- Email: [email protected]
Holding accountants accountable: Why audits fail, how they can succeed
Holding Accountants Accountable: Why Audits Fail, How They Can Succeed Jan E Muczyk, Ephraim P. Smith, and George Davis 22
Jan P. Muczyk is professor of management at Cleveland State University. Previous contributions to Business Horizons include "In Defense of Enlightened Hardball Management (july-August 1985) and "The Management Club: A Quality Circle for Managers" (January-February 1984). Ephraim P. Smith is dean of the College o f Business Administration at Cleveland State. He is coordinating author of Federal Taxation--Basic Principles and Federal Taxation--Advanced Topics, both published by the Commerce Clearing House in Chicago in 1985. George B. Davis is a visiting instructor at Cleveland State. Prior to hl's retirement, he was vice-president and treasurer of Donn Inc. and director of budgets at Lubrizol Corp. He has been a CPA since 1947.
It takes a talented player to guard Larry Bird. And it takes a skilled and streetwise team to audit the books of crafty management. T h e authors examine some reasons that audits fail and r e c o m m e n d some sop h i s t i c a t e d strategies to m a k e t h e m succeed. typical audit team, as presently constituted, is not so sophisticated as the managers inclined to engage in improprieties. Nor is it qualified to detect bad management practices and poor business judgment. In light of the position that the courts have taken, it may very well be that the unqualified opinion of auditors is expected to certify the health of the enterprise as represented in the financial statements. The audit is also supposed to ensure that, based upon the testing that was performed, the financial statements prepared by management appear to be fairly presented. If audits must bear such weight, the consequences to public accounting firms as the result of failed audits are enormous. After examining conventional explanations of audit failures, we will look at Ashby's Law of Requisite Variety, a cause for audit failures that is often overlooked. We will then recommend strategies that public accounting firms can pursue, individually or in combiT h e
nation, in the interest of making the audit team a more formidable match for unprincipled and/or inept managers.
Conventional Wisdom he accounting profession and the g e n e r a l public are increasingly confronted with a disturbing paradox: How is it that so many companies are getting clean, unqualified opinions from their public auditors immediately before filing for protection under Chapter 11 of the Federal Bankruptcy Code? Of course, this paradox is not new. The Congress, the accounting profession, and the Securities and Exchange Commission (SEC), as well as neutral observers, have proffered explanations that have been accepted more or less without challenge. This conventional wisdom consists of the following lines of reasoning. 1. Accounting and Auditing Standards Are Compromised Out of Fear of Losing a Client. A large client may
T
Business Horizons / November-December 1986
Holding Accountants Accountable: Why Audits Fail, How They Can Succeed
account for a sizable percentage of the revenues of an office of even a Big Eight accounting firm, let alone a regional or a local practice. Thus, the threat of losing the revenue pressures the auditors into stretching the interpretation of accepted accounting and auditing standards. So the question arises, Just how independent is the public auditor? a 2. Severe Competition Encourages Shortcuts. Public accounting, especially auditing, has b e c o m e very competitive. T h e r e f o r e , public accounting firms are u n d e r considerable pressure to cut costs. They do so by taking shortcuts that reduce the reliability of audits. 2 3. Compliance Testing Is Performed on Samples and Completed Months Before the End of the Client's Fiscal Year. In recent years, accounting firms have changed the manner in which audits are performed. It is now common practice to perform compliance tests on a r a n d o m sample of transactions. The sampling and compliance testing is completed several months prior to the end of the client's fiscal year. If the test proves to be adequate on the basis of the sample, little year-end work is performed on the accounts (substantive tests). 4. Auditors Must Exercise a Great Deal of Judgment. Auditors must exercise j u d g m e n t on numerous occasions: • There are at least several acceptable ways of recording a given transaction. • It is difficult to ascertain during an audit what is material and what is not. • There often exist two or more accepted accounting principles for a given situation (such as inventory valuation, depreciation, when to file unc o n s o l i d a t e d vs. c o n s o l i d a t e d statements, when to count revenue from a sale). Recently, the SEC warned the accounting profession and all publicly
1. See Gary Klott, "Auditors Feel the Heat of a New Scrutiny," New York Times, May 13, 1984, p. 1F. 2. See Lee Berton, "Audit Fees Fall as CPA Firms Jockey for Bids," The Wall Street Journal, January 28, 1985, p. 29.
held companies against the practice of enterprise and its attractiveness for "shopping" for favorable accounting investment purposes. Since this reopinions.strictive definition of an unqualified 5. Current Auditing and Account- opinion omits much more than it ining Standards Are Inadequate. A top- cludes, it is no paradox when a firm, ical example is the attempt by a task soon after receiving an unqualified force o f the American Institute of opinion, files for court protection from Certified Public Accountants (AICPA) creditors. After all, it is quite likely that to tighten standards regarding confir- a failing company will present its fimation procedures pertaining to the nancial statements fairly, based upon existence of collateral in repurchase the testing performed by the auditors. agreements. 4 This effort was inspired Federal H o m e Loan Bank (FHLB) by the failure of E.S.M. Government B o a r d examiners told General AcSecurities Inc. and Bevill, Bresler & counting Office auditors that they reSchulman Asset Management Inc. lied too heavily on financial statements 6. The Meaning of an Unqualified with regard to Beverly Hills Savings Opinion Is Very Restricted. There are and Loan Association, which became those who take the position that an insolvent in April 1985. The FHLB unqualified opinion merely states that Board examiners described the statethe financial statements prepared by ments as "useless." The statements were management appear to be fairly pre- audited by Touche Ross. 5 sented, based upon the testing that was Based on this limited definition of p e r f o r m e d . T h e advocates of this an u n q u a l i f i e d o p i n i o n , Philip B. widely held position hold that an un- Chenok, president of the AICPA, can qualified opinion does not assert that say that, of 50,000 audits done by CPA financial statements are free from any firms since 1979, only 123 of them fraudulent information. might be called "audit failures" as opNor does the unqualified opinion say posed to business failures. ~ anything about the quality of business A good example of Chenok's point decisions, and even less a b o u t the is the defense offered by Price Watersoundness of management practices. house in a civil suit brought against it Moreover, an unqualified opinion does by the SEC. Price Waterhouse and not certify in any way the health of the three of its partners were charged with securities-law violations in connection with allegedly false financial state3. Bruce Ingersoll, "SEC Warns Accountments issued by AM International. ants, Public Firms Against 'Shopping' for Audit Price Waterhouse contends that it is Opinions," The Wall Street Journal, April 18, 1985, p. 7. being blamed unfairly for poor man4. Lee Berton, "Accountants Seek to Tighten agementjudgment and business pracAuditing of Government Securities Transactices on the part of AM International tions," The Wall Street Journal, April 17, 1985, p. 8. officials and that its audit was properly conducted. 7 Chenok fails to take into account the distinct possibility that there are thousands of problem audits out there, but no one is the wiser until a firm goes "7' \ '
N -%
7". "~- ]
5. Bruce Ingersoll and Edward T. Pound, "Regulators Didn't Heed Signs of Trouble at Beverly Hills S&L, Probe Indicates," The Wall Street Journal, J u n e 19, 1985, p. 13. 6. Lee Berton, "Accountants Aim to Prevent Audit Failures," The Wall Street Journal, February 19, 1985, p. 4. For an enlightened discussion of the conventional reasons for audit failures and what can be done about them, see "A Question of Ethics," FE 1 (June 1985): 1222. 7. "Price Waterhouse, 3 Partners Charged by SEC over Audit," The Wall Street Journal, J u n e 21, 1985, p. 4.
