Of Fiddlers And Tunes

After Congress passed the Sarbanes-Oxley Act last summer, the financial markets and everyone else concerned about corporate governance eagerly waited for the SEC to issue its new rules on auditor independence. When the announcements came on January 22, it should have been a climatic, post-Enron, post-WorldCom, post-Tyco event. Instead the announcements were so insignificant as to pass unnoticed by the financial markets and business press.

The trade press, for its part, gave some coverage to the possibility of a “spill-over” effect on the restriction of services, but at this juncture arguing about the scope of services seems irrelevant. The time was right and the need was great for a new way of thinking about the entire relationship between auditor and client. Fine-tuning the existing rules and structures was not enough. It’s time to take a new look at the very nature of this relationship.

Given the financial scandals and poor market performance over the past year, a bold move to restore public confidence in audited statements and enhance real independence of the audit profession is sorely needed. Healthy financial markets rely on a foundation of confidence and trust in the results reported by listed companies and in the efficacy of the audits of those reported results. Many factors have contributed to the markets’ dramatic declines, but one major factor is the loss of investor confidence in corporate governance, the reliability of corporate annual reports, and external auditing.

We hope the Public Company Accounting Oversight Board (PCAOB) does well, but we are not optimistic. Too much of what we see and hear suggests that the PCAOB will oversee the status quo, but true independence cannot be achieved by simply creating more independence rules or writing interpretations of existing rules.

It has been axiomatic that auditors are to conduct audits as the investing public’s informed, inquisitive, independent agent. Historically, public companies have solicited, selected, and paid the external auditor who performs its mandated audit, and the inherent conflict in this arrangement has been understood from the beginning. For a very long time, the professionalism of individual auditors was relied upon as the last line of defense against a client’s exploitation of the accounting rules, and outright fraudulent behavior. Everyone has assumed that the professionalism of individual auditors would enable them to manage the inevitable pressures that arise as they worked to provide top-grade service to their clients within the spirit of the standards of their firm and the profession.

The events of the last several years suggest that for some auditors those pressures have grown past the tipping point. Some audit partners have done their job and stood tough in the face of client pressures. Many have correctly understood the requirements of the profession and their firms, but some audit partners have lacked the fortitude to stand up to their clients, and some have misunderstood their client management role. What the failures of those individual audit partners have cost their firms, the profession, and the financial community is staggering. The occasional scandal might be excused as an exception to the norm, but these last several years have seen a series of disasters. We are clearly in a different world, where the pressures being brought to bear on the practice of auditing preclude our continued reliance solely on the professionalism of individual auditors, or on a new set of independence rules. The cost to the profession and to the financial markets is too great to justify reliance on a historical model that may be out of date. We need to look at the structure of the relationship between the auditor and client.

An enduring and well-known payment principle was established in the early 17 century: “Who pays the fiddler, calls the tune.” We believe investor confidence in a company’s reported financial results can be greatly enhanced by changing who calls the tune, and to do that, who pays the fiddler must change as well.

The Sarbanes-Oxley Act, the SEC, and the NYSE have sought to change the relationship between the auditor and client by giving the audit committee of a company’s board of directors a more central role and relationship with the external auditors. We believe that this is a naïve hope and will result in further dashed expectations. With all the talk of having the audit committee “hire” the auditor, no one has talked about how fee disputes will be settled, how scope questions will be answered, or how reporting and disclosure debates will be resolved. Corporate audit committees will turn to management for help in resolving such critical questions. The audit committee is a company-centric body that must work closely with company management. More responsibility on the audit committee might result in a few more company hands on the fiddle, but the tune will substantively remain the same. This needs to change.

For over a year now the authors have asserted that shareholders need to call the tune because the audit is conducted for their benefit. Given the dispersion and transience of stockholder interests, some might say this is impossible, but we disagree. Because shareholder interests coalesce in the stock exchanges, we recommend that the exchanges hire and compensate the auditors who audit their listees’ financial statements. Such an arrangement would better align the interests of shareholders and auditors, enhance corporate governance, and bolster the confidence of the financial community.

An appeal process would be needed for those companies that are unhappy with a decision of the audit firm. Those appeals might be vetted by a subcommittee of the AAC, or of the exchange’s board of directors. Registered audit firms would be subject to a quality-review program, probably set up under the purview of the PCAOB.

It isn’t too late for the SEC to make such a bold move. Raising a company’s stock exchange annual listing fee to include an amount for the external audit would be a powerful, recurring reminder that a significant public trust is present and that careful stewardship of that trust is warranted. We believe it’s better for those costs to be incurred as an assessment levied by the stock exchanges, from whom the company receives the benefit of a public listing, rather than as just another vendor’s bill.

Given the trauma our financial markets have suffered because of a variety of accounting scandals and audit failures, and given the ever-increasing complaints about how corporations are governed, it is imperative for the stock exchanges to adopt a more proactive role on behalf of investors who purchase the shares of companies they list. Only by changing who pays the fiddler can there be a different tune called, one that has the best chance of providing a strong foundation for the rejuvenation of trust in the financial statements and corporate governance of the companies in which most Americans have a financial stake. We add our voice to an
isolated few, and we urge the SEC and the exchanges to take this additional step.

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