M. Michel Barnier
European Commissioner for Internal Market and Services
Re: Green Paper, "Audit Policy: Lessons from the Crisis"
Dear M. Barnier:
My fellow blogger, Francine McKenna, has recently observed that the negative consequences of "Big Four" dominance of auditing services to the largest EU companies have been a topic of concern for a number of years. I commend you for the publication of the Green Paper, and your personal commitment to effect significant reforms in the next calendar year. As an American, I am also hoping that constructive actions taken by the European Commission will serve as a catalyst for similar reform in my country. To these ends, I am writing to provide you with my own analysis of the problem, and the apparent solution.
Why Audit Reports Are Unreliable: More than a "Big Four" Problem
The first paragraph of the Green Paper states, in part, as follows:
"The fact that numerous banks revealed huge losses from 2007 to 2009 on the positions they had held both on and off balance sheet raises … the question of how auditors could give clean audit reports to their clients for those periods [footnote omitted] …"
Unfortunately, the audit process has become encumbered by two fundamental flaws, which explain why the audit reports referred to in the above quotation have become unreliable:
First, auditors lack sufficient incentives to perform their duties in good faith – During the hearings leading up to the passage of the U.S. Securities Act of 1933, representatives of the accounting profession successfully convinced the U.S. Congress that government involvement in corporate audits would not be necessary; and the public could safely rely on the "conscience" of auditors to perform their function with an independent state of mind.
But, "independence" as a conceptual underpinning of auditing has proven to be a failure. Imagine how difficult it must be for the new partner-in-charge to be inserted between the rock that is your firm's highly profitable relationship for more than 20 years with the audit client, and the hard place that is management's gross underestimation of bad debt reserves? To be sure, too many auditors have at critical moments, shown that their "conscience" could be defeated by the temptations of the material world. The chances are very good that whichever accounting scandal you can name, pre- or post-crisis, the same auditors had been engaged for decades.1
As I am sure you are aware, the reasoning underlying proposals for mandatory audit firm rotation is that it could potentially offset the known limitations of the independence assumption. Successor auditors would have a strong economic incentive to perform a thorough initial review of prior financial reports, so as to avoid exposure for restatements occurring on their watch. Knowing this, the predecessor auditor has an economic interest in not being found to have committed an oversight, and should be ever the more diligent as a result.
Second, and notwithstanding questions of good faith, the judgments that are required to produce a set of financial statements diminish the reliability of an audit2 – Some financial elements are capable of being determined objectively (e.g., cash and contractual amounts for receivables and payables); and auditors are relied upon to verify that such elements are correctly stated. This is well within an auditor's area of expertise and entirely appropriate.
However, and as you well know, dozens of financial statement elements depend on management's subjective estimates of unknowable future events. The problem of audit reliability is almost entirely due to requirements for the auditor to state that management's judgments and statements of intent "appear reasonable." The problems inherent in this approach are material to all reporting entities, but may be particularly acute for financial insitutions and their holdings of financial instruments, which cuts to the heart of the most recent economic crisis.
Developments in accounting standards, most particularly the recent changes undertaken or proposed by the IFRS at the behest of the EC, are moving toward greater reliance on management's estimates and statements of intent. The EC in supporting these efforts, is actually making the problems identified in your Green Paper even worse, for they are rendering audit reliability ever more questionable and salient as a systemic threat. How is the auditor supposed to attest to the reasonableness of a management assertion that an identified contingent liability is not "capable of reliable measurement"; or that a required measurement procedure would entail "undue cost or effort"; much less an estimate of bad debt losses over the next twenty years? Neither the PCAOB nor the IAASB can be expected to provide adequate guidance for auditors on these critical aspects of their work, and I would hazard that they have not even begun to contemplate some of the audit questions that have arisen from some of the newer forms of management's assertions and estimates.
A Proposed Solution
If the EC's immediate objective is to increase audit reliability, and thereby reduce systemic risk to the financial sector the economy, then mandatory audit firm rotation would be a logical place to start. However, based on the experience in the U.S. leading up to the Sarbanes-Oxley Act, the Big Four will fight tooth and nail against such a proposal. Acting in concert with the AICPA, these firms successfully lobbied Congress to actually broaden auditor services to include an attestation report covering the functioning of their client's "internal control over financial reporting" (Section 404 of the Act). As you are no doubt aware, issuers have had mixed reactions to Section 404, and I doubt that the EC would even consider imposing the considerable transition costs on companies that are already struggling during the global recession.
But, even if the EC summons the will to rebuff the efforts of special interests and require mandatory audit firm rotation, this alone will not reduce the stranglehold of the Big Four on the largest companies in the EC. Because of the fundamental flaws in the audit model I have described above, smaller firms will not be able to benefit by ramping up their capabilities to function in the current financial reporting environment. This is just one reason why I firmly believe that financial reporting itself must be reformed; for in addition to the goal of providing better information to investors, the EC should lower barriers to entry so that more audit firms can economically serve the largest companies, and enhance audit reliability.
To reform financial reporting, the EC should:
- Move to replace cost-based models for reporting assets and liabilities with current values.3
- Estimates of current values should be provided by third parties, and not management or the auditor.
- Auditor involvement should be limited to: verifying the inputs to the valuations that can be objectively measured; attesting that the third party valuation experts seemed to behave in an objective manner; and that the third party valuation experts performed the procedures they said they would perform.
- The valuation experts would provide their own reports to accompany the financial statements.
Financial reporting is at a crossroads, and there is every indication that incremental adjustments to the system that has contributed to the global financial debacles of the past decades will do little to help prevent future debacles. It is not enough to solve the problem of Big Four concentration amongst the largest companies in the EC.
Thus, the bad news is that only a comprehensive solution has a chance of effecting the reform that is so badly needed; and special interest groups will fight fiercely as one to maintain their franchises. But, the good news is that the best solution is both simple to implement, and simple to explain. Investors want information about wealth and changes in wealth; and they want that information from reliable sources that are independent of management.
M. Barnier, if you want a quick fix to the problem of audit reliability, then I would suggest that you implement a system of mandatory audit firm rotation post haste. But, if your mission is to create a financial reporting platform on which the EU's economy can recover and grow, then you should form a new accounting standards board to create a comprehensive basis of accounting predicated on current values and financial reporting transparency. Systemic risks will be reduced, barriers to entry for auditing services will be lowered, and so will the cost of capital – all in one fell swoop.
I wish you the best of luck in your endeavors.
- In 2003, the U.S. Government Accountability Office reported that the average tenure of auditors to the Fortune 1000 was 22 years.
- For helping to crystallize my own thinking on this topic, I am indebted to Walter Schuetze's (former SEC Chief Accounting and founding FASB member) remarks to the New York State Society of CPAs, Auditing: Objective Evidence vs. Subjective Judgments, on September 9, 2003.
- Both the FASB and IASB generally prefer (with certain exceptions) to estimate current values in terms of exit prices, but my strong preference is for entry prices (i.e., replacement costs). The difference between these two approaches is not inconsequential on many dimensions. However, due to space and time constraints, I will reluctantly disregard these differences in order to keep the focus on higher-level features of my proposal.