The audit model is broken. Everybody knows it. You won’t hear it, though, because the large audit firms won’t admit it in public.
Therefore, financial reporting is broken.
At one time, corporate financial reporting to current and potential investors was voluntary. Most companies did it, as investors needed a bit of info before parting with their cash. Financial statements were not uniform, but companies got rewarded over time if they did it well. Some even voluntarily hired audit firms to certify their financial statements. And audit firms had a reputation for integrity and honesty.
Then in the US, the Securities Act of 1933 and the Securities and Exchange Act of 1934 altered everything, and not for the better. The federal government mandated financial reporting and audits, for all corporations. Overnight, everything went to pot. Corporations were motivated to report because the government ordered them to. Whenever behavior is mandated, a standard response is to only partially comply. Playing games with the rules was considered smart business. The earlier rewards attached to voluntary reporting disappeared in the context of legal prescriptions. Fudging the numbers on financial statements became de rigueur. [Note: the probability of a corporation following GAAP in all respects is as likely as a driver following posted speed limits in all respects.]
Forced by the government, corporations had to hire public auditors to verify their financial statements. Now motivated by law instead of by potential return, corporations shopped for favorable auditors and opinions. Because auditors were hired on the basis of going along with corporate management, auditors correctly perceived that quality was no longer important as it had been before. Audit firms changed. They competed for clients by partnering with corporations (see Sleeping with the Auditor) because there was no longer a market for their integrity. Corporations were only willing to pay for clean audit opinions, and that’s what auditor firms became eager to provide.
European proposals to create audit-only audit firms (providing no tax or other consulting) won’t fix the problem, it will only make audit firms more desperate to go along with corporate management. There are only three ways to deal with the problem of ineffective auditing:
- Have the government pay a bonus for every financial reporting problem identified in the audit opinion. Auditors and audit firms are motivated by money. If the government pays them to spot problems (instead of corporations paying them to overlook problems), audit effectiveness can only improve. While we’re at it, might as well have the government appoint and pay all auditors.
- Regulators and government attorneys general should end their policy of limiting auditor liability. Auditor liability should be increased by a lot. If the penalties for partnering with corporate clients is made draconian, then perhaps auditors will start doing the job everybody hopes they do. Oh, this auditor liability should be applied at the firm level, not the individual auditor level. Make it possible for an audit firm to go out of business, and all of a sudden they will be motivated to catch every financial reporting misdeed perpetrated by corporations.
- Ban audit firms from providing attest services to corporations, and instead have government employed auditors provide audit opinions. Government supplied auditors can’t possibly be worse than the current audit firms.
Debit and credit – – David Albrecht