We recently realized that it's been a while since we dedicated a column to auditing. Even though some things have happened in this area, we just haven't had the heart to write about them.For example, it's been some time since the Public Company Accounting Oversight Board took over the task of defining auditing standards. While this development is important for directly increasing the credibility of audits and indirectly increasing the credibility of audited financial statements, we find ourselves suppressing a yawn.
We have also noticed efforts on the PCAOB's part to rein in excesses of non-audit services offered by auditing firms, including, but certainly not limited to, tax consulting. We're not sitting on the edges of our seats out of excitement about this development either.
Then there are the growing Sarbanes-Oxley responsibilities for assessing and certifying internal controls. This development is positive, and much good has already come from forcing managers to spend time and money on potentially getting more useful information to the capital markets. We even like the resulting stimulated demand for accounting graduates. But are we ready to write a column on those things?
So, what is it that has put its death grip on our creative juices? What has caused our hands to lock up as they approach the keyboard? Just what has given us this severe case of writers' block?
In fact, there are a couple of issues. One concerns the fee structure, and the other is a more fundamental complaint about the objective for audits in the first place.
The fee structure
Much ado has been made about potential and apparent conflicts for auditors created by non-audit fees, whether large or small, coming from their clients. When money comes to you from a particular source, it is only natural to want to ensure that the source is satisfied so that you can maintain your access to the funds flow. If there are individuals who can overcome this tendency, we believe they are relatively few. And who is to say who they are? Without some solid evidence that there is no conflict of interest in a specific situation, it is only prudent to assume that it does exist and act accordingly.
Only by an extreme force of will have the profession's critics and overseers been able to reduce the scope of non-audit services provided. We recall that in the days preceding Enron and WorldCom, the Securities and Exchange Commission held hearings in Washington, in which representatives of several of the largest auditing firms actually claimed (with straight faces) that rendering non-audit services actually increased audit quality.
While clamping down on non-audit services is a positive development, we wonder why this line of inquiry is not extended further. In particular, we have pondered why no one seems to be concerned about the compromised quality of audits that are paid for by those who are being audited.
That is, if we were financial statement users, we would attribute little credibility to today's audit opinions. We would not be sufficiently credulous to buy into the notion that most auditors can look their clients in the eye and say "no" on hard issues. We've seen too many cases where auditors have caved, and even more where auditors have brought slick schemes to their clients' attention and offered to implement them. We also believe that very few clients are willing to pay audit fees without expecting their needs to be served by those who receive them.
Our bottom line is that however much auditors might believe that they are invulnerable to temptation to support their paying clients' interests, we doubt that many users completely trust auditors' opinions.
The typical response to this observation is a snarling jeer, "Well, how would you have the auditors be paid?" We have some ideas, but our words are wasted until the profession comes to grips with the idea that the existing fee structure is so questionable that it impairs the ability of audit opinions to reduce users' uncertainty.
The objective of audits
As destructive as the fee structure might be, it pales in comparison to the issue that surrounds the objective of audits. By even raising this question, we surely face the wrath of auditors who have prospered under the existing system. We ask them to hold off until they've at least read what we have to say. Where we're headed actually has the potential to bring them even more prosperity, if they would have the courage to disengage from the status quo and decide to add real value to their clients' financial reports.
Here, then is our issue: Just what is the point of producing an opinion that a set of financial statements are prepared in accordance with generally accepted accounting principles?
There you have it. We're back to the point we continue to make: GAAP is not good enough to create useful information that serves financial statement users' needs for predicting future cash flows and estimating companies' intrinsic values.
Hopefully, we don't need to rehearse the point that accounting standards emerge from a political process that leads to compromises that take away any usefulness. How can there be any predictive value in numbers rooted in historical costs and systematic allocations that ignore or even contradict observable reality? How can there be any predictive value in systems that manipulate items on the income statement while omitting others? How can there be predictive value in systems that write assets down to market but not up? How can there be any usefulness in principles that give managers total discretion? Or, how can there be any usefulness in standards that are outrageously obsolete?
Here is our thesis: As long as the objective of audits is to verify that statements are prepared in accordance with GAAP, and as long as GAAP is guaranteed to produce information that lacks decision usefulness, then all that audits accomplish is confirmation that those statements are not useful!
If so, then what is the point? Why would society preserve a system that basically makes managers give money to their auditors to confirm that the statements are pointless? We can find no worthwhile public policy that is advanced by this mandatory redistribution of income to auditors.
The way out of this spiral
We're not ready to close, although we think the above point is enough to justify this column. Rather, we offer a new direction out of this spiral, in which auditors earn less and less because they are adding less and less value to financial reports.
The key to escaping is to quit asking at the end of the audit: "Do these financial statements comply with GAAP?"
Instead, a new world opens up if these two questions are asked: "Do these financial statements provide useful information?" and "What can be done to make them more useful?"
The old question is rooted in the preposterous assumption that mere compliance with GAAP is enough to make statements useful. It just isn't so! Also inherent in the question is the equally preposterous assumption that managers will reap lower capital costs without providing information that users need to make rational decisions.
Instead of considering GAAP to be the maximum that has to be done, it is more productive to consider those principles to be the legal minimum. Can you imagine what houses would look like if they were built only to meet local codes? Or if cars were designed to meet minimum federal standards? In both industries, suppliers have determined that money can be made by going beyond mandatory minimums to satisfy customers' demands. We think managers and auditors ought to be capable of shifting to that paradigm.
If company managers were to choose to go beyond the minimums and actually provide useful financial information, they would reduce uncertainty for investors, lower perceived risk, and reduce users' information-gathering and processing costs, thereby bringing down their capital costs.
As for auditors, going beyond the minimum would create real demand for real attestation of real information. As a consequence, the value of their services would blossom and they would enjoy greater prosperity.
So, until the auditing profession comes to grip with its dismal present and shows any interest in thinking anew, we guess we're just not going to write too much about auditing.
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 email@example.com.
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