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Why Audits Are No Longer As Effective

Jim Gaunce, CPA, Solana Beach, CA       November 2009

The number of major culprits who contributed to our current economic malaise is longer than the Will Call line at a Yankees-Red Sox game. Even among this large cast, one should not overlook the role that the auditing process has played in the issuance of erroneous or misleading financial statements.

During this decade, the accountants have understandably been trying to react to the sensational stories of the likes of Enron and some of the liability settlements by America's biggest accounting firms. Neither accountants nor auditors were ever supposed to be able to detect fraud in the normal scope of their engagements. Such detection might happen in the course of an audit but the scope of an audit has never been intended to be sufficiently thorough to detect a cleverly spun web of deception.

The reaction from the AICPA and legislatures to such events has taken the form of significant increases in regulation. All the “alphabet soup” governing bodies (ie, FASB, SEC, AICPA, ASB) have jumped into the fray to issue an onslaught of new regulations, practices and Generally Accepted Accounting Principles (GAAP) including Sarbanes-Oxley, FASB Statements (Financial Accounting Standards Board Statements), SOP (Statements on Accounting Positions), SAS (Statements Auditing Standards), SS (Staff Positions), EITFA (Emerging Issues Task Force abstracts), and so forth. The FASB eventually had to issue another statement to change the structure and hierarchy of the numerous accounting standards and pronouncements. Over the years, such regulations have had the effect of diminishing what was supposed to be the most important element in completing an audit: professional judgment.

It would be understandable if the regulations provided a better platform for an audit to be completed. However, such regulations often add layers of complexity that are not fully understood by either the client or the auditor. At some stage, the continued addition of regulations promoted the perception that they are simply rules to be followed blindly instead of principles which require professional judgment. Reason and logic are discounted or ignored in place of strict compliance. Years of seemingly endless additions to the tax code has shown us that the added complexity of regulations can lead to non-compliance and trigger the endless search for loopholes which, in turn, require more and more regulations to combat. This was never what Generally Accepted Accounting Principles were meant to become. Most of the audit failures resulted from deception or fraud which, ironically, was often spun by regulations drafted to prevent such malfeasance. Contracts or investment vehicles were designed to fall within the cracks of regulations, and were designed to be so complex and voluminous that they were often beyond even a well educated person's ability to comprehend or decipher. Think derivatives and credit default swaps.

In any event, even if such regulations were justified, mountains of regulations cannot provide answers to many questions - market values for real estate, private placements, even thinly-traded public securities -- let alone even greater imponderables such as potential litigation or litigation outcomes.

In addition, some companies have been trying to subvert the intent of an audit. The public largely believes that the sole focus of an audit is to provide an added degree of assurance in the validity of financial statements. However, a second essential element of an audit is to help assess and offer constructive criticism to improve a company's internal controls - in a perfect world, as a harmonious partnership between the company and the auditor. This important part of an audit has not been embraced by as many entities as should be.

To minimize provable liability in litigation, corporate counsel has often advised companies to destroy any documentation viewed as “unnecessary.” Regrettably, the absence of such documents makes it harder to assess the effectiveness of internal controls.

Internal controls also suffered as more companies started to make a higher priority of risk assessment as to what could go wrong and insure themselves against non-ideal events. A recent example is the attitude that many issuers of subprime mortgages took. Seduced by the large amounts of money that could be made; many companies made a mockery of the underwriting process and instead “solved” the problem by buying credit default insurance from entities such as AIG.

Speaking of AIG, complexity of their financial instruments was one reason that auditors, and the woefully undermanned Office of Thrift Supervision did not start waving red flags until the 11th hour in March 2008.

The solutions to make auditing more effective are not easy but they are necessary. The auditing process needs to start paying more attention to internal controls - even if the client balks. Auditors have to place less emphasis on regulatory check lists and more on professional judgment. The auditor should also make sure that firm executives understand their products. If not, perhaps the most important of internal control is not satisfied.

Jim Gaunce, CPA Solana Beach, CA

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