January 30, 2008
Mr. Arthur Levitt,
Jr.
Mr. Don Nicolaisen
Advisory Committee
on the Accounting Profession
Office of
Financial Institutions Policy, Room 1418
Department of the
Treasury
Dear Mr. Levitt and Mr. Nicolaisen:
I am pleased to submit comments about a number of the issues under consideration by the Treasury Department’s Advisory Committee on the Auditing Profession. I would be pleased to discuss my views with the Committee or the Staff.
Introduction
Upon retirement from academe in 2002, I had completed nearly 35 years as a professional academic accountant. I am currently a Professor of Accounting – Emeritus, a position granted by the institution in which I last served. During my academic career, one of my primary areas of teaching and research was in the field of auditing. I have been the President of the American Accounting Association (AAA) and Chairman of the Audit Section of the AAA. I have experience as an editor, co-editor or associate editor of several accounting and auditing journals, including Auditing: A Journal of Practice & Theory, The International Journal of Accounting and The Accounting Review and as an editorial reviewer for many other journals. I have kept abreast of research and practice issues through my own research, teaching and service as well as continuing interactions with practicing professional accountants. I hold certificates as a C.P.A, C.I.A., C.M.A. and C.F.E.
Prior to retirement, I served one year as an Academic Accounting Fellow at the U.S. Securities and Exchange Commission (2000/01). After retirement from academe, I returned to the SEC as the Deputy Chief Accountant (Professional Practice) for two years (2004-2005). My responsibilities as Deputy Chief Accountant focused on the professional practice of auditing SEC registered public companies. The duties also included oversight of auditing standards development by the PCAOB and handling independence issues coming to the Commission. Subsequent to leaving the Commission at the end of 2005, I accepted a part-time position with Grant Thornton LLP as a Senior Policy Advisor.
The views in this letter developed over my academic career
and during my more recent experiences at the SEC and Grant Thornton. The views expressed
are my own drawn from and informed by many sources, including numerous
discussions with many of my academic and practitioner friends and colleagues as
well as numerous published materials by academics, practitioners and regulators. I speak only for myself in this letter and
not for any of the individuals or entities with which I have been associated or
any of their personnel.
Ideas that Pervade the Narrative
Three ideas pervade my narrative. First, the ultimate driving value-added service that the audit profession provides the public marketplace is embodied completely in high quality audits performed and reported on by expert audit professionals of high integrity and independence. Other services may be offered, but the independent audit must be paramount and its credibility protected. Second, I believe that the business model of public accounting that evolved in the 70’s and 80’s and found its most complete expression in the late 90’s is fundamentally flawed. The flaw was and perhaps still is that that business model does not support the independent audit as the single most important service to the public performed by a public accounting firm. The resulting public accounting business practices of the 80’s and 90’s ultimately led to decisions that reduced the prestige and credibility of the public auditing profession. I am concerned that a culture created over twenty or more years still has strong roots among the current members of the firms. It took twenty-years for the current business model to become the orthodoxy of the day. Perhaps a new professional model could take root more quickly, but cultures are notoriously difficult to change. We cannot assume that a broad-based and deep culture change has occurred based on recent events. Third, I am skeptical about the current, almost single-minded, focus on the sustainability issue. Sustainability is important, but only if we first create the forces and incentives that will assure the preeminence of the independent audit. Sustaining a profession that meets this goal is critical to our capital markets. I do not favor sustaining a business model that does not focus first and foremost on high quality audits performed and reported on by expert and independent audit professionals of high integrity.
The Advisory Committee raised too many important issues in its Working Discussion Outline for me to address them all in detail. I make some effort to separate the practice and academic issues as in the Committee’s outline, but the prestige and contributions of academic professionals in both the academic and practice realms depend upon the success of the profession as a whole and particularly the practice profession. Failure of the practicing profession to meet its public interest goals, and gain the public prestige those goals warrant, leads to failure of the academic accounting enterprise as well.
The Practicing
Profession
Because our joint success is conditioned on the success and prestige of the practicing profession, I begin my discussion with practice. The core of the practicing profession embodies those services for which the profession has been given a legal mandate by society: the audit of financial statements. I will not make an explicit distinction in some of my comments between audits of public and private companies, but clearly the mandate of immediate interest runs to the those companies subject to the Securities Acts of 1933 and 1934 and the later amendments to these Acts by Congress.
In recent years there has been an effort by many in the practicing profession to expand the breadth and depth of services that they wish to have identified as part of the core profession beyond the audits of financial statements. In some cases the extension has been justified on the basis of the assurance nature of the service even when not subject to the Securities Acts. In other instances the argument has been made that the extension, while not strictly or solely related to the audit of financial statements, enhances the ability of the auditor to complete a high quality audit of the financial statements. And finally, some have argued that unless the professional firms can grow and expand their total revenue base, the public audit will be threatened by an inability to attract quality professionals.
I can see merit in each of these positions and they should each continue as subjects of attention by academics, practitioners, Congress and the various regulators that impact the profession. Nonetheless, in recent years some have extended this argument beyond reasonable limits, seemingly taking the position that if it is good for the firms, it is good for the profession. Unfortunately, what is good for the business of audit firms or their corporate clients is not necessarily also good for the societies we serve in the national and international arenas.
This is not to say that it is easy to decide where the line(s) should be drawn for any particular service or relationship between independent auditors and their audit clients; no matter how “client” is defined for the purposes of a specific discussion. Often, there is nothing intrinsically wrong with the proposed non-audit services and, as a result, policy decisions regarding non-audit services are often made sequentially. Unfortunately, choices are then made under the duress of crisis circumstances that do not permit the considered judgment possible with the passage of time and comprehensive study. Moreover, even when there is time for reasoned examination, the strength and power of the immediate interest groups often lead to compromises that are difficult to rationalize other than that the results served some compromised special interests. This is as true in considering auditing and accounting issues as it is in many other realms of public discourse.
