Replace the Big Four with Audits by Government? More Heat in the Kitchen -- and Less Light

What will it take, once for all, to lay forever the ghastly fantasy that audits done by government employees could provide any value to the world’s capital markets?

Like Banquo’s ghost, the gruesome spectre keeps stalking the discourse on the troubled state of privately-provided assurance – for now, dominated for global-scale companies by the fragile and threatened Big Four.

In search for a metaphor with an edge sharp enough to the task, consider:

Does anyone choosing a restaurant ever give one second’s thought to the local health inspector’s report on the state of the kitchen?

I thought not.

Never did a restaurant owner welcome diners or execute a menu with the least consideration of the requirement to pay a nuisance fee, just in order to post on his back wall the same ticket of compliance issued to everyone else – whether the tea shop or the burger joint or the elite purveyor of haute cuisine. 

Nor does that annual documentation provide any significant comfort.

On one hand, whatever that irrelevant certificate may say, competition applies relentless quality pressure in the narrow-margin food service business. A chef has ample incentive for the sake of survival to conform to the standards generally accepted among his peer group – whether running a gyros wagon or a three-starred temple of gastronomy. With ready access to reviewers’ critiques and customers’ word-of-mouth, a clientele will quickly vote the extent of its satisfaction and loyalty with its feet.

So irrespective of the commodity language of the inspector’s report, quality and value will quickly reach equilibrium.

On the other hand, the narrow limits of an inspector’s box-tick are illuminated by the commentators with inside knowledge. The celebrity ex-chef and international foodie, Anthony Bourdain, exposes to the point of hilarity the dirty little secrets of fully-compliant professional kitchens: never order fish on Monday that was carried over the weekend – the best chance for freshness is the chef’s daily special, because of the high volume and extra attention – and for salmonella’s sake, keep distance from the salad bar, never knowing who or what has rooted around there.

Bourdain makes it clear that a restaurant inspector’s annual pass-through leaves customers un-informed about what lurks beneath the grease trap or inside the meat cooler – consigning their reliance instead to the combination of peer influence and managerial attention to reputation and survival.

Which should validate the efficacy of market dynamics over further regulatory intrusion over the audit sector: restaurants, like corporate issuers, fail for multiple reasons, but above a minimal level of legitimacy, not for lack of code compliance.

Just as a health inspector is in no position to assure the quality of a dining experience, audit by government agencies would be helpless in the search for financial statement assurance of any real value -- too little, too slow, and far too late behind the speed of creative private enterprise.

Government audits could be imposed, of course – especially in the event of Big Four disintegration. But the impulse would be expedient and superficial – primarily under politicized motivations as cover for legislators and secondarily to serve the self-interested bureaucracy that would quickly become entrenched.

And the results would be much like the other models for agency-enforced compliance. Effectiveness would be measured by easily–measured inputs rather than defects exposed – think of the numbers of grandmother pat-downs reported by airport security, or inspections conducted by the PCAOB – neither of which has a record of detection or deterrence for all the wasted effort, disruption and expense.

Other examples abound. Consider drivers’ licenses. Above a minimal threshold level, anyone can get one – only to support a large and costly administrative structure interested primarily in its own perpetual existence – while delivering a compliance certificate offering no assurance on the quality of the holder’s ability behind the wheel. 

The entirely justifiable public dissatisfaction with the institutions at the heart of the financial crisis of the last four years, reflected in the legal claims working through the court systems – Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, New Century, Countrywide, Washington Mutual, as the start of the US list; plus endless examples elsewhere that would include banks in the UK and across Europe from Germany through Ireland to Iceland – rightly challenges the utility of the current financial reporting model and the performance value of privately-delivered assurance.

But great care and caution is required before speculating that the manifest deficiency of an existing model would be relieved by trashing it for another of uncertain and highly doubtful capabilities.

Or as a percipient restaurant critic might suggest – the leap from a well-seasoned but encrusted frying pan may be into an unknown and far more dangerous fire.

 

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Comments

[TJ]

I would support this move. The auditors could be organized similar to a Crown Corporation in Canada, and built with hard checks and balances in place.

[Al Mac]

Your government health inspector argument could largely be applied to private sector annual audit reports. I'm not advocating Government-performed audits, just the limitations of the main analogy.

[Jim]

Thanks, Al -- I'd agree with enthusiasm -- but then I've been arguing for years the obsolescence of the audit model inherited from Victorian times. Nothing less than a fundamental re-engineering is going to bring about the change that is coming; the only real questions are "when" and "how disruptive will it be?"
Jim

[Jim]

Thanks TJ -- This model has been floated, in the form of government charters for "audit only"firms serving public companies. I wrote on it on June 10, 2008 -- see my archive. What is needed is a holistic "blank page" approach that would cover ownership, capitalization, scope of ancillary services by the firms and their affiliates, liability, law enforcement and oversight. That's for starters, Tough, but doable, if only there were the will and the vision.
Jim

[Michael G Murray CPA]

I think government audits would be great, kinda like the IRS. But hold the report until management has had a chance at the supervisor, appeals, audit court, and district court to sort out the "correct" accounting. It would be even better if juries of average citizens were to decide the issues. Who needs professionals?
On a serious note, something needs to be done. Rarely is the government the answer.

[Mel Dick]

Jim, Having been a partner at a Big 5 firm and then an owner of several restaurants, including taking over restaurants that were considered the "best" around I find your analogy to restaurant inspectors very interesting. The quality standards in restaurants are not dictated so much by annual inspections by someone who may or may not really understand the business, rather by the pride of the restauranteur and their head chef to provide a quality product and most importantly by customers who will vote with their feet if quality and standards are not good. If the current audit process doesn't meet the needs of users, ultimately the public will demand something different. Better the private sector than some government sponsored audit. That said, the private audit sector needs to change to meet the needs of all users if it is to stay relevant.

[vimax]

I'm not advocating Government-performed audits, just the limitations of the main analogy. Cover ownership, capitalization, scope of ancillary services by the firms and their affiliates, liability, law enforcement and oversight.