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Jan 1994

"In the public interest" - is it enough? (recommendations of the Public Oversight Board)

by Knutson, Peter H.

    Abstract- The Public Oversight Board's (POB) proposals for improving the standards of financial reporting fail to effectively address the inherent problems of the accounting profession. While the POB's recommendations can be useful in tackling existing problems in the audit process, they are nevertheless flawed since they sidestep the real issues that have led to public skepticism about the profession's effectiveness in deterring fraud. A more constructive approach to filling the expectations gap would be to reverse the Federal Trade Commission's (FTC) ruling on the need for economic competition within the accounting profession. This FTC ruling is largely responsible for the current audit crisis since it has led to the destruction of the crucial balance that has long kept the relationship between auditors, clients and users of financial reports on an even keel.

The Public Oversight Board (POB) has produced a report that obviously is complete and well considered. All the recommendations are eminently sound and effectively address current concerns about the accounting profession. There is not one with which I can find fault.

My concern is that all the recommendations are like placing more bandages on an ailing patient. They are only a stopgap until diagnosis and treatment can begin. Furthermore, the volume of bandages on this patient, the accounting profession, has become so great they threaten suffocation. What I propose is to offer at least a beginning of diagnosis and some suggestions for potential courses of treatment.

What Ails the Accounting Profession?

Let's start with the so-called expectations gap. It is the difference between the quality of the profession's performance, its objectives and results, and that which users of financial statements expect. As a matter of fact, it arises from a combination of excessive expectations and insufficient performance. Users of financial statements and auditors contribute to the malaise.

I speak primarily on behalf of professional users of financial statements, financial analysts, money managers, lenders and others who earn their living by providing capital to business enterprises. These are people who invest with the goal of maximizing return while at the same time minimizing risk. They should understand the basic tenet that risk and return are positively correlated. High returns engender high risks and high risks require high returns; low risk is similarly correlated with low returns. Investors and lenders must be willing to accept the consequences of their risk-taking. They must be willing to accept the bad as well as the good. As a professional, I am often offended by litigation that stems more from bad outcomes than bad practice, that results from the mere fact that a stock's price declines unexpectedly or a loan becomes uncollectible. These are not proper bases for legal action and they should not be tolerated.

On the other hand, investors and lenders have the right to assume an auditor's report means what it says. That is, the auditor has performed a professional examination that gives reasonable assurance that an enterprise's financial statements are fairly presented and free of material misstatement. The accounting profession and the POB seem to concur that the auditor is not expected to discover certain forms of management fraud. I respectfully disagree. In my opinion, the discovery of management fraud should be at the top of any auditor's agenda. Furthermore, admittedly with the benefit of hindsight, we see some management frauds so huge an outsider cannot help but wonder how they could have been missed. I refer to matters such as inventory being transported down the New Jersey Turnpike from location to location to be counted several times, missing inventories totalling tens or hundreds of millions of dollars, fraudulent revenue recognition, and so forth.

In its report, the POB states an independent auditor cannot be expected to uncover fraud. In that case, perhaps the words of the auditors' report should be replaced by the words of the report of a limited review. Instead of saying:

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of XXX Company as of (dates), and the results of its operations and its cash flows for the years ended (dates) in conformity with generally accepted accounting principles.

The report should perhaps state:

Based on our reviews, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with generally accepted accounting principles.

The latter, not the former, appears to be the level of assurance the accounting profession wishes to provide.

Could, Should, or Would

The point can be amplified by use of the phrases "could have known," "should have known," and "would have known." They may rhyme, but the subtle differences in their meanings give substantially different perspectives on the responsibilities of auditors for the detection of fraud. The following list sets forth their differences and suggests the fairest standard is to hold auditors responsible for what they should have known.

Could Have Known. Many laymen hold auditors to the impossible standard of could have known. Furthermore, that standard has found its way into several judgments rendered against auditors and auditing firms. Hindsight has the wonderful ability of making anything possible. No matter how meticulous, thorough, and careful an auditor might be in his or her work, there is always something else that could have been done that would have uncovered a fraud. Obviously, the burden of could have known is too high a standard and should be abandoned by the courts or outlawed by statute.

Would Have Known. The standard of would have known says the auditor is responsible for anything he or she would have known, that is did know as a result of the audit procedures applied. It implies the auditor cannot be responsible for what he or she did not know. To financial-statement users, that is what the profession and the POB seem to advocate, and to them it is inadequate because it fails to establish a standard. It says, in effect, "If we didn't know about it, we couldn't be expected to know about it." Whatever audit work was done (or not done) becomes its own justification. It is the essence of the limited review.

Should Have Known. The middle ground and the standard that seems reasonable to expect is should have known. This standard looks to the appropriateness and adequacy of the audit procedures followed in a specific case. For example, there is no way auditors can predict the future collection of loan payments. But, they certainly can be held responsible for a competent assessment of the adequacy of loan loss reserves in light of past collection experience and other facts they acquired or should have acquired during their field work. Cases that fall short of the standard of should have known can be defined as audit failures and the auditors responsible should be forced to answer to those persons who relied on their report(s).