Because the issues are difficult, a reasonable conversation on these matters requires a foundation of ideas and concepts that informs the discussion. Otherwise, we will speak at cross-purposes, cross-purposes that tend to favor those special interests with leverage. The foundation concepts should be stated in as unambiguous a language as possible without the caveats and exceptions language that will no doubt arise when addressing specific issues. It is important that we understand our objectives before we decide upon the infrastructure and processes that will allow us to approach satisfying these objectives.
The Role of the
Practicing Professional Accountant
To that end, I present one concept statement addressing the objectives of the profession of public accountant as I understand the franchise granted by the 1933 and 1934 Securities Acts for audits of financial statements.
Over-Arching Audit Practice Concepts
·
The primary professional mission of public
company auditing embodies serving the public good, the capital markets, and
investors’ needs.
·
Public company auditing should be organized in
such a way to promote the prevention and detection of material accounting
errors and frauds.
·
Fulfilling the public company audit professional
mission is achieved through transparency and public disclosure of audit
results.
· The regulatory structures for public company auditors should reflect that they are private business firms engaged in a public goods mission.
The Primary
Professional
The Securities Acts of 1933 and 1934 and the decision to
leave the audit of public company financial statements in the private sector
created a difficult balance for those in the public auditing domain. They
practice in what is largely a private contracting environment with respect to
all services except the audit of the financial statements of public companies.
The contract in this domain is currently signed by a representative of the
Audit Committee of the corporate entity under audit: yet the contract embodies
a responsibility that is public in nature. The Audit Committee acts for those otherwise
unrepresented third-parties who are the underlying client for the audit of the
financial statements. The audit client is
not the corporation, the Board, the Audit Committee or the management of the
corporation; rather it is those third-party users. Despite any practical
difficulties this creates, the primary responsibility of the auditor is to
serve the third-party users. The short-hand often used in making this point is
that the auditor works for the investors. I will, no doubt, fall into using
this short-hand. The auditor’s responsibility is not to the specific company
under audit or its management, but broadly to the investors and to the
effective and efficient functioning of the capital markets. The value-added nature of the audit must be
considered, not from the individual corporate point of view but from the
broader capital market perspective.
Prevention and
detection of material errors and frauds
A great deal of rhetoric has gone into explaining the difficulties of performing audits of financial statements, particularly when faced with dishonest individuals in key management positions. Without in any way minimizing these difficulties in practice, the profession must accept its fundamental responsibility for the detection of material errors and frauds during the audit of financial statements. If the discovery of material errors and fraud is not a major part of what the audit is about, it is not clear what value-added service the auditor offers the investor and capital markets. The general comfort offered by an audit will not sustain the profession in the face of previously undiscovered material misstatements.
The auditors’ responsibility for fraud must be stated in a forthright fashion without the usual overburden of caveats, exceptions and exclusions. Once accepted that this is a part of the auditor’s responsibility we can get down to the discussions involving how this can be accomplished, the real limitations encountered in practice and auditors’ accountability if material errors or frauds are not discovered during the audit. These are critically important matters that must be dealt with by Congress, regulators, courts, Boards, investors and the academic and practice professionals. To date even the Advisory Committee’s own overarching principles do not appear to reflect an acceptance of this responsibility for the profession in clear and unambiguous language.
Transparency and
public disclosure of audit results
I take it as self-evident that the client, in this case the investor and capital markets in which the investor functions, should receive a clear and unambiguous communication about what the auditor has discovered. If the public cannot rely on the auditor’s report to do this, the report and underlying audit cease to be of value as it no longer informs the markets. This concept also embodies the need for transparent communications from the auditor’s about their relationships with the corporate body and, by extension, those who interact with the corporate body that might influence the investor and capital market interpretations of the auditor’s report. If the auditor is not in fact and perception independent of the corporate entity and those people and organizations associated with control of the corporate entity, the auditor’s veracity in reporting will be questioned, particularly because of the payment mechanism in place for the audit; i.e. the “check” is signed by a representative of the corporate body, not by those for whom the work is done.
Regulatory structures
for public company auditors
In the
Regardless of the details, the regulatory bodies have substantial powers of interpretation and implementation of the Securities Acts. Congress can, subject to Constitutional limitations, change the law. While subject to the Acts, subsequent experience has demonstrated that the regulators have substantial room to create practice and sanction environments within the context of the Acts. Regulators can establish specific practice standards, independence principles and rules, and can determine the extent of many of the sanctions faced by audit firms and corporate players.
It is also true that there is a court system beyond the
regulators domain that can impose sanctions. So much of the discussion about
auditing practice today occurs against the backdrop of the intense litigation
environment in the
Dealing with a public good contract in a setting where most other business activity is carried out in a private contracting (private good) setting raises significant hurdles. Balancing the auditor’s independence, provision of non-audit services to audit clients, the creation of business relationships with the corporate entity or those who interact with the entity and many other issues, all require adequate incentives to assure a viable business entity that can accomplish the objectives of the audit. Obfuscating the social role of auditor in order to side-step the difficulties of that role will in the long-term lead to the demise of the audit profession.
Considering some of
the questions raised by the Advisory Committee Working Discussion Outline
I realize that the Working Discussion Outline attempted to
create semi-independent sections for operational purposes. We all recognize
that these are not completely independent considerations. This letters draws
from several sections of the Working Discussion Outline to first address issues
primarily related to professional practice and then those primarily related to
the academic community. The separation is not completely artificial as there
are significantly different conditions for success in each domain. However, it
is my belief that practice and academe will succeed or fail together.
