Peeling away financial reporting issues one layer at a time

Look Beyond the Firms for the Root Causes of Audit Deficiencies*

The International forum of Independent Audit Regulators (IFIAR) has published its second annual survey of audit inspections of the Big Four plus BDO and Grant Thornton firms around the world:

  • “The leading areas of deficiency in inspected auditors of … public companies … relate to fair value measurements; internal control testing; and procedures to assess the adequacy of financial statement presentation and disclosure.
  • “The leading areas of deficiency in audits of systemically important financial institutions [SIFIs]… relate to auditing of allowance for loan losses and loan impairments; internal control testing; and auditing of the valuation of investments and securities. [emphasis supplied]

The picture is so dismal, that hardly anyone involved wants to talk about it.  Only one of the humiliated firms responded to Reuters’ request for comment.  A spokesperson for PwC said that the firm remains “committed” to improving the quality of their audits and, according to Reuters, that “it would carefully study the report to see how it can best address the issues.”

This was reaction of Cindy Fornelli, executive director at the Center for Audit Quality (essentially the paid lobbyist for the firms in question) to the report:

“[Ms. Fornelli said] that her group’s members recognize there is still ‘work to do.’ At the same time, she noted that accounting reforms enacted in the United States in 2002 ‘have led to improvements in audit quality, financial reporting, and internal controls over financial reporting.’ “

Let me un-spin that for you.  We helped Congress launch a herd of snails on a 1,000-mile journey in 2002.  Twelve years later, they’ve made it about a mile.

“We have met the enemy and he is us.”

The report also states that IFIAR expects the firms to provide information about the results of “root-cause” analysis, so as to gain a clearer understanding of the factors that underlie inspection findings and to take appropriate remedial actions.

The search for root causes usually starts with the incentives for auditors to be cheerleaders for their clients. Mandatory audit firm rotation held some promise for changing the mindset of auditors, but the firms have successfully fought off any real change.  The PCAOB reluctantly abandoned its initiatives, and the EU’s latest requirements are half-measures at best.

But, any incremental alterations to the incentives to be independent notwithstanding, the actual roots of these audit deficiencies run deeper than what currently happens at the firm level: financial statements prepared in accordance with “modern” accounting requirements are not auditable. Virtually all of the audit flaws cited by IFIAR are driven by the auditor’s inability to reliably state that management’s estimates of unknowable future events “appear reasonable.”

The deficiencies noted by IFIAR concerning tests of loan loss reserves may be the best example for illustrating the problems begat by management as self-interested seer.  Years of painful experience have taught us that management’s estimates of loan loss reserves are biased in one direction or another, depending on their needs at a particular moment. Even setting aside issues of independence, auditors lack any practical ability to challenge the ineffable; that management’s estimates of future defaults based on future economic conditions are “reasonable” (whatever that means).

This kind of problem is not going to go away with enhanced independence, more effective controls, or even “improved” methods for accruing loan losses.  Anybody who thinks that any of the cost-based accounting treatments being proposed on loan accounting — one-bucket, two-bucket or however-many-buckets-your-heart-desires — is going to make financial statements more auditable is kidding themselves.

Policy makers need to come to realize that the days where an auditor can reliably report on the financial statements taken as a whole are over.  Auditors are good at verifying facts, like what things actually cost, and who owes what to whom.  But, as the basis for financial statements has become taken over by “critical accounting estimates,”  audit reliability has, understandably, not kept pace.

Fixing the root causes of audit deficiencies is much more than a “Big Four” problem.  The judgments of unknowable future events that are required to produce a set of financial statements diminish the reliability of any audit.  It is much more the job of financial reporting regulators than the audit firms to fix a problem of this nature.  Moreover, audit regulators and accounting standards setter will have to collaborate closely, as the fixes will entail a fundamental shift in what are generally attacked one silo at a time:  the basis of financial reporting and the scope of the audit.  What is needed, though, can be straightforwardly stated:

  • Historic cost-based models for reporting assets and liabilities have to give way to current-cost-based models.
  • Estimates of current costs (values) should be produced by third parties — not management.
  • The scope of the audit should be limited to: (1) verifying the inputs to the valuations that are truly capable of verification (e.g., contractual cash flows, physical existence); (2) attesting to the independence from management of the third party valuation experts; and (3) that the valuation experts  performed the procedures they said they would perform.
  • The valuation experts should provide their own reports to accompany the financial statements.

* * * * * *

Financial reporting has been at a crossroads for at least the last dozen years.  The IFIAR report is just one more confirmation of the need for fundamental change — at much faster than the snail’s pace of the past dozen years.

If fundamental change does not occur within a reasonable time frame, financial reporting will once again be a contributor to the next financial crisis, instead of helping to prevent one.

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*I am a member of the Standing Advisory Group of the PCAOB.  The views expressed herein are my own and do not necessarily reflect the views of the Board or other Board members or staff.

