Peeling away financial reporting issues one layer at a time

Less from Auditors Would be More

The Senate Subcommittee on Securities, Insurance and Investment has announced that it will meet this Wednesday to conduct a hearing entitled "The Role of the Accounting Profession in Preventing Another Financial Crisis."

"The witnesses on Panel I will be: Mr. James R. Doty, Chairman, Public Company Accounting Oversight Board; Ms. Leslie F. Seidman, Chairman, Financial Accounting Standards Board; and Mr. James L. Kroeker, Chief Accountant, U.S. Securities and Exchange Commission. The witnesses on Panel II will be: Mr. Anton R. Valukas, Chairman, Jenner & Block LLP; and Mr. Lynn E. Turner, Former Chief Accountant, U. S. Securities and Exchange Commission.…" [bold in original]

If I could whisper in the Subcommittee's collective ear, I would congratulate them on picking a topic to investigate that finally has some chance of calling auditors and financial reporting regulators to account for their role in the financial crisis. But, if they actually want helpful responses, they should focus their questions to Panel I on Jim Doty. James Kroeker is obviously there to be the punching bag for Mary Schapiro, who surely won't risk revealing her ignorance of financial reporting to hostile members of Congress; and both Kroeker and Leslie Seidman have been so IFRS-fixated for so long, and have had so little to say on the Subcommittee's topic, it's doubtful they are in a position to do little more than defend and deflect. If they actually testify under oath that adoption of IFRS should be part of the solution, I think I might become sick.

Doty should be pressed for his opinion of the views recently expressed by the PCAOB's Investor Advisory Group (IAG), which recently stated:

"The recent financial crisis presented auditors, and by extension the Sarbanes-Oxley Act audit reforms, with their first big test since these reforms were put into place. By any objective measure, they failed that test." [italics supplied]

"… Serious questions have been raised both about the quality of these [failed] financial institutions' financial reporting practices and about the quality of audits that permitted those reporting practices to go unchecked."

"While auditors did not cause the financial crisis, it is difficult to look at the list of failed institutions that received an unqualified audit just months before they failed and conclude that auditors didn't play a role."

Even though Doty's PCAOB is discussing modifications to the auditor's report, the Subcommittee should question whether that alone is a sufficient – or even a logical first – response to the fundamental issues of audit processes and auditor independence that have been raised by the PCAOB's advisory group.

If I could also whisper in Doty's ear, I would congratulate him, too, for his apparent willingness to support whatever it might take to improve the quality of audits of public companies. I would also advise him to use the impetus of an outraged public and his own recent appointment to re-evaluate the foundations upon which financial reporting regulation is based. These can be found in the Securities Act of 1933:

[A prospectus of an issuer must include] "… a balance sheet… showing all of the assets of the issuer, the nature and cost thereof… [and an income statement] in such detail and in such form as the Commission shall prescribe… [and]… certified by an independent public or certified accountant." [15 USC §77aa(25), emphasis supplied]

I would argue that the IAG's conclusions and the Subcommittee's motivation spring from a common source of concern: the last two decades have convincingly demonstrated that it is no longer practicable to expect that auditors can serve the same watchdog role that the 1933 Congress envisaged for them. Auditors may still perform the same basic functions today, but their relative importance with respect to their impact on financial reporting quality has shifted drastically. Basically, I see auditors doing three distinct things:

  1. Verification of those components of financial statements that can be verified — for example, cash receipts and disbursements; amounts owed; and amounts owing.
  2. Assessments of the reasonableness of estimates made by others — for example, bad debt allowances, useful lives of long-lived assets, cost allocations, and the likelihood of future events.
  3. Monitoring the application of accounting standards – for example, timing of revenue recognition, determination of the functional currency of foreign operations.

Of these three functions, I can't imagine that Congress was anything but focused primarily on verification processes, as the extant (limited) accounting rules and procedures largely prescribed cost-based measurements. We could have a wonderful discussion as to why accounting standards have become as complicated as they are today, but that is not the central point for the Subcommittee. The IAG's conclusion that auditors have repeatedly failed to keep management on the straight and narrow when the stakes were highest is practically inarguable. Whether this is the fault of poor-quality auditing standards, or poor implementation of those auditing standards is also not the fundamental issue. Stated bluntly, history should have taught us by now that auditors might be good at verification of things which are capable of being verified, and very little else. This, Mr. Doty and members of Congress, is the crux of the problem we must now confront.

While one is tempted to be cynical as to the real purpose of a congressional hearing on financial reporting, the possibility that an audit of the financial statements taken as a whole, a costly and legislatively-mandated process, has become obsolete suggests a proper role for today's Congress. It should amend the securities laws to enunciate a more appropriate (and limited) role for auditors in the modern economy – where the historic cost of tangible assets has become a largely irrelevant consideration. When financial statements require estimates of current values and uncertain future events, these estimates should be produced by third parties – neither management, nor the auditor. As a result, the scope of the audit would be limited to:

  • Verification of the components of financial statements that are capable of being verified.
  • Verification of those inputs to current valuations that can be objectively measured, and hence, verified.
  • Verifying that third party experts charged with measuring current values and expectations of future events have performed the procedures they said they would perform.

In response to the Enron et al financial reporting crisis, Congress allowed itself to be persuaded that additional attestation services were an appropriate response to audit failures. If Jim Doty can manage to reverse the tide of higher audit fees as audit reliability continues to degrade, he will become my hero. And in the process, he should find that the questions that have recently been raised regarding independence, quality, the content of the audit report, and audit firm concentration will all become much easier to answer.

4 Comments

  1. Reply Independent Accountant April 1, 2011

    Bravo. However there is another question which must be asked: Does Congress want good audits of TBTF financial institutions if they audits would reveal their insolvency? I don’t think so.

  2. Reply Just Da Facts April 3, 2011

    Audit fees are getting lower, not higher. Just go look at the trend of the Fortune 100 over the last three years…

  3. Reply Superheater April 6, 2011

    As much as I think the Big 4 is, to borrow the title of Mike Brewster’s book “Unaccountable”, this smacks of being a CYA blame-fixing show trial with people outside “the profession” -lawyers and bureacrats -insisting accountants should have a crystal ball.
    Yet, the federal government has been promising it could prevent the next “crisis” since the passage of the SEC act in 1933 and with each new law, we hear the same solemn intonations about the “integrity” of our capital markets. We get more lawyers dictating accounting (SOX made the takeover a fait accompli), more bureacrats and more “crises”. NO doubt this hearing will produce recommendations for more laws, regulations, lawyers and bureaucrats and there will still be more crises.
    An audit, remember is not designed to assess the robustness of a business-nore should it-because it can’t . Admittedly an extreme example: should TEPCO’s auditor be held responsible for its financial failure after the issues with its reactors after the earthquake/tsunami?
    On the other hand, AIG was an insurer, examined according to statutory accounting principles by the NY Insurance Dept. Such an examination IS designed to assess the near term solvency of an insurer and apparently they missed it’s then impending doom as well.

  4. Reply chartered accountant melbourne April 12, 2011

    The work for auditors is getting more,whereas the pay for auditors is decreasing.The reason may be growing number of students would like to choose accounting as their major,which has fulfilled the demand of the market.

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