The shape of the 21st Century Audit

Super long post alert

In the ‘who’s going to fail first’ debate that’s been going on seemingly forever on this blog it occurred to me that Francine McKenna is right. It’s moot.

I’m coming around to Jim Peterson’s theme: Which audit firm is next to fail is a moot question. It’s going to happen sooner rather than later, porbably due to catastrophic litigation, well deserved I might add. Key is looking at the purpose the auditor and audit opinion serves and deciding right now whether it’s worth diddley squat anymore.

I don’t think so. I think regulator and legislators should drop the facade and reveal the audit opinion for what it is: A government sanctioned confidence game providing false “assurances” to no one about nothing.

Let’s find a more useful purpose for the skills and talents in the typical audit firm, one that really serves investors and other stakeholders. This new mission will be unlike what was supposedly promulgated during the financial crisis and the thousands of frauds and scams we’ve seen even since the big post-Arthur Anderson “be all end all” reform of Sarbanes-Oxley and similar regulations globally.

That the old model is obsolete is beyond discussion. It’s a dangerous artefact of a bygone age. The difficulty I suspect for Francine, Jim and many others (myself included) is figuring out how audit gets from underneath it’s Pacioliesque heritage. When I think about this I keep coming back to the same problem. At the end of the day, audit as we currently know it is rooted in an abstract understanding of frozen points in time that only seek to verify the strict validity of transactional outcomes. Context is almost entirely missing unless you want to include such delicate issues as revenue recognition. But even that is tainted because it is through the application of rules designed to be all encompassing (and therefore flawed) that we so often see the frauds which are torpedoing the industry. It needs a fresh mindset. And as I prepare to travel to SOMESSO in Zurich for a gig about social computing and the financial services industry, I had one of those serendipitous moments where a level of clarity sprang into shape. Here goes.

@Valuecruncher sent over what seemed to be a snarky tweet. It got me to look at which this guy does, who he references and who takes notice of his ’stuff.’ Among other people, Umair Haque references him. That’s a big plus in my book because Umair is without doubt one of the real revolutionaries in economics and finance. Check this on Google and Finance:

What would a Googlier finance industry resemble? What would a more Googly set of capital markets look like? That’s the $12 trillion dollar question. After all, markets are just search engines — remember?

You still think you’re in the media business. You’re not. In the 21st century, everyone’s in the same business: the awesomeness business. It doesn’t matter what you make, as long as it offers maximum awesomeness. And right now, better finance would be pretty awesome.

Yesterday, you used to change the world. If you think a bit harder, a bit smarter, a bit more disruptively — you still can. If you don’t — well, the biggest catfish in a parched, dried up pond sure ain’t the smartest catfish.

Tracked, ValueCruncher, StockTwits, and many more are the leading edge of a revolution — a revolution in what finance has been for the last several centuries, and what it must become in the 21st.

I can pull Umair up on some of what he says here. There’s a few factual SNAFUs but they don’t change the tenor of the argument. The general idea is both plausible and reasonable. But that’s only the start. In his Finance 2.0 Manifesto, Umair says (among other things):

Finance 1.0 is built on a long-obsolete set of organizing principles. Those are out of dangerously out of sync with the hyperconnected, radically interdependent economics of the 21st century. The way that we define, allocate, and utilize money, credit, value, and wealth is not fit for 21st century economics…

Social banks. Despite what marketers tell you, banks do not exist to maximize profits. They exist to maximize the safety of deposits. We’ve been taken for a very expensive ride. Next-generation banks will be structured as social enterprises — because the incentives to safeguard deposits and reinvest profits for the common good perfectly converge to a dominant strategy for long-run value creation…

Stakeholder communities. Institutional investors are so 20th century. Centralizing control over our biggest corporations in the hands of a bunch of old dudes asleep at the wheel was as good an idea as the spork: interesting in theory, useless in practice. Tomorrow’s radical innovators are already updating corporate governance for the 21st century, by letting communities of stakeholders shape managerial decision-making. Think mega-Etsy.

