Home Accounting and Auditing Audits Are Broken. Here’s a Radical Way to Fix Them.

Audits Are Broken. Here’s a Radical Way to Fix Them.

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A certain federal agency should take over all public company audits, suggests a former Big Four auditor and current accounting software company CEO, writes Michael Whitmire in CFO.com.

First Under Armour and then Mattel recently confirmed that they are the subject of federal probes of their accounting practices. This is yet another in a series of examples that suggest the auditing process for U.S. public companies requires a significant overhaul.

The health of our investment markets depends on our ability to trust that the financial statements of publicly traded companies are honest and correct. We assume that the audits of those financials have been conducted by independent audit firms with zero financial ties to the companies they are auditing, and that auditors have no financial incentive to maintain that relationship.

But, as the cases of Under Armour and Mattel as well as numerous other recent audit fails demonstrate, objectivity and independence are not necessarily what we can depend on from auditors. About a third of the Big Four’s revenue comes from audits, and partners at those firms clearly have an incentive to maintain and build their book of business.

A proven path to becoming a successful audit partner at most firms is to run profitable engagements and to have a good book of business. Sadly, it’s not about one’s skills as an auditor, but rather about skills in business development and ability to generate revenue for the firm.

I’ve been on both sides of the audit table — first as a senior auditor at a Big Four firm, and now as CEO of accounting software company FloQast. As an auditor, I saw my share of clients pushing back when a problem was identified, and I was always dismayed when audit leadership caved and found a way to see it the client’s way.

Senior managers who notice problems and call them out risk being removed from an audit team, or worse, even being fired and blacklisted. That’s what happened to Mauro Botto when he went to the SEC with his concerns about the audits of tech companies his Big Four firm was performing.

Auditors are inherently pressured to stay in their clients’ good graces. Clients are inherently pressured to make sure they’re putting out financial statements that meet the expectations of investors and other stakeholders. So there’s a really weird fine line to tow if there’s a disagreement on guidance.

Audit partners, especially at the Big Four, continue to be willing to push the envelope to put out a clean opinion on their clients’ financials — even when confronted with evidence that there are serious problems. Now, it’s not necessarily nefarious. Most audit partners are not doing this to falsely inflate stock values or anything like that. But they have a financial incentive to help their clients out and to keep the relationship running smoothly.

Instead of striving for objectivity, there’s the opposite incentive: to sanction their clients’ incorrect financial practices, or maybe just not probe too deeply beyond the surface, and take the risk that the government won’t audit a client. Although the odds are generally in the clients’ favor, the examples of Under Armour and Mattel confirm that this does not always work out.

When the fees for auditing public companies are in the millions, do you think an audit partner has any incentive to push a client to make changes that could potentially be costly for that client, or that might make that client fire its auditor?

I won’t even mention the lucrative consulting engagements that come out of the trusted relationship audit partners have with clients or the prestige that comes from adding certain clients to the firm’s consulting portfolio.

What I just can’t get past is that there is no way for auditors to be independent or objective when their clients are the ones paying the bill for their services. None of the measures that audit firms put in place at the back-end, like making sure auditors don’t have any financial interest in the companies they’re auditing, really matter.

There’s no other government-mandated oversight program that operates this way. We don’t pay private tax auditors to guarantee for the government that our tax returns are “presented fairly.” Restaurants don’t hire health inspectors to assert that the food they serve is free of material contamination.

We fear IRS auditors and other government inspectors because we know they’re looking for problems. They’re not trying to be our friends or clients for life. Their compensation isn’t contingent on staying in our good graces.

I’m fed up. I believe now is the time for change.

My proposal is simple: kill the practice of supposedly independent auditors examining and certifying the books of public companies and give that job to the Public Company Accounting Oversight Board (PCAOB).

The PCAOB, created by the Sarbanes–Oxley Act to oversee the audits of public companies and other issuers, is already publicly funded. But that supposed oversight is limited to auditing the auditors after the fact. Sometimes that oversight happens years after the fact, when it’s far too late to alert investors and stakeholders that a company they invested in has some fundamental problems with its finances.

Why should companies be treated any differently than an individual? After all, the Supreme Court ruled in Citizens United that corporations had the same rights as individuals to make campaign donations. Just as the IRS is government-funded and audits individuals and businesses, the PCAOB should do the same for public entities.

This dramatically expanded role for the PCAOB could be funded by a percentage of revenue from each public company. It wouldn’t be cheap, but it most likely would be less expensive than the enormous fees that the Big Four charge. Auditors to staff this initiative would initially come from the now-unemployed ranks of Big Four auditors.

Unlike the dwindling and thinly stretched resources of the IRS, my proposal for the PCAOB would ensure adequate resources to attract and keep the best and brightest auditors. I would propose a drastic compensation adjustment compared to what auditors are now paid. Compensation for auditors today in no way aligns to what the job entails. Finding problems means more work, but not more pay.

To counter that, I would transition to an incentive-based compensation system where auditors get a bonus for finding errors. The offending companies would be penalized and would pay more into the system.

I acknowledge that this would create an adversarial system, quite different from the one we have now.

But what would be the most important difference? True independence.