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«Corporate Audits and How to Fix Them Joshua Ronen A uditors are supposed to be watchdogs, but in the last decade or so, they sometimes looked like ...»

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Journal of Economic Perspectives—Volume 24, Number 2—Spring 2010—Pages 189–210

Corporate Audits and How to Fix Them

Joshua Ronen


uditors are supposed to be watchdogs, but in the last decade or so, they

sometimes looked like lapdogs—more interested in serving the companies

they audited than in assuring a flow of accurate information to investors.

The auditing profession is based on what looks like a structural infirmity: auditors are paid by the companies they audit. An old German proverb holds: “Whose bread I eat, his song I sing.” While this saying was originally meant as a prayer of thanksgiving, the old proverb takes on a darker meaning for those who study the auditing profession. If rational investors cannot trust financial statements from companies, they will be less willing to invest, which in turn will depress stock prices and increase the cost of capital for all firms (as a starting point in this literature, see Hughes, Liu, and Liu, 2007; Lambert, Leuz, and Verrecchia, 2007, and references cited therein).

This paper begins with an overview of the practice of audits, the auditing profession, and the problems that auditors continue to face in terms not only of providing audits of high quality, but also in providing audits that investors feel comfortable trusting to be of high quality. It then turns to a number of reforms that have been proposed, including ways of building reputation, liability reform, capitalizing or insuring auditing firms, and greater competition in the auditing profession. However, none of these suggested reforms, individually or collectively, severs the agency relation between the client management and the auditors. As a result, the conflict of interest, although it can be mitigated by some of these reforms, continues to threaten auditors’ independence, both real and perceived.

In conclusion, I’ll discuss my own proposal for “financial statements insurance,” Joshua Ronen is Professor of Accounting, New York University Stern School of Business, ■ New York City, New York. His e-mail address is 〈 jronen@stern.nyu.edu〉.

jronen@stern.nyu.edu〉 doi=10.1257/jep.24.2.189 190 Journal of Economic Perspectives which would redefine the relationship between auditors and firms in such a way that auditors would no longer be beholden to management.

A Snapshot of Audits and the Auditing Profession What Does an Audit Involve?

Under the Securities and Exchange Act of 1934, public companies in the United States are required to file audited financial statements with the Securities and Exchange Commission (SEC) each year. “Independent” auditors, external to the client, must perform these audits. Regulators, together with courts, establish standards for auditors’ practices and impose sanctions in the case of material errors or frauds.

Before the passage of the Sarbanes–Oxley Act of 2002, the auditing profession itself decided how audits are to be conducted and codified the results in generally accepted standards. Since Sarbanes–Oxley, the codification has been taken away from auditors and assigned to the Public Company Accounting Oversight Board (PCAOB), a body that was created by Sarbanes–Oxley to establish (subject to SEC approval): “auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports for [public] issuers.”1 The starting point for any audit is the financial statements prepared by corporate management, which bears primary responsibility for preparing financial statements that are free of material error or bias. These annual financial statements consist of the balance sheet and the related statement of income, retained earnings, and cash flows for the completed fiscal year, along with notes. Financial statements require applying bookkeeping procedures to business transactions that have taken place over the fiscal year. Clearly, financial statements do not contain all there is to know about the company. For example, they reveal nothing about management’s future plans.

A financial audit is a process of obtaining and evaluating evidence regarding the assertions of corporate management and ascertaining whether the assertions conform to Generally Accepted Accounting Principles (GAAP). GAAP are the accounting standards that have been developed by accounting standards-setting bodies in the United States. They reflect decisions standards-setters made regarding “recognition, measurement, and disclosure” criteria that are designed to give rise to data that are both relevant to investors’ decisions, and reliable in the sense of being accurate and trustworthy. As one example, the item “inventories... $3,750,000” in a balance sheet of a manufacturing entity embodies the following assertions, among others: the inventories physically exist; they are held for sale or use in operations; they include all products and materials; $3,750,000 is the lower of their “cost” or “market value” (as both terms are defined in applicable rules); they are properly Sarbanes–Oxley Act of 2002 (Pub. L. 107-204, 116 Stat. 745, Enacted July 30, 2002), Section 101(c)(2).

Joshua Ronen 191 classified on the balance sheet; and appropriate disclosures related to inventories have been made, such as their major categories and amounts pledged or assigned.

Evidence about the degree of conformity with Generally Accepted Accounting Principles consists of examining various sources of accounting data, including journals, which are chronological records of transactions; ledgers, which are financial effects of transactions grouped into classifications of assets, liabilities equities, revenues and expenses; and corroborating information, such as invoices, checks, and information obtained by inquiry, observation, physical inspection of assets, and correspondence with third parties. Judgments about whether firms have applied accounting principles appropriately often call for analytical and interpretive skills. For example, judging whether inventories are properly valued requires the auditor to understand and evaluate how management estimated replacement cost, selling price, and normal profit margins. The auditor must further evaluate whether provisions for losses on obsolete and slow-moving items are adequate.

Finally the auditor must understand the firm’s method of using this information, which can be quite complex, and decide whether it follows accepted principles.

Conclusive evidence is rarely available to support these judgments, but judgments must be made nonetheless.

