Audit Credibility

Credibility is based on trust

Bob Jensen poses a question on AECM (listserv for accounting professors), “Credibility? Do credible CPA audit firms add benefits to clients that exceed the audit costs?”

It’s an interesting question, I suppose, to narcissists (Big 4 auditors, government regulators and accounting professors) who believe that the world revolves around the audit function.  It isn’t a question that floats my boat, for I’m concerned with a different question, “Credibility?  Do credible CPA audit firms add net benefits to investors?”

Bob’s question would matter in a world where audits are voluntary.  In such a world, the benefits would need to exceed the costs in order to make the purchase decision.  Such was the case prior to the Securities Act of 1933 and the Securities and Exchange Act of 1934 when a majority (but not all) of big board listed companies voluntarily secured audits.

However, Congress passed these acts in an attempt to repair broken securities markets.  To President Roosevelt and members of the 73rd Congress, one of the culprits of the Great Depression had been the 1929 stock market crash caused by financial shysters. They peddled over-priced securities using bogus information.  Of course, in a bubble it matters not if information is credible or not, market euphoria leads investors like lemmings to the sea.

So, it became the law of the land that a publicly traded corporation must purchase an opinion from a private audit firm as to whether its financial statements were prepared according to the rules and fairly present its financial position.  A profitable industry of auditors emerged to sell these opinions.

Auditing narcissists pose Bob’s question as an attempt to justify the currently mandated audit model.  They contend that because audits add value to client corporations,  the current system should be perpetuated.

In this context I made the following response to Bob,

I don’t know that you can prove the effectiveness of legal regulation of financial reporting and auditing.  It just is.

As it works now, audits are a legal requirement.  Whether or not there is any value is difficult to surmise.  We can craft theories one way or the other and try to justify them.  However, how do you prove the value of an arbitrary rule?

I am part of a growing movement that questions if any value exists for a financial audit.  Actually, I argue that there are negative consequences to a government mandated private audit.  The negative consequences result when investors rely at all on the audit opinion.  All audit opinions are biased, and the degree of bias can only be effectively determined in hindsight after a thorough forensic investigation.

I say that anyone who relies, in whole or in part, on an auditor’s opinion is irrational.  It is a government rule that companies must secure an audit of their financial statements.  The government rule does not stipulate that companies must secure an effective audit, nor one of high quality.  It has been theorized that audit firms will compete for clients on the basis of providing high quality, independent audits.  However, this theory is based on the assumption that companies are free to choose whether or not they want to be audited.  This theory is invalid if companies are required to hire an audit firm and there is not a requirement to secure a good audit.  Because companies are required to secure an audit, and they have choice as to the audit firm, they exhibit normal compliance behavior and find the least onerous auditor.  And they find many audit firms all too willing to provide company friendly services, because that is legally permitted and just makes good economic common sense.

In this environment, why would anyone rely upon an audit opinion?  It is pure craziness.  Of course audit firms are going to dress themselves up to be high quality and honest. They’ll even push for a PCAOB because (1) the PCAOB has no real bite, and (2) the PCAOB’s presence contributes to a public perception of auditor quality.

But, in the final analysis, it’s all smoke and mirrors.  Companies are legally permitted to hire compliant auditors, and auditors are legally permitted to provide company-friendly services.  Until these two conditions are modified somehow, nothing is going to change.

Debit and credit – - David Albrecht