The Securities Acts require that the audit be performed by an independent accountant, a public company auditor. The independence requirement is fundamental to the credibility of the auditor’s report. The need for regulatory oversight is particularly important because in our economy the pubic accounting business is a mix of private and public contracting where the “check” is written by those primarily interested in the private contracting nature of the relationship.
If the public accounting profession’s commitment to an
independent audit is not sustained and enforced, the value-added to the capital
markets will be substantially diminished if not lost. Auditors must be independent and must be perceived to be independent
and must act in an independent manner when performing a public audit.
There is nothing intrinsically wrong with the non-audit services offered by the public accounting businesses even when offered to their audit clients except when these services threaten the integrity of the audit, actual or perceived, either because of their monetary importance or their potential individual impact on the audit, in which cases these services should be disclosed, limited or banned.
The four principles set forth by the SEC as part of the 2000 independence rules revision are a fundamentally sound beginning for any discussion about the acceptability of particular non-audit services. In considering whether a service will conflict with auditor independence, the Commission considers “whether a relationship or provision of service [note that in the bullets below the term “client” is used to refer to the corporate body and its official representatives under audit]:
· Creates a mutual or conflicting interest between the accountant and the audit client;
· Places the accountant in a position of auditing his or her own work;
· Results in the accountant acting as management or an employee of the audit client; or
· Places the accountant in a position of being an advocate for the audit client.”
[Revision of the Commission’s Auditor Independence Requirements, Securities Act, Release No. 33-7919, 65 Fed. Reg. 76,008 (Dec. 5, 2000) (to be codified at 17 C.F.R. pt. 210, 240, available at http://www.sec.gov]
Having had responsibility for the administration of the SEC
independence standards and rules and the charge to try to simplify them, I am
aware of the problems encountered by the professional auditor in both in
attempting to adhere to the standards and in arguing that some of the standards
are counterproductive to quality audits. While simplicity in adherence is to be
desired and sought, from a public interest point of view, it is only maintaining
actual and perceived independence that is of real importance. Revision of the independence standards and
rules for efficiency purposes is a clear second level consideration and should
only be done where it does not compromise the actual and perceived independence
of the audit.
Experience has demonstrated to my personal satisfaction that
human beings cannot sustain the level of integrity required to resist the conflicts
this level of freedom introduces into the audit environment. Even the most
dedicated human when faced with difficult conditions is capable of
rationalizing what to others are truly unreasonable positions. There need be no
malicious intent by the participants; it is simply a part of the human
condition, a part we seem to grossly underestimate. Some research shows that
committed professionals can overcome some of the biases that non-professionals
fall prey to, but they are not immune and they do fail. Unfortunately, in the auditing profession, individual failure impacts
the whole profession, the investors and the markets. Auditors’ failures spread often
very large losses broadly and to individuals that in many cases are least able
to sustain them. As a result, auditing is a high stakes activity and needs to
be treated as such.
Is there currently the right balance between the independence standards and rules and the performance of the highest quality audit? The answer is always likely to be “no” in the details. I am certain the answer is “no” at this time, yet I fear that the simple solutions promoted by some practitioners are not clearly beneficial to investors and capital markets.
The current enthusiasm for principles based independence standards is interesting and perhaps understandable. Too often, in my experience, the audit firm leaders I have spoken to contribute to the complexity of the rules by taking an “if it is not written, it is permitted” attitude toward independence. Neither of these behaviors contributes to the likely effectiveness of principles based independence standards. In my oversight of the audit standard setting process and participation in the independence processes at the SEC, I found that the SEC was often entreated to leave the auditor room to exercise judgment. Immediately upon the publication any standard, rule or statement representatives of a number of firms were invariably back at the table insisting that they needed further clarification before they could apply the principle. One might ascribe this concern to their fear of the litigation process outside of the regulatory domain, but then why the initial request to allow judgments? No doubt, humans desire the freedom of judgment and the assurance of protection should anyone disagree with that judgment. You can create your own rationalization here, but whatever the reason, the sequence of events tends to force us to increasingly more detailed rules. A similar problem has existed in the accounting principles and rules development domain for as many years. Breaking out of the rules orientation and applying principles based approaches requires a fundamental culture change by the profession and the regulators. Culture changes are slow to come and any shift to a principles based approach must take into account the time required for such a change to establish itself in the fundamental expectations of the all professionals. At this time, and for the foreseeable future, it is unlikely that there will be rapid enough culture change. This may explain the profession’s insistence on a new professional judgment rule and safe harbor that would “guarantee” that their judgments would not be questioned. Indeed, if the appropriate culture change were to occur, there would be no need for such a new rule to provide safe harbor for professional judgment. In reflecting on the current culture, it is interesting to note that one of the persistent PCAOB inspections findings is that audit work papers do not currently provide adequate contemporaneous documentation of decision processes and the rationale for important audit judgments.
Further, it is my experience that all too often when poor judgments
are left unchallenged, additional poor judgments follow based on the lack of
challenge,. Even worse, on occasion a string of bad judgments have been ex-post
justified as an “evolving practice.” Because
evolving practices tend to occur behind closed doors and without public
oversight, I have reluctantly concluded that a principles based approach to
independence will not be very successful in the
With that said, there is clearly room to simplify the current SEC independence standards. During my time as Deputy Chief Accountant, my staff began scoping the current standards in search of simplifications that would not put at risk the auditor’s independence in fact and appearance. I am sure that process has continued under the new leadership. These considerations covered many more issues than explicitly raised in the Advisory Committee Outline. Mr. Edmund Bailey, no relation, delivered a speech summarizing the current staff position at the time about how a simplification might occur. It requires more than simplifying the rules; it also requires action by the firms, the PCAOB and SEC if the resulting system is to be successful. I refer you to that speech for some insight into the model envisioned by the staff at that time [Bailey, Edmund W., “Remarks Before the 2005 AICPA National Conference on Current SEC and PCAOB Developments,” Washington, D.C., December 5, 2005,
http://www.sec.gov/news/speech/spch120505ewb.htm
Globalization
While recognizing the real difficulties in working in a multi-cultural setting, involving different professional and legal systems, six of the firms performing public audits have chosen to develop international networks. In each case, the clear signal to the market has been that those firms can deliver audits that meet the quality and independence standards of the relevant jurisdictions. I am on record in my role as Deputy Chief Accountant as stating that, in my opinion, the firms built out the business side of the global structures well-ahead of the infrastructure necessary to support delivery of a quality independent audits. In recent years, all six of the firms have worked hard to improve their control over network member performance. A great deal still remains to be done, particularly, in accepting that a world-wide network brings global responsibility despite differing cultural, legal and regulatory regimes.
