New Report Calls External Audit Independence The “Big Lie”

Calls for reform of external audits are nothing new. Proponents around the world are constantly advocating the need for greater independence of the individuals/firms who undertake external audits of publicly traded companies. Last week the U.S. “independent watchdog,” Project on Government Oversight (POGO), added its voice to the debate, and the report it published didn’t mince words. Even the title, “Accounting’s Big Lie – And How to Fix It,” is intensely provocative.

The report was authored by David S. Hilzenrath, and he makes his case right up front:

“Corporations, big accounting firms, and the federal government have been selling the public a lie.

They claim that the financial statements of public companies — including those traded on the stock market — are audited by independent accounting firms.

But the audit firms are not independent.

They are dependent.

The audit firms are chosen and paid by the companies they audit. Just as the company hires its auditor, the company has the power to fire its auditor.“

Hilzenrath and POGO are not the first to make this argument, and they certainly won’t be the last. But, how fair of an assessment is it, and what can be done to improve the system? The report doesn’t shy away from pointing fingers, offering harsh assessment of motives and exploring proposals for radical reforms.

By way of full disclosure, I spent almost 5 years with PWC before my tenure as President and CEO of The IIA. While I was not in PWC’s external audit practice, I had the chance to watch first-hand the exhaustive lengths to which the firm went to foster its independence from the external audit clients it served. Based on my experience, I am not persuaded by arguments that the system is corrupt and that the firms have no independence. There are too many outstanding men and women in the profession to paint them with such a broad brush.

Yet, despite my reluctance to “pile on,” there is ample evidence that the system has serious flaws. There have been too many accounting frauds over the past decade where the external auditors were caught looking the other way or completely oblivious to “books being cooked” right under their noses. For that reason, we should all remain open to serious reform proposals that would strengthen auditor independence. For the record, the suggestion of having “the government could do the auditing itself” is not one with which I would agree at all.

Other proposals that have been curated from various sources and are explored in the report have varying degrees of merit. In addition to the traditional reform proposals of mandatory rotation and restriction of non-audit service, the report explores some less familiar and more drastic proposals such as:

• Have a government regulatory agency assign audit firms and pay them with money collected from corporations.
• Some other authority (such as stock exchanges) playing the third-party role — assigning, reassigning, and disbursing payments to audit firms?
• Companies selecting external auditors from lists of audit firms approved by their insurance carriers.
• Eliminating the audit requirement and forcing companies to elect to be audited to prove they have nothing to hide.
• Companies engaging third parties to come in and, on a contingency-fee basis, look for problems with their external audits.

While I am not totally sold on any of these proposals, the debate over auditor independence isn’t going away, and any solution that strengthens auditor independence can only serve the public good by fostering confidence in the capital markets.

The POGO report offers an extensive examination of this important topic, and the only way to fully appreciate the arguments put forth is to read the entire publication.

For those interested in learning more, POGO is “a nonpartisan independent watchdog that investigates and exposes waste, corruption, abuse of power, and when the government fails to serve the public or silences those who report wrongdoing.”