Innovation in audit oversight

I bet you never thought you’d see that as a headline. Neither did I but then Joe Weisenthal’s ‘Nuke the SEC’ post I started to think differently. Let’s start with Joe’s assertions:

First, we nuke the SEC. This isn’t really that radical. There’s precious little evidence that it does what it purports to — namely, protect investors. If anything, it protects investment managers and others from investors, who might suspect they’re getting ripped off. Sure, it can catch the occasional insider trading case, but they’re usually pretty obvious when you see a massive trade right before big news comes out.

Second, we stop letting companies hire their own auditors. Companies have little incentive to hire aggressive auditors. An auditor won’t get business by being a pain in the ass to the company it’s auditing. The game is to do the bare minimum that makes everyone happy. That state of affairs works fine in the boom times, but when the recession comes, the whole charade is exposed for what it is.

Finally, we make each listed company pay a fee to an independent auditing organization. Rather than hire the auditors directly, companies will pay some portion of their revenue to an independent industry body (like the SIPC or some such) that then hires auditors for its member companies. The auditor would work for this group, and it’s ability to get business year-on-year would be tied to its performance. Whiff too often? You’re done. No more work for you.

Joe bases these thoughts on the idea that corruption and conflict of interest are at the root of current regulatory problems, a concept with which I agree. Why should this work? In back channel discussions with my Irregular colleagues about the Satyam fraud, one of the things that emerged is that my colleagues were of the opinion that Satyam had previously enjoyed a solid reputation for ethical practices. This in turn should have meant it was well governed.

But as I observed, if the steady stream of frauds tell us anything, it’s that there is a human tendency to avoid doing the right thing when things start to go wrong and the pressure is on. It matters not that reporting cycles leave execs under constant pressure to meet analyst expectations. That is always going to be there. It matters even less that the current system of oversight is weak. In other words, you’re never going to put an end to fraud.

From the audit oversight, what matters is that the combination of vested interests, weak oversight, a lack of qualified internal supervision and inadequate training has led to a situation where the likelihood of detecting anything going awry is nigh on zero. There is no incentive to change because despite the weight of litigation lining up agains the major players, there is no appetite for root and branch change. That’s especially true when auditors can hide behind the eons old mantra that an audit is not designed to detect fraud.

Introduce a new system where the auditor will be actively penalized by a body that is disinterested in the outcomes of those audits and attitudes change rapidly. Some might see this is as a moving around of the deck chairs but I don’t see that as necessarily the case. For many audits, the next tier outside the Big 4 can do a perfectly good job, if they are given the opportunity. What’s more, auditors will be encouraged to be a lot more transparent about what they’re doing. So in the event that things go wrong, rather than hide behind client confidentiality as PwC is currently doing, they’d be playing to a different tune.

OK – this is only a stake in the ground designed to stimulate debate. I’m sure plenty will disagree with the details. But if free market America – or rather financial commentators in that country – are coming to the conclusion that radical change is required, then why argue? If, as some of my colleagues believe, the ‘governance’ edifice has finally crumbled, then something viable and DIFFERENT has to replace it. If as seems the case that India’s commentators are jumping all over the audit profession (which I’m sure is a prelude to considering the role of oversight bodies), then we all can’t be wrong.

Big questions are being asked around the world. They demand innovative solutions and not the sticking plaster of fresh PCAOB/SEC/ICAEW/ICAI…etc responses. Over to you.

Pic courtesy of Geek & Poke

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