The PCAOB's Concept Release: What Might a Truly Useful Auditors' Report Actually Say?

First reaction to the Public Company Accounting Oversight Board’s Concept Release of June 21 (here), which puts on the table a buffet of possible revisions to the long-standing commodity language of the standard auditors’ report: 

It’s like Bob Dylan’s observation on the twelve-string guitar – you spend half your time tuning the damned thing, and the other half playing out of tune.

Thanks to readers for asking – more will be coming, through the comment period ending September 30.

A second reaction should be positive, since the project puts the US regulator’s stamp on a vital question, posed by Chairman James Doty during the public meeting (here), “how audit reports can be more useful to society?” 

But optimism should be carefully tempered. This is only the latest in the cyclical spasms of user dissatisfaction, going back to such barely-remembered efforts as the Cohen Commission of 1974 and the Treadway Commission of 1985. Vision and will have consistently turned to failure, over-taken by the return of bubbly investor enthusiasm, and this spring’s exuberant reception of the new media IPO’s (here), during which rational attention to the boundaries of quality accounting and reporting has been blinkered by investor frenzy, does not bode well.  

Researchers in group psychology have long known that human attitudes are asymmetrical towards rewards and detriments: people are risk-seeking on the upside, but risk averse on the downside.

Which means that the pain of a losing investment will more than outweigh the pleasure of a similar gain.

And therein lies the fallacy behind the traditional “pass-fail” audit report. As shown by recent behavior, investors will ignore all cautionary limitations within a clean report on such recent bubble companies as LinkedIn or Pandora – or the sketchy accounting proffered ahead of the upcoming launches of Facebook or Groupon. But on the other hand, they will never be satisfied – whatever the PCAOB staff may think they have accomplished with their “outreach” – absent an advance “fail” signal on a company poised to fall – Lehman, Bear, Countrywide, AIG, Fannie, and so on – not because the real desire is for a coherent and comprehensible articulation of a business model destined to failure, but to avoid the failure itself, at all.

What this “second-order” disconnect means, then, is that the auditor is truly at one remove from the core issue in today’s world of short-term score-keeping -- financial reporting is, essentially if emotionally, only a proxy for investors on the ultimate future success of the reporting enterprise. So it misses the point to keep belaboring the messenger.

Resolution is ready to hand, right within the framework of the Concept Release itself. But radical adjustment will be required, both to the reporting by issuers themselves and in the auditors’ report language.

That is, it must be for the company, not the auditors, to fully satisfy the regulators’ disclosure goals regarding, for example, the achievability of results dependent on management’s judgments, critical estimates, and difficult choices among permissible or alternative accounting policies – all of which contain and reflect the company’s business, operational and strategic risks, on which actual results depend.

The accountants then have two socially useful but limited roles:

First, to provide the necessary technical and professional competence to assist issuers in navigating through their many politicized and judgmental reporting choices – a process, by the way, which brings to the fore the many irrationalities involved in the unending fables of “convergence” among standards and the essentially irreconcilable inconsistencies between and among IFRS and the various versions of GAAP (for which, as always, see The Accounting Onion).

Second, the assurance role: to support – to the extent possible -- the clarity and transparency of the representations made in the financial statements to the community of users.

And that’s it – so much, and no more.

What may this mean for legitimately useful audit report language? Messages are required like, “We don’t know …. we cannot tell from the evidence …. we cannot test or provide a meaningful comment ….”  These, with some work on the drafting, can be properly articulated under several of the Concept Release’s rubrics -- whether Auditor Discussion & Analysis or Emphasis Paragraphs or Clarification of Language.

The profession’s leaders have been leery of any such rationalization of their role – a fear driven by economic self-interest and their unwillingness to confront the fragility of their business model.

Staying the present course to nowhere, however, risks their being revealed, like the Wizard of Oz, as little figures behind the curtain, puffing smoke and noise of no value or significance.

It needn’t come to that. Stay tuned – the upcoming months may tell.

 

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Comments

[James McRitchie]

Another approach would be that suggested by Mark Latham, the founder of VoterMedia.org. Let shareowners choose the auditor by vote. See section 5 of Latham’s article “Proxy Voting Brand Competition” in the Journal of Investment Management, January 2007.

Latham proposes shareowners should at least be permitted to vote on a company-by-company basis through private. Unfortunately, the SEC has allowed management to exclude such proxy proposals, buying the argument that auditor selection is an “ordinary business” matter. I don’t know how anyone can agree with that after the collapse of Enron after a relatively clean bill of health from their auditor.