Audit Contracting Entities: Organizations That Might Change Everything

By John W. Berry

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The audit contracting entity (ACE) is not a single organization but a type of organization. If and when ACEs are introduced, they will number in the thousands, one for every sizeable corporation that is audited.

What Is an Audit Contracting Entity?

An audit contracting entity (ACE) is an organization independent of management that takes the place of the board of directors in selecting, monitoring, and compensating a company’s auditors. In pursuit of independence, the history of auditing has in some respects been one of kicking corporate responsibility for monitoring audits farther up the ladder of corporate management. The problem is that no matter how far up the responsibility is moved, it is still management.

Few people conversant with modern auditing would disagree that, in an ideal world, management should not be in a position to influence or control the auditor. During the recent crisis, it has been proposed that the stock exchanges select the auditors for their listed companies. From an independence standpoint, this arrangement makes sense because it removes management from the equation for audit contracting purposes. The stock exchange proposal has never been seriously considered, probably because it would result in “one-size-fits-all” audits that would ignore the subtleties and nuances of the individual corporations being audited.

The ACE system falls somewhere in between the stock exchange contracting proposal and the current system. Proponents of the ACE concept recognize that selecting auditors should not be a function of management at any level. Yes, the directors should hire executives and set policies and procedures for preparing the corporation’s financial statements. But ACE proponents hold that if the purpose of auditing is to perform an independent review of the statements for the benefit of outsiders, then management should not be able to influence or control that process.

Relevant Outside Interests

ACE proponents would identify relevant outside parties that should control the audit process as stockholders not affiliated with management, the company’s bankers and lenders and other creditors, and potential investors and creditors and their representatives in the credit-rating and analyst fields who depend on the statements.

The system does not work that way now because, prior to governmental regulation of companies in Great Britain and the United States in the 19th and 20th centuries, corporate management had unlimited control over access to its books and facilities. That control gave management an absolute veto over whatever auditing system might be adopted. Add the fact that outsiders with an interest in the audits had a range of interests and it should come as no surprise that the process had been left in the hands of management insiders. Much of that has now changed. Power has shifted dramatically away from management. Unfortunately, that power has shifted not to the relevant outside interests, but to the regulators. That power is being exercised to increase the pervasiveness of regulation and enhance government bureaucracy rather than to excise the impedimenta of management at the root of the problem.

The ACE system would effect the needed change in control over the audit process by selecting representatives of those relevant outside interests and putting them in charge of that process. ACEs would likely emerge at the state level because states control the incorporation of companies and the accreditation of professions.

To forestall the possibility of ACEs becoming subservient to the organizations that bring them into being, the manner of selecting the members of the ACE boards would have to be objective, such as random selection from authorized pools. In New York, for example, the legislature could make ACEs available through the State Comptroller’s office, which would guarantee that the selection was conducted free of bias. The legislature would set the criteria to be applied to a request from a corporation for the establishment of an entity on its behalf. In carrying out its function, the State Comptroller’s office would prepare generic charters for such entities and make them available for corporations to use. Other charters could be made available from independent organizations that sponsor the establishment of ACEs.

Typical ACE Operations

A typical ACE might have a seven-member board with staggered seven-year terms: three members selected at random from a pool of stockholders not affiliated with management; a fourth from a pool of bankers; a fifth from a pool of bondholders; a sixth from a pool provided by pension funds; and a seventh from a pool provided by mutual funds. The number of members and their terms would vary across companies, and the makeup of the pools and the method for authorizing them would be set by ACE legislation.

A corporation could elect to use an off-the-shelf ACE or propose one of its own. If a corporation provided an entity of its own makeup, the designated state regulator would apply the criteria set by the legislation and approve or disapprove it. Thus, management would have input into the composition of the board (the interests to be represented) but not the actual selection of board members. The regulator’s role would be limited to determining whether the composition of the board was appropriate in representing the interests of those who rely upon the audits; it might also supervise the initial process of selecting board members to ensure that the board is free of outside influences. Once established, the entities could oversee future selection of board members. They would do so in accordance with the random-selection processes provided for in the legislation and subject to monitoring. Entity boards chosen in this fashion would be independent not only of management but also of the organizations that established them, and they would represent the interests of those who rely on the corporation’s financial statements.

After an entity is established (probably in the form of a special public corporation), the members would meet, organize, elect officers, set meeting dates, solicit bids for audit work, select the auditors, contract for the audit, and monitor audit work. Management would have the right to challenge actions of the entity that it believed were not in the best interests of the corporation. It could do so by legal action or by appeal to a vote of stockholders not affiliated with management.