A Comment About Privity

Frankly, as a financial-statement user, I am baffled by the idea of privity. When I see an auditor's report averring a set of financial statements is fairly presented and free of material misstatement, why should I not believe it? First of all, one of the preceding paragraphs in the same report points out clearly that management is responsible for the content of the financial statements. Therefore, the auditor's report must be directed at persons other than company's management. Even though the report may be addressed to the board of directors or the stockholders, in privately held firms (which are the only ones to which privity applies), the stockholders and the board are, with notable exceptions, the self-same managers of the firm. In the largest number of cases, the auditor's report must be intended to provide assurance to outsiders.

Second, if in fact the auditor intended only certain eyes to view his or her report, I would expect that restriction to appear in the body of the report in large letters informing outsiders that their reliance on it, should they happen to see it, is forbidden, and whoever shows it to an outsider is guilty of breach of contract or possibly fraud. There has to be some positive action on the part of independent accountants to forestall or warn against "unauthorized" reliance on their reports.

Incentives and Rewards

How can auditors be made to want to do work of the highest possible quality? It seems all the incentives to do so are negative: gigantic litigation costs for some, being forced out of business for others. Positive rewards--promotion, remuneration, respect and admiration--seem often to be bestowed disproportionately on those who contribute to the problem, not solve it. Many professional users of financial statements are convinced independent public accountants see their success as a direct function of 1) how well they keep their present clients happy and 2) how many new clients they bring into the fold. Given the inherent conflict of those incentives with the oversight function of an independent audit, the only effective controls over auditor behavior have come from a larger and larger body of strictures and a detailed body of accounting rules generated by the AICPA and FASB, respectively.

On that note, consider the additive effect of the POB's multiple recommendations. They are well thought out, rational, addressed to real problems, and potentially effective individually. But, on the whole, do they provide new incentives to improve the lot either of auditors or those who rely on their reports? Probably not.

If I were a young person considering a career choice today, I am afraid the POB's special report would drive me away rather than attract me to professional accounting.

What Should Be Done?

There are no easy or quick cures, but there has to be a better way. I offer below a few suggestions for directions that might be taken. Given the restraints on the length of my remarks and the long-term nature of the problem, they represent only preliminary views and indicators. But, I do not want to criticize the approach taken by the POB without offering at least some constructive alternative view.

The Villain is Nominated

My nominee as the prime villain in all this resides in Washington, D.C. It is the Federal Trade Commission (FTC). Several years ago, the FTC mounted a successful campaign to force the various professions to compete on economic terms. In my opinion, the resulting price competition, open and sometimes overly enthusiastic solicitation of prospective clients, competitive bidding, and the like have had dreadful effects. In a manner of speaking, professional accounting has been victimized. Audit revenues tend to flow to those who compete most effectively. Both actual and prospective clients seek to minimize the fees they pay (and often the accounting methods they employ). Profits go to auditors who are able to keep their costs under control, but that carries the immeasurable cost of continually tempting auditors to cut comers as well as costs. All of this economic competition has caused a continuing decline among financial-statement users in their perception of and respect for the integrity of the auditor's report.

What the FTC, the courts, and many others have misjudged is the unique nature of the attest function. Physicians and attorneys owe their duty and allegiance to their patients and clients, respectively. An independent auditor's primary duty is to the third parties who rely on his or her report. If they cannot rely on that report, the raison d'etre of the auditor ceases to exist. The FTC disturbed and destroyed the tense but balanced relationship among the auditor, the client, and financial-statement users, in my opinion, to the detriment of all. The auditing profession and the attest function are unique and need to be recognized as such.

Serving The Hand That Feeds

Until the first World War, the U.S. was a debtor nation. During the latter part of the nineteenth and early part of the twentieth centuries, industrialism in this country was financed largely with imported capital, primarily from Britain. The imported capital was accompanied by imported accountants, primarily from England and Scotland. Messrs. Price and Waterhouse; Peat, Marwick and Mitchell, all were British. Those accountants were sent here by British providers of capital and their duty was to their principals. The providers of capital bore directly the costs of whatever accounting services were performed on their behalf. The return on their investments was net of those costs.

Compare that to today's arrangements after a century of institutional changes in business and finance. Providers of capital still bear the costs of the information they receive, but only indirectly. Auditing services are procured on their behalf by the senior managers of business enterprises who sometimes, but not always, seek to serve their own interests by employing aggressive accounting and defending it with the implication that the auditor could be replaced. Such situations are inimical to the interests of financial-statement users. If matters do not improve soon, financial-statement users may once again have to underwrite the audit function themselves. If we consider, for example, the field-audit activities of asset-based lenders, we can see a movement in that direction might already be underway. These are my opinions and I assuredly am not in the vanguard of cadres of financial-statement users, checkbooks in hand, eagerly seeking to hire independent auditors.

Peter H. Knutson, PhD, CPA, is an Associate Professor of Accounting at the Wharton School of the University of Pennsylvania. He has been a member of the Financial Accounting Policy Committee of the Association for Investment Management and Research (AIMR) since 1980. He is also accounting consultant to the Robert Morris Associates, the national association of bank credit executives.

This article is based on a presentation given by Professor Knutson at a symposium on the proposals of the Public Oversight Board, "In the Public Interest," sponsored by The CPA Journal.

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