A Prescription for What Ails Large-Company Audit: Real Medicine, for a Change

“Reality must take precedence over public relations, for nature cannot be fooled.”

            -- Physicist Richard Feynman's appendix to the Rogers Commission Report on the space shuttle Challenger disaster, January 28, 1986   

 A reader of my July 17 post acknowledged the continuing sterility of the dialog among the community of financial statement users, about the degraded status of the standard auditors’ report and the deep illness threatening the survival of the large accounting firms. But he chided me for offering only “bromides” rather than my own substantive prescription.

I felt the point of that needle – even though potential solutions have figured for the nearly ten years since this blog’s predecessor, my column "Balance Sheet," launched in the International Herald Tribune.

After the Enron debacle, the politicians’ infliction of Sarbanes/Oxley, and the many-faceted and still-unfolding events of the financial crisis, book-length treatment is surely called for -- despite the discouraging message from authors’ agents and publishers, that while the topic is worthy, the size of the interested audience would not support their investment.

Faute de mieux, I have stayed this course, appreciating the interest and support of a readership well prepared to share suggestions and criticisms.

It is a challenge to address the complex issues, within both column-length constraints and a comprehensive “holistic approach,” such as called for in June by PCAOB chairman James Doty (here), who himself lacks the vision, authority or resources to achieve it.

But by way of synthesis, a snapshot is possible of a sustainable future, using links back to the archives for detail.

First, a few background assumptions:

• A forthright reading of the projects to re-consider the scope and language of the standard auditors’ report, by the PCAOB and the IAASB among others, confirms an emerging consensus that the current “pass/fail” report is obsolete, serves no purpose other than securities laws compliance, and should be supplanted by assurance of real value.

• The existential threat hanging over the Big Four firms’ complete dominance of the large-company audit market -- the “supply side” – is simply not addressed by any of the so-called “solutions” addressed to market concentration – whether mandatory rotation, break-up or new entries, liability reforms, audit catastrophe insurance or bonds, living wills, leadership replacement, etc., etc., blah, blah, blah. As the first head of the PCAOB confirmed, regulators “don’t have a clue” – a widely shared and unchanged attitude of denial.

• There is no credible case for government-controlled delivery of audits worth the effort and expense – whether by direct execution, engagement assignments or otherwise. The output of the artificial and pathetic “profession” that would exist under such regimes would be inferior even to today’s devalued state, much less to the evolved conditions now called for.  

• And, it is time to acknowledge, the entire intellectually fragile structure of auditor independence is anachronistic, ill-suited to today’s conditions, and deleterious to both performance quality and the potential for useful change – a sacred cow that should be taken out and put to a quick and humane end (here and here).

So, now what? 

A framework does exist for regulators to license or charter sustainable audit-only firms (here). But – if and only if – a reconfigured legal and regulatory environment both permits, invites and encourages: 

• Full-service relationships between auditors and providers of other services.
• The attraction and deployment of outside capital, as would be required to support such new multi-service providers, with corresponding changes in permissible ownership structures.
• The appropriate involvement of meaningful regulatory oversight, quality enforcement and investor rights recognition.
• The emergence of geographic and industry-based new competitors.
• And, perhaps, even the return of today’s understandably reluctant insurance industry. 

Under such a fundamentally re-engineered regime, truly new and valuable forms of reporting could be designed and delivered (here and here).

These could be responsive to the needs of financial management and audit committees, welcomed by both executive teams and directors alike, and subscribed to by users under sustainable liability terms). They could be, at the same time, respectful of the value perceived by shareholders and others of the influential presence of “outside experts.” 

Simultaneous attention to all aspects of this framework is essential, however, because until then – as today’s impasse shows -- neither issuers nor auditors have any incentive to take on the increases in both cost and liability imposed under today’s exposed conditions.

I have been calling for years for an adult dialog among the inter-locking and antagonistic interests, who today are only wasting their energy in paralysis and finger-pointing. Without seeking endorsement or even agreement, I suggest that there is much more available here than “bromides.” 

Be the judges – and please let me know.   

 

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Comments

[Richard E. Brodsky]

"The appropriate involvement of meaningful regulatory oversight, quality enforcement and investor rights recognition." Aha, now we're getting somewhere. Unfortunately, there will never be any of the three because these require political change.

Meaningful regulatory oversight: the Congress has purposely starved the SEC, and even when it wasn't being starved it was fast asleep, along with FINRA. Meanwhile, the PCAOB lives on in obscurity and the politicians stand ready to defang the FASB whenever it wakes up from its slumber/

Quality enforcement: the SEC is late to every fire, misses the big ones, and can't even investigate a high-flying broker-dealer that is the custodian for its clients' trades (Madoff).

"Investors rights recognition": "The profession" got what it wanted when the Gingrich Congress and the Reagan-Bush Supreme Court made it virtually impossible to sue accounting firms for faulty auditing.

[Jim Peterson]

Thanks -- not that I'm so naive as to confuse "desirable" with either "likely" or "achievable." To do so would fall into the "Nirvana fallacy" -- that is, to mistakenly include a fanciful assumption and then assert the unrealistic as possible.