Although convergence in auditing, accounting and independence standards, principles and rules can improve the situation by simplifying the necessary infrastructure of controls, it would be a mistake to converge on the lowest common denominator to accomplish this simplifying task.
While improvements are in process, it is still true that virtually
no other jurisdiction has as effective an accounting and auditing regulatory regime
as the
Pricing and Quality
Competition
We currently have six global firms. But four of these firms
dominate the
There is sound economic theory that supports the idea that even in a highly concentrated profession such as auditing, price competition can take place. In fact, it is well-known that monopolists or oligopolists use selective price competition and other protective measures to remove incentives for others to enter their markets. Further, based on research when I was an Academic Accounting Fellow at the SEC, audit fees are generally such a small portion of the costs of doing business as to be largely a non-issue, even after Sarbanes-Oxley, except possibly in the very smallest companies. In any case, the complaints about audit fees seem to be based on the idea that the corporate body is the primary beneficiary of the audit rather than the investors and capital markets. The measure of value-added should be to investors and capital markets rather than to the corporate entity.
The more important
competitive issues relate to competition for audit quality and independence:
matters so critical to the continuing success of the profession. Each firm
in a highly concentrated profession has less incentive to protect the reputation
of their firm or the profession as whole and is thus more inclined to “cash-in”
on the reputations built by earlier generations. The experience of the 1990’s demonstrated
the fragility of reputations in the hands of those who did not have to earn
them. The damage to the profession’s prestige and credibility was profound, and
it continues. Recommendations for change
should take into consideration whether they will lead to further concentration.
Capitalizing the firms
Capitalizing the firms through public equity offerings would
result in a culture focused on the market performance of the public accounting
firm. This would emphasize the private contracting nature of the firms rather
than the public good nature of the audit. Even if, and I doubt the assertion,
capital were a limiting factor on the growth of firms capable of auditing in
the registrant markets, the idea would raise serious concerns with respect to
“partner” incentives and independence from “owners.” The focus on investor
returns rather than the professional mission of high quality independent audits
accepted and respected in the market place would be inappropriate. Further, considering
the potential for stock options as a part of the partners’ remuneration would
only emphasize the concern for market performance over professional commitment. This option is suggested as a means to
reduce the current levels of concentration in the profession. Because the large
firms already have the largest capital base, it would, in fact, add incentives
for further concentration. The largest firms in the current market would be the
greatest beneficiaries and would thus be able to exploit their even stronger
financial positions in further concentrating the industry.
Insurance
I do not have the expertise to address the insurance issues in any detail. This is a good place to once again recognize the unique public good nature of the audit. Perhaps society should bear some of the costs of insuring the performance of the auditor and insuring the users against auditor failure. Virtually all of the insurance hypotheses involve not simply providing insurance for those who suffer losses, but also instituting structures that allow the user to have confidence in the culture, incentives and audit processes of the firms. We should not forget the second element of these proposals.
Care should be exercised in adopting any insurance scheme that might contribute to the further concentration of the currently largest firms. If insurance is subsidized in any way and a greater recovery potential is tied to the size of a firm, any firm that is not already in the top tier of large firms, will suffer in obtaining new public clients thus providing incentives to further concentrating the industry. This does not argue against some form of public insurance as it relates to the audit as a public good. It merely suggests that there are concerns about the concentration of the industry that must be taken into account when developing any insurance scheme.
Another discussed insurance proposal would actually place insurance companies between the auditor and the entity under audit. Corporate entities, for example, would not engage an independent auditor, but would buy insurance from an insurance company as a signal to the markets. Insurance companies would employ auditors in a private contracting setting to audit the corporate body in order to set insurance premiums. Aside from the fact that auditing would cease to be organized as a profession, there are numerous questions about the details of how this would work. One question that should be of concern: what would be the incentive for an insurance company to disclose a failure in the reporting of one of its corporate clients uncovered by their auditor’s audit?
Liability
Like the issues of capitalizing firms or providing insurance
against audit failure, the liability issue will only provide additional
incentives to concentration, if not handled carefully. The largest firms will benefit most by any simple liability CAP.
Further, simple CAPS reduce the audit effort problem to a business cost/benefit/risk
analysis. There are few matters on which most academic research agrees, but one
of these is that reducing the cost of failure will lead to a lower level of
effort in attending to the activity in question. Audits are no exception. CAPS
simply reduce the risk of loss and can be expected, all else equal, to lead to
less effort on the audit. I strongly
suspect that simple CAPS will eventually result in a rash of audit failures of
varying size and impact unless accompanied with very effective quality
oversight, something far more intrusive than the current PCAOB inspection
processes.
This does not argue against litigation reform, only against overly simple solutions such as simple CAPS. Proportionate liability coupled with some form of tailored CAPS and enhanced PCAOB and SEC oversight may be possible.