Let’s just ponder on what this really means. You can sum it up in one word: reputation. Today we have armies of social computing buffs who think they have the lock on reputation but are almost exclusively skewing it in favour of a marketing play of some kind. Maybe that’s its primary purpose but in audit terms it’s a meaningless concept. Let’s try something else.

In recent times, Tom Raftery has been arguing that carbon accounting reputation will determine your company’s value. During conversations last week I said to Tom that we don’t need more accounting. We need something much more radical if we’re going to be talking sustainability as a core part of business going forward. Step in Brian Sommer who says:

Putting sustainability into ERP solutions will be very intrusive, very disruptive and expensive, if it is done correctly. Why? Well, sustainability requires new ways of looking at:

• - which products to make
• - what the true costs of a product are including costs for carbon offsets
• - which production facilities should/should not be used to achieve optimal business, financial and ecologic outcomes
• - how product scheduling should be optimized to take advantage of lower emission, lower carbon generating, etc. plants and machinery
• - etc.

Let’s examine this further. In an ERP solution today, does a cost accounting module account for carbon offset costs as part of a product’s actual or standard cost? No…

Sustainability is a great example of what’s wrong with innovation in ERP today. Vendors have forgotten how to innovate. The fact that this ERP representative is asking customers and bloggers for ideas and items to put on their development list is appalling. The vendor should already know, by their own assessment, what needs to change in their product line to support sustainability. If they have to ask me, they are doomed.

Innovation is not (and please understand this point) about order-taking but you’d swear that’s how ERP vendors see it. Innovation involves imagination, empathy and the anticipation of future market needs/demands/wants. That’s the part ERP vendors don’t get.

What Brian’s really saying is that we have to completely rethink ERP (for all intents and purposes, large chunks of accounting.) As someone who has clearly thought about it, Brian is EXACTLY the kind of person this vendor (and I know who it is) should be approaching. But they’re going to need pay a shed load of money to extract the value of what Brian thinks needs doing. Will they? Doubtful.Can they? Who knows? Are they talking about the issues to which Brian alludes? I’ve never heard it. Instead they are feeding the rest of us with a diet of same-old-but-hopefully-cool-looking accounting. And it won’t work.

Some of the inputs Brian describes are at the heart of Tom and my argument. Tom says: ‘But nobody knows.’ My argument, well they’ll never know if they’re looking for accounting accuracy. Better to take a stab at it than throw your hands up in despair. Tom argues ’standards.’ Wishful thinking when you consider the infinite variety of business types, the way they manufacture, different inputs etc.But it’s a nice idea for the long term. Trouble is we need solutions now.

If we take what Umair and Brian are saying and mash them up then the connection to reputation and a radical rethink starts to become clearer. We need something new in the process department because current systems don’t give us any real way to get to sustainability measures that make more than the barest of sense. We know that reputation is one of the few truly precious commodities. Taken together, why on earth are we not seeing the brightest of the best at the research units of the Big Four yelling about this stuff? Did I say that? I surely did because despite their many failings, the Big Four have some super smart people working in edge research. Here’s some reasons why we need new and disruptive thinking front and centre:

PWC is arguably the most vocal on sustainability yet nearly all I have seen is FUD centred around selling accounting based reporting. If anyone’s seen anything that talks to the issues above then please let me know. This from former PWC CEO Sam diPiazza (PDF download):

An essential role for CEOs is to ensure that robust reporting mechanisms and reduction strategies are in place within their companies. Progress in achieving climate change goals should be reviewed and discussed at board meetings. Paul S. Otellini, president and CEO, Intel, observes: “Clear, consistent and comparable reporting is important not least to prevent some companies’ messaging from getting ahead of its actions.

