Peeling away financial reporting issues one layer at a time

Reforming the Market for Audit Services: Some Advice for the EC

M. Michel Barnier
European Commissioner for Internal Market and Services

Re: Green Paper, "Audit Policy: Lessons from the Crisis"

Dear M. Barnier:

My fellow blogger, Francine McKenna, has recently observed that the negative consequences of "Big Four" dominance of auditing services to the largest EU companies have been a topic of concern for a number of years. I commend you for the publication of the Green Paper, and your personal commitment to effect significant reforms in the next calendar year. As an American, I am also hoping that constructive actions taken by the European Commission will serve as a catalyst for similar reform in my country. To these ends, I am writing to provide you with my own analysis of the problem, and the apparent solution.

Why Audit Reports Are Unreliable: More than a "Big Four" Problem

The first paragraph of the Green Paper states, in part, as follows:

"The fact that numerous banks revealed huge losses from 2007 to 2009 on the positions they had held both on and off balance sheet raises … the question of how auditors could give clean audit reports to their clients for those periods [footnote omitted] …"

Unfortunately, the audit process has become encumbered by two fundamental flaws, which explain why the audit reports referred to in the above quotation have become unreliable:

First, auditors lack sufficient incentives to perform their duties in good faith – During the hearings leading up to the passage of the U.S. Securities Act of 1933, representatives of the accounting profession successfully convinced the U.S. Congress that government involvement in corporate audits would not be necessary; and the public could safely rely on the "conscience" of auditors to perform their function with an independent state of mind.

But, "independence" as a conceptual underpinning of auditing has proven to be a failure. Imagine how difficult it must be for the new partner-in-charge to be inserted between the rock that is your firm's highly profitable relationship for more than 20 years with the audit client, and the hard place that is management's gross underestimation of bad debt reserves? To be sure, too many auditors have at critical moments, shown that their "conscience" could be defeated by the temptations of the material world. The chances are very good that whichever accounting scandal you can name, pre- or post-crisis, the same auditors had been engaged for decades.1

As I am sure you are aware, the reasoning underlying proposals for mandatory audit firm rotation is that it could potentially offset the known limitations of the independence assumption.  Successor auditors would have a strong economic incentive to perform a thorough initial review of prior financial reports, so as to avoid exposure for restatements occurring on their watch. Knowing this, the predecessor auditor has an economic interest in not being found to have committed an oversight, and should be ever the more diligent as a result.

Second, and notwithstanding questions of good faith, the judgments that are required to produce a set of financial statements diminish the reliability of an audit2Some financial elements are capable of being determined objectively (e.g., cash and contractual amounts for receivables and payables); and auditors are relied upon to verify that such elements are correctly stated. This is well within an auditor's area of expertise and entirely appropriate.

However, and as you well know, dozens of financial statement elements depend on management's subjective estimates of unknowable future events. The problem of audit reliability is almost entirely due to requirements for the auditor to state that management's judgments and statements of intent "appear reasonable." The problems inherent in this approach are material to all reporting entities, but may be particularly acute for financial insitutions and their holdings of financial instruments, which cuts to the heart of the most recent economic crisis.

Developments in accounting standards, most particularly the recent changes undertaken or proposed by the IFRS at the behest of the EC, are moving toward greater reliance on management's estimates and statements of intent. The EC in supporting these efforts, is actually making the problems identified in your Green Paper even worse, for they are rendering audit reliability ever more questionable and salient as a systemic threat. How is the auditor supposed to attest to the reasonableness of a management assertion that an identified contingent liability is not "capable of reliable measurement"; or that a required measurement procedure would entail "undue cost or effort"; much less an estimate of bad debt losses over the next twenty years? Neither the PCAOB nor the IAASB can be expected to provide adequate guidance for auditors on these critical aspects of their work, and I would hazard that they have not even begun to contemplate some of the audit questions that have arisen from some of the newer forms of management's assertions and estimates.

A Proposed Solution

If the EC's immediate objective is to increase audit reliability, and thereby reduce systemic risk to the financial sector the economy, then mandatory audit firm rotation would be a logical place to start. However, based on the experience in the U.S. leading up to the Sarbanes-Oxley Act, the Big Four will fight tooth and nail against such a proposal. Acting in concert with the AICPA, these firms successfully lobbied Congress to actually broaden auditor services to include an attestation report covering the functioning of their client's "internal control over financial reporting" (Section 404 of the Act). As you are no doubt aware, issuers have had mixed reactions to Section 404, and I doubt that the EC would even consider imposing the considerable transition costs on companies that are already struggling during the global recession.