Communications
The weight users attach to the audit opinion depends upon the confidence the recipients have with respect to the auditor’s relationship with the corporate body and those who function for the corporate entity. Actions that increase market confidence in the auditor report will increase the value-added nature of the report. Those firms performing audits of registrant companies should positively consider two actions that are under discussion: (1) the addition of independent public members either to existing governing boards or newly created boards; and, (2) public financial and key indicator disclosures. Both of these ideas, but particularly the second, will require careful consideration before implementation to avoid contributing to the further concentration of the profession.
Good corporate governance is highly valued by the markets and supported by and relied upon by the auditor. While audit firms are not and should not be publicly traded organizations, the public good nature of the financial audit suggests that independent board members similar to those found on public company boards would be a good governance practice and would signal the markets about the firms’ positive commitment to the public good.
Concentration
The recently issued GAO update report on the industry’s concentration: (1) recognized the degree of concentration; (2) concluded that price competition exists in the audit market for audits; (3) concluded that it is difficult to measure audit quality; and, (4) made no recommendation addressing concentration in the audit industry.
The loss of another of the largest firms in the audit market is often cited as a reason to create a more competitive market. I do not disagree with this point because, as recently demonstrated, even egregious misbehavior by a large firm can be managed in such a way that the firm continues to exist and function in the audit markets. We have not yet delved the depths of options in this realm. Saying that the firms are “too big to fail” does not mean that they are too big to be put into some form of receivership, painful to all of the participants, hopefully particularly so to those responsible. Yes, a larger number of competitive firms would be desirable in order to avoid the market dislocation attendant to another failure, but the various proposed protections for the exiting firms are not the only ways to mitigate the cost to society of another “failure.”
The GAO’s focus on price competition is not surprising as lack of price competition is the traditional concern when industries become sufficiently concentrated as to act as an oligopoly. But a good case can be made that concentration does not always eliminate price competition. A pricing problem that may exist, but on which it is difficult to obtain supporting data, is the use of predatory price competition for specific audits to maintain the status quo or increase concentration in the industry. With only four giant firms dominating all aspects of the audit market, if they chose to they could “buy” virtually any or all registrant clients held by a firm not in their size league by lowering the prices on those audits. Admittedly, this will not likely occur on any broad basis. The largest firms have incentives to maintain a group of smaller, but still large firms as a buffer against regulation based on predatory pricing practices and the concentration issue. I do not have evidence that predatory pricing is a pervasive problem, but whenever control over capacity is concentrated the opportunity and incentive exist to exercise at least selective price discrimination.
The GAO’s decision not to make any recommendations concerning concentration may be misconstrued by some as accepting the “appropriateness” of the current market concentration. I would interpret their position as only recognition that they could not identify an economically or politically viable means to address the issue.
The real problem with the GAO’s focus is that it puts the concentration concern in the wrong place. Economic theories concerning price competition assume either uniform quality or the ability of the ultimate user to observe and judge quality. Since neither of these conditions exists for auditing, the GAO’s concern should be focused on quality competition rather than price competition. George Akerof won the 2001 Nobel Prize for Economics for the simple insight that in cases where users cannot observe quality competing solely on price leads to a downward spiral of both prices and quality. The real problem, even if current prices were above purely competitive prices, is the likely loss of quality competition in the audit marketplace. There are potentially severe impacts on the quality of audits performed throughout the industry because of the concentrated nature of the industry. This is a particularly insidious problem because audit quality, as noted by the GAO, is such a difficult metric to grasp and analyze. From the investors’ point of view, what is needed is a set of incentives for auditors, management and boards that cause the auditor to focus on the quality of the audit at the time the audit is performed. Recent attention to the audit because of Sarbanes-Oxley has undoubtedly affected a change in audit quality. Because time will soften its impact, we cannot hope for it to be a sustaining mechanism.
Does the current level of concentration contribute or detract from the likely effectiveness of ex-ante incentives to quality performance? At least one characteristic of concentration works against any expectation of success on this score, and this is the fundamental fact that the largest firms are trading corporate audit clients over time. If one firm loses a client through poor relationship development, poor service, perceived pricing problems, disagreements, or real audit failure, one of the other firms steps in to pick up that audit. Because the reputation loss, whether large or small, is unlikely to remove the first auditor from the field, and it is likely that one of the other firms will encounter similar difficulties with one of it current clients, the first auditor need only wait and work for the opportunity to capture a replacement. It is, of course, hard work to even maintain this state of affairs, but short of real and persistent dereliction, it is a viable system in which only minimum quality is needed to maintain the audit portion of the larger non-audit-service business.
Rather than try to address the current environment in any
complete way, I will make only two other points. First, our recent efforts to
deal with failed audit performance have been to ramp up the independence
requirements, audit performance standards and oversight of the auditors. The
PCAOB standards setting and inspections processes are the most recent
reflection of the standards and oversight approach to creating audit quality
incentives. Second, if the past is prelude, the next crisis in the profession
will either result in even more strictly defined standards and oversight
processes or some radical adjustment to the structure of the profession such as
“GAO for Public Company Audits” or a precipitous break up of the largest firms.
The costs of such precipitous approaches will be high for both people working
in those largest firms and the capital markets. Changes proposed to deal with the current concentration and firm structures
should be considered in light of the incentives they create to do independent
quality audits now and to expand the set of firms capable of handling SEC
registrant audits.
What about some of the changes under consideration at this time? Will they contribute to increasing or reducing incentives for concentration? I have commented on several of these proposals earlier:
· Simple CAPS on auditor liability favor the largest firms and appears to increase the trend toward higher concentration.
· Capitalizing the firms, even ignoring other quality and independence incentive problems, will favor the largest firms and appears to increase the trend toward higher concentration.
· Subsidized insurance for the large firms would favor the large firms and increase the trend toward higher concentration.
