With few exceptions, we don't write much about auditing; however, we're seeing a troubling situation and some opportunities, so we're sending an open memo to chief executives of CPA firms of all sizes.
OVERHEATING ON CONVERGENCE
First, we suggest it's time to temper your enthusiasm for International Financial Reporting Standards as a replacement for GAAP. Hardly a day passes without a gushing e-mail claiming that IFRS is coming and GAAP is going away. We've seen faculty grants to revamp courses and new textbooks with expanded IFRS coverage and breathless enthusiasm.
On the day we started this column (July 28, 2009), PricewaterhouseCoopers sent a mass e-mail to accounting professors that came across as warning them that the firm won't hire students unless they toe the convergence line. This message was not well received by our colleagues because it intrudes into curriculum design.
Coincidentally, we also received a report on the same day from the Financial Crisis Advisory Group of the International Accounting Standards Foundation with future recommendations including, you guessed it, convergence. In this case, however, the group tried to cool everyone's jets by first suggesting convergence will best occur when the Financial Accounting Standards Board and the International Accounting Standards Board produce common standards, and then acknowledging that the IASB is not ready to be the sole standard-setter because it lacks political strength and independent funding.
In assessing your irrational over-exuberant support, we offer three hypotheses.
First, perhaps we don't fully comprehend the advantages of switching to IFRS now. (Note: It wouldn't be "convergence" if FASB and GAAP were to be summarily tossed overboard. Because FASB and the IASB are creating joint standards, allowing IFRS to be used in the U.S. would be an abrupt and unwise abandonment of this collaboration that has bolstered both entities in their efforts in reforming accounting standards and has the greatest potential to create more progress.)
Second, perhaps you've overlooked the new Securities and Exchange Commission's reluctance to advance the agenda pushed through in the waning days of the chairmanship of Christopher Cox. Even President Obama's recent wide-ranging plan for stronger regulation only tepidly endorses convergence, without suggesting that the IASB be the only standard-setter.
Third, it's possible that you realize the political momentum behind abandoning GAAP has stalled, so you're trying to revive it by convincing everyone they'd better get on board the IFRS train.
If the first hypothesis is correct, we'll admit we're wrong and support whatever system emerges as dominant, but we'll not stop criticizing weak standards. (However, we're still waiting to hear anyone offer anything but platitudes for explaining why the IASB going it alone would be better than working alongside FASB.) If the second hypothesis is correct, then your enthusiasm should be redirected toward improving GAAP (and IFRS) by working with both boards on their joint projects. But if the third hypothesis is correct, it's possible that you're misleading people toward believing what is simply not true.
THE FOUR E'S
We now offer some observations and an opportunity concerning your strategy for supplying attestation services. We offer up these four "E" alternatives: exploitation, enforcement, enablement and enlightenment. The choice among them shapes how your firm performs audits. It also drives the value created by your efforts and your resulting rewards.
* Exploitation. One possible explanation for your firms' behavior in performing audits is that you're exploiting your statutory monopoly advantage to enrich yourselves. Ultimately, this strategy is not good for anyone, including you, because it keeps useful information out of financial statements.
Readers may recall a recent column that quoted a practitioner, Jeff Koch, as being highly in favor of value-based reporting. In response, we received a bitter and callous letter from an auditor staunchly defending cost-based balance sheets as the best defense against litigation filed by what he considers to be less-than-intelligent bankers. It never occurred to him that his preference for cost measures doesn't help his clients, their lenders, and the rest of the capital markets and society at large. It was all about him.
Even though this attitude doesn't characterize all auditors, we think it's time to root it out and move on. So what's in this change for your firms? How about greater income for you because your services would actually create real value for your clients, instead of being mere exercises in minimum compliance that don't help anyone very much?
* Enforcement. Under an enforcement mindset, your audits focus on whacking clients for not meeting standards, regardless of the information's quality. This "check the box" attitude causes your people to miss the bigger goal of helping clients provide capital markets with useful information. That is, standards exist only to define your testing criteria. No one's in trouble if they meet minimum requirements, even though the markets aren't well-informed or efficient. It seems to us that management is the primary beneficiary through relief from regulatory action, but users are left unserved and with no recourse against you or management.
Your future profit prospects under this strategy aren't great. In fact, absent statutory requirements for audits, management wouldn't need you at all. As it is, they do the next best thing by frequently seeking new bids to cut their costs. Because enforcement-driven audits create such limited value, who can blame your clients for doing that?
* Enablement. Under the enablement strategy, an audit firm helps client management present the ostensibly best possible appearance while complying with standards. As examples, we point to the virtually unanimous rejection of the recommended practice of reporting option expense before it was required. Another is your assistance to clients for creating GAAP-compliant but totally misleading off-balance-sheet financing arrangements, most notably operating leases and derivatives.
In effect, enablement involves colluding with your clients to misinform the capital markets. Ironically, this means your services are most valuable to your clients if their reports do not contain decision-useful information. This bizarre twist would make Machiavelli proud.
While you may earn more revenue by "helping" your clients play the game, your efforts are transparent to the markets. Further, the resulting uncertainty (and distrust) means they impose higher capital costs on your clients, instead of the lower ones they seek.
This longstanding strategy is lose-lose-lose because it suffocates your ability to add real value to your clients' statements by reducing risk for users.
* Enlightenment. Because it runs counter to the conventional ideas described above, the enlightenment strategy hasn't been generally identified, much less given wide consideration.
In brief, pursuing it would have you collaborate with clients to exceed minimum reporting requirements in order to reduce users' uncertainty. Mere compliance with GAAP (and IFRS) can never be enough because they are too politically compromised and outdated.
The outcome would be greater reporting quality because clients would choose preferable alternatives and, more important, voluntarily provide supplemental information that users want but aren't getting. One example would be eschewing off-balance-sheet financing through bogus operating leases. Another would be using the direct method of reporting operating cash flows. Still another would be disclosing fair value information for all assets and liabilities. Yet another would be reporting more frequently than once every 90 days.
Unlike exploitation, enforcement and enablement, the enlightenment strategy creates real value by allowing users to make decisions under less uncertainty. Your real contribution would be more efficient markets with lower capital costs and higher security values by reducing users' risk. (There is much trustworthy evidence that high-quality reporting produces lower capital costs, so this strategy seems worthwhile. In contrast, little, if any, compelling evidence shows that the present approach to convergence produces any benefits whatsoever.)
Bottom line, your audit opinions would assure users that statements are not merely in compliance but also fully dependable. Their greater usefulness would surely multiply your revenues and produce more personal satisfaction for your people because their efforts would actually make things better for everyone. As for your litigation exposure, all you have to do is be sure that the statements reflect honest efforts to tell the truth.
CONVERGENCE REDUX
If you're still sold on convergence, please stop thinking of it as happening between GAAP and IFRS. Instead, pursue the enrichment strategy to converge reported information on the capital markets' wants and needs. If you want to serve this goal, don't hire or promote people who cling to the status quo, but find those who are willing to persuade clients that more useful reports are more valuable despite costing more.
In short, we're encouraging you to think differently because we envision no prosperity for auditors in an unchanged future. Today's weak standards certainly don't bring out the best in our profession or provide its hardworking members the compensation and satisfaction they deserve but can't earn.
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
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