REFLECTIONS ON AUDIT REFORM

The history of the United States has shown that periods of financial euphoria lead to abuses and bursting market bubbles, which then lead to auditing scandals and accounting reform. Indeed, much of the rise of the profession of certified public accounting is due to the rise of the corporate form in the late 1800s, various scandals in the aftermath of the stock market crash of 1929, and the perceived need to protect the public investor. There was also a burst of accounting reform after the market downturns of the early 1970s, and we are now going through a similar period due to the bursting of the financial bubble that ran through March 2000.

There has been much discussion lately about the lack of integrity in the accounting profession, but some of this discussion is unrealistic. It’s not that accountants no longer possess integrity but—due to changes in the profession in the past 20 years—the pressures on accountants have made it more difficult for them to stand up for integrity in accounting.

Let’s face facts. Accountants are hired and paid by the very entities they are supposed to be reporting on. The inherent difficulties of this relationship have been exacerbated by changes in the profession. In a love affair with unfettered capitalism and the desire to have free markets in public accounting, the rules against solicitation and marketing by CPA firms were struck down years ago. One results has been pressure on audit fees. When audit fees are under pressure, auditors are under pressure to reduce the most expensive parts of auditing: the testing which uncovers irregularities and the time-consuming thinking that is a basic requirement for a good auditor.

In my own locale, for example, large school districts are being charged more than $4,000 for an audit. An audit-efficiency consultant may point out that ratio analysis and some internal control work and writing up the report can be done for $4,000, but the auditor certainly won’t find anything wrong. He isn’t going to discover the 20 teachers being paid the wrong wages, by comparing percentages of gross teaching pay to last year’s levels for the entire school system. Nor will he find out whether the purchasing agent is doing his job, unless he looks at source documents. The school districts may be receiving audit reports, but they aren’t truly being audited. Reversing this problem will require government authorities to realize that ridiculously low audit fees significantly erode the watchdog effect of auditing.

Efficiency is one thing, but audit fees have been so drastically reduced by factors such as bidding and price competition that firms have been forced to think of ways to reduce the time spent working on audits. Accountants are under pressure to fit the expenses of the job into the fees they can charge.

Many of the firms involved in the continuing high-profile accounting scandals had their workpapers done by firms that easily passed peer review. The auditors probably did their jobs efficiently, but didn’t have the luxury of thinking about what might be wrong. Auditing fees should be high enough so that auditors can think on the job instead of quickly and mindlessly doing paperwork that will pass inspection.

Eliminating the rules against marketing and solicitation set the stage for a change in the culture of CPA firms. The accountants who rose to the top were those who could bring in the business, not those who took a hard line against accounting irregularities. Audits became one of many accounting “products” used to establish relationships with clients that could lead to other, more lucrative business. When the people at the top are talking constantly about growth and new markets, the young people at the bottom can read the writing on the wall. The stuffy, old, principled accountants were left in the dust by the new, aggressive marketers who can lead their firms to prominence and prosperity. Integrity was eroded, and the public was unaware of the problem. But the public has to be educated to understand that companies should be paying for auditing, not just audit reports. Auditing takes time and costs money. It isn’t always efficient, but it is worthwhile because our complex financial system cannot survive without faith in financial statements.

Partner compensation is another area in which accountants have been unfairly maligned because of unrealistic expectations. When the profession started veering toward marketing and promotion, partners who commanded greater fees and profitability demanded to be compensated for their productivity. Sounds great, but the old, patriarchal systems of partner compensation protected a partner’s income from being destroyed by losing a single large account. How can we expect a partner to stand up for audit principles when his compensation will be drastically reduced if he loses a large client? This situation certainly doesn’t encourage the critical mind set demanded of an auditor.

We’ve heard a lot of discussion recently about boards of directors and their effectiveness in monitoring their companies. Before considering this issue, you must first divide business entities into three categories: publicly traded companies, privately held companies, and not-for-profit organizations.

Publicly traded companies have many distant owners who are seldom involved in the management of the companies and who need investor protection. Someone needs to watch over management to keep CEOs motivated, by job security or self-enrichment from falsifying or distorting results. Foreign companies with American subsidiaries have the right idea: they separate the CEO from any control over the CFO, controller, internal auditing, or finance department. The American CFO reports directly to the foreign division without any influence by the American CEO. He is their watchdog over the numbers.

The way to do this for an American publicly traded company is to have the audit committee hire, fire, and control the finance arm of the company, independent of the influence of the CEO. This won’t happen if the CEO is allowed to select his own audit committee the way most CEOs select their boards of directors. When the CEO selects the board, and the audit committee is selected from the board, you’ll never have independence.

Obviously, the government can’t pay audit committee members of every publicly traded company in America. This has to be done by the companies themselves. But what if audit committee members of all publicly traded companies were selected by the SEC from a pool of qualified applicants? There are huge numbers of retired CPAs in this country who, if adequately compensated, would serve as audit committee members and watch over the integrity of financial reporting. The duties of the audit committee would be to hire, fire, and evaluate the outside auditors, the CFO, the controller, the internal auditing division, and the finance and accounting staff.

The bottom line is that as long as CEOs have the power to force auditors and finance team members to “meet the numbers,” financial fraud in publicly traded companies will be commonplace. Separating the audit team and the internal financial reporting from the control of the CEO will insulate internal and external financial reporting from the CEO’s influence.

As for closely held companies, in general, an owner will watch closely over the chief executive because the stock of the company is a greater percentage of the owner’s personal assets. Because they are not issuing stock on the equity markets, these companies get their financing from banks, which watch their borrowers very closely, knowing the potential for mismanagement and abuse.

The SEC should pay special attention to monitoring closely held companies that go public and are still run by their original owners. Former owners who are still running publicly traded companies have a natural tendency to continue treating the company as if it were their own.

Not-for-profits have no shareholders to protect, but it is in the public interest for them to have accurate financial reporting and protection from abuses by their executive directors. Every nonprofit should have an audit committee or a finance committee that functions as one. This should be spelled out as a requirement at the state level, and each not-for-profit should be required, as a part of its annual reporting, to submit a list of its audit committee members and their financial qualifications. The important thing is not to have an audit committee selected by the executive director.

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