Audit Failures – Urban Myth and Reality

Evidence suggests that many found our website by searching for “audit failure.”  I don’t know why, but if you are interested in the subject, let me add the benefit of my 30 plus years in the audit profession to your education.

“Audit failure” strikes at the heart of the audit profession.  Occurrence is an admission of failure to perform to the expectations of those relying upon the profession. Far worse, irrespective of circumstances, “audit failure” is code for professional negligence.

So what is the reality of “audit failure” and what is urban myth?  In Auditing 101, we learned that the audit purpose is to confirm the integrity of management’s financial statements. While not an assurance of “error free,” the audit does assure the reader that the auditor has done a “professional” job of having examined controls over risk and gathered supporting evidence.

The auditor is engaged, therefore, to provide credibility to management’s assertions, not to catch them lying.  Therefore, the auditor, in the absence of information to the contrary, has a right to assume integrity on the part of management.  It follows that if the auditor is not engaged to detect fraud then for management to mislead the auditor is a violation of the fundamental client auditor relationship.

Complicated?  Try explaining this to the public when an “error” is detected, or the entity files for bankruptcy with a “clean opinion.” Suffice it to say, there is enough grey here to support legions of lawyers.

Let’s distinguish myth from reality by considering examples of “audit failures” that have occurred over time – some more publicized than others, but all in the public record.

The first is Enron.  “Audit failure?” Well, it all depends on how you look at it.  Management did not “deceive” the auditor.  The use of special purpose entities in managing asset valuations and debt was not only obvious, but had been endorsed by the auditor.  If anything, the auditors were more in the role of “co-conspirators.”  As such, they did fail in their responsibilities.  Enron was an example of an egregious “audit failure.”

Next is WorldCom.  Among other things, the facts suggest that WorldCom was capitalizing rather than expensing substantial maintenance costs – clearly a violation of GAAP.  Since the costs were material, it is reasonable to assume that the audit procedures should have been adequate to detect the fraud.  Again, this meets a reasonable test of “audit failure.”

Next, we have an auditor who failed to note that the entity was inventorying “bricks” rather than the disc drives indicated on the balance sheet.  Was failure to detect this material fraud an “audit failure?”  Again, an egregious “audit failure” by any reasonable standard.

Next, we have an auditor hired to verify the financial statements of a member owned grain cooperative.  The primary assets are grain stored in huge silos.  According to the balance sheet, the grain in Silos #1, 2 and 3 is “premium.”  The grain in Silos#4 and 5 is “standard.”  The grain is priced accordingly.  The auditor “tested” the inventory by releasing a portion of the grain in each silo and by dipping into the top of each silo.  The resulting tests confirmed managements’ assertion.  What the auditor did not know was that only the top and bottom 10% of Silos#1, 2 and 3 was “premium.”  The remaining 80% was “standard” and as a result the inventory was substantially overstated.

After the inevitable bankruptcy, discovery in the subsequent coop suit against the auditor indicated a substantial conspiracy between the owners — who were also the major farmers benefiting from the fraud —  and the manager — whom they had hired — to purchase their “standard” grain at “premium” prices and store it in such a manner as to deceive the auditor.  In other words, as I explained to the judge, the auditor was being sued for not detecting the fraud that those who hired him to protect them from fraud had perpetrated.  This isn’t “failure” on the part of the auditor. It is conspiracy to defraud compounded by chutzpah on the part of the owners who engaged him.  The judge agreed and the “audit failure” claim was dismissed.

Now let’s address the urban myth of “audit failure” with the following example. This involves the financial statements of a bank.  Their loans are carried at their “fair value” as supported by the value of the underlying collateral – in this case land being developed by real estate entities.

Six months after the release of the statements, a macro – financial crisis results in substantial loss in collateral value underlying the loan value.  The financial position of the bank is dramatically and negatively impacted.  The result is a public and congressional hue and cry!

Now, the fun begins.  The banks seize the collateral and now must carry it at “fair value.” Since there is little market for such land, it is carried at the amount considered “fair” based on market activity– say isolated sales at 70% of the original value.  The auditor then attests to those amounts at 70% of value.

Unfortunately, the “market” will not pay 70%.  Market conditions result in sales being realized at 50% of original value.  Therefore, the financial condition is now obviously overstated.  And so it goes throughout the financial crisis.  The public continues to scream “audit failure” and congress tightens the regulatory screws to keep this obvious “failure” from recurring.

Does this meet the test of “audit failure?” I would argue “no.” Where is the undetected “fraud?”  What “risk” was not addressed?”  What audit test was omitted?  The consistent answer is none, but here is the question. Is a macro-economic debt crisis an event that the auditor is obligated to predict?  If not, where is the “audit failure?”

Congress and the public obviously do not agree and need somebody to blame.  Hence, the PCAOB and Dodd Frank are empowered to ensure that such “failures” do not recur.  Are we to believe that Chris Dodd and Barney Frank know anything about an “audit failure?”  No matter.

Unfortunately, since these losses had nothing to do with “audit failure,” the initiative to mitigate such losses by hammering the audit profession is pointless.  Worse, if continued, it will have a debilitating effect on the profession and the credibility of our financial markets.

The audit profession is being subjected to pressures that reasonable audit partners are not going to indefinitely endure.  The “so what” is that eventually smart young college graduates will no longer find auditing an economically or intellectually attractive profession and take their talents to Wall Street where they will advise clients on ever more ingenious ways to manipulate accounting rules to their own advantage.  And who is going to protect us from that — the regulators who are now hammering the profession for their “failures?”

The regulators are not unaware of the problem – they are just conflicted as to solving it.  One of my Big Four audit partner friends told me recently that the PCAOB regulators had advised his firm that based on their recent examination, they were concerned about the “significant, adverse morale” of the engagement partners.  Wow! Next, they’ll be “shocked and appalled” at the resulting “brain drain”

Chicken Little?  Look at the medical profession.  Why would any reasonable person endure eight to ten years of post graduate medical training to get paid what a good software engineer makes?   That may be acceptable if you want a good software engineer diagnosing your heart condition, but not a situation most of us would consider acceptable.  As it is, try finding a brain surgeon or OB/GYN in many parts of the country.

To consider my suggestions for mitigating the risk of “audit failure” and how it can be subjected to reasonable oversight, I suggest you read my articles that appeared in the Journal of Accountancy as set forth in the publications section of this website. Nothing has changed since I wrote them.

The “audit failure” issue is one that we should all be concerned about, but in doing so, we need to separate reality from urban myth while we still have the time.

As always, we would appreciate your input.

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