23
"In 1933 the accounting profession sought out the role of public watchdog in exchange for handsome fees. Its argument was that no one else was as qualified to certify annual reports. Now the courts are asking public accountants, for better or worse, to sleep in the bed that they made for themselves." 24 bankrupt or a massive fraud is uncovered. Understandably, the accounting profession supports the narrow interpretation of an unqualified opinion because it minimizes the auditors' legal liability. However, this restrictive construction poses a f u n d a m e n t a l question: What good is an unqualified opinion, and why should the law require publicly held firms to seek it? 7. The Courts Are Applying Product Liability Law to Accountants. Individuals who have examined legal decisions have concluded that the restrictive definition of an unqualified opinion has been seriously eroded, if not rejected outright. The courts appear to have applied product liability law to accountants' liability, s After all, in 1933 the accounting profession sought out the role of public watchdog in exchange for handsome fees. Its argument was that no one else was as qualified to certify annual reports. Now the courts are asking public accountants, for better or worse, to sleep in the bed that they made for themselves. 9 C o u r t s have also e x p a n d e d the classes of people to whom public accountants may be !iable and the classes of actions for which accountants may be held liable. It is estimated that at least 75 percent of the lawsuits against
8. Newton N. Minow, "Accountants' Liability and the Litigation Explosion," Journal of Accountancy, September 1984: 70-86. 9. Lee Berton, "Investors Call CPAs to Account," The Wall StreetJournal, January 28, 1985, p. 30.
standards and issuing more qualified opinions.ll An Overlooked Reason: Ashby's Law the nation's largest firms are brought by third parties, such as investors and creditors. A Partial Explanation
large percentage--a precise figure is incalculable--of audits conducted by public accountants may fail, however, because of Ashby's Law of Requisite Variety.12 Simply stated, Ashby's law posits that only variety can control variety. For a control system to be effective, the controller must possess as many countermeasures as the controlled has courses of action, and the countermeasures must be as sophisticated as the courses of action. In an auditing context, Ashby's law means that, in order to produce consistently reliable audits that will protect the interests of investors, creditors, customers, and the general public, the audit team must know as much about the business as the people running it. This knowledge includes being streetwise--being familiar with the legerdemain and chicanery that are likely to take place in the business. To use a sports analogy, if Larry Bird is to be prevented from amassing his average points, rebounds, and assists, Ashby's law would prescribe his being guarded by an equally talented defensive player.
A
o doubt a certain proportion of public audits fail for one of these seven reasons. According to Public Accounting Report, the industry newsletter, of the 370 companie,s that reported a change in outside auditors in 1983, only 24 percent had received less than an unqualified or clean opinion from the auditor that their financial statements gave a fair picture of their operations, according to g e n e r a l l y a c c e p t e d a c c o u n t i n g principles. The most popular ~teason for changing auditors, cited by 36 percent of the companies, was to get a break on audit fees. T h e Cohen Commission, a panel appointed by the AICPA, produced evidence that some cutbacks in auditing work had taken place because of the pressure that auditing fees had placed on accounting firmsJ ° It is e n c o u r a g i n g to see that the public accounting profession appears to be resisting the economic pressures to issue unqualified opinions when 11. Lee Berton, "Number of Qualified Opindoubt exists. It is tightening audit ions Is Increasing," The Wall StreetJournal, June
N
10. See Ktott (note 1).
5, 1985, p. 6. 12. See Peter Blau, "Formal Organization," AmericanJournal of Sociology 63 (1957): 58-69.
Holding Accountants Accountable: Why Audits Fail, How They Can Succeed
"In order to produce consistently reliable audits that will protect the interests of investors, creditors, customers, and the general public, the audit team must know as much about the business as the people running it. This knowledge includes being streetwise being familiar with the legerdemain and chicanery that are likely to take place in the business." 25
Why Is Ashby's Law Absent from Audits? Ashby's law is violated by the customary composition of the audit team in a large accounting firm. The makeup of an audit team is determined by the customs that prevail in large accounting firms. These customs are, in part, a function of economics.
Homegrown Teams and the Pecking Order Large accounting firms, especially the so-called Big Eight, prefer to homegrow their own auditors. Therefore, they hire accounting majors with high grade point averages immediately after these young people receive their baccalaureate degrees. The firms assist these young men and women in obtaining their CPA certificates and then, through in-house training programs, teach them the proper auditing approach as envisioned by each firm. Generally, these recruits have not held any sort of significant full-time job prior to j o i n i n g the public accounting firm. These new college graduates join a public accounting firm as staff accountants. After two years or so, the novices a r e p r o m o t e d to seniors. (Sometimes there is an intermediate step called "in-charge".) A f t e r approximately three years as seniors, the auditors are promoted to supervisors. Barring public atrocities, promotions up to this point are routine. Henceforth, the promotions become competitive.
After the supervisor spends three or four years in-grade, he or she is either promoted to manager or counseled out of the firm. After four or five years as manager, the auditor is either promoted to partner or counseled out of the practice. On the average, it takes twelve or thirteen years to make partner. Of course, numerous individuals who would have made partner had they stayed leave for what they consider better or more suitable jobs. The composition of audit teams depends on the size of the engagement. Most audit engagements, however, consist of staff accountants, seniors, at least one supervisor, a manager, and a partner in charge of the engagement. Unless an engagement is quite large, the manager and the partner are responsible for multiple engagements. Even a supervisor is responsible f o r m o r e t h a n o n e small engagement. In other words, until one reaches the manager or partner level, no one on the engagement is likely to have a great deal of sophistication regarding the practices and abuses of a given industry.