Each of the above proposals have a common characteristic, they all lower the cost or risk of auditing. There is nothing intrinsically wrong with lowering costs or risks. But, basic economics requires that we consider the following fact. Lowering costs or risks, all else equal, will lead to lower effort. Lower effort, all else equal, is a good surrogate for lower quality. Some may point out that more effective tools can lower costs and risk while maintaining quality. Economically, whether new tools are developed or not, the long-term net impact will be to lower the effort applied to the audit. Thus, it is still true that lowering of costs or risks will lower effort. So, what should change in addition to lowering cost or risk if quality is to be maintained? Very likely stricter independence and audit standards and enhanced oversight will be part of the answer: now or after the next crisis. On the other hand, a competitive environment generally leads to innovation in the underlying technology to provide a service.
Academics agree on little, but academic research invariably
indicates that lowering the costs or risks of an activity will cause the
participants to exercise less effort. It
is almost inevitable that by creating a lower cost and/or lower risk
environment there will be a decrease in quality over time unless there is an
offsetting process to assure that quality rises or is, at least, held constant.
There are, no doubt, exceptions to this rule where unnecessary or inefficient
practices and regulations have arisen. These should be eliminated. When making
your recommendations, your most difficult task will be to independently
determine whether you are dealing with the exception.
Even in the context of the current highly concentrated industry, there are actions that might be taken to weaken the effects of concentration and encourage the other firms to grow and even enter the registrant market. These include, but are not limited to, the following:
· Publication of data concerning corporate and market characteristics where firms outside of the largest firms have successfully managed quality audits.
· SEC staff consideration of the “right size” issue when making case-by-case decisions applying current independence rules.
· SEC and PCAOB consideration of comprehensive disclosures about the reasons for auditor switches: restrictive contracts with underwriters, audit committee concerns, etc.
· Promotion of more open and substantive communication between predecessor and successor auditors.
· Greater inclusion of these firms when forming commissions, task forces, committees and roundtables.
· More active attempts to include members of these firms in fellow positions such as those already in place at the FASB and SEC.
· Consideration of more fellowship and internship opportunities for members of these firms.
· Promotion of mergers and acquisitions among smaller firms.
The Academic
Accounting Profession
I have chosen to discuss the human capital issues with a focus on the academic accounting profession for two reasons. First, I was a part of the academic accounting profession for most of my career and, while I have limited regulatory and practice experience, I remain at heart an academic. This will, of course, color my thinking much as I expect practitioners experiences also color their presentations when writing on practice issues. I will, as I am sure they do as well, try to be as objective as possible. I do have one advantage over many academic professionals: I am a retired academic and no longer subject to the pressures of my past faculty and administrative positions; and, I have some direct association with the regulatory and practice domain. Second, it will be impossible to ignore certain practice issues related to human resources as success in this area requires an integrated consideration of the whole production function for developing professionals from creating faculty, faculty creating curriculum, and students subjected to faculty, curriculum, and practice expectations to entry to the profession and their subsequent experiences.
Unlike the practicing professional auditor, there is no Education Act similar to the Securities Acts of 1933 and 1934 to help me frame overarching concepts similar to those related to audits. I have attempted my own overarching concepts statement because, as with practice, it frames the rest of my discussion.
Similar to the practicing professional serving not only private contracting aims as well as the public contract nature of the audit, education serves more than one function. For example, academics have traditionally been given the time and reflection necessary to seek out new knowledge about their discipline as well as to contribute to its application through research, teaching and practice. Nor do academic accounting professionals currently produce students solely for entry to the public auditing function, nor even solely for the public accounting business broadly defined. I do not have exact statistics, but I suspect less than half of the student output enters the business of public accounting and a smaller fraction than that will enter as junior auditors. Also, many of those who enter as junior auditors will leave the audit function within the firm and will ultimately leave the firm altogether. These students need an education that recognizes these varied paths within and through the public accounting business. In addition, the other half of the class with either no interest or no opportunity to enter the public accounting business are nevertheless part of the broader accounting profession and need the same quality of education, perhaps with differing emphases, as demanded by the public auditor.
The common threads in discussing the academic domain are the search for new knowledge and the student experience. The student’s need should dominate the education experience. I have tried to craft the following Over-Arching Academic Practice Concepts in a way largely parallel to the Over-Arching Audit Practice Concepts. This is a work in progress and may stir controversy among my academic colleagues. Nevertheless, they inform my personal observations.
Over-Arching Academic Practice Concepts
· The primary professional missions of the academic accountants are to contribute to maintaining leadership in accounting research, teaching, service, including, but not limited to, contributions to practice.
· Individual academic institutions will choose, or in some cases may be assigned, a mission that will vary the balance of research, teaching, service, including, but not limited to, contributions to practice.
· All academic institutions should organize themselves to serve the long-term life and career interests and needs of their particular student body.
· Fulfilling the academic mission is achieved through transparency and public disclosure of individual and institutional performance based on the mission chosen by or assigned to the institution.
· Public oversight structures and support of academic institutions should reflect that the academy is engaged in a public good mission.
· Where educational programs are paid for by private funds, private contracting will determine the mission and focus of the institutions or programs.
Academic accounting professionals are a part of the academic
community serving broad social purposes that include the education of entry
level accountants destined to become practicing professional accountants. As in
any profession, to meet their primary mission academic accountants must
function effectively within the general academic community. Failing to function
effectively within the academic community will lead to a failed academic
accounting endeavor and, eventually, in the failure to meet the specific needs
of entry level accountants destined to become practicing professionals. This
point is crucial to what follows because, many of the recommended “solutions”
to the current “academic problem” suggested by the practicing professional
domain, tend to short-term “solutions” that fail to recognize the critical
importance of accounting’s prestige as an academic discipline, which depends
highly on the broader academic acceptance of its research. Failure of the academic accounting endeavor will lead to an ever
diminishing supply of qualified entry level accountants.