The audit process itself can be divided into three steps: setting the scope, gathering and evaluating evidence, and reporting (O’Reilly, McDonnell, Winograd, Gerson, and Jaenicke, 1998). The scope of an audit is determined on the basis of the assessed risk of omissions or misrepresentations in the financial statements provided by management. In turn, these risks depend on the size and complexity of the company, the adequacy of its internal controls, and the auditor’s assessment of the trustworthiness of management. Once the audit scope has been determined, the auditor performs substantive tests, like looking at details of transactions and account balances, on a sample of the business’s transactions. If the substantive tests uncover problems or additional risk factors, the scope of the audit is reset. Once the substantive tests satisfy the auditor that there is an appropriately low risk that the audit will result in an inappropriate opinion (even the appropriate risk level is subject to judgment!), the auditor reports an opinion.

If the auditor finds no material problems with the statements, or if such problems are corrected before issuance of the statements, the auditor issues its report with a standardized statement of assurance: “In our opinion, the financial statements above fairly present, in all material respects, the financial position of __________ Co., as of (date) and the results of its operations and its cash flows for the year then ended in conformity with GAAP.” If the auditor’s attempt to correct the accounting misstatements is unsuccessful, then the auditor issues a qualified opinion that refers to either limitations on the scope of the audit (such as inability to access information) or departures from GAAP. Since 1989, two types of audit reports have been issued: the standard clean unmodified report, and a modified report for “going concern” uncertainty, which is issued under a requirement that auditors evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern for a period not to exceed one year from the date of 192 Journal of Economic Perspectives the financial statements being audited. Modified going concern reports make up less than 10 percent of all audit reports (Francis, 2004), and there is considerable doubt as to whether they accurately provide information about the risk of a firm.2 Throughout this process, the importance of independence of the auditor cannot be overestimated. Accounting standards require, among other things, that audits be performed by a person or persons having adequate technical training and proficiency as an auditor; who have “independence in mental attitude”; and who will exercise due professional care in performing the audit and preparing the auditor’s report. Independence requires that the auditor maintains an impartial attitude in selecting and evaluating evidence and the absence of bias in the audit reports rendered. After all, for capital markets to function properly, investors must have access to credible information to mitigate hazards of misrepresentation by management.

Unfortunately, throughout the history of auditing, independence proved to be the requirement that the auditing profession had the most difficulty in satisfying.

The primary reason is that when auditors are hired and paid by the companies they audit, auditors are tempted, at a minimum, to shade all gray area judgments in the direction of companies’ managements. Lack of independence has been suspected as an important factor in the major accounting scandals of recent years. As one example, Arthur Andersen’s independence was questioned in the cases of Enron, for whom it provided $52 million in auditing and consulting services in 2000. The charges of obstruction of justice filed against Andersen upon its announcement on January 10, 2002, that it shredded significant documents brought about the firm’s demise by the time it was convicted on June 15, 2002.3 Allegedly, the shredded documents would have implicated the firm in either knowing that it misleadingly issued unqualified audit opinions, or that it knowingly and purposefully neglected to gather evidence that would have caused it not to issue a clean opinion, causing losses and risks to go undetected for years.

In extreme cases, after problems have surfaced, it will be possible to determine in retrospect that an audit was performed poorly. However, as will be discussed below, audit quality of any given company is notoriously difficult if not impossible to observe in real time, and even in retrospect, it can be hard to make fine-tuned Chen and Church (1996) document a 13 percent less-negative market response to bankruptcy announcements following a going concern audit report, implying that bankruptcy is less of a surprise to investors. However, Carcello and Palmrose (1994) report that seven in ten bankruptcies have a clean audit report. Moreover, auditors appear to over-issue going concern reports: six out of seven were “false positives” over the period 1990–1994 (Francis and Krishnan, 2002). Based on AuditAnalytics data for 2006 and bankruptcies fi lings over the subsequent two and a half years, the probability of bankruptcy (relative to all audit opinions issued) is 2.1 percent, the probability of bankruptcy given no going concern report is 1.9 percent, and the probability of bankruptcy given a going concern report is

2.9 percent. In short, these auditing qualifications have both high numbers of false positives and false negatives, which means that the quality of the information they contain is limited.

A subsequent unanimous Supreme Court opinion in Arthur Andersen LLP v. United States (544 U.S. 696 [2005]) overturned the conviction of Arthur Andersen on the grounds that the instructions to the jury failed to portray accurately the law that the firm was accused of breaking.

Corporate Audits and How to Fix Them 193 judgments about whether an audit was quite strong, only somewhat strong, average, or somewhat below average.4 Audit Profession Evolution and Concentration In the late 1980s, the eight largest auditing firms began merging with each other, leaving five large firms accounting for the majority of revenue from auditing public companies. In 2002, following the legal troubles faced by Arthur Andersen, the U.S. audit profession had only four large firms: Deloitte & Touche, Ernst & Young, Price Waterhouse Coopers, and KPMG.

These four firms audited 98 percent of the 1,500 largest public companies with annual revenues over $1 billion and 92 percent of public companies with annual revenues of between $500 million and $1 billion, according to Audit Analytics.

In addition, these four firms collected 94 percent of all audit fees paid by public companies in 2006. However, audits of small and mid-size public companies were more open to smaller firms, as shown in Figure 1. The figure shows the percentage of companies (distinguished into groups by size) using auditing firms in the smaller, midsize, and largest categories. For small public companies (those with annual revenues under $100 million), the share audited by the largest firms declined from 44 percent in 2002 to 22 percent in 2006; for mid-size public companies with annual revenues between $100 million and $500 million, the share audited by the largest firms fell from 90 percent in 2002 to 71 percent in 2006.

Audit fees appear relatively small from the company’s point of view, but they loom large to the auditing firm. For example, using 2002–2003 audit fee disclosure data in the United States, Francis (2004) reports that aggregate audit fees for 5,500 large U.S.-listed companies represented no more than 0.04 percent of sales and

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