But, even if the EC summons the will to rebuff the efforts of special interests and require mandatory audit firm rotation, this alone will not reduce the stranglehold of the Big Four on the largest companies in the EC. Because of the fundamental flaws in the audit model I have described above, smaller firms will not be able to benefit by ramping up their capabilities to function in the current financial reporting environment. This is just one reason why I firmly believe that financial reporting itself must be reformed; for in addition to the goal of providing better information to investors, the EC should lower barriers to entry so that more audit firms can economically serve the largest companies, and enhance audit reliability.

To reform financial reporting, the EC should:

  • Move to replace cost-based models for reporting assets and liabilities with current values.3
  • Estimates of current values should be provided by third parties, and not management or the auditor. 
  • Auditor involvement should be limited to: verifying the inputs to the valuations that can be objectively measured; attesting that the third party valuation experts seemed to behave in an objective manner; and that the third party valuation experts performed the procedures they said they would perform.
  • The valuation experts would provide their own reports to accompany the financial statements.

Conclusion

Financial reporting is at a crossroads, and there is every indication that incremental adjustments to the system that has contributed to the global financial debacles of the past decades will do little to help prevent future debacles. It is not enough to solve the problem of Big Four concentration amongst the largest companies in the EC.

Thus, the bad news is that only a comprehensive solution has a chance of effecting the reform that is so badly needed; and special interest groups will fight fiercely as one to maintain their franchises. But, the good news is that the best solution is both simple to implement, and simple to explain. Investors want information about wealth and changes in wealth; and they want that information from reliable sources that are independent of management.

M. Barnier, if you want a quick fix to the problem of audit reliability, then I would suggest that you implement a system of mandatory audit firm rotation post haste. But, if your mission is to create a financial reporting platform on which the EU's economy can recover and grow, then you should form a new accounting standards board to create a comprehensive basis of accounting predicated on current values and financial reporting transparency. Systemic risks will be reduced, barriers to entry for auditing services will be lowered, and so will the cost of capital – all in one fell swoop.

I wish you the best of luck in your endeavors.

Notes

  1. In 2003, the U.S. Government Accountability Office reported that the average tenure of auditors to the Fortune 1000 was 22 years.
  2. For helping to crystallize my own thinking on this topic, I am indebted to Walter Schuetze's (former SEC Chief Accounting and founding FASB member) remarks to the New York State Society of CPAs, Auditing: Objective Evidence vs. Subjective Judgments, on September 9, 2003.
  3. Both the FASB and IASB generally prefer (with certain exceptions) to estimate current values in terms of exit prices, but my strong preference is for entry prices (i.e., replacement costs). The difference between these two approaches is not inconsequential on many dimensions. However, due to space and time constraints, I will reluctantly disregard these differences in order to keep the focus on higher-level features of my proposal.

6 Comments

  1. Reply Lisa McConkey, CPA October 20, 2010

    Sorry, I’m in huge disagreement that reforming financial reporting by replacing the cost-based models with “Current Values” would help in any way. As a matter of fact, this move would certainly bring down the house. The current economic state of things is largely due to the overstatement of values on housing by 3rd party appraisers. Having anyone, 3rd party or otherwise, give their opinion on what the current value is, is just asking for trouble. The ONLY true value that the financial statement should attest to is the HISTORIC COST. Yes, investors want to know the current economic value – but that is clearly subjective and the last 3 years of the housing industry is a perfect example of why that should NEVER be adopted as an accounting norm. Just my opinion.

