Home Accounting and Auditing How the client-pays model can twist audit results

How the client-pays model can twist audit results

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As Accounting Weekly and the SA Institute of Business Accountants (Saiba) have long argued, we will not fix the “audit problem” that is eating away at the profession’s reputation until we fix the way auditors are paid.

Accounting is as public good, and accountants are required to operate in a way consistent with this ethos – even though the client is paying the fees.

You can see right away the perverse incentives that can creep in. As we wrote in The next Steinhoff is around the corner, adding more accounting standards to the tomes already in existence will not correct the biases that inevitably bleed into the profession.

Fix remuneration and you fix the auditing biases

We have to fix the way the audit profession is remunerated. It would be a brave young auditor who would stand toe-to-toe with a bull-headed CEO client and inform him that he will not sign off on his latest revenue boosting scheme. Nor would the young auditor’s seniors allow this to pass and jeopardise perhaps R60 million in annual audit fees.

One solution is to make an independent body such as the Independent Regulatory Board for Auditors (Irba) appoint and remunerate auditors using fees paid by client companies. Professor of Accounting at University College Dublin, Niamh Brennan, told Accounting Weekly that “unconscious biases” are inevitable under the current regime of client-pays model. To fix this, she suggests fixed, limited contract periods during which auditors cannot be fired. All fees and other contractual arrangements would have to be agreed in advance. At the end of the period, the client would be prevented from rehiring the auditor. This would force clients to rotate audit firms. Audit rotation has since been introduced in SA and other countries, but this may not be enough to solve the problem.

There’s a vast body of research highlighting the deficiencies inherent in the existing professional structure of accounting that produces catastrophes such as Steinhoff, Tongaat, and – on a far bigger scale – Enron.

Fixing the problem of who pays the piper

Aileen Pierce of University College Dublin, in a study entitled Ethics and the Professional Accounting Firm: A Literature Review, argues that similar to the medical and legal professions, society grants public accountants and exclusive right to perform certain activities and it expects something in return. “Professional practitioners are expected to act in the best interests of society when resolving issues that arise within the scope of their franchised practice. The core issue in the context of the accountancy profession is the statutory order probably privileged enjoyed by public accounting practitioners and the accountability that is demanded by that privilege. This monopoly is defended by the profession on the grounds of the profession superior qualities of independence, integrity, and of serving the public interest,” she writes.

The accountancy profession has claimed to be both moral and ethical throughout the 20th century, but this assertion has been questioned again and again. In fact, this assertion is tested almost monthly as new accounting scandals pierce the public consciousness.

One of the problems identified by Aisleen Pierce in her research was the secretiveness of accounting firms, and the tendency to prioritise commercial over professionalism interests. “There is a conflict between these business models that underlies most investigations into order to independence an order quality, and some research into earnings management and earnings quality,” writes Pierce in a study commissioned by the research committee of the Institute of Chartered Accountants of Scotland.

One of the primary values of the accounting profession is the trust that non accountants afford them. Society trusts professionals “to provide socially valuable knowledge in a competent and socially responsible way”. Yet the profession would prefer that it be self-regulating while enjoying such an exalted status in society.

When in trouble, the accounting profession engages in reputation management

Impression management, though not labeled as such in earlier times, was practiced at least as far back in history as the 1930s in America when regulators responded to the “moral crisis in capitalism generated by the immoral behavior of the capitalist elite”, according to a study by Merino and Mayper in 2001.

New accounting and auditing rules are introduced in response to threats of increased regulation. Some of these changes are sufficiently flexible to enable the status quo to remain while at the same time creating the appearance that the profession is taking action in response to criticisms. That’s according to research by Byington and Sutton in 1991.

Accountants are able to claim their exalted status because of the relatively high barriers to entry (the board exams) and the technical standards.

The accountancy profession attaches considerable importance to its image of independence when seeking to defend and extend its jurisdiction.

Whenever damage control is required, the profession emphasises its technical competence and integrity as well as its intolerance for members who broke the rules. Yet, research shown that accounting students and auditors are generally unaware of the moral aspects of their discipline.

The big accounting firms resemble multinational companies in their size and structures , yet they increasingly adopt a commercial ethos as distinct from a traditional professional culture, says Pierce. There is a longstanding tension between the commercial side of accountancy firm’s and the public oriented audit side of the professional practice.

While the audit is considered a public good, in practice what has happened is that audit services are significantly discounted as a door opener to other, more lucrative business, particularly consulting.

Globalisation presented massive opportunities for accounting firms

The globalisation of large accountancy firms has facilitated clients in their pursuit of global profits, however this will structure can be abandoned by the firms when they’re being held accountable across legal jurisdictions. This is illustrated by the conclusions of the US Senate investigation into the BCCI scandal, where the partnership structure was deemed inappropriate for international regulatory arrangements. In the 1980s, accounting firms in the US began promoting themselves, not as auditors who served the interests of the public, but as client service professionals who solved business problems. It was a result of this move that non ordered fees began to become a huge source of revenue for the accounting firms. They started moving into consulting, legal and IT businesses spheres.

Accounting firms may have high standards and a good reputation, but individuals within the firm may gain personally from behavior that is inconsistent with high ethical standards, such as giving in to pressure from clients. And this lies at the core of the “accounting-as-a-public-good” problem.

Revenue growth and profits became the top priorities

in the latter part of the 20th century, the accounting culture changed to promoting revenue growth and profitability as primary objectives, to a situation where to risk losing clients for matters of accounting principle was considered naive. Ordered firms services were expanded in the last three decades of the 20th century to the point where almost any service that could generate revenue was undertaken.

At the root of the ethical dilemma facing accountants is a definition of who precisely constitutes the client: the entity paying the audit fees, or the public? These are two entirely different masters with different expectations.

It is this conflict which explains the increasing number of audit failures and litigation against audit firms , with resulting increases in professional indemnity insurance premiums . Auditors have been criticised for issuing clean audit reports in situations where companies have gone into liquidation soon afterwards.

Accountancy Professor Niamh Brennan of University College Dublin told CFO Talks that the Big Four audit firms, while competing with each other in the marketplace, tends to speak with one voice when under attack or scrutiny from regulators.

Capital markets reward accountants for “earnings management”

And what clients demand, clients get. Capital markets provide companies with both positive and negative incentives to manage earnings. Substantial contract and economic incentives exist to “motivate selective financial misrepresentation” according to a study by Revsine in 2002. These include increasing reported profits to avoid debt covenant violations; Under reporting company earning so that favorable prices in management buyouts can be facilitated; Managing reported earnings upward so that bonus compensation can be increased; And managing earnings appropriately so that loans can be obtained on favorable terms.

The auditor reliance on accounting standards, with its cavernous scope for judgment and interpretation, has gnawed away at the usefulness and truthfulness of financial statements. A study by Dye identified situations in which certain users of financial statements benefited from earnings management. Shareholders had a demand for the earnings management that boosted the share price in the short run, whereas non shareholders did not. While managers engaged in earnings management to increase the stock price, they also engaged in earnings management for personal gain.

Do we need more rules?

Do we need more rules, more standards, to fix the problem?

No, the incentives alone will fix most of it. When auditors are paid by an independent body like Irba, and cannot be fired by the client until the end of the engagement, you will start getting better audit results.