[My emphasis added.] It’s interesting stuff and the report from which it comes talks heavily about climate change, managing the economics of power usage, switching to non-fossil fuels and the like. But almost nowhere is there a radical agenda that comes close to addressing the issues Brian and Umair identify. Tragically it seems, Pacioli’s ghost hovers over the thinking of business leaders like the ghost of Christmas Future with little thought to the design of 21st century business.

The remainder follow suit. Why? Because it’s an easy sell requiring little more than a lick of paint over existing systems and the comfort of knowing that it’s really just a little more accounting. It doesn’t come close to meeting the needs of stakeholders in understanding what a company is doing. I’ve seen some of the sustainability reports. Terrific PR in many cases with commitments left and right but almost entirely silent on the need for new business designs that reflect what a few of us see as the radical jump off point the brings the kind of change 21st century business needs.

It is in understanding those needs framed against a failed banking system and an urgent requirement to rethink sustainability that we will see the new audit emerge. Of course some of the traditional audit skills will be needed, but the framework will be set by those progressive investors who understand the issues far better than the mainstream. It will come from a reworking of the banking system – perhaps in part along the lines of Kiva. I’ve been saying in recent times that I’d like to see the return of something that reflects the underlying principles behind the co-operative societies.  But what of the analysis that accompanies investment? Check out what Valuecruncher has been considering in recent times:

Notice how open sourced commentary appears and in some cases takes prime position. Check his conclusions:

Discount Brokers – Challenged across all scenarios. Must follow a low-cost strategy and only add services if that will increase trades (and commissions).

Financial Blogs – Winners across all scenarios (a role to play in all scenarios). Two distinct approaches – aggregating content VS traditional journalism on the web. We would expect one to come to the forefront (our bet would be on aggregating content – but it is too early to say).

Community Sites – Winners in the “We Live In Public” and “Rock Stars” scenarios. Significant opportunity if community is the way that people choose to make investment decisions. A business model has proven to be a challenge to date for players like the Motley Fool (“We Live In Public” scenario). It is more obvious if investors will pay to be part of the community (“Rock Stars” scenario) – this is currently unproven however.

Paid Finance Services – Business as usual in the “Walled Garden” scenario and challenged across all other scenarios. Even in the “Walled Garden” scenario there is the potential for the paid financial services to be disrupted (low-cost disruption) by the portals offering extended services (i.e. Google Domestic Trends). Currently users of paid services also use the free portal services (Yahoo Finance and Google Finance). There are limited options to defend this. Paid services do provide the data used by the finance portals. Reuters are also moving into the free space.

On-Line Finance Portals – Winners across all other scenarios. In the “We Live In Public” and “Rock Stars” scenarios – it is closest to business as usual. These players are the ones with the ability to acquire or build community sites. Investors that are part of communities still require basic financial information and tools. In the “Super Commons” and “Walled Garden” scenarios there are big opportunities. Both require adding analysis tools. Partnering with financial blogs is key. Adding analysis tools is an arms race between the different finance portals.

The fact that stuff is open sourced doesn’t necessarily translate into ‘free.’ It implies an economic model the new audit will certainly need. Note that this contrasts squarely with what Richard Murphy has been saying about bringing audit into the public sector because in my world, the new governance is shaped by a different set of principles. Might not the rise of such community based methods of disseminating information value a new form of reputation based audit? I suspect they would. And daft as it may seem given all the ranting I do around the profession, I think the framework around which we used to train: imputing the notions of independence, ethics and judgment are exactly the traits we’ll need going forward. Back to the Future?

Some while back, Jim Peterson asked that people like myself give more thought to what the new audit might look like. This is a starting point. It isn’t complete by any stretch and may be difficult to codify. It is something that I will be talking about tomorrow to delegates at the SOMESSO conference. It will be interesting to hear what they think, given the emphasis will be in social computing and how that can surface all manner of commentary and unstructured information against which reputation may be assessed. At the very least I will get the opportunity to see just how whacked out the financial services industry really is.

Tagged as: Business, Corporate governance, Francine McKenna, StockTwits, Tom Raftery