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.
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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.