Lack of Sophistication about Specific Industries
• Because of the problems experienced by the agricultural industry, many of the farm loans that agricultural banks hold in their portfolios are questionable at best. Yet only a person who knows the agricultural industry thoroughly can correctly value these loans. • Only people who had a complete appreciation of the oil industry could have audited reliably the Penn Square and Continental Illinois banks, which relied on loans to oil exploration firms. • American Savings & Loan Association created a real estate task force to evaluate the quality of its loans. As a result of the study, American Savings & Loan Association increased its loan-loss reserves from $90.5 million to $472.5 million. 1~ Could a typical auditing team make an accurate valuation of those real estate loans? • Ernst & Whinney contends its auditors could not possibly have detected that Jake Butcher was shifting bad loans from United American Bank of Tennessee to other Butcher-controlled banks.t4
Turnover Precludes Intimate Knowledge
Not only m u s t the a u d i t t e a m be A number of managers and even gen- knowledgeable about industry praceral audit p a r t n e r s have advanced tices, but also it must know intimately through the ranks by auditing com- the organization being audited. For panies in a variety of industries. So even that to happen, a given team needs to though they know the auditing process audit a given organization over time. thoroughly, they have not necessarily acquired in-depth knowledge about a 13. Kathleen A. Hughes, "Financial Corp. of single industry. America Is Still Struggling," The Wall StreetJourCases abound where such industry- nal, June 24, 1985, p.6. specific knowledge is necessary. 14. Klott (note 1).
"Currently we are asking young people between 22 and 28 years of age who do not know much about a client or the industry to detect questionable practices of senior managers who know a great deal about their business and their industry and are motivated to disguise these practices as best they can." 26 Yet, because o f f r e q u e n t reassignments, rapid promotions, and the high turnover rate, especially at the staff, senior, and supervisor levels (a Big Eight firm turns over every five years), the necessary stability is frequently lacking.
Delegation Isn't Always Wise
T h e Federal Deposit I n s u r a n c e Corporation (FDIC) estimates that 50 percent of the 79 bank failures that occurred last year resulted at least in part from criminal conduct. 15 A federal bankruptcy judge in Toledo, Ohio, recently approved a $383,512 settlement against Arthur Young & Co. for failing to uncover fraud in the costliest brokerage firm collapse in U.S. his-
It is necessary to examine carefully who tory. 16 on an audit engagement does what in Of course, there are a number of order to ascertain whether the dele- reasons that the kind of role reversal gation of duties and responsibilities being suggested may not be well remight be a source of certain audit fail- ceived by public accounting firms. ures. Many of the improprieties that Managers and partners are unlikely to have led to problem audits could best condescend to such routine tasks, even be detected at the level of compliance with staff accountants, seniors, and testing and not at the review level, supervisors to assist them with the most providing the persons conducting and mundane duties. overseeing the compliance tests are as If managers and partners were to sophisticated as those committing the get involved in compliance testing, improprieties. Managers and part- more of them would be needed. This ners are far more savvy than staff ac- fact, coupled with the high billing rates countants, seniors, and supervisors. that they charge, would raise the cost T h e r e f o r e , because they are m o r e of an audit significantly. And if partlikely to uncover irregularities, they ners were spending a considerable should be involved in compliance test- amount of time on compliance testing, who would be developing the ing to a greater degree. Moreover, managers and partners practice and managing the partnerof the auditing firm are less likely to ship? be intimidated by managers and executives of the client than are staff ac- Sophisticated Strategies for Auditors countants, seniors, and supervisors. Let hat happens if we concede us face up to reality: currently we are that a typical auditing team asking young people between 22 and is no m a t c h for a crafty 28 years of age who do not know much about a client or the industry to detect management bent on engaging in imthe questionable practices of senior 15. Charles P. Alexander, "Crime in the managers who know a great deal about Tzme,June 10, 1985, p. 56. their business and their industry--and Suites," 16. "Arthur Young Accord with Bell and are motivated to disguise these prac- Beckwith Is Approved by Judge," The Wall Street tices as best they can. Journal, June 6, 1985, p. 31.
W
proprieties and/or questionable business practices? If we concede that the team is inadequately prepared to uncover serious negligence or incompetence? The solution is to devise an auditing team that is management's equal in sophistication, experience, and cunning. Toward that end, public accounting firms should contemplate the following strategies.
1. Greater Specialization. To the extent possible, public accounting firms should encourage entry-level auditors to specialize by industry rather than making them auditing generalists. It appears that such a trend already has emerged in large public accounting firms, 2. Role Reversal. Managers and partners should spend more time designing and overseeing compliance testing. Career managers specializing in the review process and exceptional supervisors with recent graduate degrees could fill in for the partners and managers in the review process. 3. Industry Guides. The Department of Energy is currently investig a t i n g a l l e g e d oil p r i c e c o n t r o l violations by the Atlantic Richfield Co. The investigation was prompted by testimony provided by a former Arco executive. "Trying to prove that certain transactions were structured to evade price regulations is like trying to follow trails in the jungle," a federal investigator said. "You don't know how to use them
Holding Accountants Accountable: Why Audits Fail, How They Can Succeed
unless you have a guide. ''17 The former Arco executive became the guide. The E. F. Hutton check overdraft scheme by which hundreds of banks were defrauded was uncovered by a clerk at one of the affected banks on the basis of a transaction pattern that indicated possible "kiting." Such a pattern would be familiar to someone who knows that facet of the banking business. But would it be recognized by an auditor with no banking experience? Auditing teams need guides as well. In those instances where the audit team lacks an industry specialist, one should be included, even if it means hiring an industry specialist at an advanced level. If one office cannot support an industry expert, then the specialist can be shared by two or more offices of the public accounting firm. (Clearly, this strategy is not practical if the public accounting firm audits j u s t one company in an industry, unless the company is very large.) Utilizing industry experts who already are on the management consulting staff to assist with audits is another option. After all, Arthur Andersen is the largest U.S. consulting firm, and seven of the Big Eight public accounting firms a p p e a r in the top twenty consulting firms in the nat i o n ) S M o r e o v e r , public accounting firms are acquiring expertise in certain industries by merging with companies in those industries. 19 Retaining "external" consultants on an ad hoc basis is still another possibility. Requiring a second partner review for all audits, especially when the second partner is an industry expert, also makes eminent sense. 2° 4. Rethinking Training. Perhaps public accounting firms need to rethink the training that they provide their auditors. Specifically, courses on the possible accounting abuses in general and on abuses that are peculiar to a particular industry might improve 17. Allanna Sullivan, "Ex-Aide's Testimony Leads to Inquiry of Arco," The Wall Street Journal, May 15, 1985, p. 6, 18. "Who Gives the Most Advice,"Forbes, October 10, 1983, p. 142. 19. Mark Stevens, "Is Your Accounting Firm Still An Accounting Firm?" FE 1 (July 1985): 24-29. 20. Arthur M. Wood, "Statements in Quotes," Journal of Accountancy, August 1985: 142-48.
