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
The Summa 
FWIW,
I do think that the point needs to be to have the auditor be in an adversarial role to managers. The question is how you can do that in a way that won’t cripple audit as a profession.
I agree with Jim on points 2 and 3. Since I’m not ultimately knowledgeable about insurance (or, hehe, anything), I can’t say whether or not 4 would apply to the FSI model, but I think it’s a shame that people don’t even *mention* it as an option (perhaps because of prejudices against the current insurance industry — when the FSI model doesn’t need to have current insurance carriers be the carriers for FSI, or because it seems more radical than keeping the system structurally the same). I think it is preferable over government auditors at the very least, but maybe that’s because I’ve grown more cynical of government (not to say I’m not cynical of private industry…which is why I think any solution, in order to work, must pit the players against each other).
Dave — Readily agreeing that the audit model is broken, as I have written for years, I have a number of serious issues. Until someone takes the initiative to convene a full-blown adult debate (which should be welcome), this too-brief summary will have to do.
1. A bonus or bounty system, putting the auditor in an explicitly adversarial role, would up-end the entire basis on which the function of independent audit was invented. Whatever that role might be called, it would be new, different, intrusive and dubious in effect.
2. Increased liability, imposed after-the-fact, will only speed disintegration of the profession – already all too likely. Complex systems designed and run by humans cannot achieve “zero defects,” so motivation to do as good a job as possible, as often as possible, is not increased by a death penalty for failure; if it were otherwise, Russian Roulette would be a popular game in Las Vegas.
3. Government or nationalized audit? With all the efficiency and effectiveness of the people who have brought us the IRS, the TSA and the PCAOB? Litttle value as there is to today’s reporting, the market would quickly vote a loud “no” on any value from government audit.
4. As for the comment on insurance — that industry long since walked away from real cover at meaningful levels. The conditions of insurability – diversity and quantifiability of exposures — are not met, and the large firms are effectively “bare.”
Meanwhile, those of us struggling to fight the good fight will keep it up — thanks again.
Cheers and happy holidays–
Jim
PS It is more than a quibble, that the US securities laws imposed audit requirements for “public” companies — unlike regimes such as Italy and others even less functional than the US, where indeed all corporations must have what passes for “audits” — thus severely degrading the stature and performance quality of the “profession” there.
Jim,
I’ll be able to write more when this semester is over.
It most definitely is a problem when audit firms partner with the corporations whose financial statements they audit. My solution? Reverse polarity and turn it adversarial. This will surely get investors informed of compliance issues. I fail to see why this would be a bad thing.
Another of my solutions is to have government auditors who, I hope, would be independent enough to be adversarial. Don’t we want traffic cops, enforcers of speed limits and traffic laws, to be adversarial? We certainly don’t want them to be in partnership with the speeding drivers.
Beneficiaries are investors in particular (as represented through a fiduciary institution cooperatively determined between the insurance carrier and the corporation). The FSI model is designed to put stockholders back at the forefront of the matter (since the stockholders will vote in a proxy statement on the amount of coverage to take and be notified of the premiums), and put company managers on the backburner (since managers do not pay the auditors or functionally determine the auditors anymore).
I don’t see how this would validate corporate misreporting of financial reporting. After all, riskier corporations would be charged higher premiums (or would seek lower coverage), and those premiums, which would be public, would be a signal to investors of the quality of financial statements. Auditors would not be beholden to the managers for life and livelihood, so they wouldn’t have the incentive that they currently do to kowtow to managers’ desires. The insurance carrier’s goal is to minimize claim losses (tantamount to minimizing shareholder losses); the auditors are paid by the insurance carriers and are aligned with them (and thus to the shareholders).
Prospective investors would look at the insurance coverage and the premiums paid as a signal to the quality of a company (and accordingly will invest as they see fit).
What about a financial statement insurance model? I guess this is kinda like option 1 in effect, but not really.
Who would be the beneficiaries, the American public (who all rely on securities markets)?
Besides, doesn’t this just validate corporate misreporting of financial reporting? I mean, they have prepaid for the damages of mis-reported financial statements.