Implementation Issues

While the decision to establish an ACE would be voluntary, the parties that rely on the audits might insist on it. For example, the SEC could set a policy requiring that registered companies adopt the ACE method. It would be in the interests of stockholders, who have traditionally been passive when no opportunity was available to install this type of oversight.

The composition of interests represented by the entities would evolve over time to fit the purposes of the audits. Management would tend to favor stockholder majorities to ensure that cost was a significant consideration. Bankers and other creditor interests and rating agencies might tend to favor nonstockholder majorities. The SEC might develop a set of characteristics that it would prefer or require. Whatever the ultimate makeup of a particular ACE, it would necessarily be more independent than a board representing solely management interests.

ACEs’ operating expenses would probably be paid for by the corporation, although those costs could theoretically be covered in some other way, such as through a charge against stockholders or a regulatory fee. Determining the remuneration for board members might involve a provision in the entity’s charter tied to objective yardsticks, such as the corporation’s revenues, the number of employees, and similar elements. Special cases might require a court proceeding.

While the overall cost to society of maintaining ACEs would exceed the current costs of monitoring audits through boards of directors, the boards would be relieved of this responsibility and their remuneration could be adjusted accordingly, partially offsetting the cost. Compared to the hundreds of billions of dollars lost to audit failures over the last few decades, the cost for maintaining the ACE system might be a bargain.

Short-Term Effects on Routine Activities

In many cases, audits conducted under ACEs would be virtually undistinguishable from those conducted under the board of directors system. Where earnings and solvency are not especially critical, and management is not under inordinate short-term pressures, auditors are accepted as outside experts and independent advisors whose judgments management respects and accepts regardless of the potential bottom-line impact. Auditors would be less inclined under the ACE system to defer to management in minor matters, but the relatively independent working relationships they are accustomed to would be maintained and the final audit results would be identical.

A person unfamiliar with auditing might then ask, “If in many if not most cases the results will be the same, why bother setting up the ACE system?” The answer is that auditing is essentially about the exceptions. While it is not unreasonable to assume that in most cases management’s statements are correct, outsiders want auditors to sort out the few bad reports from the vast majority of good ones.

The same tendency of auditors to be less deferential to management in an environment free of undue pressure on management will have a profound impact in other audits where those characteristics are not present. In an Enron or WorldCom, the audit contracting entity will have maximum impact. Free of the pressures that management might otherwise exert, auditors will be able to go about their business. In some situations, auditor independence would be carried to a counterproductive extreme and management would be plagued with frivolous complaints. This possibility should be weighed against the extraordinary damage to the financial markets arising from the scandals already a matter of record, and the loss of credibility those scandals entail.

Long-Term Effects

Once ACEs are firmly established, the short-term change in the auditing environment will grow into a longer-term change in the auditor mind-set. In persuading management to engage them for their audits, auditors must now emphasize the positive service aspects of their relationship to management rather than the benefits of independence. Persuading an ACE to engage a firm for an audit is a different matter. In dealing with an independent entity anxious to uncover any misrepresentations, the auditing firm will be inclined to point out situations where the firm uncovered misstatements or misleading statements, or its ability to ferret out fraud, especially management fraud.

This perspective will tend to drive the auditing firm at every level. Within the firm, that perspective will show itself in the treatment of colleagues and employees. Those who uncover errors during the audit will be improving the image of the firm in the eyes of the ACE client, and they will be rewarded.

Another long-term effect is the potential development of a more concrete institutional form to represent investors’ interests and the gravitation of auditors to the center of that institutional framework. Although auditors have always had the skills, knowledge, and access to take the lead in representing investor interests, their relationship to management has (not unreasonably) resulted in their being viewed as in management’s camp. With the freedom of action that ACEs will give them, auditors will more likely be recognized as the ideal party to articulate investor concerns. ACEs will play the leading operational role in their function of selecting, monitoring, and compensating auditors; however, they will do so because of the independence they bring to the function, not because they will necessarily bring any profound knowledge of financial concepts in general or any in-depth knowledge of a corporation’s financial condition. Lacking the expertise that auditors bring to their function and the specific knowledge that an intensive examination of the company’s records and procedures entails, ACEs will have to defer to the auditors in the broader scheme of elaborating investor interests. We can expect the SEC to continue in its role of looking out for investors’ interests with respect to SEC-specific legal compliance issues, but once an ACE system is well established, an organization like the SEC would probably assume a more supportive role, because the auditors will be doing the SEC’s work on the front lines, where they have constant, direct access to corporate management, records, and facilities. Auditors would move to the forefront in ensuring appropriate financial reporting and would become the focal point in the expression of investor interests.