"The fox knows much, I i but more he that catches him." [Mucho sabe la zorra, pero mas , el que la toma.]
ship, but the brass ring would not be so important if the direct and indirect compensation were more lucrative at the lower grades. 21
Accounting Must Be Accountable
ince 1980, Arthur Andersen & Co. has had court settlements in excess of $137 million. In New t York State three of the five insurers for the state's 1,600 CPA firm offices recently stopped offering such insurance. Premiums from the remaining the audit team's chances of uncover- two insurers have risen as much as 400 ing irregularities. Moreover, auditors percent. In California, premiums for might be put through a training pro- more than 1,700 CPA firm offices have gram that would teach them how to just been boosted 140 percent. And think along the lines employed by per- 14,000 CPA practice units insured unsons predisposed to committing im- der a program of the AICPA have just proprieties. It may very well be that, had their premiums for liability insurin order to catch a dishonest person, ance raised as much as 300 percent. 22 If this trend continues, many public one must be able to think like one. It appears that the courts insist that accounting firms in the U.S. will have audited financial statements accu- to go without insurance. One large lerately reflect the financial health of gal award against them could precipthe organization. Financial state- itate financial disaster. In Britain, international accounting ments could prove misleading because the auditors failed to uncover firms are considering becoming corillegal behavior on the part of man- porations in o r d e r to shield themagement or because the auditors failed selves against mounting law suits. The to detect poor management practices Bank of England filed a $125 million or bad business judgment. If such is suit against Arthur Young & Co. over the case, the audit team needs to per- the failure of Johnson Matthey Bankform a management audit as well as ers. 23 The British government filed a a financial audit. An MBA degree $240 million suit against Arthur Ancombined with management experi- dersen regarding the failed De Loence may then be just as important as rean Motor Co. 24 Thus, on both sides an accounting degree with auditing of the Atlantic the incentive is great experience. for increasing the sophistication of the 5. Greater Stability of Auditing audit team. Experience teaches us that, if an inTeam. Public accounting firms might make a greater effort to preserve the dustry on which the public depends continuity of the audit team assigned cannot police itself, the federal govto a particular client. Toward that end, ernment eventually will step in. Public the firm may elect to increase the in- accounting is no exception. It is only centives for staff, in-charge, seniors, and supervisors to remain longer with 21. For a more detailed discussion of ways to the firm. turnover, see Barry F. Doll, "Staff T h r e e c h a n g e s readily c o m e to decrease Turnover: How to Manage It," Journal of Acmind: countancy, December 1983: 76-82. 22. See Lee Berton, "As Accounting Firms' 1. Better pay; Premiums Soar, Some Might Drop Liability In2. Better fringe benefits; and surance," The Wall Street Journal, May 30, 1985, 3. Providing more time in a grade p. 10. before the auditor must be promoted 23. "Britain Plans to Sue Arthur Young & Co.," The Wall Street Journal, June 31, 1985, p. or counseled out of the firm. Pursuing this last strategy would re- 24. 24. George Anders, "U.K. Accountants May quire individuals to wait longer until Incorporate to Ward Off Suits," The Wall Street they were invited into the partner- Journal, June 28, 1985, p. 22.
Spanish proverb
S
27
a
"Experience teaches us that, if an industry on which the public depends cannot police itself, the federal government eventually will step in. Public accounting is no exception. It is only matter of time before negative public opinion is translated into public policy in other words, regulatory legislation."
28 a matter of time before negative public o p i n i o n is translated into public p o l i c y - - i n o t h e r words, r e g u l a t o r y legislation. 25 T h e sentiments expressed by two influential Congressmen should suffice to drive the point home. According to Congressman J o h n D. Dingell of Michigan: T h e work product of the large firms is evaluated through a peer review system that they [the Big Eight] have set up. This system is overseen by the Public Oversight Board--selected and paid for by the m a j o r firms t h e m selves. T h e firms review each other's work, congratulate each other after noting a few minor errors, perform the whole process in the d a r k - - a n d then destroy the work papers so nobody can later check into or question their judgment. The "clean" review opinions they give e a c h o t h e r a r e s i m i l a r to t h e "clean" audit opinions they have given many of their clients shortly b e f o r e those businesses have gone b a n k r u p t or experienced serious losses. Those failures have had devastating effects on shareholders, depositors, customers, suppliers, communities and, often, the federal government, when it has had to pick up the tab at the end. 26
His words are echoed by Congressm a n Ron Wyden of Oregon: What we have on the table is very obvious and that is a massive failure of the i n d e p e n d e n t auditing system in this country. What disturbs me is that the system literally breeds this kind of buck passing. 27 Financial s t a t e m e n t s t h a t receive unqualified opinions from public auditors could be misleading because the auditors failed to uncover illegal behavior on the part of m a n a g e m e n t or because the auditors failed to detect bad m a n a g e m e n t practices and poor business j u d g m e n t . T h e impact on the creditors, investors, and the general public, however, is the same. In light of the position that the courts have taken, it may very well be that the unqualified opinion is expected to certify the health of the enterprise as r e p r e s e n t e d in the financial statements, as well as to ensure that, based u p o n the testing that was performed, the financial statements prepared by m a n a g e m e n t appear to be fairly presented. 28
vestigation. For his entire speech, see "DingeU Voices Concerns on Accounting Profession at D.C. Meeting,"WG&L Accounting News 6 (Summer 1985): 10. 27. Wyden, a member of the House Energy and CommerceSubcommitteeon Oversightand Investigation,was speakingat the April 17, 1985, hearing on the auditor's role in financial re25. For a better appreciation of the relation- porting. See "Dingell Hearings Continue to ship between public opinion and Congressional Probe Auditor's Role in Financial Reporting," action, see WilliamJ. Corbert, "PR Challenges WG&L Accounting News 6 (Summer 1985): 8. 28. Dan C. Kneer et al., "Just How Much Facing the Profession,"Journal of Accountancy, Should a Financial Statement ReallyDisclose?" August 1985: 112-22. 26. Dingell heads the House Energy and Business Horizons, November-December 1985: CommerceSubcommitteeon Oversightand In- 65-71.
I f such expectations become law-and evidence that supports this view is m o u n t i n g - - t h e n the auditing team will be responsible for a m a n a g e m e n t audit as well as a financial audit. A n d m a n a g e m e n t audits require different kinds of expertise than financial audits alone. iven the litigious nature of our ,society, it is unlikely that t h e restrictive d e f i n i t i o n o f an unqualified opinion will ever be reinstated. On the other hand, it is extremely likely that the application of product liability law to accountants' liability will be extended even further. T h e r e f o r e , it behooves public accounting firms to take all the necessary steps to ensure that an unqualified opinion means that the financial statements accurately represent the actual financial condition of the audited organization. Otherwise, the very existence of public accounting firms is threatened. Public accounting firms need to adopt strategies--which can be pursued individually or in c o m b i n a t i o n - to make the audit team a more formidable match for unprincipled and inept managers. True, adopting our recommendations will increase the cost of an audit. However, if all public accounting firms were to adopt some or all of the suggestions, the cost increase would be the same for all firms, and no one would be at a competitive disadvantage. T h e cost of failed audits and unchallenged but inaccurate audits must be weighed against the cost and benefits of audits that are accurate. []
G
Jan P. Muczyk is professor of management at Cleveland State University. Previous contributions to Business Horizons include "In Defense of Enlightened Hardball Management (july-August 1985) and "The Management Club: A Quality Circle for Managers" (January-February 1984). Ephraim P. Smith is dean of the College o f Business Administration at Cleveland State. He is coordinating author of Federal Taxation--Basic Principles and Federal Taxation--Advanced Topics, both published by the Commerce Clearing House in Chicago in 1985. George B. Davis is a visiting instructor at Cleveland State. Prior to hl's retirement, he was vice-president and treasurer of Donn Inc. and director of budgets at Lubrizol Corp. He has been a CPA since 1947.
