002),
p. 8.
36
Ibid., pp. 8“10.
Credit Grantors 115


These accounting standards are summarized in the following paragraphs.

In November 1987, the FASB issued SFAS No. 95,
Reporting Cash Flows
“Statement of Cash Flows.” The board recognized that a presentation of a com-
pany™s cash flows is a better measure of liquidity by the users of financial state-
ments. Prior to the issuance of SFAS No. 95, companies could present their funds
flow statement on either a working capital or a cash basis. Under the new ac-
counting standard, companies are required to classify cash flows as operating, in-
vesting, or financial activities.37 Management is required to provide additional
information on cash flows in its presentation of management™s discussion and
analysis of financial condition and results of operations. Although the FASB has
encouraged management to report cash flows from operating activities by the di-
rect method, which consists of classes of cash transactions, the indirect method is
commonly used. For example, Accounting Trends and Techniques”1990 dis-
closed that in 1989, 583 companies out of 600 used the indirect method.38 Under
this method, the net income is reconciled to net cash flow from operating activi-
ties by adjusting for deferrals, accrual, and noncash charges.

In the late 1980s, the accounting treatment associated
Financial Instruments
with financial instruments and transactions received a great deal of attention be-
cause of the lack of financial accounting and disclosure standards. Typically, such
financial instruments were treated as off-balance-sheet financing arrangements or
unaccrued loss recognition in the financial statements. In March 1990, the FASB
issued SFAS No. 105, which deals with disclosures about off-balance-sheet risk,
credit risks, interest rates, and current market values of financial instruments.39 For
example, SFAS No. 105 requires companies to disclose concentrations of credit
risk from accounts receivable financing arrangements and other financial instru-
ments. In the event that there is nonperformance by the parties to the financing
arrangement, management is required to disclose the dollar amount of the loss re-
sulting from credit risk.40
Subsequent to the issuance of SFAS No. 105, in December 1991 the FASB is-
sued SFAS No. 107, which requires all financial and nonfinancial institutions to
disclose the fair value of financial instruments whether recognized in the balance
sheet or not. If management is unable to obtain the quoted market price of a finan-
cial instrument, then it may use the quoted market price of a similar instrument or
use a valuation technique, such as estimated future cash flows. Fair value disclosure

37
Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 95, “State-
ment of Cash Flows” (Stamford, CT.: FASB, 1987). See SFAS Nos. 102 and 104 for amendments.
38
American Institute of Certified Public Accountants, Accounting Trends and Techniques”1990 (New
York: AICPA, 1990).
39
Financial Accounting Standards Board, Statement of Financial Accounting Standards, No. 105,
“Disclosure of Information About Financial Instruments with Off-Balance Sheet Risk and Financial
Instruments with Concentrations of Credit Risk” (Norwalk, CT.: FASB, 1990).
40
For further review and discussion, see Chad F. Coben, “Implementing SFAS No. 105™s Disclosure
Requirements,” Journal of Commercial Lending 74, No. 7 (March 1992), pp. 13“23; and Nathan M.
Lubow, “New Disclosures FASB No. 105,” Secured Lender 48, No. 6 (November/December 1992),
pp. 112, 114.

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