Customers are best served and protected when they have many competitive alternatives. We are suspicious of self-serving monopolies. Of course, as sellers, we all want to be monopolies, with little competition, and the ability to charge high prices, bar entry to potential competitors, be able to rest on our past successes, and not have to perform the difficult job of constant innovation and experimentation where value is determined by the external customer, not internal industry standards, credentials or ineffective government regulations.
Yet if we are serious about transforming the audit function from its present moribund state, we are going to have to face some unpleasant truths. The present accounting model is over 500 years old and is in bad shape. In an intellectual capital economy, it may be possible to track revenue and expenditures, but it is difficult to know how expenditures relate to value created outside of an organization (it is easier to count the bottles than describe the wine, as they say).
Accounting is a mature profession, and its last true innovation was the financial statement compilation and review standards, effective in 1978. This is a 31-year innovation curve, and counting. Additional regulations will only slow this innovation down further. Heavily regulated industries are rarely hotbeds of innovation. If the computer industry were as heavily regulated as CPAs, we would have Vacuum Tube Valley, probably located in West Virginia.
The traditional GAAP statements are based upon a liquidation value of a business, essentially historical cost assets less liabilities - a heroic attempt to assign static value to a dynamic concern. Even though intellectual capital is the main driver of wealth in today's economy, you will look in vain to find it in the traditional GAAP statements.
GAAP is competent at recording value only after a transaction takes place; it cannot peer into the future and predict value since it's an identity equation, not a theory, such as economists' supply and demand. This is why mark-to-market accounting is so misguided - by asking GAAP to do what it is not competent to do, it actually obscured the real financial position of entities.
In addition, the recent spate of accounting scandals taught the profession - the hard way - that the audit is not a commodity. When was the last time a bale of hay created so much financial havoc? The audit is actually an insurance product, and rather than pricing it by some arbitrarily determined hourly rate, auditors should be pricing it based upon its actuarial risk. If we have to hire actuaries in order to accomplish this, then so be it. Their first lesson would be: There is no such thing as bad risks, only bad premiums.
THE ROAD LESS TRAVELED?
History teaches there are three possible roads the profession can travel. On the first, it can do nothing, which is usually the road most traveled by stagnating industries. Thinking the past will somehow equal the future, the leaders simply see no reason to change. No doubt the professions would survive in some shape, since a lot of its work is governmentally mandated, but it will relinquish its status as the premier financial profession if it chooses this path.
On the second road, outsiders could replace the profession with the "perennial gale of creative destruction," that Austrian economist Joseph Schumpeter wrote about. In some instances, this is already taking place, with respect to key predictive indicators, the Enhanced Business Reporting Consortium, social audits, brand valuation, and IC measurements, among others, being performed by private industry, consulting firms and nongovernmental organizations. This is unfortunate, since the accounting profession should be out in the forefront in these areas, but it is too busy fiddling around with mark-to-market and other distractions, as Rome burns.
Finally, on the third road, the profession could innovate and become its own creative destroyer (similar to Intel deriving 100 percent of its revenue from products that didn't exist three years ago). Why not give up the attest monopoly altogether and allow competition to enter the auditing marketplace? You couldn't fill a Mini Cooper with competent economists who do not seriously believe that deregulation over the past 30 years hasn't redounded to the tremendous benefit of consumers.
INNOVATION THROUGH COMPETITION
If consulting created an independence conflict for auditors, then what about the ultimate conflict: the fact the auditors are paid by the very companies they are auditing? Economists focus on incentives, not compliance with ineffective regulations such as Sarbanes-Oxley, which simply imposed enormous compliance costs on companies without addressing the incentives between auditors and their clients.
Why should the audit be a state-granted monopoly? Open it up and let the free market innovate new solutions to attesting to the financial performance and risk position of companies. The goal is to protect the public, and deal with the principal-agent dilemma, yet there are myriad ways of accomplishing these objectives; we don't have to suffer with a one-size-fits-all monopoly offering.
Insurance companies and banks could innovate new products, and the stock markets could enter the fray by hiring the auditors themselves, thereby removing the major conflict of interest. There are so many permutations of what an unfettered free market could accomplish in this arena that it's difficult to even begin speculating about the many new and dynamic ways that investors could be assured of receiving timely and accurate information, and insured against the risk of audit failure.
What we do know is that there is no better way for innovation and new knowledge to diffuse throughout society than to have entrepreneurial experiments take place in order to satisfy the needs and wants of consumers. Ask yourself which products and services have gotten dramatically better over the past decades - computers, financial services, telecommunications, the Internet, automobiles, trucking, airlines, electronics, etc. - and which have stagnated and left the consumer with little or no freedom to choose among competing offers - Social Security, the public school system, Medicare, the Postal Service, and the audit, to name just a few. The difference between these two sectors is the extent of regulation and barriers to entry, which stifle creativity, innovation, risk-taking and experimentation.
The history of economic growth and dynamism is the story of crackpots, cranks and outsiders innovating new products and services that decimate and replace the existing infrastructure of entire industries. There are many routes to knowledge and learning. The path to growth and dynamism is to allow experimentation over rigid orthodoxies and credentialism that no longer serve the needs of customers. Thomas Edison had little formal education and could not have been licensed as an engineer under today's guidelines, while Frank Lloyd Wright and Mies van der Rohe would not qualify to sit for the architect's certifying exam.
None of these three roads are going to be very pleasant journeys, as they will cause major disruptions to the status quo, but can there be any doubt that the current offering of auditors is the Edsel of our time? Is it not incumbent on the profession's leaders to shape its own destiny, rather than being relegated to part-time governmental bureaucrats destined to comply with the ever-increasing GAAP and Public Company Accounting Oversight Board rules? It is not the automobile that is being rejected, but instead the make and model. Until we relinquish the profession's monopoly audit status, we will never breathe new life into the attest function. We will simply be tinkering at the margins, and making incremental improvements at best.
Nothing focuses an individual, a company or an industry like unregulated competition. Let us begin to innovate and create a better tomorrow by offering a new financial reporting model to the public, throw off the shackles of a regulated attest monopoly, and put ourselves to the ultimate test - providing value in a free, unfettered marketplace while serving the interests of the public we are privileged to serve.
Ronald J. Baker is the founder of VeraSage Institute, a think tank dedicated to advancing the professions, and the author of The Firm of the Future: A Guide for Accountants, Lawyers and Other Professional Services (John Wiley & Sons). Reach him at ron
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