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A case study in auditor failures

By Jim Peterson at CPA Journal: Public criticism of the accounting profession is intense. Users of financial statements are dissatisfied. Under pressure from politicians and regulators, accounting firms are hampered by structural and financial fragility. Santayana’s maxim, however, contains both a plan and a call for action.

Auditors differ from other professions and businesses, whose scrutiny of performance quality involves detailed case-by-case examination and self-criticism. Instead, auditors have no common forum where experiences can be shared, penetrating questions asked, and data collected for pattern analysis and lessons to be learned and put into practice. The profession does no shared “failure study”; there is no systematic support for its legitimate but unaccomplished aspirations to get better.

For all the passionate criticism, accountants continue, unlike many others, to lack a structure by which to answer the question, “How can you hope to improve, if you can’t tell if you’re good or not?”

‘Where Were the Auditors?’

Value is still ascribed to independent audits, for the benefit of investors and the success of the capital markets. But with its long history, the community of users might have expected the profession to have solved the “expectations gap” by now.

Dramatic incidents continue to occur. The financial crisis of 2007–2008, with the failure and bailout of a parade of iconic companies—all bearing clean audit opinions—came half a decade after the ostensible improvements of the Sarbanes-Oxley Act of 2002. But fresh occurrences have continued to erupt, in the United States and around the globe.

The familiar cry, “Where were the auditors?” has rung out often in recent years: in the $625 million judgment in the FDIC’s case against PricewaterhouseCoopers over the failed Colonial Bank, the collapse of public contractor Carillion in the United Kingdom, the political influence of the Gupta family and the $12 billion write-downs taken by Steinhoff in South Africa, the reported looting of the 1Malaysia Development Berhad fund in Malaysia, and the €200 billion laundered through Danske Bank’s branch in Estonia. Examples of failure in the United States include Bernard Madoff, MF Global, Hertz, Valeant, Wells Fargo, and even the Academy Awards. Equally impactful examples elsewhere include Tesco and Autonomy in the United Kingdom, Toshiba and Olympus in Japan, Petrobras in Brazil, FIFA in Switzerland, Volkswagen in Germany, and Noble Group in Hong Kong, with others certain to come.

Public criticism, expectations, and calls for accountability are broad. Challenges to auditor performance extend from shortcomings in audit execution to issuer abuse of the principles of accounting and reporting, including the auditors’ distance from management misconduct affecting financial reporting and share prices.

In the United Kingdom, official inquiries under the aegis of the Competition & Markets Authority and a committee charged by Parliament released reports in December 2018, giving authoritative consideration to potentially disruptive “solutions” that go so far as to include breaking up the large firms, compelling a reduction in their dominant market share, or stripping their ancillary services so as to reduce them to “audit only.”

In all these areas, public expectations are that auditors perform with “zero defects.” That is, however deeply investors may be informed or concerned with actual auditor conformity with professional standards, their interest is that investment values not be affected by corporate malfeasance. To investors, auditors are expected to be the watchdogs guarding investor value.

The model for the delivery of assurance on the financial statements of large public companies is sure to evolve. The arrival of new tools and methods based on the capabilities of data analytics and artificial intelligence will be transformative. In that emerging future, and in order to have an audit function fit for purpose and worthy of public trust, there is an unfilled need: a solution to the profession’s longstanding and perplexing inability to respond to the challenges of its critics in every case of significant financial breakdown, corporate malfeasance, or share price collapse.

The absence of a forum by which to scrutinize the profession’s inevitable instances of questionable performance reveals a gap that is equally as broad as its exposures. The profession’s traditional defensive assertions—“not in our scope” or “isolated exception”—are neither responsive nor publicly satisfactory. Failure study is not just lacking; it is sorely needed.

Failure study is an article of faith in other professions, even where instances of breakdown are far less frequent and less consequential.

Examples in Other Sectors

Failure study is an article of faith and long applied in other professions, even where instances of breakdown are far less frequent and less consequential in broad public impact than among the auditors and their public company clients. Hospitals study their surgeries and their emergency rooms—often literally postmortem—to improve procedures and patient outcomes. Engineers dissect the causes of collapsed dams and bridges and fallen buildings. Assembly lines are halted until defects are identified and cured.

