Take Away the Auditors' Mandate
There were two stories this week reinforcing my view that Congress should revoke the valuable franchise it created for the accounting profession 80 years ago when it made outside audits mandatory for public companies. PricewaterhouseCoopers was the subject of both of them.
The first was a feature by Bloomberg News reporter Jesse Drucker about a Pricewaterhouse partner in Dublin who helped turn Ireland into a global tax-avoidance hub -- and saved some of Silicon Valley's largest companies billions of dollars in U.S. income taxes. The other was the news that Pricewaterhouse is buying the consulting firm Booz & Co. for an undisclosed sum.
The idea of requiring audits when Congress passed the Securities Act of 1933 was that they would be carried out by trusted professionals whose priority is the public interest. If big accounting firms want to pursue commercial endeavors such as selling clever tax shelters and management advice or otherwise serving in advocacy roles, that's fine. But the public shouldn't have to subsidize them with a guaranteed revenue stream written into federal law. Even if the big firms were audit-only shops, they still would have glaring conflicts. That's because the audit clients pay for the audits.
Up through the 1990s, the major firms' business models to a large degree revolved around using the audit as a loss leader to sell more lucrative consulting services. Pricewaterhouse, Ernst & Young and KPMG sold or spun off the bulk of their consulting arms, in response to pressure from securities regulators. (Deloitte & Touche didn't.) Within a few years, the firms were steadily rebuilding their consulting operations, although now there are more restrictions on the services they can perform for audit clients.
There is no evidence that this shift back to consulting has improved audit quality. On the contrary, each of the Big Four firms has consistently received terrible inspection reports from the Public Company Accounting Oversight Board.
As for Pricewaterhouse and Booz, we can assume that the newly combined firm wouldn’t provide consulting services to audit clients in ways that run afoul of the Securities and Exchange Commission’s auditor-independence rules. But that isn't necessarily saying much.
The rules are based on three main principles: (1) an auditor shouldn’t function in the role of management, (2) an audit firm can't audit its own work, and (3) an auditor can't serve in an advocacy role for an audit client. Yet there still are lots of nonaudit services that the firms can legally provide to audit clients, even though they clearly violate the spirit of one or more of those principles.
As long as a particular category of nonaudit service isn’t expressly prohibited, it’s generally allowed. Some forms of management consulting are still permitted. The firms can still design aggressive tax strategies for audit clients -- and then audit their own work when reviewing the tax shelters' effects on clients’ financial statements (a violation of principle No. 2). They even are allowed to lobby Congress on behalf of audit clients (a violation of principle No. 3).
Here’s a nutshell version of a market solution that Lynn Turner, who was the SEC’s chief accountant from 1998 to 2001, recommended for a column I wrote last year. (Disclosure: Turner and I used to work together at the research firm Glass Lewis & Co., which we both left in 2007.) End the audit mandate, and require that shareholders be asked to vote on having an audit.
If they vote yes, and an auditor failed to detect a major fraud or weakness in a company’s internal accounting controls, the firm would be fired and replaced. Additionally, companies would have to provide information to shareholders (before they voted) showing key audit-quality indicators, such as the level of experience and turnover among the people doing the audit.
Regulation of the audit firms hasn’t worked. If investors don't want them, they shouldn't have to pay for them.
(Jonathan Weil is a Bloomberg View columnist. Follow him on Twitter.)