ARROGANCE OR IGNORANCE: WHY THE BIG FOUR DON’T DO BETTER AUDITS

ARROGANCE OR IGNORANCE: WHY THE BIG FOUR DON’T DO BETTER AUDITS
ANTHONY H. CATANACH JR.
J. EDWARD KETZ

Auditing

Oct 22 2012

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.
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.

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.