I’m grateful for the provocative writing of Jim Peterson (re:Balance), Francine McKenna (re: The Auditors) and Sara McIntosh (Sara McIntosh). Without their blogging, I might never have realized how naively I was conceptualizing the audit model.
The simple view of the audit model is that public accountants (aka auditors) serve the public (and investor) interest when they render an opinion as to whether financial statements have been prepared in accordance with the rules. This is their raison d’être (reason for being). At least, this was the intent of the original legislation (Securites Act of 1933 & The Securities and Exchange Act of 1934). Since then, the SEC has many times stated that (1) it is the auditor opinion of the financial statements that makes them credible, and (2) without credible financial statements there can be no effective capital markets in the U.S. In other words, auditors work for the public, but get paid by companies.
I wonder if this model works, anymore. First of all, there is nothing “public” about auditors. They are in business for themselves–to make a profit. Audit firms seek to maximize revenues and minimize expenses. Secondly, auditors are more likely to describe their relationship to companies as a partnership instead of being “independent of.” Thirdly, auditors serve their paying companies, not the public.
I’ve been pondering theory, going way back to the original principal-agent theory and motivation for auditing (described by Jensen & Mecking, summarized by Thornton, expanded by Simunic and Stein, interpreted and dressed up by Watts and Zimmerman). The basic theory is that in the absence of government regulation companies (and their management) are motivated to secure independent audits of their financial statements, and investors are not. If ownership is dispersed, then no single investor can own a large enough share of ownership to make worthwhile the funding of an audit. These independent auditors are motivated to provide opinions free from bias or influence from management because they compete for clients on the basis of reputation and audit quality. The market for auditors is characterized by perfect competition (lots of auditors competing only on basis of reputation and quality). The theory also describes that audit opinions serve the public interest.
In the same way that we’ve discovered EMH doesn’t really exist in the real world, I think it safe to say that the above auditing scenario doesn’t exist in the real world.
The asymmetry of information flow between the company and auditors is problematic and expensive for auditors to overcome. The market for audit services is not characterized by perfect competition. Governments have stepped in to limit competition by providing barriers to entry. Unchecked consolidation has had many side effects. In theory, the cost to audit firms of poor quality is loss of clients and lawsuits. Theory doesn’t mention that audit firms face legal costs unrelated to audit quality (biz failure provokes lawsuits, so auditors have interest in seeing long-term survival of companies). Also, in the real world, lack of auditor competition means that audit quality is less important. Firms don’t need to compete on quality, being able to exist at all is a basis for competition. When pressures for audit quality are diminished, then firms can benefit from getting along with management. When firms are predisposed to get along with management, management is sometimes more willing to reveal information if auditors won’t act on it in their opinions. This cuts costs to audit, but simultaneously increases barriers to effective audit opinions. When companies realize that audit costs have decreased, they start forcing auditors to accept lower fees. This price competition means that once audit firms have accepted competing on the basis of price, they must now be even more compliant to management desires than ever before.
I think this condition results in a situation similar to that which preceded the 1929 market crash. Prior to 1929, companies were free to disclose whatever financial info they wanted (a blue sky situation). Public outcry over the stock market crash (that followed the financial reporting abuses) resulted in government regulation in the form of SEC. We are now back to a situation where bad information is leading to frequent and extreme market bubbles. Public outcry over the bubble pops is getting loud and overwhelming. The government is likely now motivated to step in.
If the government is going to step in, what is the best way to do it? The market for auditors is very imperfect and has resulted in many unintended consequences. Is the audit profession resurrectible? I simply don’t see how breaking up the big 4 (actually the top eight) into 20 or 30 audit firms is realistic or able to be accomplished. After audit firms have learned to get along with corp execs, can they unlearn it? No.
A completely new form of attestation is needed, I think we should fire all the audit firms.
Debit and credit – – David Albrecht