  2. Reply Independent Accountant October 20, 2010

    Tom:
    I’ve complained about auditor incentives for 34 years. What else is new? As for subjectivity, look at SFAS 133.
    I do not believe government auditors would be better than the Big 87654. Why? They will say what they are told. Will the PCAOB conclude the Big 87654’s audits of TBTF financial institutions were flawed? Will the PCAOB say the Fed’s “stress tests” were just a public relations device? Who is kidding who?
    I doubt mandatory CPA firm rotation will help either. Why? Will say PWC “rat out” what it concludes was a poor audit by D&T? Or vice versa? No way. When was the last time a Big 87654 firm testified against another Big 87654 firm in a CPA malpractice case?
    I do not think using “third party” valuation will help either. The third parties will want Big 87654 recommendations, so will value things as their Big 87654 firm “referral sources” want. I’ve seen many valuations by PhD economists, that I saw as worthless. The Big Three rating agencies do some valuations. Would you trust the Big Three raters?
    Financial reporting is a political tool. Remember Barney Frank telling Robert Hertz the “fasbee should not be the slowbee”, or some such thing when Frank wanted more “flexibility” in SFAS 157?
    The “classical agency problem” cannot be resolved with any reform you suggest.

  3. Reply Steve October 22, 2010

    Hi Tom,
    I’d like to offer two proposals to improve current financial reporting process.
    1st Proposal – SEC should require companies to issue non-audited financials as soon as quarters close. The reports will still be audited, but the auditor can take more time now if needed.
    The benfits: a) Investors will get information much sooner. b)If there is audit adjustment, the public will know it and that information can be valuable. c)It takes the time pressure off the audtiors for them to do a better audit.
    2nd Proposal – Auditors should provide more informaiton on how imporatnt assumptions are tested, situations where they disagree with management initially but later, important correspondence with audit committe, etc, etc.
    The above information can be easily provided by the auditor and is 1000 times more valuable than the current one page boiler plate audit report.
    Come on, they are payed millions of dolloars to audit and that is all they can share with the public!!!
    Steve

  4. Reply Independent Accountant October 25, 2010

    Steve:
    I proposed your 1st proposal 30 years ago. Welcome aboard.

  5. Reply Joel C Font October 27, 2010

    Tom,
    Excellent proposals. However, as some of the previous commentators point out, the issues are pregnant with conflicts of interest and a political culture that needs to maintain audit reports vague and auditors weak. For years calls for change have been ignored and we only get token changes when an Enron comes along.
    I wrote an article about this in Today’s Audit Journal, titled: “Auditing Career: Do “Dumb Auditors” have more Professional Longevity than “Smart” ones?”
    Regards.

  6. Reply Superheater October 29, 2010

    [The following lengthy comment has been significantly shortned.]
    I must disagree with you about improving audit effectiveness by requiring mandatory auditor rotation (MAR). MAR might reduce disincentives to bend judgments on “grey areas” to favor the client, but it doesn’t address the root problem.
    After leaving auditing, I wondered why, with significant owner involvement and no potential for a shareholder lawsuit or SEC action- why my client, a small company, retained a “Big 4”anyway? There could be only one answer-creditor insistence. Do creditors care about the technicalities of an audit? No, they care about repayment and a clean “Big 4” opinion includes an embedded credit default swap. That’s a generally ignored aspect to the Big 4 hegemony that obviates the need to improve audit effectiveness.
    In short, assurance is offered with implicit insurance. I’m not sure if a “Big 4” audit is better, but it’s definitely more expensive. That guarantees “capital adequacy” if there’s a undisclosed financial frailty.
    Based on my experience, the greatest impediment to audit effectiveness isn’t unlimited auditor tenure but MANAGEMENT procurement with the right of discharge at will (subject to disclosure). Essentially, we buy information that’s assayed by an entity selected by the seller and serving solely at their pleasure. Auditors should be selected by boards, the SEC, a surety company-ANYBODY but the foxes in charge of the henhouse.
    Would MAR “discourage” this sort of behavior? Maybe, but it would be a weak control, if management retains the right of discharge at will. Indeed, the incentive to please the client is magnified when there’s MAR-since there is a limited time to earn a return on the acquisition costs involved with new clients- and to develop efficiencies gained through direct client experience.
    Unfortunately, I don’t think there’s enough pressure required to improve audit effectiveness. There’s plenty of acclimation to the present system and those that are harmed can be indemnified with legal action. In short, while we might lament the degradation of the profession described in Mike Brewster’s book “Unaccountable”, it’s a fact of life, not just accounting.
    We routinely complain about voice-response systems that allow ANYTHING but a human connection. Yet, we continue to buy from vendors with known “customer no-service”, as long as they have liberal return policies. It seems economic efficiency and quality (audit effectiveness) are at war with each other. Perhaps it’s more efficient to offer lower-quality products with embedded swap or put options-its what we seem to prefer.

Leave a Comment