ANTHONY H. CATANACH JR. is an associate professor in the School of Business at Villanova University, as well as the Cary M. Maguire Fellow at the American College Center for Ethics in Financial Services. His professional experience includes five years as an audit manager with KPMG and six years in the financial services industry. Dr. Catanach has received numerous awards for his publication, teaching, and curriculum innovation efforts. He has authored numerous articles on a variety of accounting, finance, and management issues, as well as several business education texts..
This year we have been outspoken critics of the Big Four’s auditing “prowess.” See “The Auditor’s Expectations GAP…Not Again! Excuses, Excuses, Excuses!” and “Who Really Cares About Auditor Rotation? Not Us!” Each of these commentaries implicitly, if not explicitly, called on these firms to make substantive, meaningful changes to their audit models so that they might once again fulfill their oversight responsibilities to the investing public. Instead, according to David Ingram and Dena Aubin at Reuters, the Big Four continue to channel resources into lobbying efforts presumably to maintain the status quo, rather than reengineering the defective service that they label an “audit,” which they continue to peddle with the tacit approval and blessing of the SEC.
Public Company Accounting Oversight Board (PCAOB) board member Jay Hansen seems to agree that auditors face some significant hurdles. In a recent speech (“The PCAOB’s Role in Investor Protection”) at University of Nebraska, Mr. Hansen stated,
Recent inspection findings tell us that auditors have struggled with auditing fair value measurements, impairment of goodwill, indefinite-lived intangible assets, and other long-lived assets, allowance for loan losses, off-balance-sheet structures, revenue recognition, inventory and income taxes. Our inspection results in 2010 and 2011 showed an increase in inspection findings, particularly in the area of fair value, but also in the auditors’ testing of internal controls.
Basic business strategy demands attention to the customer value proposition, as well as product and/or service differentiation. The fact that the Big Four continue to ignore the real customer (the investing public), and make no attempt to distinguish their audit product on any dimension (quality would be nice), dooms whatever “strategy” that they think they may have to complete to utter failure.
So what’s prompted our recent rant? Well, several weeks ago one of our Executive MBA students (i.e., a mature, experienced, and motivated individual) shared with us an interaction that he and his audit committee recently experienced with their Big Four auditor. This particular student serves as both the corporate secretary and as a member of the board of directors and audit committee for a medium-size financial institution. At a recent meeting with its independent auditor, the audit committee asked the external auditor what the firm was doing to address concerns expressed by the PCAOB about the quality of audits conducted by their firm. Here is where it gets interesting.
Instead of addressing the question posed by the audit committee or acknowledging that their firm needed to improve audit quality, the engagement partner chose to blame the CLIENT for the firm’s poor audit quality. Moreover, the partner suggested that if the client would pay higher fees, then their firm could do more work and improve their audits!
Does this Big Four audit partner’s argument have any merit? Yes, but only a little…we have known for quite a while that declining audit fees were becoming a problem. And of course, companies must also share in the blame to the extent that they play the “auditor shopping” game. But a bigger and more troubling question is “why is the audit firm accepting engagements if the fees are not sufficient to guarantee a quality audit?” The answer of course is that the Big Four just “can’t say no!” What…walk away from a client over fees?
Well, these two Grumpy Old Accountants remember a day (yes, it was almost 30 years ago), when the big accounting firms would actually do this. Of course, back then, reputations mattered, firms recognized their public service responsibilities, and audit quality was a firm differentiator. Some will remember the days when if you needed an aggressive accounting treatment blessed, at a cheap price, you hired a certain Big Eight firm. On the other hand, if you wanted good advice and a high quality audit, and were willing to pay for it, you sought out Price Waterhouse. Those were the “polar” extremes of audit firm quality, with the rest of the firms falling somewhere in between. My how times have changed…increasingly audits have become a homogeneous, undifferentiated commodity, and the Big Four offerings are virtually indistinguishable.
So, we ask again…does this audit partner’s statement reflect arrogance or ignorance? We think BOTH, and that is very sad indeed. The arrogance is in ignoring the audit committee’s question about improving audit quality, and blaming the client. The ignorance is in the partner’s lack of understanding of his responsibilities to the investing public, as well as strategy and business model fundamentals. And we forgot one more descriptor…the partner’s statement reflects stupidity for actually going on the record to admit that the audit firm is a “revenue junky,” so addicted to revenue, that it will do lower quality work instead of actually dropping a client.
What can be done about all of this? A lot frankly—and Jon Weil’s question “When Will the SEC Finally Go After the Auditors?” points us in the right direction. The ultimate solution can be found in regulatory enforcement as we discussed in “Big 4 Audits: A Thing of the Past?” Let’s refresh our memory. Until the Enron debacle (when Arthur Andersen was effectively closed by the regulators), regulatory agencies had no problem going after the auditors. For example, during the savings and loan crisis of the 1980’s, banking agencies had no problem routinely suing big auditing firms for shoddy work.
