Peeling away financial reporting issues one layer at a time

I’m for Auditor Term Limits, But …

I was in Minneapolis a couple of months ago, and my client was kind enough to put me up in a very swanky hotel near its offices. While waiting for my dinner at the lobby bar (I don't like to sit alone at a table), I overheard a young woman a couple of seats away mention that she was a Big Four auditor. Let's call her Leslie.

During my brief conversation with Leslie, I learned that: she worked out of her firm's Seattle office; she and about 150 of her colleagues from all over the country would be staying in the hotel for something like three months while they audited a bank; though brimming with confidence, she had only about two years of experience as an auditor; she had never audited a bank before; she knew very little, and seemed to care very little, about how banks did their accounting; and she hadn't the slightest idea what even her first task would be. Basically, all Leslie knew was where she had to be the next morning.

What were the prospects that Leslie, or the minions soon to join her, had the technical qualifications, much less the skepticism and backbone to do more than dutifully perform each task assigned within the allotted time? Why must it take 150 dislocated professionals three months to audit a bank (especially when 100 percent of the records to be examined must have been available electronically? Will the value of the audit exceed even the cost of the massive hotel bill to come?

Read as much or as little from my anecdote as you would like. For me, it is one more vivid reminder that the practice of auditing is in complete disarray; and nothing the PCAOB is considering, including mandatory audit firm term limits, will change that sad state of affairs in any significant way.

Yet, I am still in favor of mandatory audit term limits. At the very least, audit firms will more carefully consider who staffs an audit, how it is conducted, and how it is supervised. At best, it could actually catalyze a fundamental re-thinking of the financial reporting function. Some believe that Armageddon will ensue if mandatory audit term limits were to be put into place, but maybe it will indirectly open the way to the first real discussion since the advent of the securities laws of what ails financial reporting.

What such a discussion should reveal is that neither auditing standards nor auditor conduct are the root causes of the financial reporting failures that have rocked the economy, and the reputation of practitioners and regulators alike. That distinction goes to the accounting standards promulgated by the overpaid FASB, and largely with the tacit support of a moribund SEC. I have maintained here, here and elsewhere that there is no way that auditors can be expected to challenge management's estimates, which permeate virtually every line item on the financial statements. And, this doesn't even begin to address the issue of needless complexity in accounting standards, of which Leslie may have known barely enough to pass the CPA exam on her third try.

It is time to amend the securities laws to enunciate a more appropriate (and limited) role for auditors in the modern economy. It needs to be a role that Leslie can readily understand and perform:

  • Verification of the components of financial statements that can be verified.
  • Verification of the 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.

When financial statements require estimates of current values and uncertain future events, these estimates should be produced by third parties – i.e., neither management, nor the auditor. As a result of that constraint, financial reporting regulators would have to consider the following questions:

  • Which inputs and other aspects of financial reporting are subject to verification, and hence covered by an auditor's report?
  • Which of these are to be provided by other independent experts? What should be the nature of their representations, and to what extent should auditors verify those representations?

The conventional wisdom is that historic cost accounting is fact-based, objective, understandable, and even verifiable. We have learned the hard way that this is a fiction; however historic cost accounting has been practiced. To get to a point where financial reporting can be useful and reliable, the FASB and SEC must dedicate themselves to the establishment of accounting standards that yield financial statements capable of being audited and understood by people like Leslie.

Sometimes, 'little strokes will tumble great oaks,' but the sad history of financial reporting since the passage of the securities laws is the accumulation of little, half-hearted, chops in random points on the tree. The time has come for a chainsaw.

If that chainsaw is mandatory audit firm rotation, then so be it.

3 Comments

  1. Reply Steve December 27, 2011

    All big 4 firms outsource their tax and audit work to India. It is reasonable to assume that they know or care even less than Leslie about their audit clients!
    In my opinion, audit, in many ways is a huge waste of public resources. SEC needs to explore other ways of ensuring investor confidence in corporate reporting.

  2. Reply Steve2 December 28, 2011

    Only Wells Fargo or US Bank could command that kind of an audit team in Mineapolis.

  3. Reply Matt Kelly December 30, 2011

    There are swanky hotels in Minneapolis?

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