“The dozy watchdogs” – Deep discussion in The Economist on the state of audit profession

Gotta’ love the drawing of a seated Doberman with a wondering look on his face as he stares at a trail of muddy feline paw prints. Staring around helpless are three other dogs. The befuddled watchdog has a tag labeled “PwC” in case you hadn’t yet caught the point.

The previous drawing was of an overfed cat in a three-piece suit helping himself to a bag of cash from a safe as four dogs snoozed in front of the safe. Said dogs have a tag identifying each as a member of the Big 4.

If you are an auditor, you really should get a fresh cup of coffee and check out The Economist’s discussion of The dozy watchdogs. Will let you see what non-accountants think of the profession (not too much) and the job the big firms are doing (not so great).

Yeah, there is a problem

Article gives a survey of recent fiascos:

Tesco announced that its profit guidance for the first half of 2014 was £250m ($408m) too high, because it had overstated the rebate income it would receive from suppliers.

… a Spanish court reported that Bankia had mis-stated its finances when it went public in 2011…

…Hewlett-Packard wrote off 80% of its $10.3 billion purchase of Autonomy, … after accusing the firm of counting forecast subscriptions as current sales …

…Olympus, a Japanese optical-device maker, revealed it had hidden billions of dollars in losses.

[The FDIC] is suing PwC for $1 billion for not detecting fraud at Colonial Bank, which failed in 2009.

…two KPMG auditors received suspensions for failing to scrutinise loan-loss reserves at TierOne, another failed bank.

…EY’s audit kept mum about the repurchase transactions that disguised the [Lehman] bank’s leverage.

… Satyam, an Indian technology company, admitted it had faked over $1 billion of cash on its books.

…North American exchanges have de-listed more than 100 Chinese firms in recent years because of accounting problems.

Concentration

Doing anything to address whatever issue you perceive is the problem has to deal with severe concentration of the industry.  The Big 4 audit companies with 98% of total market capitalization. Article says that in many markets there are only 2 or 3 of the big firms with expertise in a particular industry. It takes a huge firm with lots of diverse talent on tap to complete a big audit. That massive scale isn’t available in many places.

The smallest of the Big 4, KPMG, is larger than the next four firms combined, according to the article.

A bit of history

Article gives a good history of how the audit profession, and especially the requirement for mandatory audits, developed.

In the 1920s, 80% of public firms voluntarily obtained an audit, even though it wasn’t required.

The article is worth a read just to go through the history.

Motivators to do a good job

The article discusses four factors the big firms cite as motivators to do a good job.

The audit industry cites four main factors that counteract this conflict of interest.

One is the separation of the audit committee from management. …

Another potential defence against conflict is reputation: …

A potentially stronger deterrent is legal risk. …

That leaves only one truly effective force: regulation. …

Article then dismisses the first three as ineffective but concedes PCAOB may be having some impact.

Having worked over a decade at in a tiny national firm and over a decade now running an intentionally one-person sole proprietorship, I chuckle at that list for the small firm environment. Reputation and legal risk is an exquisitely powerful motivator for small and medium-sized firms. Another factor for non-big 4 firms is peer review, which is a biggie.

Article discusses multiple ideas on how to improve Big 4 performance. Unlike what you will see elsewhere, this article admits there are tradeoffs and drawbacks to all suggestions.

The most creative idea is to replace the requirement for an annual audit with a requirement to obtain financial statement insurance. The downside is that would only require an overhaul of the entire legal and regulatory structure for public markets and the audit profession along with development of a brand new huge niche in the insurance industry.  Check out the article for a few ideas how that might work.

What might really help

Not that it will every happen, but restoring reputation risk and legal risk to individual partners would provide a quantum leap in motivation and attention to detail.

One of the biggest lessons I’ve learned running my firm is the power of ownership.

A first step would be publishing (in a readily visible way) the name of the lead partner and all of the partners working on the engagement with a description of their roles, and perhaps hours on the engagement. Just the name of the lead partner, especially if buried in some obscure SEC filing, isn’t helpful.

Disgruntled investors might think about suing partners individually and seeking specific judgments. Pondering the remote possibility of that happening gives me tremendous freedom and would make it really easy to fire an integrity impaired client.

The worry of getting tagged in the Google era for association with a massive fraud would improve focus.

Lots more auditors would have a stainless steel backbone if their future income, retirement account, hundreds of non-billable hours wasted on legal defense, and personal residence were on the line.