by Paul B. W. Miller and Paul R. Bahnson

The reason for public accounting’s existence always has been auditing, because most everything else that CPAs do can be done nearly as well by lawyers, bookkeepers, information technologists and management consultants.

But what is today’s situation?

Auditing may be vital for the public accounting profession, but is auditing itself vital? Hardly. In fact, we think auditing is becoming moribund. It is well past time for major reformation, even revolution — not tinkering, not tiny little shifts, but massive reform. A great deal is at stake — not only the future of the profession but also the efficiency of U.S. and global capital markets. Before explaining what should be done, we want this column to explain how auditing got into this mess.

(To be clear, we want to say that the following generalizations don’t apply to everyone; however, they do apply, and all auditors should pay attention. If we aren’t talking about you, we are talking about people who are alongside you and the decayed environment in which you’re working.)

To lay down bedrock, auditing was devised to assure users that reported information is actually usable. Intervention by a trustworthy third party helps users believe that they are not being bamboozled. But audits actually add value to financial statements only when two factors are present. First, auditors must be experts in accounting principles and systems, forensics, and financial analysis. Second, auditors must have (and be perceived to have) integrity in the form of high ethics and independence.

In effect, the fundamental purpose for audits is to serve a “gatekeeping” function by determining whether managers’ self-representations pass muster before they access the capital markets. Gatekeeping is important because it allows users to focus on financial analysis with less distraction from the possibility that the statements might be misleading.

When looked at this way, auditing is a high calling worthy of a lifetime commitment. After all, when audits are done well, good things happen: The economy is better off because the capital markets are more efficient and companies have legitimately lower capital costs. By filling this pivotal role, auditors are worthy of respect and compensation by sharing in the value they add to financial statements.

However, a steady 30-year process has devolved this higher purpose into something entirely different, and auditing’s contributions are diminished.

As we see it, auditing has lost its gatekeeping role and has become what psychologists call an “enabler.” Enablers actually help others engage in dysfunctional behavior, even to the point of self-destruction. In this context, many auditors have lost sight of their higher calling and their need to serve the markets and society. Instead, they are now conjoined with clients in the antisocial process of worthlessly embellishing financial statements. Instead of safeguarding the public, auditing has become part of management’s public relations efforts, putting a positive spin on bad news at every turn.

What signs suggest that we’re right?

Look at the volume of fraud-based litigation and restatements, and see how auditors have failed to be vigilant. There is also the matter of opinion shopping — in the 1980s, when the profession had the chance to slam the door on this dubious practice, the Auditing Standards Board instead produced guidelines on how to do it.

Other evidence of devolution is the rise of fixed-fee audits. Most never knew, others have forgotten, but there once was an American Institute of CPAs Ethics Rule 3.03 that said, “A member shall not make a competitive bid for a professional engagement. Competitive bidding for public accounting services is not in the public interest, is a form of solicitation, and is unprofessional.” This rule was struck in the 1970s in acquiescence to a sincere but misguided federal effort to make public accounting more competitive.

When the rule was in effect, auditors contracted only to provide services at specified hourly rates. Doing so provided them with the flexibility needed to deal with the unexpected, such as audit sampling results that suggested an internal control flaw. To know for sure, a larger sample would be taken, and the cost of drawing it would be borne by the client, who, after all, created the problem. Once competitive bidding became acceptable, it was only a short step to fixed fees — after all, how could a potential client compare a $100 hourly rate with a $125 rate without knowing how many hours would be applied?

As we understand it, virtually all audits are now done for fixed fees. What happens when sampled results are out of line and more testing needs to be done? The auditors are faced with three bad choices: asking the client for more money — a ludicrous choice in a competitive market; losing part of their hard-earned profit by testing without additional compensation; or doing nothing except swallowing hard and hoping everything will be all right.

Inevitably, users have less protection. In turn, this vulnerability creates more risk and the client’s stock price is discounted. The client is being penny-wise and pound-foolish, and auditors are well down the slippery slope, and from short-sighted vision.

More signs of decline
Other evidence of devolution can be found in the growth of non-audit services. Although legislation and some common sense has abated the tsunami, it often remains true that audits are loss leaders and that auditors have less independence.

The devolution of the profession is also evident in ineffective ethics enforcement and the recent stripping of self-regulation from the AICPA. Paul Miller is still astounded by an experience he had on an institute committee investigating a situation in which an auditor opined favorably on financial statements for a business combination that listed each predecessor companies’ common stock in the equity section. Amazingly, one committee member voted against sanctions by saying, “We all make mistakes.” The profession cannot stand with that attitude.

Other evidence is the rush to the lowest common denominator. If one company does something and “gets away with it,” others want to do the same thing. This lemming mentality can be seen in options, poolings, special purpose entities, off-balance-sheet financing, tax shelters, and on and on. If auditors don’t say “No,” they themselves will just be dragged lower and lower. Even worse things happen when auditors themselves propagate bad practices, charging fees to help managers present rosy, but phony, statements.

Enabling is also evident in the virtually complete withdrawal of auditing firms from the Financial Accounting Standards Board’s due process.

In the early days, auditors
supported reformation. Now, they’re seldom heard from, although we welcome a recent joint Big Four letter on options.

Another sign of devolution is the erosion of independence. When auditors have an interest contingent on the audit’s outcome (even the fee), no one can trust the opinion. Yet this time-honored concept has been repeatedly chipped away by managers at the largest firms chafing at the opportunities that it puts out of reach.

As just one example, consider the impact of revising the ethics code to allow holdings in clients’ shares. Trusty gatekeepers take no bribes, however small, from those who are being monitored; the sole test must be the statements’ worthiness, without regard to the return on the auditors’ 401(k).

Bottom line, the devolution is nearly complete. The auditing profession (and thus all public accounting) is no longer as honorable as it was, and perhaps not even honorable at all. Affiliation with an audit firm no longer carries as much status or stability, and brings with it intense pressure to lasso new clients and little concern for protecting the rest of us against bad accounting. Can there be as much personal satisfaction in protecting one’s own assets instead of the public’s? No.

In fact, auditors don’t really guard the gate to the markets any more. They are essentially part of the management team that waltzes into the markets expecting, even demanding, higher stock prices, offering nothing but non-credible and otherwise low-quality information.

Our next column will address how to restore auditing to its role as gatekeeper.


Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@QFR.biz.

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