Many observers have bemoaned the fact that auditors performed nonaudit services for companies, under the theory that nonaudit services income tends to corrupt auditors. This argument holds some truth, but it ignores the fact that the income from the audit itself has an even more direct potential for corrupting the auditor. Whether the ACEs decide to limit the nonaudit services performed by auditors or not, the amount of work auditors would do under the ACE system would probably increase substantially. ACEs would undoubtedly turn to auditors not only to audit their corporations’ financial statements but to investigate other matters of direct interest to stockholders and of collateral interest to bondholders, bankers, and others. There is reason to believe that the amount of auditing work required of auditing firms would at least double because of the need for more reliable, objective information concerning major operations and acquisitions.

Management might resent the introduction of ACEs, as it would be natural for any group to resent the loss of a prerogative to which they are accustomed. Ultimately, though, management will probably adapt positively to the new paradigm. Management should eventually appreciate being freed from a conflict-laden responsibility that has brought them much grief. They should also enjoy the greater weight that will attach to a “clean bill of health” from auditors over whose selection they had no influence.

Potential Impact on Auditing Concepts

Some changes that might occur would be mundane on the surface but fundamental in their implications. For example, to whom is the audit opinion letter to be addressed? The board of directors? Probably not. The opinion would presumably be addressed to the entity commissioning the audit and to which the auditors report.

As for testing, the present system may have been subconsciously tailored to provide justification for prospective failures. The range of industries over which failures have occurred and the range of major firms that have been implicated indicate a more general flaw with the design or application of major testing procedures. As for the degree to which internal control testing has been emphasized over substantive testing, this move toward the abstract may represent an unconscious search for a safe harbor in situations where auditors may be ambivalent about discovering exceptions. Something like this may have been involved in a recently reported major audit that did not uncover a $300 million overstatement of cash.

Another area that might come into the spotlight is the performance of sample testing at the expense of judgmental testing. The advantages of sample testing in quantifying and comparing particular tests are well known. But what about the auditor’s skills, honed through years of experience and involving more variables than any computer could process? The dividing line between areas subjected to judgmental testing and those where sample testing is being used may need to be redrawn.

As for peer review, which many observers herald as a cure-all, its operation might have a sinister aspect. For example, a lone holdout among the Big Four against what it perceives to be a poor testing approach could be brought into line by “peer pressure” through peer review. And if that could happen, what chance would midsized firms or sole proprietors have to resist standards set by the larger firms and, ultimately, the profession? Could peer review have the paradoxical effect of being a mechanism for enforcing a descent toward the lowest common denominator?

From an outsider’s standpoint, perhaps the most significant overall difference between auditing under management oversight and under ACE oversight is that in the latter context auditors will be more inclined to view the substance of financial statements over their form. If management attempts to stretch a particular rule to fit its predilections, an auditor operating in an ACE environment will probably be more concerned with the impression the presentation leaves on the reader than with whether a particular rule is technically acceptable.

There is also the matter of the systematic study of audit failures. It is one thing to read about an audit failure in the newspapers and have the auditor involved punished by the courts. Having such audits formally studied by auditing experts with a view to assessing the causes of those failures is another matter. Would accountants, with the financial community’s endorsement, support a system for monitoring audit failures where such events would be formally reviewed by an independent group charged with establishing the failure’s causes?

These and other questions about testing might well be raised when a profession that has plodded along with testing standards that are themselves fairly resistant to testing becomes confronted with an environment where firms openly compete to demonstrate the superiority of their testing approaches. The result might be a ringing endorsement of present standards; then again, it might not.

Thinking the Unthinkable

The ACE concept allows us to expand beyond the strictures of our current conceptual framework. Under ACEs, would the financial community and auditors themselves come to see the auditor’s role not as one of verification, but as one of preparation of statements using management’s as their guide. This is a radical change in a theoretical sense, but it might not differ much from how statements are often prepared in the real world. In the process, the concepts of qualified and adverse opinions would be left behind. The financial community would probably be inclined to give greater credence to statements independently prepared by auditors than to those issued by management.