It takes a talented player to guard Larry Bird. And it takes a skilled and streetwise team to audit the books of crafty management. T h e authors examine some reasons that audits fail and r e c o m m e n d some sop h i s t i c a t e d strategies to m a k e t h e m succeed. typical audit team, as presently constituted, is not so sophisticated as the managers inclined to engage in improprieties. Nor is it qualified to detect bad management practices and poor business judgment. In light of the position that the courts have taken, it may very well be that the unqualified opinion of auditors is expected to certify the health of the enterprise as represented in the financial statements. The audit is also supposed to ensure that, based upon the testing that was performed, the financial statements prepared by management appear to be fairly presented. If audits must bear such weight, the consequences to public accounting firms as the result of failed audits are enormous. After examining conventional explanations of audit failures, we will look at Ashby's Law of Requisite Variety, a cause for audit failures that is often overlooked. We will then recommend strategies that public accounting firms can pursue, individually or in combiT h e
nation, in the interest of making the audit team a more formidable match for unprincipled and/or inept managers.
Conventional Wisdom he accounting profession and the g e n e r a l public are increasingly confronted with a disturbing paradox: How is it that so many companies are getting clean, unqualified opinions from their public auditors immediately before filing for protection under Chapter 11 of the Federal Bankruptcy Code? Of course, this paradox is not new. The Congress, the accounting profession, and the Securities and Exchange Commission (SEC), as well as neutral observers, have proffered explanations that have been accepted more or less without challenge. This conventional wisdom consists of the following lines of reasoning. 1. Accounting and Auditing Standards Are Compromised Out of Fear of Losing a Client. A large client may
T
Business Horizons / November-December 1986
Holding Accountants Accountable: Why Audits Fail, How They Can Succeed
account for a sizable percentage of the revenues of an office of even a Big Eight accounting firm, let alone a regional or a local practice. Thus, the threat of losing the revenue pressures the auditors into stretching the interpretation of accepted accounting and auditing standards. So the question arises, Just how independent is the public auditor? a 2. Severe Competition Encourages Shortcuts. Public accounting, especially auditing, has b e c o m e very competitive. T h e r e f o r e , public accounting firms are u n d e r considerable pressure to cut costs. They do so by taking shortcuts that reduce the reliability of audits. 2 3. Compliance Testing Is Performed on Samples and Completed Months Before the End of the Client's Fiscal Year. In recent years, accounting firms have changed the manner in which audits are performed. It is now common practice to perform compliance tests on a r a n d o m sample of transactions. The sampling and compliance testing is completed several months prior to the end of the client's fiscal year. If the test proves to be adequate on the basis of the sample, little year-end work is performed on the accounts (substantive tests). 4. Auditors Must Exercise a Great Deal of Judgment. Auditors must exercise j u d g m e n t on numerous occasions: • There are at least several acceptable ways of recording a given transaction. • It is difficult to ascertain during an audit what is material and what is not. • There often exist two or more accepted accounting principles for a given situation (such as inventory valuation, depreciation, when to file unc o n s o l i d a t e d vs. c o n s o l i d a t e d statements, when to count revenue from a sale). Recently, the SEC warned the accounting profession and all publicly
1. See Gary Klott, "Auditors Feel the Heat of a New Scrutiny," New York Times, May 13, 1984, p. 1F. 2. See Lee Berton, "Audit Fees Fall as CPA Firms Jockey for Bids," The Wall Street Journal, January 28, 1985, p. 29.
held companies against the practice of enterprise and its attractiveness for "shopping" for favorable accounting investment purposes. Since this reopinions.strictive definition of an unqualified 5. Current Auditing and Account- opinion omits much more than it ining Standards Are Inadequate. A top- cludes, it is no paradox when a firm, ical example is the attempt by a task soon after receiving an unqualified force o f the American Institute of opinion, files for court protection from Certified Public Accountants (AICPA) creditors. After all, it is quite likely that to tighten standards regarding confir- a failing company will present its fimation procedures pertaining to the nancial statements fairly, based upon existence of collateral in repurchase the testing performed by the auditors. agreements. 4 This effort was inspired Federal H o m e Loan Bank (FHLB) by the failure of E.S.M. Government B o a r d examiners told General AcSecurities Inc. and Bevill, Bresler & counting Office auditors that they reSchulman Asset Management Inc. lied too heavily on financial statements 6. The Meaning of an Unqualified with regard to Beverly Hills Savings Opinion Is Very Restricted. There are and Loan Association, which became those who take the position that an insolvent in April 1985. The FHLB unqualified opinion merely states that Board examiners described the statethe financial statements prepared by ments as "useless." The statements were management appear to be fairly pre- audited by Touche Ross. 5 sented, based upon the testing that was Based on this limited definition of p e r f o r m e d . T h e advocates of this an u n q u a l i f i e d o p i n i o n , Philip B. widely held position hold that an un- Chenok, president of the AICPA, can qualified opinion does not assert that say that, of 50,000 audits done by CPA financial statements are free from any firms since 1979, only 123 of them fraudulent information. might be called "audit failures" as opNor does the unqualified opinion say posed to business failures. ~ anything about the quality of business A good example of Chenok's point decisions, and even less a b o u t the is the defense offered by Price Watersoundness of management practices. house in a civil suit brought against it Moreover, an unqualified opinion does by the SEC. Price Waterhouse and not certify in any way the health of the three of its partners were charged with securities-law violations in connection with allegedly false financial state3. Bruce Ingersoll, "SEC Warns Accountments issued by AM International. ants, Public Firms Against 'Shopping' for Audit Price Waterhouse contends that it is Opinions," The Wall Street Journal, April 18, 1985, p. 7. being blamed unfairly for poor man4. Lee Berton, "Accountants Seek to Tighten agementjudgment and business pracAuditing of Government Securities Transactices on the part of AM International tions," The Wall Street Journal, April 17, 1985, p. 8. officials and that its audit was properly conducted. 7 Chenok fails to take into account the distinct possibility that there are thousands of problem audits out there, but no one is the wiser until a firm goes "7' \ '
N -%
7". "~- ]
5. Bruce Ingersoll and Edward T. Pound, "Regulators Didn't Heed Signs of Trouble at Beverly Hills S&L, Probe Indicates," The Wall Street Journal, J u n e 19, 1985, p. 13. 6. Lee Berton, "Accountants Aim to Prevent Audit Failures," The Wall Street Journal, February 19, 1985, p. 4. For an enlightened discussion of the conventional reasons for audit failures and what can be done about them, see "A Question of Ethics," FE 1 (June 1985): 1222. 7. "Price Waterhouse, 3 Partners Charged by SEC over Audit," The Wall Street Journal, J u n e 21, 1985, p. 4.
