Are the Audit Firms Sustainable? If There are no Answers, Change the Questions

To borrow from Oscar Wilde, only the truly hard-hearted could watch the US Treasury’s Advisory Committee on the Auditing Profession’s pathetic meeting of July 22 – webcast -- without breaking into hysterical laughter.

The Committee’s final report is now out in draft for comment – here. So a nearly year-long effort is whimpering down, in spasms of self-congratulations -- palpably uttered through the members’ clenched teeth of obligatory politesse and mutual antagonism.

The gross reason for the Committee’s failure to advance its mission – to scrutinize the sustainability hazard facing the auditing profession – is plain enough. It could not even reach agreement on the most basic proposition – that the Big Four firms’ business model and very survival are legitimately under the threat of catastrophic litigation risk.

But a subtler dynamic is at work, in the constricted manner of the Committee’s proceedings. To students of negotiation theory, practice and behavior dynamics, it’s a classroom study in the need for “re-framing” the inquiries that have caused the blockage.

That is, because the Committee locked into the binary rhetoric typical of a fault-finding exercise, it was fatally unable to conceive, articulate or pursue the necessary array of non-simplistic, multi-dimensional questions -- to which the only effective answers would have been both sophisticated and holistic beyond the Committee’s vision.

Two examples of the fundamental limitations of this “either/or” vocabulary will illustrate:

First, the need was stated to bring “two disparate sides” together at the table on a sensible recommendation to address the large firms’ litigation risk and exposure. As if there really were two “sides,” or a single and simple solution.

Instead, shortness of vision defined the perspectives of all involved. On one hand, the Big Four audit firms argued for the necessity of liability limits, despite the fact that – having their multiple litigations with exposures exceeding $10 billion each -- there are no politically achievable money limits nor fault allocation percentages small enough to protect a capital-challenged firm from the devastating effect of an adverse big-case result.

Conversely, critics of the profession mouthed the two-fold importance of investor protection and the assurance function, but gagged before agreeing that the next mega-verdict starts a domino effect that will cascade all the Big Four into disintegration – which would kill off their historical function without even starting the search for an evolved and re-engineered replacement.

A second example of the Committee’s overly limited issue-framing: whether the primary cause of the current travail was either a failure of audit quality, or the heavy and inevitable burden on the firms of responsibility for large public company audits.

In fact, it’s both. And much more as well. The politicized nature of complex accounting guidance and the unpredictability of the American legal system combine to set a performance standard that the Big Four cannot fulfill at the expected fail-safe level.

At the same time, the profession’s insistent attempt to focus on its successes and its improvements misses two points: that systemic stress is driven by failure, not success; and that the profession has not overcome the persistent recurrence of unsatisfactory audit performance, legitimately subject to criticism and liability exposure.

So it comes to this: only against a very low bar of achievement can the Treasury Committee’s endeavor be viewed as successful. Its members recite the pieties of corporate audit importance, but the vigor of their shared back-patting is in inverse proportion to the level of their accomplishment.

Whatever their own expectations at the outset, Treasury Secretary Henry Paulson and the Committee’s leaders will be obtaining the low-level result of their tolerance for incremental thinking and mediocrity of vision.

For all the time, energy and posturing, the entire community of those involved in the creation and use of audited financial statements deserved better.

Watch this space:  Next week, as an interesting event in the August holiday season, I will be an outsider among some 3000 academics at the annual meeting of the American Accounting Association in Anaheim, California.

One of the sessions there, on which I will be a panelist, will address this question: “Is the current business model of the audit firms sustainable?”

We may not have the clout or the visibility of the Treasury Committee. But it’s a good bet that we will cut closer to the core of the issues on which that group has so sadly under-performed.        

Comments

[anonymous]

"shortness of vision"

That's pretty much all you need to know about the current state of affairs in the CPA profession. Personally, I think it's broken beyond repair.

[Jim]

Perhaps, Anonymous, but if the state of affairs is indeed "broken beyond repair," then the focus had best shift over to a the design and implementation of a replacement, or else all the sanctimonious rhetoric about how vital the profession ostensibly is to the world's capital markets comes to very little.

[George Hill]

The core of the problem has been the growth of inappropriate accounting procedures blessed by the FASB. The trend to LAWYER LIKE PROSE that could then be interpreted to serve special interests so as to mislead the public which allowed fraud under GAAP. Further the misuse of "fair value" accounting created false income "under the rules" and allowed the major mistatements.

Auditors must be professional and they have not been. Perhaps the shift to International Principles and the elimination of GAAP will be the solution. The issue is integrity, character, honesty, independence - the return to such professional standards would correct much of what the public distrusts.

[Jim]

Thanks to George Hill for his comment. The politicized nature of the standard-setting process is certainly an element -- but changes there involve not just the profession's challenge, but the interplay with the other players as well -- including issuers and regulators as well as standard-setters. So the idea of changes that are "necessary, but not sufficient" is definitely part of the dialog.