If auditors won’t audit, mandatory rotation won’t help. Part 1

I read an unsettling post by Tom Selling, “Thinking, Fast and Slow” about Auditing, which made an interesting argument in favor of auditor rotation.  Essence of the concept deals with the halo effect.  His post got me to thinking.  Mentioned my discomfort here.

In a sentence, the halo effect in the audit context is unconsciously concluding that management is right this time because they were right so many times before and therefore the halo effect biases auditor’s judgment so severely that mandatory audit rotation in needed to get good audits.

I’ve read a large portion of the book and have resolved my discomfort.

If auditors won’t audit, in other words if they don’t take their work seriously and try to do a good job, mandatory rotation won’t change anything. Neither will disclosing the name of the partner, nor disclosing the names of the audit team, nor increasing penalties from the SEC, nor increasing auditor liability.

This series of posts will go far beyond the mandatory rotation issue and the other suggestions to improve the audit process by opening up the issue of how we can do audits better.

Halo effect and auditors

Let’s talk about the halo effect. 

It is real.  It is hard to counter.  It affects everybody.  Not just auditors.  Everybody.

Let’s discuss its impact on auditors.  Prof. Selling suggests it affects auditors who have been on the audit too long.  Such auditors are in danger of assuming that management is right and honest and that the accounting is right because everything’s been okay for the last 5 or 20 audits.

Maybe.

How early does the halo effect start?

If you can’t recognize and fight your biases, that halo effect can start before the first day of the first year on a brand new audit. 

All CPAs do some level of due diligence to make sure we are taking on honest clients. We check with the prior CPA, banking or legal contacts we know, try to gauge management’s attitude toward accountability, and do a ‘net search.  If you are a CPA, you know all the stuff you are supposed to do.

I also use a public database to see if there are criminal or civil cases involving the organization or senior management.  It seems to do a good job at picking up cases.  Usually traffic tickets, but more serious things have surfaced.

I understand the big firms do an extensive investigation of the senior management and the company.  Read somewhere a long time ago that the big firms spend $10k investigating a potential client before taking them on.

Suppose that could create a halo effect?  The company and senior managers cleared the background check.  Before you submit a proposal you’ve concluded the senior leaders are honest. 

Yeah, that could create a halo effect before arriving for the first day of field work.  If you think management is honest before you start the audit (if you didn’t reach that conclusion, you wouldn’t submit a proposal), they will probably will be honest the day after you start.  That’s the halo effect.

Mandatory rotation won’t do anything about that.

The danger of halo effect starts immediately, not in the 6^th year of an engagement.  It is a risk every day.

Next post – two side trips on idea of thinking fast and slow.  Then a post on how the underlying design of the audit process helps to counter the halo effect.