This column is approximately the 250th that has appeared under the title of "The Spirit of Accounting." Paul Miller has been around for all of them, and Paul Bahnson for the latest 150. As we were looking ahead to what to write about next, we looked back to the first few columns we published to see whether their messages might still be relevant for today.It turns out that they were, and we thought it would be insightful to reprint this one that first appeared in September 2000. One of the issues being debated at that time was the question of whether non-audit fees could compromise auditor independence. In those days, Enron was considered to be an amazing company, instead of the economic disaster that we now know was going to happen in 2001.
We provided a different take on that issue, and we think the questions raised in the column still need to be addressed. We hope you will agree.
"Fixation" is a common human frailty that makes people focus so intently on one problem that they fail to notice others coming their way. Its first cousin is "oblivion," which arises when they get so comfortable and complacent that they can't notice opportunities for improvement. It's not that they choose to ignore their surroundings - they literally cannot see what is happening.
This phenomenon is illustrated in a scene from the original Pink Panther movie, in which Inspector Clouseau pays so much attention to a parking violator that he fails to notice that the bank across the street is being robbed. He is so focused on a minor infraction that he overlooks a major crime. This condition is also summarized by an ancient parable that talks about "straining at a gnat while swallowing a camel."
So, what's the connection to financial reporting? Unfortunately, as we look around at the issues being debated and the positions that leaders are taking on them, we see gnats being strained at, while camels are going down smoothly. A lot of people are oblivious to the profession's big shortcomings, while they have magnified relatively minor controversies.
In particular, we think a couple of camels have been gulped as sides have been drawn on auditor independence. Virtually everyone has focused on the Securities and Exchange Commission's proposal that would allow certain audit firm personnel and their families to own securities issued by the firm's clients, and prohibit certain categories of non-audit services by audit firms. The latter has been the most controversial, because it is opposed by three of the largest audit firms. [Note how life was different before Sarbanes-Oxley.]
Nearly all who debate these points are straining at these gnats: Which family members? How much stock? What about debt securities? Which services do and don't compromise independence?
In doing so, they have failed to notice two huge issues that ought to be addressed before going on.
First, why look so closely at fees for non-audit services? Isn't it more likely that audit fees compromise the auditors' independence? Don't the capital markets look at least a little askance at audit opinions because the client pays the auditors?
Consider the analogy of selecting a car with good safety features and low maintenance costs. You've kicked the tires, but you need some objective expert evidence. You have three choices: a sales representative, a third-party research report paid for by the manufacturer, and a third-party report without any fees from any manufacturer. It's a slam-dunk that you'll prefer the third option.
Of course, the rep's promises are like unaudited financial statements - while potentially interesting, they can't be trusted. The commissioned report is like today's audited financial statements. Unfortunately, the analogy ends here, because there is no independent agency to tell us what to believe about a company's stock. It's especially unwise to rely on sell-side financial analysts, because so many are eager to attract clients to their investment banks for public offerings.
Why do nearly all accountants swallow the audit fee camel? We think it's because they have never looked up from their ledgers long enough to notice that reality differs from their assumptions. Clients pay auditors because ... well, because that's the way it has always been done. Anything different would be change, and everyone knows that change destroys experts and their expertise.
This attitude embalms the status quo, which, in turn, floods the capital markets with financial reports that can't really be trusted. Thus, these markets perceive greater risk and demand a higher rate of return, which leads to higher capital costs and lower stock prices.
GAAP ISN'T GOOD ENOUGH
The second camel is even bigger. It's the assumption that generally accepted accounting principles can produce useful financial statements. Conventional wisdom holds that useful information surely follows when managers comply with GAAP. While naive observers might believe it, managers, auditors, professors, regulators and statement users shouldn't believe it for a second.
The first reason is that GAAP emerged from a political process. As if that isn't bad enough, the process has been so thoroughly dominated by managers and auditors that the users' and the public's interest have been buried.
A second reason is that many of the principles are very old. Not many realize that classifying current and noncurrent items and accounting for depreciation and inventory are governed by Accounting Research Bulletins that were originally issued in 1946 and 1947. That's simply unbelievable, not to mention embarrassing.
A third reason that GAAP does not lead to useful information is that they are nothing more than minimum standards; unfortunately, managers and auditors treat them as maximums. Once the letter of the law is met, no one goes a millimeter beyond. For example, SFAS 89 recommends that companies report market-based information. Nobody does. SFAS 95 recommends that managers report operating cash flows with the direct method. Only 1 percent do.
We used to think that withholding relevant information was a failure to live up to the ethical value of truth-telling. However, we have realized that today's managers and auditors are real-life embodiments of Inspector Clouseau.
They mean well, but they just don't see what is going on. They think the capital markets actually believe the financial statements, and they think the capital markets trust auditors. While accountants sit around arguing about pooling and non-audit services, the markets are across the street gathering their own data and making decisions under immense uncertainty because GAAP reports don't help very much.
Could our claim be an overstatement? Perhaps, but give us a few months [years?] of columns to convince you. We will soon begin to explain the Quality Financial Reporting perspective that asks whether financial statements reduce uncertainty as much as they could. We hope to get a great many people to consider whether the camels they've swallowed might be the source of the indigestion they feel, instead of the occasional gnat or two that gets through. We hope you will have as much fun reading the columns as we will have writing them.
And we hope that we have kept you stimulated and made you more thoughtful over the intervening seven years. We thank you for continuing to read our words, and we especially thank Bill Carlino for providing this avenue for speaking our minds and encouraging our colleagues to think differently.
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.
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