What if…there was no audit?
The other week, Francine McKenna predicted: When another one bites the dust:
I say “when” not “if” since Jim Peterson and I agree most strongly on this:
Another large firm will fail soon.
Soon, to me, means in 1-3 years, not 5-8 or 10-13.
That’s one heck of a prediction but it raises the question what happens next? If, as Francine says, one of the many lawsuits currently on the go does kill off one of the Big Four then some interesting scenarios become possible. Earlier today, Francine and I discussed this and the conclusion I/we reached is that it could signal the end of auditing – at least as we know it.
Francine and I agreed that almost no-one we know reads audit reports. Or if they do, then it’s only when there is a qualification because you just know that it must be serious. Yet we still see continuing frauds and other catastrophes. It begs the question: why do we have audits anyway? Are they really serving any useful purpose for most investors, customers, suppliers, banks etc? Jim Peterson thinks not but that in the US at least, government simply hasn’t thought this through:
Put another way, those sincerely believing in the importance of large-company assurance are avoiding an election between two unappealing choices: Either put every effort to assure that the Big Four are insulated from the very catastrophic risks that the critics insist they must remain exposed to, or start the process of designing the new audit model that must arise after the collapse of the Big Four under the abdication of the Treasury Committee and its counterparts.
In the loud clanging of the Committee’s cognitive dissonance is the tolling of its usefulness. Chairman Nicholaisen’s concession of futility in the face of catastrophic risk says as much.
Prem Sikka thinks that auditors work under a different regime to the rest of us when it comes to accountability:
There is hardly any evidence to show that the UK fines are effective or have resulted in any improvement in audit quality. Despite recurring failures, no partner from any major UK auditing firm has ever been banned from practising and no major firm has ever been suspended from selling audits. Most stakeholder lawsuits against auditors are barred after six years, and the much-delayed disciplinary findings are of little use to them. In any case, generally auditors only owe a “duty of care” to the company as a legal person and not to any individual shareholder, creditor or other stakeholder who may have suffered loss as a result of auditor negligence.
In the UK, most arguments for an alternative favour a state sponsored model but to me that is recipe for disaster. What’s the alternative?
If you believe that de facto, we live in an era of meket driven economics then it follows the market should decide. Given free rein, I’d expect to see a completely different type of framework where the interests of investors are protected by measures that have real teeth. Not because it is mandated but because the market will decide. That raises all sorts of spectres, not least the extent to which the systems which support the global economy will come under scrutiny. We already know they are brittle. We already know that smart people can and will dance around them. The profession just isn’t equipped to understand or respond to the problem. So why are we kidding ourselves that audit matters – at least in its current form?
Unfortunately, given the lobbying power of the Big Four, it may well take a catastrophic failure to bring them to the table to understand that the gravy train is coming to a grinding halt. That’s what Francine believes and I have a feeling she’s right.
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About This Post
You do raise some strong points.
I’ll play “status quo’s advocate” with a simple quote:
“Do you ever see all those accounting people and IT people run around trying to fix things near year end? It’s all because of me.”
How many times do you hear of people running around getting their books in order – not that they’re doing anything wrong, just because they’re not always finishing their work properly – I’m not even referring to clients, mind you, but friends’ workplaces.
Audits are designed to catch material errors, not fraud.
The problem is that the “dancing around the rules” phenomenon is fraud. And of course, when the fraud is so big that it BECOMES material and it’s STILL not caused, that’s when you run into trouble. And I suppose that’s how I come full circle to agree with the point you’re getting at.
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@Krupo – so what is an audit designed to achieve? That we know how to put debits on the left and credits on the right? If that’s it then we’re looking at a colossal waste of money for any interested party.
My discussion with Francine was a genuine ‘head exploded/ah-ha’ moment. There are no clear answers but then government is clueless on this issue. That’s why the prospect of another major failure is so tantalising. What might emerge from those ashes?
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One thing U of T did teach me was audit history, and in that respect, one of the problems may be that audits haven’t evolved sufficiently to keep with the times.
The original goal was to make sure the financial statements are based on reality and not make-believe.
I’d be more interested to find out if the ‘proper’ audit methodologies used for most audits WERE in fact being followed when the major fraud-detection failures occurred (leading to the doom and gloom point of view) or whether it was in fact negligence.
If the process is at fault, like with any audit, you have a fundamental DESIGN failure, and we really need to rip it up and start over.
If on the other hand, the problem is the PEOPLE not following the proper process, then clearly the mechanisms (I’ll say it… “CONTROLS”) need work. Controls are WAY easier to fix or set up, all things held equal, compared setting up a new process from scratch.
I haven’t followed the big failures in sufficient details to know if we’re worried about design vs. operation. Is this publicly available knowledge?
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@Krupo – there is a basic issue at stake here. As Francine said on our call, most auditors are trained in things like access controls etc. But if I said to you – go audit the methodology behind the Monte Carlo simulation that defines this derivative in Argentinian Beef futures, what would you do? That’s an example of the kind of thing with which the auditors of the future not only have to be savvy but capable of asking the tough questions. We’re now in a process control world where Dr/Cr fall out rather than ARE the basis upon which business is done. Are you honestly telling me that your training equips you to handle that?
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If I was a financial auditor I would say “it damn well better”.
Fortunately I get to use the hypothetical cop-out answer in this scenario, but I understand what you’re getting at.
Auditors SHOULD understand the logic behind such math and if the junior staff can’t figure it out it better get kicked up the ranks to someone who does, otherwise you’ve got serious questions to ask about how that derivative is valued, fer sure.
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I tend to agree with Dennis that we need more “caveat emptor” in the whole process. If the purpose of an audit for a company is to lower its cost of capital – because investors feel safer placing their money in its shares or handing it over as loans – then there ought to be stiff competition for reliability and depth of opinion on their reported numbers. You go with a shonky audit outfit, your investors raise an eyebrow and demand higher returns, natch. (Although, right now, I’d bet most investors still see the Big Four as “the best” on those counts…)
Of course, that isn’t why companies currently undertake audits – and most investors make their decisions based not on auditable information, but on management views, strategy, market position and their own hunches. So why not make the whole thing optional?
You’d need a pretty good government-sponsored propaganda campaign to make sure smaller investors understood the risk of investing in a company that didn’t provide reliable third-party assurances on its numbers. But it probably wouldn’t change the way things work in bigger businesses very much. Big funds like to see a tick in the audit box – but their decisions are based on presentations of mostly non-audited information in any case.
Check out the discussions around this subject in CIMA’s look at IFAC’s Financial Reporting Supply Chain study: http://snipurl.com/cima_frsc [www2_cimaglobal_com]
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