23
"In 1933 the accounting profession sought out the role of public watchdog in exchange for handsome fees. Its argument was that no one else was as qualified to certify annual reports. Now the courts are asking public accountants, for better or worse, to sleep in the bed that they made for themselves." 24 bankrupt or a massive fraud is uncovered. Understandably, the accounting profession supports the narrow interpretation of an unqualified opinion because it minimizes the auditors' legal liability. However, this restrictive construction poses a f u n d a m e n t a l question: What good is an unqualified opinion, and why should the law require publicly held firms to seek it? 7. The Courts Are Applying Product Liability Law to Accountants. Individuals who have examined legal decisions have concluded that the restrictive definition of an unqualified opinion has been seriously eroded, if not rejected outright. The courts appear to have applied product liability law to accountants' liability, s After all, in 1933 the accounting profession sought out the role of public watchdog in exchange for handsome fees. Its argument was that no one else was as qualified to certify annual reports. Now the courts are asking public accountants, for better or worse, to sleep in the bed that they made for themselves. 9 C o u r t s have also e x p a n d e d the classes of people to whom public accountants may be !iable and the classes of actions for which accountants may be held liable. It is estimated that at least 75 percent of the lawsuits against
8. Newton N. Minow, "Accountants' Liability and the Litigation Explosion," Journal of Accountancy, September 1984: 70-86. 9. Lee Berton, "Investors Call CPAs to Account," The Wall StreetJournal, January 28, 1985, p. 30.
standards and issuing more qualified opinions.ll An Overlooked Reason: Ashby's Law the nation's largest firms are brought by third parties, such as investors and creditors. A Partial Explanation
large percentage--a precise figure is incalculable--of audits conducted by public accountants may fail, however, because of Ashby's Law of Requisite Variety.12 Simply stated, Ashby's law posits that only variety can control variety. For a control system to be effective, the controller must possess as many countermeasures as the controlled has courses of action, and the countermeasures must be as sophisticated as the courses of action. In an auditing context, Ashby's law means that, in order to produce consistently reliable audits that will protect the interests of investors, creditors, customers, and the general public, the audit team must know as much about the business as the people running it. This knowledge includes being streetwise--being familiar with the legerdemain and chicanery that are likely to take place in the business. To use a sports analogy, if Larry Bird is to be prevented from amassing his average points, rebounds, and assists, Ashby's law would prescribe his being guarded by an equally talented defensive player.
A
o doubt a certain proportion of public audits fail for one of these seven reasons. According to Public Accounting Report, the industry newsletter, of the 370 companie,s that reported a change in outside auditors in 1983, only 24 percent had received less than an unqualified or clean opinion from the auditor that their financial statements gave a fair picture of their operations, according to g e n e r a l l y a c c e p t e d a c c o u n t i n g principles. The most popular ~teason for changing auditors, cited by 36 percent of the companies, was to get a break on audit fees. T h e Cohen Commission, a panel appointed by the AICPA, produced evidence that some cutbacks in auditing work had taken place because of the pressure that auditing fees had placed on accounting firmsJ ° It is e n c o u r a g i n g to see that the public accounting profession appears to be resisting the economic pressures to issue unqualified opinions when 11. Lee Berton, "Number of Qualified Opindoubt exists. It is tightening audit ions Is Increasing," The Wall StreetJournal, June
N
10. See Ktott (note 1).
5, 1985, p. 6. 12. See Peter Blau, "Formal Organization," AmericanJournal of Sociology 63 (1957): 58-69.
Holding Accountants Accountable: Why Audits Fail, How They Can Succeed
"In order to produce consistently reliable audits that will protect the interests of investors, creditors, customers, and the general public, the audit team must know as much about the business as the people running it. This knowledge includes being streetwise being familiar with the legerdemain and chicanery that are likely to take place in the business." 25
Why Is Ashby's Law Absent from Audits? Ashby's law is violated by the customary composition of the audit team in a large accounting firm. The makeup of an audit team is determined by the customs that prevail in large accounting firms. These customs are, in part, a function of economics.
Homegrown Teams and the Pecking Order Large accounting firms, especially the so-called Big Eight, prefer to homegrow their own auditors. Therefore, they hire accounting majors with high grade point averages immediately after these young people receive their baccalaureate degrees. The firms assist these young men and women in obtaining their CPA certificates and then, through in-house training programs, teach them the proper auditing approach as envisioned by each firm. Generally, these recruits have not held any sort of significant full-time job prior to j o i n i n g the public accounting firm. These new college graduates join a public accounting firm as staff accountants. After two years or so, the novices a r e p r o m o t e d to seniors. (Sometimes there is an intermediate step called "in-charge".) A f t e r approximately three years as seniors, the auditors are promoted to supervisors. Barring public atrocities, promotions up to this point are routine. Henceforth, the promotions become competitive.
After the supervisor spends three or four years in-grade, he or she is either promoted to manager or counseled out of the firm. After four or five years as manager, the auditor is either promoted to partner or counseled out of the practice. On the average, it takes twelve or thirteen years to make partner. Of course, numerous individuals who would have made partner had they stayed leave for what they consider better or more suitable jobs. The composition of audit teams depends on the size of the engagement. Most audit engagements, however, consist of staff accountants, seniors, at least one supervisor, a manager, and a partner in charge of the engagement. Unless an engagement is quite large, the manager and the partner are responsible for multiple engagements. Even a supervisor is responsible f o r m o r e t h a n o n e small engagement. In other words, until one reaches the manager or partner level, no one on the engagement is likely to have a great deal of sophistication regarding the practices and abuses of a given industry.
