Why are Top Tier Audit Failures so Common?

By William K. Black
Quito: March 10, 2015

The Wall Street Journal recently provided one of those stories that are invaluable and frustrating.  In fairness, it was a brief blog entry entitled “Almost Half of Global Audits Have Problems” and was based on the release of a study by the International Forum of Independent Audit Regulators.  The blog also noted that the rate of deficient audits was nearly as high for top tier firms’ audits conducted in the U.S.

“The study follows one released late last year by the U.S. audit regulator, the Public Company Accounting Oversight Board, which found nearly 40% of studied 2013 audits performed by the four largest U.S. firms weren’t up to snuff.”

But why was it such a brief blog?  Why did these two studies not lead to major articles on the front page of the WSJ?  Why did the blog neither (1) consider that these results represented an appalling, unacceptable result that required an emergency response and (2) ask why these results were occurring?  The WSJ did not even hint at these two points though one would think that both points would emerge immediately as the critical issues for even the most junior reporter working for the nation’s leading financial paper.  It is the WSJ’s staggering indifference to what should have been one of the most important stories of the year that continues to surprise.  Of course, the New York Times’ twin embarrassments, Deal Book and the Upshot that purport to cover economics and finance, were even worse than the WSJ.

The Gresham’s Dynamic Explains Why Top Tier Audit Failures are Common

The National Commission on Financial Institution Reform, Regulation and Enforcement (NCFIRRE) investigated the causes of the savings and loan debacle.  Its 1993 report explicitly found that the “Gresham’s” dynamic first named in the economics literature by George Akerlof in his classic 1970 article on “lemons,” had produced endemic accounting fraud during the S&L debacle.  A Gresham’s dynamic is produced when cheaters gain a competitive advantage over honest rivals.  This turns market forces perverse and “bad ethics drives good ethics out” of the markets and professions.

“[A]busive operators of S&L[s] sought out compliant and cooperative accountants.  The result was a sort of ‘Gresham’s Law’ in which the bad professionals forced out the good” (NCFIRRE 1993).

Bad Audits Become Endemic When Accounting Control Fraud Becomes Endemic

Here is NCFIRRE’s key paragraph.

“The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used…. Evidence of fraud was invariably present as was the ability of the operators to ‘milk’ the organization” (NCFIRRE 1993).

Note that “fraud was invariably present” at “the typical large failure.”  The “weapon of choice for these frauds was “accounting.”  I will add a key fact – each of these S&L frauds was audited by a top tier audit firm, which blessed the fraudulent financial statements with clean opinions.  Fraudulent CEOs hired top tier audit firms because their reputation aided his ability to “loot” “his” S&L through accounting fraud.

The next great epidemics of control fraud that will produce renewed financial crises are likely to occur once the economic recovery becomes significantly stronger.  The knowledge that such an enormous number of audit engagements have material defects now gives us a priceless opportunity to stop the already rampant Gresham’s dynamic that is producing endemic audit defects and failures before it leads to a financial crisis.

Conclusion

When you see this extraordinary number of audit problems you know not simply that there are severe problems in the auditing profession, but even more dangerous problems in the top leadership of the corporations being audited.  It is the leaders of these corporations who suborn the top tier audit partners.  The art is to suborn, not defeat, the outside auditor and turn the audit partner into the fraudulent CEO’s most valuable ally.  As long as we allow the leaders of the corporate client to choose the audit partner we make it child’s play for fraudulent corporate leaders to suborn the audit partner.