The National Transportation Safety Board (NTSB), charged by law to investigate civil aviation and other transportation accidents, puts forensic teams on the site of crashes as soon as possible. There, even “close calls” and other deviations are examined and reported, providing learning that is unavailable in less dedicated sectors where “minor” matters are passed over as incidental.

Notorious public tragedies are also learning laboratories. In 1912, the Titanic was in literal compliance with the rules on the number and deployment of lifeboats, and was extolled as representing the best of marine engineering—until its iceberg encounter created the opportunity for study and revision of both. As of 2001, the twin towers of New York City’s World Trade Center were considered so safe that 50,000 people worked there daily in complete confidence, until the results of engineering studies after their collapse on September 11 gave a diagnosis and appreciation of their fateful design weaknesses, ensuring that the deficiencies in their construction would never be replicated.

A Vacuum of Opportunity

The reasons why the accounting profession lacks structures and protocols for failure study provide explanations, if not justifications:

  • There is an absence of incentives. The commodity language of the auditor’s report is mandated by law and regulation. At the same time, a reader has no way to extract any quality differentiation, one way or the other. Users have no way to discern a good audit from a poor one, and the profession has lacked sufficient motivation to search for a fix for a system not perceived as broken.
  • Legal advisors profess their fear of the adverse litigation hazards of generating discoverable post hoc analysis. The armor of attorney-client privilege is clapped around work done in litigation defense, shielding attempts at learning and improvement even from internal sharing, much less from transparent exchanges across the profession or with users and standards setters.
  • With the customary human desire to admire the upside and claim “success” wherever possible, the profession has absorbed the intrusive inspections of its regulators, the PCAOB and its counterparts around the world, suffering occasional wrist slaps and survivable settlements of its lesser litigations while taking pride in expanded revenues and accelerated diversification into new areas of practice.

The board could, by design and legislative authorization, be housed within one of the existing federal agencies; the SEC or the PCAOB would be likely candidates.

There is history to these ideas, as accounting professor and author Sri Ramamoorti of the University of Dayton reminded this author. In March 1993, the nearly forgotten Public Oversight Board, whose remit covered the SEC Practice Section of the AICPA, issued its equally forgotten report, “In the Public Interest: Issues Confronting the Accounting Profession.” As reported in the December 1993 CPA Journal:

The Board observed the auditing profession does not have a system to dissect its failures, ferret out the causes, identify the symptoms related to those causes, and develop methods to prevent their recurrence. (Jerry D. Sullivan, “In the Public Interest—A Progress Report.”)

Predictably, the proposal was met with indifference and inaction, overcome by the antagonistic reactions to the board’s more immediately provocative proposals on such difficult subjects as auditor liability, internal controls reporting, fraud detection, and the role of audit committees. Viewed in hindsight, the board’s proposals in general retain considerable relevance to issues of unresolved urgency today, of which the absence of a failure study forum is only one.

The profession proclaims its attention to indicators of improved quality, which works very well at the level of process and routine execution, most of the time. But the inability to achieve the publicly expected “zero defects” means that firms have not solved their recurring exposure to the “megacases” that would blow up their capital-thin balance sheets, shown by the painful outcomes for Deloitte and PricewaterhouseCoopers of the litigation relating to Taylor Bean & Whitaker, Colonial Bank, and MF Global, as well as the ongoing threats on a similarly devastating scale.

Structure and Operations

Taking as a target population the list of public companies reporting to the SEC, what would a useful forum for audit failure study look like, and what would be required? The broad terms of reference are not difficult to articulate for such a body, which for the sake of this discussion could be named the National Audit Performance Board.

The board could, by design and legislative authorization, be housed within one of the existing federal agencies; the SEC or the PCAOB would be likely candidates. Alternatively, authority could be devolved to a private body, newly formed or evolving from one already in place, whose scope and performance would function under official delegation, monitoring, and oversight.

