Fraud Updates on January 31, 2003

**Feeling cynical?**
If you aren’t (cynical) now, you will by the time you finish the new Bebchuk and Fried paper on executive compensation. They paint a fairly gloomy picture of managers exerting their power to “extract rents and to camouflage the extent of their rent extraction.” Rather than designed to solve agency cost problems, the paper makes the case that executive pay can by an agency cost in and of itself. Let’s hope things aren’t this bad. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=364220 They say that patriotism is the last refuge To which a scoundrel clings. Steal a little and they throw you in jail, Steal a lot and they make you king. There's only one step down from here, baby, It's called the land of permanent bliss. What's a sweetheart like you doin' in a dump like this? Lyrics of a Bob Dylan song forwarded by Damian Gadal [DGADAL@CI.SANTA-BARBARA.CA.US]

Jan. 2, 2003 (Thomson Media) — The latest accounting debacle is shaking up not only the financial industry, with bankers probed about loans to corporate miscreants, but also our political environment with the White House being maneuvered toward reforms. The question on the minds of everyone from executives to the President to the SEC is, how do we fix the audit system? The real question, however, should be, is the audit system even necessary?

In the name of full disclosure, I received my CPA well over 10 years ago working for the accounting firm KPMG. I did not keep up my certification programs and no longer practice as a CPA. My current mission of improving corporate value via productivity makes me passionate about efficiency.

My fervent recommendation is to eliminate the entire public auditing industry. In this new world, sans the auditing industry, auditors would still have a vital role in ensuring compliance, but not through an artificially forced extra layer, such as is currently in place. Half of the auditors would work for the SEC to reinforce interpretation and opinion. The rest of the auditors would work directly for the companies who file their financial statements with the SEC. The companies themselves would provide the sole and detailed opinion on their financial statements. Checks and balances would occur directly between the company and the SEC -- which would remain an unbiased and financially independent compliance organization.

The auditing perspective is based on principles of public auditing that I learned at KPMG in my early years. The perception of conflict of interest is to be avoided as much as the realities of it. In the case of the audit profession, the fact that the firms are "for profit" partnerships paid by clients is the fundamental conflict of interest issue -- not specifically the payments made for the consulting work. Too many control points dilute rather than reinforce accountability. This is the problem in almost all of the current situations. Auditors blame management, which is ultimately accountable. But management blames the auditors upon whom it relies. One proposed solution is to implement an overseeing body to supervise the auditors-adding even more layers of theoretical control. This is a true waste of resources and puts us in a vicious cycle. Bad business models create bad business judgment.

The value of public auditing is difficult even for auditors to justify. If the company is reporting according to principles defined by the SEC, then the public audit provides little additional value. Though there are certainly mistakes caught inside an audit that are fixed and never make it to the public's attention, a strong internal audit group could likely provide the same level of value. If the company has financial and management issues and is not reporting correctly, then the role of the outside auditor is conflicted. It is clear current audit methods often do not go far enough. For external audits to provide real value, they would likely need to be significantly deeper and less influenced than they are today.

From the productivity point of view, our economic system can provide just so many resources for overseeing company accounting activities. If they are spread unevenly across internal auditors, internal accountants and finance departments, internal compliance, external auditors, external auditor review boards, and the SEC, we are likely to continue to get the results we have seen in the last nine months: too many touch points with too little assurance. The redundancy is ineffective and expensive. Eliminating the public system altogether and putting the onus on the company to report correctly and directly with the SEC makes the most sense.

So what would this change really look like and will anyone take it seriously? CPAs would continue to be trained on SEC regulations, but wouldn't be required to work at a public firm to receive their licenses. Instead of working for audit firms, they'd work directly for companies. Internal auditors and these SEC-trained auditors would work together to ensure the company followed correct accounting procedures. Direct corporate repercussions from the SEC would alleviate concerns about management influence over their audit employees.

The reality is we'll probably just add another layer of governing to the already cumbersome public auditing industry. But just for a moment, wouldn't it be nice to imagine efficiency and responsibility winning over wasted resources, additional red tape, and continued finger-pointing?

-- Thomson Media