In 1605, Miguel de Cervantes Saavedra published part one of The Ingenious Gentleman Don Quixote of La Mancha. In 1615, he published part two. In various ages, the novel’s theme has been thought to be a comedy, a philosophical defense of the individual in a crazy world, and a social commentary.
The novel’s protagonist is a retired country gentleman who became obsessed with the ideal of a knight as one who does good by righting wrongs. The gentleman renamed himself Don Quixote, donned an old suit of armor, and set off seeking knightly adventure while guided by the principles of honor, generosity and courtesy. Don Quixote regularly deceived himself, deluded into interjecting himself as a solution to imaginary problems. He fared poorly, because the people and things of the world correctly viewed him as irrelevant. They ridiculed and beat him. His typical retreat is brilliantly portrayed in one scene when Don Quixote gets bested by a windmill.
Four hundred years later, the PCAOB is embarking on a Quixotic quest to improve the state of auditing in the United States. I’m sure the PCAOB would describe its quest as knightly. However, when you charge at a windmill, your quest is Quixotic. As surely as Don Quixote got beat by a windmill, the PCAOB is about to get beat down by auditor rotation.
The audit model used in the United States and the rest of the world is fundamentally flawed. These flaws lead directly and inevitably to untrustworthy and therefore worthless audit opinions. Investors who rely on financial statements because they receive clean audit opinions are deceived into making sub-optimal investments.
By law, publicly traded companies are required to have their financial statements audited by “public accountants.” States certify and license these auditors. Many audit firms serve as public accountants, with the largest collecting over $1 billion annually in revenue.
Companies have a significant financial incentive to secure clean audit opinions, for investors would shun their securities if the financial statements were accompanied by unfavorable audit opinions that pointed to problems in part or in whole with the financial statements. Indeed, since the passage of the Securities Acts of 1933 and 1934, the corporate practice of shopping for favorable opinions continually has vexed government regulators.
The problem persists because audit firms correctly perceive they will lose clients and revenue if they don’t play ball with any company whose hand feeds them. There are no major penalties to any audit firm that issues undeserved clean opinions. How so? Ketz and Catanach of Grumpy Old Accountants point out the PCAOB is a paper tiger (a paper tiger has no bite). They argue that audit firms are not disciplined by the PCAOB for living in and off of corporate pockets. I might add that the audit industry has been extremely effective in securing legislative shields from lawsuits from shoddy audits.
Let’s review. By law, publicly traded companies are required to have their financial statements audited by “public accountants.” States certify and license these auditors. There are many audit firms that serve as public accountants. Companies have significant financial incentives to secure favorable audit opinions, and public accountant auditing firms have significant financial incentives to provide favorable audit opinions. There are no effective regulatory checks on the practice of providing favorable audit opinions. Consequently, a large percentage of investors don’t rely at all on clean audit opinions, and published financial statements are not heavily used in making investment decisions.
Aware of the many failures of large audit firms to check the misreporting of financial results by publicly traded companies, the PCAOB under new chairman James Doty is now examining the audit model with a goal or making changes that would result in more effective audits that would provide a measure of protection to investors.
Instead of zeroing in on one or more of the major flaws of the audit model, the PCAOB has decided to attack a windmill: audit firm tenure. The PCAOB thinks that frequent rotation of auditors will produce better audit opinions. It most surely won’t.
Requiring audit firm rotation puts the regulatory seal of approval on opinion shopping! Instead of impeding corporate searches for compliant auditors (for example, by random assignment), new regulations considered by the PCAOB would require new searches on a regular basis.
Instead of removing the monetary incentives for audit firms to play ball with audited companies, companies will still be required to pay the audit firm. If payment came from a third party, perhaps auditor allegiance would shift from satisfying corporate wishes to protecting investors. But new changes being consider do nothing with this problem.
Instead of penalizing audit firms for soft and undeserved audit opinions, the proposed changes do nothing to discipline audit firms.
Therefore, I don’t think the proposal of frequent auditor rotation will produce the desired results of more effective audits and audit opinions that finally mean something. Mark this Quixotic quest as FAIL!
Debit and credit – - David Albrecht