So much has been written lately about accounting scandals, audit failures, and the financial crisis. Reforms have been passed, yet accounting problems persist. This prompted me to ask: What’s the value of an external audit at all these days?

In the beginning, the purpose of an external audit was to validate the accounts of management for the suppliers of capital. Over time, auditing evolved from providing a service to the suppliers of capital (a private good) to a service for investors (a public good). The current audit is required as a result of the 1933 and 1934 Securities Acts (which came about as a result of the stock market crash of 1929). These acts required that public companies obtain an audit from a registered certified public accounting firm. The acts require that an audit provide reasonable assurance that the financial statements are fairly stated.

The objective was to determine that the accounting records are accurate and complete, prepared in accordance with generally accepted accounting principles, and that the financial statements prepared from the accounts present fairly the organization’s financial position and results of operations. The acts also gave the Securities and Exchange Commission jurisdiction over the accounting profession and its rules.

Until the enactment of the Sarbanes-Oxley Act in 2002, this oversight was largely delegated to private standard-setting bodies: the American Institute of Certified Public Accountants for auditing standards, and the Financial Accounting Standards Board for accounting standards. The AICPA was largely a self-policing group for the auditing profession, with firms conducting peer reviews on competitor firms on a regular basis. SOX, however, created the Public Company Accounting Oversight Board to register and inspect all accounting firms, and to set auditing standards. FASB still sets accounting standards for U.S. companies as it has since the 1970s, but more on that later.

SOX also resolved the conflict that existed as a result of how FASB was funded. Prior to SOX, FASB was funded through donations mostly from large accounting firms, large public companies, and groups representing those constituencies. Whether that created a genuine conflict of interest is unclear, but it did create a perception of conflict, so SOX required that both FASB and the PCAOB be funded by public companies on the basis of their relative market capitalizations. Both budgets are approved annually by the SEC.

SOX also attempted to resolve the conflict of interest that exists due to the auditors being hired and paid for by management. Effectively, management was paying for an outside opinion that they were doing a good job. To resolve this conflict, SOX required that the company’s audit committee hire and fire the external auditors—although it ignored the remaining conflict that audit committee members are still paid by the company. In fact, most made more money after SOX because of the increased workload and risk they shouldered. In reality, company management still maintains the daily working relationship with external auditors.

With that background in mind, I go back to the question: What value does the external audit bring? Most surveys and studies I’ve seen say that the most important reason for an external audit is that it adds credibility to financial statements. In addition, many in management note that it “imposes discipline to the financial reporting process.” (I remember using the threat of the external audit to get much data I needed internally in my roles in large companies—whether or not the auditors actually requested it. The mere mention of the audit was enough to get desired information promptly!)

In many companies, with competent, honest staff, the additional value that an audit brings may be negligible. But investors don’t really have any insight into which companies have competent, honest employees (I would venture to guess that 95 percent of companies fall into this category) and which have workers who might be less competent or who are easily tempted to push the envelop too far.

Expressing Opinions

While the audit profession was evolving, so was the nature of the audit opinion. The audit opinion moved from providing an assessment of the “true and fair” presentation of the financial statements simply to providing an opinion as to whether the financial statements are in compliance with GAAP. This evolved for various reasons.

What value does the external audit bring? Most surveys and studies I’ve seen say that the most important reason for an external audit is that it adds credibility to financial statements.

Foremost, increasingly complex accounting standards created more complex and subjective accounting decisions. Standards have come to be rules-driven thanks to our litigation-prone world and standard setters move to require that more items be stated at fair-market value when they had no ready market. Auditors (and companies) want to do the right thing, so they asked for more bright lines and guidance.

The standard setters will say that they are issuing “simpler” standards because they offer fewer choices and concepts. We all know, however, that sometimes “simple” concepts (say, report all items at fair value) are incredibly complex to implement. This growing complexity requires that the auditors need both professional expertise (valuation experience in the case of fair value) as well as independence.

We’ve also seen increased pressure for management to manage earnings, as executive compensation has grown more aligned with stock price; that makes the audit more difficult, too.

Due to all of the above—particularly the increase in litigation—there was a clear shift from opining on whether the financial statements were a true and fair view to whether or not they complied with GAAP. Want to avoid litigation? Then simply opine on whether the company followed the rules, irrespective of the economic reality. That self-interest may be understandable considering the environment audit firms work in, but still—is that type of audit opinion really as valuable as one that might be less boilerplate and compliance-centric?

We now have a large (and growing) gap between what the audit opinion actually represents and what the investing public believes it represents. Accounting is subjective and imprecise for many of the reasons outlined above. This is becoming even more acute with the push to require more fair-value accounting for items that have no ready market. Users sometimes believe that audited financial statements have more precision than they actually do. This expectations gap is exacerbated by our litigious environment and the auditor’s growing focus on compliance.

Room for Improvement

There have been many suggestions over the years on how to improve the current system. They range from a government agency performing the audits to a government agency appointing the audit firm to insurance products to protect shareholders to not having an audit at all. This last suggestion has received much attention lately, given the painful increase in audit fees to keep pace with the cost of compliance with SOX and ever-more complex accounting standards.

Most people believe that the audit adds value. That being said, we still have some continuing conflicts and issues that need to be resolved.

First, we need a fundamental shift away from the rules and complex accounting standards we currently use in the United States. The move to International Financial Reporting Standards would certainly help. IFRS is based more on principles and concepts, and while some people worry that these are “lesser” standards than U.S. GAAP, I believe that we will see more transparency about choices, options, and assumptions through enhanced disclosure under IFRS.

Auditing firms also need to reassess their current structure globally and to provide a compensation structure that rewards enhancing their greatest asset: their credibility and their long-term reputation. This can only occur with building a reputation for high-quality audits. Easier said than done.

While the audit has evolved so much over the years, the large audit firms still attract the best and brightest to work for them. They want to be challenged and valued. Perhaps the audit opinion should be less boilerplate to allow the auditors to provide more information and commentary. This could add needed transparency. Unfortunately, the litigious environment in which we operate would make this a risky proposition.

Finally, we need to ensure that corporate audit committees really are fully engaged with the hiring and firing of audit firms and the negotiating of audit fees. In many companies management still takes care of this, then presents it to the audit committee for approval. A more hands-on approach serves to mitigate the inherent conflict of the company paying the external auditors for the audit.

Topics