3 Comments

  1. Reply Russ May 27, 2014

    I agree that one does need to look beyond the firms for the root causes of audit deficiencies. One of the main roots lies in the arrangement where a company hires, fires, and pays the auditor, as you have alluded to. This is ridiculous on its face. But, what is a better alternative? Having government or some “regulator” do it presents a different set of problems, as demonstrated by regulators failure to recognize loan losses in 2008 and even into 2009 and now requiring banks to carry unsupportable ALLLs in the aftermath. Sliding this responsibility from management to an audit committee is marginally helpful, but only marginally. An audit committee, even with “independent” members, is still part of the company. When the truth about a company’s financial position and results of operations would/should result in a reduction in stock value, then any internal member of that company is conflicted. I think the PCAOB was a reasonably good approach. A somewhat independent body regulating the auditors. But there are problems there too. The PCAOB plays politics, as is required in this human world, by telling auditors they are not doing enough or properly (which often is true), but then publicly berating the audit firms for increasing audit costs because the PCAOB was feeling the heat for rising audit costs. Quality audits are expensive. Certainly some audit efforts and reactions were misguided, but audit fees/budgets needed to increase substantially to achieve quality audits, and they still do. But that isn’t really socially acceptable, at least until the next catastrophe.

  2. Reply Russ May 27, 2014

    “The deficiencies noted by IFIAR concerning tests of loan loss reserves may be the best example for illustrating the problems begat by management as self-interested seer… Even setting aside issues of independence, auditors lack any practical ability to challenge the ineffable; that management’s estimates of future defaults based on future economic conditions are “reasonable” (whatever that means).” I agree that predictions of the future are problematic. But, given that current GAAP precludes consideration of future economic events in the estimation of an allowance for loan & lease losses (e.g., ASC310-35-4b. & 310-35-10), I don’t see how this is even a poor example, much less the best example. Current GAAP, in this regard, actually represents a wise compromise. If one could see the future, then one would not support carrying a loan, that will ultimately default, as an asset today. But, no one can reliably predict this (assuming reasonably good underwriting to begin with), particularly in relation to an entire loan portfolio and given cost/benefit constraints. Therefore, the reasonable compromise is to recognize losses that have been incurred based on existing facts, including current economic conditions, but not projected future economic conditions. So when losses are probable (which is defined as likely to occur – not a particularly high hurdle), given current information and events, they should be recognized. Precluding “consideration” of projections of the future, at least to some extent, is a reasonable compromise. A significant part of the problem in relation to ALLL accounting is that very few people understand what GAAP is trying to do. Many, if not most (even “knowledgeable” people) view the ALLL as a “reserve” for future losses. So, for example, when the financial world fell off the cliff in 2008, the complaints about inadequate ALLLs began. But, while some ALLLs may have been inadequate due to the never ending problems in implementation of ALLL accounting, many were not. Significant losses were recognized in the latter part of 2008 because that was when the economic events that caused the loan losses were realized. Losses continued to be recognized in 2009, 10 & 11 as the economic events of declining borrower cash flows and declining collateral values continued. This was appropriate. The losses were largely recognized when the losses were incurred. If Banks had already recorded ALLLs sufficient to cover the losses of 2008, 2009, 2010, 2011, then losses would have been recorded against the results of operations in previous periods (and when? – 2007, 2006, 2005, 2000?) and significant losses would not have been recognized as they were actually occurring. Rather than seeing the economic ruin in the results of operations, one would have had to notice that ALLLs were declining as loans were charged-off (which involves no expense recognition, just debit ALLL and credit Loans) to realize what was going on. Again, if most could have accurately predicted what was going to happen, then consideration of the future in estimating the ALLL would be a reasonable requirement. But most can not do that (can anyone really?). If management could, then it seems likely that many of those loans would never have been made.
    The FASBs new CECL model is a politically-correct reaction to these misguided complaints. This model will require “life of loan” projections of losses, which is absurd. Further, implementation will likely have the opposite of the intended effect. Will bank management and boards then project adverse economic conditions, or will they project better economic conditions?

  3. Reply JC September 26, 2014

    Well there are a lot of issues. 1) the pcaob is not independent and many reviewers have serious personal agendas – either systematically (which is prima facie illegal) or individually the pcaob regulates the big 4 on a completely different standard than smaller firms. I have personally seen and had pcaob employees or alumni admit to this wholeheartedly. Almost no smaller firm – so below a BDO – would have a clean inspection report if the pcaob held them to the same standard as the big 4. They are a federal regulator and therefore not allowed to apply different standards to different parties for the same function. 2) The time constraints on 10-Q and 10-k – which are significantly different than other countries causes misstakes, sloppy work, etc and 3) as noted before the firms fees by hour worked have gone down, not up, so to be able to recruit (in huge numbers no less) qualified people to perform the audits is very difficult as auditing is more difficult, the accounting is much more complex then 20+ years ago, hours worked more, and inflation adjusted fees by hour down. Fix those and then we can talk who is at fault

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