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The End of the Audit Industry As We Know It?

August 16, 2011

There is a disturbing trend in America to create new regulations whenever problems are encountered. New regulations are easier than enforcing current regulations or otherwise addressing the problem.

There is a disturbing trend in America to create new regulations whenever problems are encountered. New regulations are easier than enforcing current regulations or otherwise addressing the problem.

An example of this is a recent speech by James R. Doty, the chair of the Public Company Accounting Oversight Board – the PCOAB. (The PCOAB is the nonprofit corporation established by Congress to oversee the audits of public companies and further the public interest.) In his speech, Doty expresses concern that auditors are not as independent as they should be when examining the financial records of their long-standing clients. He cited a couple of examples gleaned from the PCOAB’s review of over 2,800 audits and “hundreds of audit failures”. His potential solution? Mandatory auditor rotation – but is this really his objective? Read on.

I do not believe this is a sound idea or a viable solution to the problem – and I am not denying that the problem exists. What I don’t know is how pervasive the problem is. There are hundreds of thousands of audits performed by independent CPAs each year. I am sure that some of these are of a lesser quality than society demands and deserves. I believe strong action should be taken when audit failures come to light. The audit firm of Arthur Andersen went out of business as a result of the Enron audit failure. Many good people who worked for Andersen were temporarily hurt during this crisis, but the audit world became better for it and our free enterprise system got rid of the bad fruit.

Mandatory auditor rotation is going to be more expensive and could ultimately lead to an audit industry substantially different and less efficient from what currently exists. Doty cites a lack of auditor skepticism and an” inherent conflict created because the auditor is paid by the client.” If the client is going to continue to pay the auditors, auditor rotation every 5 years or so is not going to change this perceived inherent conflict. Is mandatory auditor rotation only the interim step in Doty’s plan?

Where is Doty really headed? If the client is not going to pay the auditors, then you have an audit function whose cost is going to be paid from some other form of assessment (read “tax”) placed on business. Of course in the nonprofit world it will not be a tax; it will just be a reduction in funding subtracted even before you receive your grants.

The question is, do we want a professional audit function that is similar to the IRS audit experience? The IRS auditor is a Federal employee, paid for by tax collections. Is this the type of bureaucracy we want performing annual business audits and audits of not-for-profit organizations?

The standing joke is the IRS Agent who appears at the door of your business and announces, “Hi, I’m from the IRS and I’m here to help you.” No one believes that the IRS is there to help. Thus, the IRS audit function is an adversarial process moving toward a negotiated settlement and neither side believes that the truth or fairly stated financial information is the objective or the result. Is this what we want for annual financial information from the companies in which we are investing?

Most CPAs were attracted to this industry because they wanted to assist people building their businesses and complying with the law. We did not go into the police or other enforcement business and certainly did not opt to join the IRS in the tax collection business. The CPA wants to assist people who want to do things correctly. In this process the CPA may occasionally make calls that the regulators would prefer to see go the other way. But there are ways already in place for making these changes. There is no need to turn the system completely on its head.

And don’t be misled into believing that since the PCOAB only oversees audits of public companies that this will not affect your local nonprofit organization. Remember the Sarbanes-Oxley Act of 2002 and how it applied only to publicly held companies? There is a great deal of Sarbanes-Oxley in all of our lives right now regardless of whether you work for a public company or not.

Throwing the ‘baby out with the bath water’ is usually never a good idea and this situation might very well be a case of ‘throwing the baby out and adding dirty water’ to the bath.

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