The remit of the board would need to be broadly stated: to investigate and report on incidents of allegedly inappropriate accounting and reporting, audit performance insufficiency, or personal malfeasance—at either the audit firms or their issuer clients—for lessons and areas for improvement. Incidents that would require the board’s attention could include shareholder or other litigation, proceedings by agencies of law enforcement or oversight, restatements of financial results, large company bankruptcies, bailouts, or rescue interventions. Other matters possibly within the board’s authority could include third-party complaints, as well as voluntary submissions of cases of complex accounting or other judgments in the course of engagement performance, either to obtain advisory advance guidance in individual cases or to flag an emerging issue for broader inquiry and dialog.

Also within both the remit and aspirations of the board, especially once it had attained maturity and a base of experience, would be the close calls where a serious problem did not materialize, but could have. These near misses, avoided or averted by good performance or by luck—or perhaps only rationalized away—would otherwise lie quiet and festering until the conditions for breakdown emerged.

Notification would be made and pursued promptly on the arising of an issue, for the sake of realistically timed investigation and advances in learning, unlike the delayed and unsatisfactory timetables of either today’s PCAOB inspection program or its antecedents in the SEC Practice Section of the AICPA.

Staffing of the board would include senior-level experts across the relevant disciplines, drawn from volunteered secondment or direct hiring from the profession as well as from industry executive and finance personnel. The board would also have the support of research academics and professional and legal standards setters. Competencies would include auditing and accounting standards, engagement and methodology design and execution, risk analysis and management, forensics, data analytics, and behavioral evaluation. Secondments of junior staff from CPA firms, as with the fellowship opportunities at the SEC, would be seen as valuable sources of experience and serious career enhancements for those signing on.

The board’s outputs would cover a wide spectrum of reporting and commentary:

  • Post-event reports on individual cases, including analysis of performance quality and behavior, application and evaluation of standards and judgments, and event causation
  • Broader studies based on identification of trends and patterns to be referred to standards setters and other bodies
  • Articulation of optimal practices—actually raising the bar above the minimal satisfaction of generally accepted standards—drawing on the board’s accumulated experience and, optimistically, its capacity to identify cases of superior performance.

Operationally, while the willing participation of audit firms and corporate issuers would be essential, a federal-level legislative mandate would be required in order to capture and build a body of data complete and robust enough to be informative and credible. Among other reasons, this would be necessary both to have regulatory buy-in as well as to protect the entire exercise from hostile use and effect in civil litigation.

As a reality check, the accounting profession’s long and futile attempts to reduce its legal exposures suggest that to obtain a tradeoff by which submission to the board’s inquiry process would include actual reworking of liability thresholds—through the creation of “safe harbors” or other means—would likely be a step too far for politicians. On the other hand, the reasonableness and practicality of such an expanded remit is illustrated by the lengthy list of specialized tribunals charged with the application and enforcement of broad areas of U.S. laws and regulations, such as the Foreign Intelligence and Surveillance Court, the Executive Office for Immigration Review, and the Court of Appeals for the Federal Circuit (with its jurisdiction over appeals from a host of administrative agencies).

While the willing participation of audit firms and corporate issuers would be essential, a federal-level legislative mandate would be required in order to capture and build a body of data complete and robust enough to be informative and credible.

In this way, concerns for exposure would be reasonably manageable, just as the results of NTSB investigations and determinations of probable cause cannot be used as evidence in courts of law, nor can ameliorative company acts in such areas as consumer product safety.

While it is easy to see that compulsory participation in a failure study forum could be frustrated by the profession and the business sector and doomed to fail from the outset, it is also clear that achieving a productive state of virtuous cooperation would be no small task. As a matter of cultural change, firms, the profession’s leaders, and the communities of preparers and users would need to be willing participants, endorsing the value of the forum as a matter of mutual trust and appreciation for its value.

Benefits and Support

Those standing to benefit from a robust and transparent program of audit performance evaluation would include all players in the audit community. The profession’s claims on behalf of its programs for improvement would acquire a measurable body of empirical evidence. Standards setters would build a base of experience on which to evaluate and evolve their guidance. Corporate issuers would achieve increased credibility for their commitments to quality governance and reporting. Government agencies of oversight and law enforcement could legitimize their claims for leadership in cooperative efforts to improve audit performance quality. Investors and other users would see increased convergence and comparability of information, along with a divergence of issuers’ positions in areas of complexity.

The broad outlines of the failure study concept are readily available. What is needed now is endorsement and uptake across the financial information community.

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