Regulators have created the public audit market by requiring an audit for all publicly traded companies. But regulators have decided to overlook obvious declines in audit quality (e.g., auditor malpractice in the financial crisis of 2008). As long as regulators continue to accept substandard audits to meet their requirements, the Big Four have no incentive to change the status quo.
Mr. and Mrs. Regulator, please forget “too few to fail.” Hold the Big Four accountable for their deficient work, and remember that your primary obligation has always been to the investing public.
This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.
J. EDWARD KETZ is an associate professor of accounting in the Smeal College of Business at Pennsylvania State University. He has a bachelor’s degree in political science, a master’s degree in accountancy, and a Ph.D., all from Virginia Tech. Professor Ketz has been a member of the Penn State faculty since 1981. He also has taught at the University of Connecticut and the University of Maryland. Professor Ketz has authored and edited 17 books including Hidden Financial Risk (Wiley, 2003) which examines the corporate culture and the institutional setting that engendered recent accounting scandals. Dr. Ketz has been cited in the popular and business press, including The Wall Street Journal, The New York Times, The Washington Post, Business Week, and USA Today. He also has appeared as an accounting commentator on CNN, National Public Radio, and Bloomberg Radio.
Very good points. As an auditor for PwC, I would like to point out that starting last FY, our #1 point of audit emphasis is quality, and there have been quite a few changes to increase senior level oversight and inspection of individual evidence gathering activities (at manager, SM, partner level). Overall message here is loud and clear – and absolutely true.
Have you Professor Grumpsters exercised artistic license in describing your student’s issues? I’ve dealt with many partners from the Big 4, and I can’t believe that a partner would speak publicly in those brazen terms. “Blaming the client for the poor quality” sounds far fetched. I can see them talking about challenges in getting access to people and documents and other euphemisms, but “blaming” sounds outlandish even for the Big 4. If you look at auditor performance reports for IndyMac or Countrywide, I think competence, inability to retain good seniors on accounts, and the basic conflicts in the “company hires the auditor” model are critical.
I believe that I identified a model for auditing of public financial statements that can produce better audits, drive down costs, and establish risk-based pricing.
No, no artistic license. We are just reporting what the EMBA student said.
While I agree with the gist of your article, that the partner in questions was acting a bit arrogantly/stupidly, you seem to paint all Big 4 partners with the same brush.
At least in my Big 4 firm, we’re definitely changing our methods in light of PCAOB suggestions and comments.
However, it’s a good point to bring up, and the partner in question WAS acting stupidly in my opinion. Why not be proactive and bring the issue of fees and the quality of the audit to light sooner?
Obviously this partner was not “getting smarter” year after year, and was merely “rolling forward” the audit methodology.
The huge lapses in Audit in the last decades are at C-level, with C-Level choices that gain Audit Partner acquiescence. As a former auditor, we saw few lapses in Internal Controls in pure “booking” cycles… company controllers have those cycles (AR, Invy, Accruals) tied down.
Yet Auditors still test these as if every firm is a McKesson & Robbins (1938) – massive bogus documentation for A/R & Rev, e.g.
What’s needed is more focus and over-sight on the theoretics and big picture moves — the reclass of deferred rev into current year rev, capitalization of cash-out expenses, and write-ups/write-downs of assets.
Client front-line controllers are not much involved here. In fact, front-line is generally doing everything close to perfect.
The risky calls are C-level, ‘manage EPS’ decisions. A Sr. Auditor or Audit Manager have little input in a Client’s “moving billions” from one statement to another. It’s to the Audit Partner to really fathom the impact. And to NOT assume that the Client will be in business forever.
It’s good to hear that PwC is back to Quality. As former AA&Co… well… we know what happened.
Audit Quality Review should focus on Client assumptions. Those very big picture ones. Audit Partners should be evaluated on a scale from 1 to 5 as to the quality of their assumptions and their “passes” with the Client. The Audit Partner — esp Big Four — should not be immune to his/her own internal review… of how much he/she placed the Firm at risk, potentially, with acquiescence to C-level big picture assumptions.
Limiting risk is essential to the signing of an opinion. We’ve gotten away from that idea, that our risk is the investors’ risk. Okay, well, how about a different dialectic, that when a Partner vouches for an opinion, his/her Quality is rated on the potential risk that he/she has placed upon the Firm.
