Evolution Of Under Auditing

J. Edward Ketz
(J. Edward Ketz is associate professor of accounting in Penn State's Smeal College of Business. He specializes in corporate financial reporting issues.)

From the beginning, Congress has expected the public accounting profession to watch over management and attempt to prevent corporate managers from engaging in the accounting abuses or from engaging in any new fraudulent schemes. Auditors, however, have little power relative to corporate managers and little has been done since the 1930s to amend this power relationship. Because of this unequal affiliation, there have always been managers who committed accounting fraud and there have always been auditors who either have looked the other way or neglected to examine some important evidence.

Despite the ubiquitous existence of some corrupt managers and auditors, the past decade or so has ushered in a plethora of accounting abuses and the absence of auditor involvement either to stop the frauds or report them once they occurred. I believe there are several reasons for this increase in accounting fraud and the contemporaneous development of under auditing.

One cause is the metamorphosis of the large accounting practice. In the past such firms mostly did audit work and some tax work; today they mostly do consulting and some auditing and tax. In the past these entities hired mostly accountants and everybody knew they comprised an accounting partnership; today they hire many types of professionals and have evolved into professional organizations. The firms also engender enormous tension between the senior partners and those in the trenches. Most auditors in the field know the problems and risks of their clients and attempt to address the audit concerns. Yet the only message they hear from their bosses is that they must generate profits. The tone at the top is unambiguous, but misguided. Those on the firing line need support when they confront managers who want to push the limits of accounting truth and propriety. Clearly, this metamorphosis has triggered a confusion of roles, and many accountants do not have a grasp of their fundamental responsibilities to the public.

Another explanation for the increase in accounting abuses and under auditing rests with litigation reform. In 1995 Congress passed the Securities Litigation Reform Act, which had the purposes of making it more difficult for plaintiffs to file a class action suit against business enterprises, corporate managers, and public auditors and curbing the awards when plaintiffs won. Litigation attorneys naturally turned to the state courts, but this strategy was thwarted in 1998 when Congress passed the Securities Litigation Uniform Standards Act which requires class action lawsuits brought because of accounting issues to be filed in federal court. Since audit effort is directly related to the penalties from audit failures and to the probability of losing the case, the natural consequence is a lessening of audit effort. Why incur the incremental costs to audit a firm when the expected value of losing money in a court case becomes less significant?

A third reason for the higher incidence of accounting abuses is the incredible pressure by financial analysts for firms to meet the analyst forecasts and the consent by managers to play this game. What started out as a useful service to society by analysts when they collect and study the financial statements and other news about a corporation's welfare to predict its future earnings has become an insane escapade.

Accounting is simply not precise enough to allow people to predict that a company is going to have, for example, quarterly earnings of $1.23 per share and then actually expect the firm to meet the number exactly. Given the limitations of accounting, I cannot understand why anybody becomes troubled if the earnings number actually turns out to be $1.22 or $1.21 per share. But, investors do react to a firm's missing its forecast even by one penny, by punishing the company with a big drop in the stock price. It makes me wonder how much accounting these investors and analysts really understand. Unfortunately, managers have observed this stock behavior and they understand the importance of meeting earnings forecasts. Given that so much real money is riding on meeting these forecasts, it is easy to understand (but not accept) why some managers lie about the actual results by the corporation. In turn these managers put pressure on auditors to allow them to book events and transactions in the manner that managers see fit.

With these factors at work today in the financial world, there is little surprise at the number and the extent of accounting irregularities found in American financial statements.