Lack of Sophistication about Specific Industries
• Because of the problems experienced by the agricultural industry, many of the farm loans that agricultural banks hold in their portfolios are questionable at best. Yet only a person who knows the agricultural industry thoroughly can correctly value these loans. • Only people who had a complete appreciation of the oil industry could have audited reliably the Penn Square and Continental Illinois banks, which relied on loans to oil exploration firms. • American Savings & Loan Association created a real estate task force to evaluate the quality of its loans. As a result of the study, American Savings & Loan Association increased its loan-loss reserves from $90.5 million to $472.5 million. 1~ Could a typical auditing team make an accurate valuation of those real estate loans? • Ernst & Whinney contends its auditors could not possibly have detected that Jake Butcher was shifting bad loans from United American Bank of Tennessee to other Butcher-controlled banks.t4
Turnover Precludes Intimate Knowledge
Not only m u s t the a u d i t t e a m be A number of managers and even gen- knowledgeable about industry praceral audit p a r t n e r s have advanced tices, but also it must know intimately through the ranks by auditing com- the organization being audited. For panies in a variety of industries. So even that to happen, a given team needs to though they know the auditing process audit a given organization over time. thoroughly, they have not necessarily acquired in-depth knowledge about a 13. Kathleen A. Hughes, "Financial Corp. of single industry. America Is Still Struggling," The Wall StreetJourCases abound where such industry- nal, June 24, 1985, p.6. specific knowledge is necessary. 14. Klott (note 1).
"Currently we are asking young people between 22 and 28 years of age who do not know much about a client or the industry to detect questionable practices of senior managers who know a great deal about their business and their industry and are motivated to disguise these practices as best they can." 26 Yet, because o f f r e q u e n t reassignments, rapid promotions, and the high turnover rate, especially at the staff, senior, and supervisor levels (a Big Eight firm turns over every five years), the necessary stability is frequently lacking.
Delegation Isn't Always Wise
T h e Federal Deposit I n s u r a n c e Corporation (FDIC) estimates that 50 percent of the 79 bank failures that occurred last year resulted at least in part from criminal conduct. 15 A federal bankruptcy judge in Toledo, Ohio, recently approved a $383,512 settlement against Arthur Young & Co. for failing to uncover fraud in the costliest brokerage firm collapse in U.S. his-
It is necessary to examine carefully who tory. 16 on an audit engagement does what in Of course, there are a number of order to ascertain whether the dele- reasons that the kind of role reversal gation of duties and responsibilities being suggested may not be well remight be a source of certain audit fail- ceived by public accounting firms. ures. Many of the improprieties that Managers and partners are unlikely to have led to problem audits could best condescend to such routine tasks, even be detected at the level of compliance with staff accountants, seniors, and testing and not at the review level, supervisors to assist them with the most providing the persons conducting and mundane duties. overseeing the compliance tests are as If managers and partners were to sophisticated as those committing the get involved in compliance testing, improprieties. Managers and part- more of them would be needed. This ners are far more savvy than staff ac- fact, coupled with the high billing rates countants, seniors, and supervisors. that they charge, would raise the cost T h e r e f o r e , because they are m o r e of an audit significantly. And if partlikely to uncover irregularities, they ners were spending a considerable should be involved in compliance test- amount of time on compliance testing, who would be developing the ing to a greater degree. Moreover, managers and partners practice and managing the partnerof the auditing firm are less likely to ship? be intimidated by managers and executives of the client than are staff ac- Sophisticated Strategies for Auditors countants, seniors, and supervisors. Let hat happens if we concede us face up to reality: currently we are that a typical auditing team asking young people between 22 and is no m a t c h for a crafty 28 years of age who do not know much about a client or the industry to detect management bent on engaging in imthe questionable practices of senior 15. Charles P. Alexander, "Crime in the managers who know a great deal about Tzme,June 10, 1985, p. 56. their business and their industry--and Suites," 16. "Arthur Young Accord with Bell and are motivated to disguise these prac- Beckwith Is Approved by Judge," The Wall Street tices as best they can. Journal, June 6, 1985, p. 31.
W
proprieties and/or questionable business practices? If we concede that the team is inadequately prepared to uncover serious negligence or incompetence? The solution is to devise an auditing team that is management's equal in sophistication, experience, and cunning. Toward that end, public accounting firms should contemplate the following strategies.
1. Greater Specialization. To the extent possible, public accounting firms should encourage entry-level auditors to specialize by industry rather than making them auditing generalists. It appears that such a trend already has emerged in large public accounting firms, 2. Role Reversal. Managers and partners should spend more time designing and overseeing compliance testing. Career managers specializing in the review process and exceptional supervisors with recent graduate degrees could fill in for the partners and managers in the review process. 3. Industry Guides. The Department of Energy is currently investig a t i n g a l l e g e d oil p r i c e c o n t r o l violations by the Atlantic Richfield Co. The investigation was prompted by testimony provided by a former Arco executive. "Trying to prove that certain transactions were structured to evade price regulations is like trying to follow trails in the jungle," a federal investigator said. "You don't know how to use them
Holding Accountants Accountable: Why Audits Fail, How They Can Succeed
unless you have a guide. ''17 The former Arco executive became the guide. The E. F. Hutton check overdraft scheme by which hundreds of banks were defrauded was uncovered by a clerk at one of the affected banks on the basis of a transaction pattern that indicated possible "kiting." Such a pattern would be familiar to someone who knows that facet of the banking business. But would it be recognized by an auditor with no banking experience? Auditing teams need guides as well. In those instances where the audit team lacks an industry specialist, one should be included, even if it means hiring an industry specialist at an advanced level. If one office cannot support an industry expert, then the specialist can be shared by two or more offices of the public accounting firm. (Clearly, this strategy is not practical if the public accounting firm audits j u s t one company in an industry, unless the company is very large.) Utilizing industry experts who already are on the management consulting staff to assist with audits is another option. After all, Arthur Andersen is the largest U.S. consulting firm, and seven of the Big Eight public accounting firms a p p e a r in the top twenty consulting firms in the nat i o n ) S M o r e o v e r , public accounting firms are acquiring expertise in certain industries by merging with companies in those industries. 19 Retaining "external" consultants on an ad hoc basis is still another possibility. Requiring a second partner review for all audits, especially when the second partner is an industry expert, also makes eminent sense. 2° 4. Rethinking Training. Perhaps public accounting firms need to rethink the training that they provide their auditors. Specifically, courses on the possible accounting abuses in general and on abuses that are peculiar to a particular industry might improve 17. Allanna Sullivan, "Ex-Aide's Testimony Leads to Inquiry of Arco," The Wall Street Journal, May 15, 1985, p. 6, 18. "Who Gives the Most Advice,"Forbes, October 10, 1983, p. 142. 19. Mark Stevens, "Is Your Accounting Firm Still An Accounting Firm?" FE 1 (July 1985): 24-29. 20. Arthur M. Wood, "Statements in Quotes," Journal of Accountancy, August 1985: 142-48.