If the statements were issued by the auditors, would they still be “fairly presented”? If one is examining someone else’s statements, it might be reasonable to use the expression “fairly” to indicate that a particular presentation is an acceptable one among a number of reasonable interpretations. If, however, the auditor prepares the statements and has concluded that they accurately depict the company’s financial situation, it may be more accurate to describe the presentation as “correct” or “appropriate” rather than merely “fair.” If the auditor prepared the statements, they should reflect that auditor’s best possible interpretation of the underlying financial activity rather than merely a fair choice among many.

A further fundamental issue could also be raised by ACEs. Whether one is expressing the opinion that statements are “fairly presented” or “appropriately presented,” the affirmative opinion itself implies a lengthy and complex mental process. If such is the case, can the opinion really be a collective process? Can a firm really speak of “our opinion”? The procedures followed by the designated decision-maker can be reviewed by peers at the firm as to their form, but the substance of the opinion is necessarily limited to that particular person. Under the circumstances, if the ultimate responsibility for preparing the financial statements moves from the entity being audited to the audit firm, identifying the particular person who makes those decisions becomes important. At some point it may seem more precise to have the auditor in charge formally identified and required to sign the report, with the auditing firm recognized in a supporting capacity. Of course, the current wording could be abandoned in favor of wording stating that nothing had come to the attention of the firm to indicate that the statements were not fairly or accurately presented, but that would not be an affirmative opinion.

Other questions could be raised with regard to legal liability and professional ethics. Would the legal liability applied to audits change from fraud to negligence? Might the legal liability of an auditor for an audit failure be limited by legislation in a situation where a systematic study of that failure, endorsed by the state regulator, showed that failure was due to causes beyond the control of the auditor? Furthermore, would auditor ethics need to be completely rewritten? Would the end product look more like attorneys’ ethics than what we are accustomed to?

Awakening the Sleeping Giant

The auditing profession has fallen into disrepute because of the series of scandals that has recently plagued it. These scandals can be viewed as resulting primarily from ethical failures on the part of individual auditors. But the ethical failures must be judged within the broader framework of how the institution is organized. We must ask ourselves whether auditors in general are being put into situations that are a slippery slope into ethical lapses. Forced to choose among dauntingly abstruse economic concepts, with a wide range of reasonable interpretations available, and knowing that one’s standard of living may rest on a decision that upsets client management, a formidable trap awaits. Is it reasonable to set a standard of such heroic proportions? And does such a standard merely have the effect of clearing the path to the top for the least scrupulous and the most morally indifferent? Is something more fundamental afoot?

In the broad institutional sense, the root cause of audit failures may be viewed as arising from a serious flaw in the institutional structure in which auditing operates. Within that structural framework, the operating mechanism that governs the auditing process is the auditor-management relationship, in which the operating interests of management are represented while those of unaffiliated stockholders, bondholders, bankers, creditors, and prospective investors and creditors are not. This misalignment of interests at the operational level is a serious flaw that might be the root cause of not only recent problems but also those that have plagued auditing since the beginnings of modern auditing in England and Scotland early in the 19th century.

In that context, it is interesting to read the minutes of a meeting of the Scottish Institute, as reported in The Accountant on June 26, 1897. All of the participants that responded to a paper presented at that meeting on the subject of independence took the position that as auditors they lacked independence because they were beholden to the directors who chose them and compensated them. One participant declared, “Under the present system, the independence of the auditor is a mere farce … although many shareholders imagine they appoint the auditor—[laughter] he [is] the nominee of the directors and under the control of the directors.” Another said, “It [is] perfectly plain that even the most conscientious auditor, whose appointment lay in the hands of the directors, might allow certain things to take place which otherwise would not take place.” Clearly, the problem that brought Andersen down is not a new one.

The ACE system deals with the independence problem by installing an operating mechanism in which the relevant interests are properly aligned. The practical impact is that auditors are given incentives that directly encourage them to uncover false and misleading assertions and to verify ones that are true. Auditors are still called upon to act in an ethical manner, but they are not asked to choose between maintaining their ideals and maintaining their careers.

It has been argued pessimistically that auditors are a dying breed on the brink of irrelevance. That is a depressing commentary on how things have been allowed to deteriorate, considering that auditors enter the profession as the best, the brightest, and the most idealistic. But it is not surprising, given auditors’ relationship to management, because as that relationship develops, these brilliant minds become trapped in a competition to accommodate management, a competition to reach the lowest common denominator. No wonder the auditing profession has stumbled into failure after failure. If the stranglehold that management has over auditors can be broken, just the opposite might occur. The slumbering giant might awaken. The auditing profession might throw off its shackles and take its place at the forefront of the financial information industry, protecting the vital interests of investors and other members of the public in the process.