Around the Media – “The Economist” Gets A Good Deal Right

Recognition should be given where deserved. Mainstream media reporting on the grave challenges to the viability of the Big Audit model is typically so uneven and ill-informed that generosity favors freely extended tips of the hat.

Perhaps especially to express appreciation for the pick-up of a few choice words of my own.

So please do read the piece in the current issue of the Economist – “Accounting scandals - The dozy watchdogs”.

I had spoken at length with its author, Dan Rosenheck – with whom I am in considerable alignment, especially on our shared view that the historical “pass-fail” auditors’ opinion is sadly deficient to provide value to the complexity of today’s demanding capital markets.

Rosenheck quotes me thus:

“An auditor’s opinion really says, ‘This financial information is more or less OK, in general, so far as we can tell, most of the time’, says Jim Peterson, a former lawyer for Arthur Andersen, the now-defunct accounting firm that audited Enron. 'Nobody has paid any attention or put real value on it for about 30 years.'"

Where next? With the “expectations gap” so glaringly wide, and the perception of inadequate auditor performance so widely expressed, where does the dialog need to go?

Regular readers here will know my attention to the unachievable nature of the “magic bullet” solutions put forward by those who combine their passion for the subject with their ignorance of how Big Audit actually operates – for examples of which, see the reader comments reacting to the Economist piece as representative.

In this, I admit lack of success in calling off Rosenheck from two glaring examples:

• Selection or actual performance of audits by agencies of government – suggested by the New York Times but which I have discussed (August 20, 2014) as being so impractical as to attract and deserve nothing but howls of derision.

• And the fantasy of “audit insurance” – a long-discredited notion from academia that not only fails both the basic principles of insurability and the capacity of the market to provide coverage for the multi-billion dollar failures that threaten the lives of the Big Four accounting firms, but which is conclusively shown to be impractical by the simple fact that if realistic, it would already have been put in place by the insurance industry itself (see my posts going back to May 5, 2008, and July 15, 2008).    

Which does not take away from this central point:

If the dialog on the survivability of Big Audit is not treated as important and worthy of candid engagement by all the interested players, then its very viability is threatened by the kind of “Black Swan” event that would require re-design of large-company audit out of the wreckage after a catastrophic collapse.

And that threat should be appreciated as far too disruptive to be tolerable. 

 

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Comments

[Greg Carney]

The problem with governments taking larger roles in audits or directing audit firms is that this would necessarily result in the audit profession becoming slower in responding to the needs of changing business and far less useful (if that is possible) to the day to day needs of their clients and their clients' investors. It would also replace the perceived problem of the deleterious influence of economic consideration on the accuracy and usefulness of the audit with a problem of political considerations (think of the ramifications of CO2 emissions related disclosure and risk assessment requirements) doing the same.

As for audit insurance, for better or worse, the audit firms do act in effect as underwriters to Boards and investors of not the risk of inaccurate financial reporting but of business reverses and failure. Unfortunately the premiums charged (audit fees) do not accurately account for or reflect the true underlying business risk as the audit is not designed to determine that. Furthermore, the audit fee/risk calculus is further confused when other fees from the audit client are considered (as the case of Enron and numerous incidents at most of the large audit firms suggest). As the profession does not set audit fees appropriately, there might be a benefit from involving those large insurance institutions who are adept at evaluating existential risk and charging appropriately.

The audit profession is largely a creation of government requirements rather than market demand. If there was no requirement for an formal audit imposed by the SEC, what services would audit clients demand of the profession? What would they rather pay for? Since companies are forced by governments to have audits, the profession should try as much as possible to understand the value actually provided, provide those services that deliver that value, and charge appropriately. It is hard for an industry made up of highly competitive professional groups to move as an industry away from current practices and adopt a new approach. It is also hard for a profession with such a focus on consistency, year to year, to make changes like this, but the current situation is obviously far from the best.