"The fox knows much, I i but more he that catches him." [Mucho sabe la zorra, pero mas , el que la toma.]
ship, but the brass ring would not be so important if the direct and indirect compensation were more lucrative at the lower grades. 21
Accounting Must Be Accountable
ince 1980, Arthur Andersen & Co. has had court settlements in excess of $137 million. In New t York State three of the five insurers for the state's 1,600 CPA firm offices recently stopped offering such insurance. Premiums from the remaining the audit team's chances of uncover- two insurers have risen as much as 400 ing irregularities. Moreover, auditors percent. In California, premiums for might be put through a training pro- more than 1,700 CPA firm offices have gram that would teach them how to just been boosted 140 percent. And think along the lines employed by per- 14,000 CPA practice units insured unsons predisposed to committing im- der a program of the AICPA have just proprieties. It may very well be that, had their premiums for liability insurin order to catch a dishonest person, ance raised as much as 300 percent. 22 If this trend continues, many public one must be able to think like one. It appears that the courts insist that accounting firms in the U.S. will have audited financial statements accu- to go without insurance. One large lerately reflect the financial health of gal award against them could precipthe organization. Financial state- itate financial disaster. In Britain, international accounting ments could prove misleading because the auditors failed to uncover firms are considering becoming corillegal behavior on the part of man- porations in o r d e r to shield themagement or because the auditors failed selves against mounting law suits. The to detect poor management practices Bank of England filed a $125 million or bad business judgment. If such is suit against Arthur Young & Co. over the case, the audit team needs to per- the failure of Johnson Matthey Bankform a management audit as well as ers. 23 The British government filed a a financial audit. An MBA degree $240 million suit against Arthur Ancombined with management experi- dersen regarding the failed De Loence may then be just as important as rean Motor Co. 24 Thus, on both sides an accounting degree with auditing of the Atlantic the incentive is great experience. for increasing the sophistication of the 5. Greater Stability of Auditing audit team. Experience teaches us that, if an inTeam. Public accounting firms might make a greater effort to preserve the dustry on which the public depends continuity of the audit team assigned cannot police itself, the federal govto a particular client. Toward that end, ernment eventually will step in. Public the firm may elect to increase the in- accounting is no exception. It is only centives for staff, in-charge, seniors, and supervisors to remain longer with 21. For a more detailed discussion of ways to the firm. turnover, see Barry F. Doll, "Staff T h r e e c h a n g e s readily c o m e to decrease Turnover: How to Manage It," Journal of Acmind: countancy, December 1983: 76-82. 22. See Lee Berton, "As Accounting Firms' 1. Better pay; Premiums Soar, Some Might Drop Liability In2. Better fringe benefits; and surance," The Wall Street Journal, May 30, 1985, 3. Providing more time in a grade p. 10. before the auditor must be promoted 23. "Britain Plans to Sue Arthur Young & Co.," The Wall Street Journal, June 31, 1985, p. or counseled out of the firm. Pursuing this last strategy would re- 24. 24. George Anders, "U.K. Accountants May quire individuals to wait longer until Incorporate to Ward Off Suits," The Wall Street they were invited into the partner- Journal, June 28, 1985, p. 22.
Spanish proverb
S
27
a
"Experience teaches us that, if an industry on which the public depends cannot police itself, the federal government eventually will step in. Public accounting is no exception. It is only matter of time before negative public opinion is translated into public policy in other words, regulatory legislation."
28 a matter of time before negative public o p i n i o n is translated into public p o l i c y - - i n o t h e r words, r e g u l a t o r y legislation. 25 T h e sentiments expressed by two influential Congressmen should suffice to drive the point home. According to Congressman J o h n D. Dingell of Michigan: T h e work product of the large firms is evaluated through a peer review system that they [the Big Eight] have set up. This system is overseen by the Public Oversight Board--selected and paid for by the m a j o r firms t h e m selves. T h e firms review each other's work, congratulate each other after noting a few minor errors, perform the whole process in the d a r k - - a n d then destroy the work papers so nobody can later check into or question their judgment. The "clean" review opinions they give e a c h o t h e r a r e s i m i l a r to t h e "clean" audit opinions they have given many of their clients shortly b e f o r e those businesses have gone b a n k r u p t or experienced serious losses. Those failures have had devastating effects on shareholders, depositors, customers, suppliers, communities and, often, the federal government, when it has had to pick up the tab at the end. 26
His words are echoed by Congressm a n Ron Wyden of Oregon: What we have on the table is very obvious and that is a massive failure of the i n d e p e n d e n t auditing system in this country. What disturbs me is that the system literally breeds this kind of buck passing. 27 Financial s t a t e m e n t s t h a t receive unqualified opinions from public auditors could be misleading because the auditors failed to uncover illegal behavior on the part of m a n a g e m e n t or because the auditors failed to detect bad m a n a g e m e n t practices and poor business j u d g m e n t . T h e impact on the creditors, investors, and the general public, however, is the same. In light of the position that the courts have taken, it may very well be that the unqualified opinion is expected to certify the health of the enterprise as r e p r e s e n t e d in the financial statements, as well as to ensure that, based u p o n the testing that was performed, the financial statements prepared by m a n a g e m e n t appear to be fairly presented. 28
vestigation. For his entire speech, see "DingeU Voices Concerns on Accounting Profession at D.C. Meeting,"WG&L Accounting News 6 (Summer 1985): 10. 27. Wyden, a member of the House Energy and CommerceSubcommitteeon Oversightand Investigation,was speakingat the April 17, 1985, hearing on the auditor's role in financial re25. For a better appreciation of the relation- porting. See "Dingell Hearings Continue to ship between public opinion and Congressional Probe Auditor's Role in Financial Reporting," action, see WilliamJ. Corbert, "PR Challenges WG&L Accounting News 6 (Summer 1985): 8. 28. Dan C. Kneer et al., "Just How Much Facing the Profession,"Journal of Accountancy, Should a Financial Statement ReallyDisclose?" August 1985: 112-22. 26. Dingell heads the House Energy and Business Horizons, November-December 1985: CommerceSubcommitteeon Oversightand In- 65-71.
I f such expectations become law-and evidence that supports this view is m o u n t i n g - - t h e n the auditing team will be responsible for a m a n a g e m e n t audit as well as a financial audit. A n d m a n a g e m e n t audits require different kinds of expertise than financial audits alone. iven the litigious nature of our ,society, it is unlikely that t h e restrictive d e f i n i t i o n o f an unqualified opinion will ever be reinstated. On the other hand, it is extremely likely that the application of product liability law to accountants' liability will be extended even further. T h e r e f o r e , it behooves public accounting firms to take all the necessary steps to ensure that an unqualified opinion means that the financial statements accurately represent the actual financial condition of the audited organization. Otherwise, the very existence of public accounting firms is threatened. Public accounting firms need to adopt strategies--which can be pursued individually or in c o m b i n a t i o n - to make the audit team a more formidable match for unprincipled and inept managers. True, adopting our recommendations will increase the cost of an audit. However, if all public accounting firms were to adopt some or all of the suggestions, the cost increase would be the same for all firms, and no one would be at a competitive disadvantage. T h e cost of failed audits and unchallenged but inaccurate audits must be weighed against the cost and benefits of audits that are accurate. []
G