Several Practitioner recommendations
Practice association
or government mandated curricula
I am surprised, though perhaps I should not be, that those
who argue most strenuously for their own flexibility and judgment are most
ready to make proposals designed to remove those same attributes from other
professionals.
Current recommendations that involve professional association or government intervention in determining the curriculum assume that these agencies have better capabilities and insights than those operating in the market place for ideas and student resources. I seriously doubt this assumption. They also seem to assume that the practitioner looks beyond their immediate practice concerns, an assumption I also have learned to discount. As a group, field practitioners and recruiters clearly do not look very far into the future. They have an immediate demand that must be satisfied in some manner to keep the enterprise going and growing.
Accepting recommendations of this type will, without doubt, lead to: uniformity across institutions; an inability to accommodate the diversity of ideas a real education requires; myopic and dysfunctional responses to observed short-term changes in the environment; an inability to respond to projected fundamental long-term change; and, a stifling of academic enquiry. Further, those who desire this level of uniformity can obtain it by creating and paying for their own, privately supported, “academic” institutions. They do not need legislation to accomplish this task.
One could even argue that to some extent the response of the academy during the 80’s and 90’s already exhibited the very aspects of the academics’ capture by the practicing profession implicit in the above recommendations. The overly vocational and technical educational commonly found in virtually all four-year accounting programs and most five-year programs exist because the profession demands them when hiring students, despite rhetoric to the contrary.
While a complex and subtle matter, the five-year programs as they exist in most institutions are an example of the profession’s inability to think and act in a manner consistent with a long view of the value of a broad based education. Prior to creating five-year programs many institutions offered accounting masters programs and MBA programs that arguably provided students with the opportunity to gain the kind of conceptual and broad based business and accounting knowledge the profession needs and claimed to want. On the other hand, my experience clearly indicates that the profession did not pay a substantial premium for these students. Nor did they organize their firms to take advantage of these students. In fact, they handled these students in the same manner as the four-year student, paying only a minor premium on entry and eventually merging most of them into the common stream of field experience. Clearly these more academic accounting masters programs and broad based business MBA programs of the past did not meet their perceived needs. The demise of these masters programs also damaged an historic pipeline to the Ph.D. programs in accounting.
Many, if not most, of the resulting five-year programs are largely extensions of the four-year programs, focused on giving undergraduate accounting students more accounting and perhaps some exposure to MBA-like coursework. That is, they are not as intellectually challenging as the old accounting masters program and not as broadly based in business as the MBA program. This is not to say that a well-developed five-year program cannot produce a better entry level accountant, but I suspect most do not. Now, one could argue that the academic community is at fault and I do not doubt that we are a contributing factor. Academics are subject to all the same biases as practitioners in their own domain. But we contribute to the problem most in our fear to take truly radical actions to produce an intellectually more interested and capable student. The fear arises from the fact that we may be advising a student to adopt a high risk position that will not pay off in a professional position. Instead we tend to produce a student more attuned to the immediate professional culture and stated job needs.
Practice recommendations that seem to come off the shelf to serve immediate needs without consultation with the academic community and consideration of student long-term needs are likely to contribute to the continuing failure of the profession to adapt to their mission as discussed above and will ultimately diminish the status of the academic accounting endeavor.
Adding substantial
numbers of practitioners to the faculty body
This area seems to have two dominant ideas within it. First, it is often offered as an immediate solution, sometimes couched as of short-term duration: populating the academic profession with retreads and early retirees from practice. This may sound harsh, but I have received these calls in the past when I was head of departments of accounting. I find it amazingly that the senior leadership in practice, who would surely not consider placing an academic with a short-course in field auditing in an operational line auditing positions, considers being an academic so easy that they can walk in or, if really desiring to work at it, take a short-course from the AACSB and become an academic. There are clearly practice professionals that make excellent contributions to some of the most highly rated accounting programs in the country. Talk to those who have succeeded and they will tell you that to be a good full service faculty member is difficult. I submit that these practitioner academics are not your common practitioners just as it would take an uncommon academic to enter the profession as a line practitioner.
Effective teaching is not easy, nor can it be divorced from the other aspects of the academic mission, most specifically from the discovery of new knowledge: the research mission. There is a reason why the most respected academic institutions are also identified as outstanding research institutions within their mission domain. An effective long-term teaching mission will not be served by a large influx of non-PhD “faculty.” A selective cross-fertilizing of academe by practice and of practice by academe is to be encouraged as it will enrich both domains. At this point, academe has done a better job on the cross-fertilization dimension than has practice.
A disturbing aspect of this recommendation is its obvious long-term appeal to Deans and Presidents. Business school deans generally do not identify with the accounting program. Their program is the MBA program. Accounting programs, particularly expensive Ph.D. programs that draw funds away from the undergraduate and MBA program, are not generally going to raise the Dean’s reputation. Anything that reduces the costs of accounting faculty is a candidate for permanent incorporation into future budgetary processes. Academic institutions will be quick to adopt this cheaper approach to accounting training and build budgets accordingly. Altering the resulting budget arrangements in the future will not be an easy exercise. Further, the effect of a large component of professional “educators” will lower the reputation of the accounting discipline in academe, strengthening and justifying the lower budget regime.
An alternative preferred and hoped for reaction from among the more astute and respected universities might be a rejection of the concept. These universities would continue to use professionals selectively and where they can make the greatest contribution to both the students and faculty, but not as substitutes for full-service faculty.
Attempts to solve the faculty shortage problem by replacing full-service faculty with large numbers of practice teachers will not be without severe first and second order consequences that, if they become a permanent part of the academic structure, will over time reduce the quality of output by academe on all of its mission dimensions.
