The "Independent" Auditor's Real Client? Time to Re-Assess, I Kid You Not

 "Ahh, but the strawberries -- that's where I had them. They laughed at me and made jokes, but I proved beyond the shadow of a doubt and with geometric logic that a duplicate key to the wardroom icebox did exist, and I'd have produced that key if they hadn't pulled the Caine out of action"

    --Capt. Philip Francis Queeg, 1954

Comprehensive review of the scope and language of the standard auditors’ report has been long overdue. So with measured enthusiasm (here and here), the initiatives of both the Public Company Accounting Oversight Board and the International Auditing and Assurance Standards Board are welcome.

High on the list of barriers to clear thinking and potentially constructive evolution, however, is the persistent canard, renewed by PCAOB member Steven Harris at its June 21 public meeting (here), that auditors “must fully embrace the concept that the company paying their fee is not their client.”

This proposition is confusing in logic, wrong in history, and malign in its influence. Until snuffed out once for all, it will continue to deflect and distract from the achievable task of re-engineering a role for outside auditors that brings real value to the community of financial statement users.

Since the middle of the 19^th century, when Mr. Deloitte and his pioneering colleagues were first engaged to assist the “auditors” of Victorian-era public companies – themselves selected from among the body of corporate shareholders, to advise their fellows in their shared financial interests – the auditor/client relationship has been contractual, consensual and private.

The appliqué of “public interest” has been allowed not only to stick, but to become an incrustation on the auditors’ appropriate functions. Fostered since its infancy by the newly-invented profession itself, to its discredit and lately to its mortal threat, the label did fend off – if only temporarily – the prospect of government-provided assurance – but at high cost and under the now-realized hazard of exaggeration and misapprehension of its capacities.

The shaky structure on which Harris bases his claim, that “the ultimate client of an auditor of any publicly traded company must be investors” is the 1984 case of United States v. Arthur Young. There, perpetuating the unfortunately long tradition of judicial malappreciation of the auditors’ role, Chief Justice Burger invoked the inapposite image of the “public watchdog” -- that “the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.”

As a matter of jurisprudence, Burger’s gratuitous dictum was unnecessary to the Court’s holding that tax accrual working papers could be reached by IRS subpoena.

And as a matter of unexamined rhetoric, Burger defied the logic of canine behavior, by expecting even the most vigilant watchdog to bite the very hand that feeds it.  

Events have now shown that on such a tenuous rationale, the bulky but fragile edifice of constrained client service and “appearance of independence” cannot stand. 

Critics such as Harris of the “pass/fail” audit report model have much to complain of – but there will be no solutions in shooting at the messengers, for continuing to deliver this outdated and devalued commodity product. 

Instead, history provides many examples of the dangers that lurk in broadening the distance that separates the payor of fees or benefits from the subsidized interests ostensibly served:

• Raising the limits on depositors’ insurance incentivized the reckless behavior of the American savings and loan institutions in the 1980’s, underlying their ruinous boom-and-bust.

• Lodging the management of health care cost reimbursement decisions with self-interested insurers has opened the doors to the waste, abuse and mis-allocations in the pricing and delivery of medical services.

• And most recently, requiring an issuer-paid rating agency’s report as a “green light” to sell complex derivatives was a central element in the inflation of the subprime-mortgage driven crisis that has plagued the financial markets for four years and counting.

None of which is to say that the “agency problem” of close auditor relationships with corporate boards and managements can be addressed successfully by the further intrusion of government. The prospect that an audit regulator could take on and satisfy the task of providing even today’s out-dated “pass/fail” assurance is beyond Panglossian fantasy or imagination. 

Rather, hope for progress lies in a realistic re-framing of the results that can reasonably be expected from the auditors, in an environment where legitimate and valuable new forms of assurance can be designed and delivered.

Which requires putting aside inflated language, moderating unrealistic expectations, and nurturing the profession’s acknowledged and considerable expertise.

 

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Comments

[Francine McKenna]

During your essay I went from disagree to agree to disagree again. You ask for a rethink of the audit report, but not of the structure by which audit services are to be procured and paid for.

The auditors do serve the corporation and its shareholders but must not be beholden to management. There are a million ways to move their current toady behavior in the right direction, but we have seen that beholden Audit Committees can rarely accomplish it.

[Richard E. Brodsky]

As always, you criticize every solution to what you recognize as the fundamental problem -- expecting the dog (auditor) to bite the hand (client) that feeds (pay) him -- but, as usual, you offer no actual solution, other than bromides such as "putting aside inflated language, moderating unrealistic expectations, and nurturing the profession’s acknowledged and considerable expertise." Please set forth in simple terms, in concrete words, exactly what changes, if any, you would make to the current model of providing an acceptable level of assurance that the client does not cook the books.

[Jim]

Thanks Francine --
As usual we are largely on the same page -- except for my consistent difficulty with government-provided or even government-managed assurance. Here, though, to use the chance to fundamentally re-engineer the language of the current obsolete report would be a huge improvement over the other actions taken by the bureaucrats in recent history.

[Jim]

Thanks Richard -- I appreciate the acknowledgement as to the fundamental nature of the problems.I would feel more acutely the point of your needle about "bromides" if I had not in fact been offering details on a possible sustainable future since the launch of this blog's predecessor, my column in the International Herald Tribune, in 2002.
Since those column-length pieces cannot achieve the necessary "holistic" attention demanded by the complexity of the issues, however, it's right to think of a unified summary -- for which this comment process is not adequate (links being impossible) and because I am away from my archive until next month.
So a post is coming, and likely a link to a new Page for the purpose as well.