Suppose you've started planning your upcoming summer vacation by getting a guide that rates hotels and restaurants at your destination. Imagine your surprise upon discovering that every establishment is rated as "meeting minimum standards." Since you had something nice in mind, you decide to go elsewhere.
Now you're thinning down the applicant list for an opening on your staff. One applicant responds on the grade point average line by simply saying, "Passed all courses." Since you want the best person, you shake your head and put the application in the reject pile.
It's the U.S. Open, and 180 golfers have qualified to compete. After two days, the full field is invited to return for the final two rounds simply because they finished the first 36 holes. At the end of the fourth round, each participant is crowned champion simply for having played all 72 holes. When a reporter asks who had the best score, the tournament chair scoffs, "Who cares?" Within a matter of days, the USGA loses its television contract, the next year's host course rescinds its invitation, and the players announce that they will no longer compete in the Open.
These scenarios seem ludicrous, don't they?
Why would anyone think it is enough to meet minimum standards? Why would anyone fail to anticipate negative consequences from withholding information from those who need it to make decisions? Unfortunately, such has been the case in auditing for uncountable years.
What do we mean? Since modern auditing was born, the auditor's report has come in three flavors. The statements:
* Do not comply with minimum standards;
* Comply with most minimum standards; or,
* Comply with all minimum standards.
Alas, there has been no interest in going beyond this ancient pattern to describe some financial statements as better than minimum. "Just barely good enough" seems to be the profession's hallmark.
Recently, however, some influential leaders pondered whether more value would be added to opinions that go beyond this pass/fail mentality to actually rate statements in terms of their quality. Specifically, the Standing Advisory Group of the Public Company Accounting Oversight Board was asked in February to provide feedback on this question.
According to the March 14-April 3, 2005, Accounting Today, a PCAOB staff member characterized Securities and Exchange Commission requirements as compelling all public companies to receive nothing less than unqualified opinions - but nothing more ("PCAOB mulls reporting model reforms," page 1). Further, because no distinctions are made among unqualified opinions, the result is like giving everyone a "pass" grade instead of distinguishing among the A, B, C and D students.
Barbara Roper, a member of the advisory group and director of investor protection at the Consumer Federation of America, showed how clearly she understood the issue by saying, "If you have a company that is trying to push the line as far as they can get away with, the auditor report would provide that company with essentially the same rating as the one that does an excellent job of providing high-quality financial information."
That is, a D looks the same as the highest A.
Although a few SAG members want to explore this question, the rest are not interested. Call us skeptical, but we're not surprised.
Why?
Because they are the same sort of managers and auditors who have long shaped standards into the pretzel-like political compromises called generally accepted accounting principles and generally accepted auditing standards.
They could do no better than bleat tired excuses like, "It might confuse investors," or "You have to keep things simple" because investors are so unsophisticated. Another standby claims that more details in the opinion would lead to "information overload," as if financial analysts with millions at stake can't be bothered to learn more. We characterize these comments as mindless twaddle.
Our profession's long tradition of resisting change needs to end, having survived this long for two reasons. The first is the monopoly position as audit providers. The very existence of the PCAOB is evidence that the cushy past is over. The second is an almost universal ignorance among managers and auditors of basic ideas of how capital markets work. Incomplete and otherwise inferior information does not win the hearts and minds of investors, any more than "passed all courses" wins a job.
The consequences of incomplete information are uncertainty, enormous data gathering and processing costs for users, higher risk, and higher capital costs. Evidence of the stagnation created by ignorance is revealed in how little reporting and auditing have changed over the decades, even though information and measurement technologies have advanced by light years.
For example, today's depreciation practices were created before anyone realized that the universe is composed of galaxies instead of individual stars. Although astronomers (and other scientists) now make astoundingly precise measurements of various phenomena (from very large to infinitesimal), accountants still subtract a predicted salvage value from cost and divide the result by a predicted useful life. If these practices weren't still in use, they would be on display in a museum dedicated to quaint, outdated customs of the past.
Therefore, we challenge the naysayers' knee-jerk objections to replacing the current pass/fail audit report. If wisely implemented, graded opinions would provide more useful information to users while creating powerful incentives for preparers to improve their reporting quality. It would also allow auditors to add more value to financial statements, thus enabling them to earn larger fees. Despite the pessimism of so-called leaders, graded audit opinions will be a win for everyone, except those who sneak through at the bottom of the quality barrel.
What do a couple of ivory tower academics know?
Well, we've been grading our students for years, so we have first-hand knowledge both that they benefit from having feedback in the form of an independent assessment of their competence, and that employers rely on grade information to reduce their risks of making poor hiring decisions.
We also know that the supposed simplicity of pass/fail is illusory. The single critical threshold produces agony in deciding how to treat those on the bubble because the decision is for all the marbles. Furthermore, scores cluster around the bubble because human nature leads people to try to get by with just barely enough to meet the standards. Instead of freeing students from pressure so they'll do their best, rewarding mediocrity at the same level as exceptional performance encourages the former while making the latter disappear.
This behavior is not limited to the classroom, but already exists in financial reporting. Consider that the Financial Accounting Standards Board has strongly recommended that options be expensed, that the direct method be used on the cash flow statement, and that assets' market values be disclosed. Until lately, virtually all managers have just said no, and their auditors have backed them up.
So what if the opinion doesn't distinguish those who do good jobs from those who barely sneak through? The result is an incentive to do as little as possible for the lowest cost, a behavior that goes against the inarguable truth that the capital markets' craving for more information leads them to reward those who provide it and discount the securities of those companies that don't.
Of course, some argue fatuously that it won't be possible to construct a useful rating system because quality is so elusive. As we just mentioned, FASB often distinguishes between preferable and merely acceptable practices. What about giving a C opinion to companies that follow merely acceptable practices, while giving a B to those that apply some preferable practices, and an A to those that use all preferable practices? If there is a large enough incentive, the practice will be developed.
Would this system improve financial reporting? Absolutely, because preparers will respond to direct incentives to prepare more informative reports in order not just to make an A, but to access lower capital costs.
Would it be difficult for auditors? Probably not, but even if it was, so what? More hours and more expertise always translate into more fees. By adding more value, the auditors can harvest more of it for themselves.
Bottom line, everyone would win. The problem is getting people to step off the curb and join in the parade. Unfortunately, as long as knee-jerk reactions rule the day, accountants will end up as spectators craning their necks to see a financial reporting parade that has already passed them by.
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.