Changing the character
of faculty education
To some extent the suggestion discussed above is a rather more radical way of changing faculty education: instead of revising Ph.D. programs, it simply requires a four or five-year accounting education and some number of years of practice. The less radical recommendation proposed by practice is to dictate that the Ph.D. should become something different for accountants than for the other academic disciplines. The recommendations are not easy to pin down in detail, but simplest and, thus, likely most appealing, generally involve shortening the time to obtain a degree, altering the focus of the Ph.D. curriculum by deemphasizing research, and by extension altering the criteria by which accounting academics will attain promotion in the academy.
This is the same rhetoric that was used when promoting the
Independent Schools of Accounting. As the profession was not prepared to pay
for these independent schools, those that exist do so within the current
institutional structures of the academy. A handful of these units have done
well academically and professionally, but generally it is my observation that those
units were already doing well academically and professionally. Most Schools of
Accountancy are merely promotional platforms with a name, but no fundamental
difference from a Department of Accounting in any
Recommendations that essentially ignore the needs of the academy in calling for it to serve the short-term interests of the profession, will lead to the loss of a prestigious discipline in the academy and the long-term decline of the quality of students and student education.
Nevertheless, there are issues worthy of discussion in this domain. Like the practice issues, many are not easy to grapple with when we get to the details. For example the question of whether current Ph.D. programs are “too long” does not have a simple answer, and certainly not a one-size-fits-all answer as implied by some of the recommendations. Nor is the balance between the so called “exotic” research methods over practice-based methods a simple one. Solving the academic Ph.D. shortage is unfortunately a very difficult problem, perhaps even more difficult than altering professional practices.
Unless we (academe and practice) figure out how to recapture the long-standing and recently severely damaged reputation of the profession, the profession will become nothing more than another business, and academic accounting will become nothing more than training programs. For the public accounting industry this will ultimately mean another loss in professional status.
Academics need to be aware that their prestige as accounting academics is derived from the profession’s prestige in audit practice. Solving the practice problem is a pre-condition to solving many of the perceived academic problems.
This does not mean that academe should not adapt in some ways immediately, but unless the profession regains its prestige, academic accounting will wither, losing its best faculty and students to fields like economics, finance and law. See the first part of this submission for some thoughts on how the profession needs to change.
Money of course cannot be ignored. Academics are well-paid, but not nearly as well-paid as their successful practice colleagues who attain partner status, particularly senior partner positions in the largest firms. Historically, the prestige of the profession, the prestige of being in the academic community, the love of the hunt for new knowledge and teaching have sustained the demand for academic careers. These are still the most important factors leading to an academic life. As prestige dwindles, accounting programs become more vocational and technical and the pay does not rise to compensate for the loss of psychic income, we should expect declines in the attractiveness of Ph.D. programs and faculty positions.
Altering the character of Ph.D. programs in the manner often suggested will not make them more desirable academic positions. It will diminish the respect of the rest of academe for the accounting academic and eventually result in lower demand by high quality students in all programs, including the Ph.D. program. The whole endeavor will spiral down.
There is no simple solution, but any solution should involve not merely recommendations or actions by one of the stakeholders, but by all of them. We need an exerted effort to involve not merely accounting practitioners and academics, but also the leading academic thinkers from other respected fields to help us find viable solutions that serve all of the stakeholders. Yes, students should also have a voice. Too quick a knee-jerk reaction to changing the academic endeavor will have long-term negative consequences to the practicing profession.
I have my own ideas about change in academia, some of which can be implemented immediately. Some of them the profession would find appealing, others not so appealing, but this is not the place or means to begin a discussion about specifics. We need a process that will allow all of the stakeholders to have effective input.
Rather than take precipitous action that may have long-term negative impacts on the whole of the profession, I suggest that the Committee formulate recommendations for an immediate and on-going public dialog on these important issues: a dialog with benchmarks for action, not merely a forum for discussion.
Closing Statement
The Committee is dealing with core issues for the profession of accounting, not merely the public accounting business. The recommendations of this Committee will carry the full weight of its membership and Treasury Department and will likely influence future legislation and regulation in both the academic and practice arenas.
I know that great care will be exercised to make recommendations for immediate action only where the evidence clearly supports the need for such action and only after considering the possible negative consequences of the actions.
Where the evidence is not clearly compelling, I urge you to recommend processes that will bring all of the stakeholders to the table for a continuing dialogue and benchmarks for action.
Sincerely,
Andrew D. Bailey, Jr., C.P.A.,
C.I.A., C.M.A., C.F.E.
Professor of Accountancy – Emeritus
and
Senior Policy Advisor
Grant Thornton LLP
928-634-0487 Phone
928-451-1392 Cell
Appendix
Outline of Letter Submitted to the
Advisory Committee on the Accounting Profession
Office of Financial Institutions Policy
Department of the Treasury
January 30, 2008
by
Andrew D. Bailey, Jr.
Content Page
Introduction 1
Ideas that Pervade the Narrative 2
The Practicing Profession 2
The Role of the Practicing Professional Accountant 3
Over-Arching Audit Practice Concepts 4
The Primary Professional
Prevention and detection of material errors and frauds 4
Transparency and public disclosure of audit results 5
Regulatory structures for public company auditors 5
Considering some of
the questions raised by the Advisory Committee
Working Outline 6
Capitalization, Insurance, Liability,
Communications, and Concentration 6
Globalization 9
Price and Quality Competition 10
Capitalizing the firms 11
Insurance 11
Liability 12
Communications 12
Concentration 13
The Academic Accounting Profession 16
Over-Arching Academic Practice Concepts 17
Several Practitioner Recommendations 17
Practice association or government mandated curricula 17
Adding substantial numbers of practitioners to the faculty body 19
Changing the character of faculty education 20
Closing Statement 22