A lot of it does have to do with the client. You ask when will the SEC go after the auditors, well when will the SEC go after the clients. To say the auditors are held to a higher standard than the public companies we audit is like saying the first step off the top of the empire state building is a doozy. Last year one of my clients got a comment letter about an issue that we continuously make a big deal about and they act like isn’t a big deal. Finally they were going to see what we were talking about. But no, the SEC let them off with the lamest freaking response I have ever seen. How the hell are we supposed to be the enforcement of the rules when the entity that enforces the rules won’t?
Everyone loves to blame the auditors, but nobody wants to blame the people that create the financial statements. Everyone says that an audit is a commodity, but you still see articles like the one above. You know something, auditing is damn hard, and the regulator keeps changing the rules. None of our clients have a clue about the environment we are in or have any idea how difficult it is to audit them. All they care about is saving a few hundred grand in fees, but nobody wants to write about that.
Great article and very interresting subject.
Eric.
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http://www.suikervrije.com
http://www.suikervrijerecepten.com
This has to be one of the most ignorant, ill-informed articles i have ever read when it comes to criticism of the Big 4 or a clear understanding for what drove the 2008 financial crisis to begin with. It lacks any understanding of the PCAOB inspection process, any perspective of the actual type of work Big 4 auditors do perform, and it clearly takes “artistic” license in describing the Big 4 partner’s comments to the Audit Committee. Even if every word of that quote were true, you are sorely mistaken if you think such comments are reflective of the general attitude of Big 4 partners. As academics, i would expect better research from you and a more balanced understanding of the depth of extensiveness that goes into audits, rather than relying on snipits from the Wall Street Journal and convenient quotes that only serve to push your agenda.
Gentlemen,
With your education and other experience, I am surprised by the lack of thought put into this article.
Artistic license or not isn’t the issue. You trust the words of an executive MBA student and are using them to tear down the quality of work of 4 of the world’s largest business service firms (which I should add are made up of a large amount of professionals, young and old, who have post-graduate degrees and are on their way to obtaining a highly regarded professional certification) instead of putting some thought into this and assessing the more complex issues in the industry.
As someone who has dealt with executives and seen how they interact with audit firms and audit committees, I can put this into a little more context; the context that is absent from your article. If that executive is asking that question in a meeting, it’s likely because he’s putting on a show for his audit committee. If you were to ask him if he would pay double the audit fee for double the audit quality, what do you think he would say?
Who was it you said should ultimately be looking after the investor? Ah, right, the auditor is responsible for them. Gone are the days when management was considered fully responsible for creating value in information for the investor. We don’t see articles about executive MBA students talking about their efforts to improve the quality of their financial information, no matter how much it costs in audit fees. The only way investor value is linked to financial statement audits by a Company is through a reduction in audit fees. I find it hard to believe that increased audit quality is frequently considered, and that’s the business environment in our country. While I agree that IF a partner turned this into a fee discussion in the middle of an audit committee meeting (very unlikely), it was a stupid decision. But make no mistake, there will never be a discussion about improving audit quality without talking about the increase in audit effort (hours). It makes no sense. If you want to talk about that in terms of dollars, go ahead. It might make the firm sound more like a “revenue junky,” but it’s the same thing.
The other part of your article that’s completely void of context is where you insinuate that PCAOB findings equal low-quality audits. We are in a different regulatory environment right now and audits are vastly different and more complex than when you were in the industry. Transactions are also becoming more complex and transactions of higher complexity are more frequent. At the same time, audit firms are under more scrutiny than ever before and are continuously subject to increasingly stringent requirements. But we are also dealing with increasing pressure from the business community to cut down audit fees and audit effort. And, as another reply noted, the SEC puts little more effort into holding companies accountable.
So when, at the drop of hat, the PCAOB will decide that what was once acceptable practice is no longer both for audit firms and companies alike, the number of inspection findings immediately swells, executive MBAs get on their high horse, and people like you write articles such as this. But at the end of day, the Big 4 firms are the ones taking on the risk of their names being dragged through the mud every time a high-profile company plays games with their numbers. Their professionals are the ones putting themselves through hell to do this dirty work. So the next time your executive MBA student speaks up, show a little more respect for public accountants and yourself, and consider what side he/she is on and the motivation behind the words.
First up, completely enjoyed the post, and the comments as well. Always love a good fight.
What I think some of the responses aren’t getting… is the Point you’re trying to make.
Regardless of the language used by the Big 4 partner, the point is that the Big 4 have tried hard, and suceeded in stalling changes in regulation relating to auditor rotation, joint audits and the like. At the same time, if they are gonna treat this as a validation of what they are doing, it is going to result in a dangerous situation.
I really like what Bob Dohrer, our global leader for quality and risk, said during our RSM International conference this year “if we as auditors are not warning the market of systemic risks, then what are we there for?”