Authentic Audit Reform: Relinquish the Monopoly

Had retailing been organized like the professions, supermarkets with lower costs and prices and a wider range of goods and services could never have emerged. Indeed, had the professions been dominant through manufacture and trade over the past two centuries, we would never have got to the horse-and-buggy stage, let alone beyond it.
––D. S. Lees, Economic Consequences of the Professions, 1966

Customers are best served when they have many competitive alternatives, and they are suspicious of self-serving monopolies. Of course, as sellers we all want to be monopolies, with little competition, the ability to charge high prices, bar entry to potential competitors, and be able to rest on our past successes and not have to perform the difficult job of constant innovation and experimentation where success is measured by the external customer, not internal industry standards, or ineffective government regulations.

Yet, if we are serious about transforming the audit function from its present moribund state, we are going to have to face some unpleasant truths. The present accounting model is over 500 years old and it is in bad shape. In an intellectual capital (IC) economy, it may be possible to track revenue and expenditures, but it is difficult to know how expenditures relate to results created outside of an organization (it is easier to count the bottles than describe the wine, as they say). The traditional GAAP financial statements are based upon a liquidation value of a business, essentially historical cost assets less liabilities––an heroic attempt to assign static value to a dynamic concern. Even though IC is the main driver of wealth in today’s economy, you will look in vain to find it in the traditional GAAP statements, increasingly referred to as the “three blind mice.”

In addition, the recent spate of accounting scandals taught the profession–– the hard way––that the audit is not a commodity. When was the last time a bale of hay created so much financial havoc? The audit is actually an insurance product, and rather than pricing it by some arbitrarily determined hourly rate, auditors should be pricing it based upon its actuarial risk. If we
have to hire actuaries in order to accomplish this, than so be it. Their first lesson would be: There is no such thing as bad risks, only bad premiums.

The recent articles by Paul Miller and Paul Bahnson (“Auditing’s devolution: Gatekeeping to enabling,” and “Audit revolution: From compliance to adding value,” July 12-25, and July 26 – Aug 8, 2004, respectively) put part of the blame for the present state of audits on fixed prices versus hourly rates, even going so far as recommending all audits be priced by the hour (what about risk?). This is unadulterated nonsense. By the same logic, the airlines should price by the minute so they won’t skimp on safety and kill people. All businesses charge fixed prices, and to think it would harm the consumer to do so reminds me of what George Orwell once wrote: “One has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool.” Are we really willing to state, publicly, CPAs must be paid in order to do the right thing?

The accounting profession is a mature profession, and its last true innovation was the financial statement compilation and review standards, effective in 1978. This is a 26-year innovation curve, and counting. Additional governmental regulations will only slow this innovation down further (heavily regulated industries are rarely hot beds of innovation; if the computer industry were as heavily regulated as CPAs, we would have Vacuum Tube Valley, probably located in West Virginia).

History teaches there are three possible roads the profession can travel. On the first, it can do nothing, which is usually the road traveled most by stagnating industries. Thinking the past will somehow equal the future, the leaders simply see no reason to change. No doubt the professions would survive in some shape, since a lot of its work is governmentally mandated, but it will relinquish its status as the premier financial profession if it chooses this path.

On the second road, outsiders could replace the profession with the “perennial gale of creative destruction” Austrian economist Joseph Schumpeter wrote about. In some instances, this is already taking place with respect to Key Performance Indicators, social audits, brand valuation, and IC measurements, among others, being performed by consulting firms and nongovernmental organizations. This is unfortunate since the accounting profession should be out in the forefront in these areas, but it is too busy fiddling around with whether or not stock options are an expense, as Rome burns. And if consulting does create a conflict for auditing firms––and I believe it does not––then what about the ultimate conflict: the fact the auditors are paid by the companies they are auditing? One solution to this is to have audits performed by the government.

Finally, on the third road, the profession could innovate and become its own creative destroyer (similar to Intel deriving 100 percent of its revenue from products that didn’t exist 3 years ago). Why not give up the attest monopoly altogether and allow competition to enter the auditing marketplace? You couldn’t fill a Mini Cooper with competent economists who didn’t seriously
believe deregulation over the past thirty years hasn’t redounded to the tremendous benefit of consumers.

So, why should the audit be a state-granted monopoly? Open it up and let the free market innovate new solutions to attesting to the financial performance and risk position of companies. The goal is to protect the public, and deal with the principal-agent dilemma; yet there are myriad ways of accomplishing these objectives, we don’t have to suffer with a one-size-fits-all monopoly offering. Insurance companies and banks could innovate new products, the stock markets could also enter the fray, perhaps by hiring the auditors themselves and thereby remove the major conflict of interest. There are so many permutations of what an unfettered free market could accomplish in this arena it cannot even be speculated what types of new and dynamic ways investors could be assured of receiving timely and accurate information, and insured against the risk of audit failure.

What we do know is there is no better way for innovation and new knowledge to diffuse throughout society than to have entrepreneurial experiments take place in order to satisfy the needs and wants of consumers. Ask yourself which products and services have gotten dramatically better over the past decades––computers, financial services, telecommunications, the internet, automobiles, trucking, airlines, electronics, etc.––and which have stagnated and left the consumer with little or no freedom to choose among competing offers––Social Security, the public school system, Medicare, the Postal Service, and the audit, to name just a few. The difference between these two sectors is the extent of regulation and barriers to entry, which stifle creativity, innovation, risk taking, and experimentation.

The history of economic growth and dynamism is the story of crackpots, cranks, and outsiders innovating new products and services that decimate and replace the existing infrastructure of entire industries. There are many routes to knowledge and learning and the way to growth and dynamism is to allow experimentation over rigid orthodoxies and credentialism that no longer serve the needs of customers. Thomas Edison had little formal education and could not have been licensed as an engineer under today’s guidelines. Likewise, Frank Lloyd Wright and Mies van der Rohe would
not qualify to sit for the architect’s certifying exam.

None of these roads are going to be very pleasant journeys, as they will cause major disruptions to the status quo, but can there be any doubt the current offering of auditors is the Edsel of our time? Is it not incumbent on the profession to shape its own destiny, rather than being relegated to part-time governmental bureaucrats destined to comply with the ever-increasing GAAP and PCAOB rules? It is not the automobile that is being rejected, but instead the make and model. Until we relinquish the profession’s monopoly audit status, we will never breathe new life into the attest function. We will
simply be tinkering at the margins, and making incremental improvements at best.

Nothing focuses an individual, a company, or an industry like unregulated competition. Let us begin to innovate and create a better tomorrow by offering a new financial reporting model to the public and throw off the shackles of a regulated attest monopoly, and put ourselves to the ultimate test––providing value in a free, unfettered marketplace while serving the interests of the public we are privileged to protect.

© Ronald J. Baker, 2004

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