Professor Ed Ketz of Penn State rightly calls out the large accounting firms, in “The Myth of Independence” (March 2020). He joins a wave of criticism that spans the globe—charges against KPMG in the United States relating to the theft of PCAOB inspection information, Carillion and Patisserie Valerie in the United Kingdom, Steinhoff in South Africa, Wirecard in Germany, and Luckin Coffee in China.
Justified as his views may be, two responses are in order: the premise that the “problem of independence violations [is] mostly one of unconscious bias” is flawed, and the suggested recommendations only re-hash ideas long in circulation but short in uptake, feasibility, or relevance.
First, auditors have been engaged directly by their clients since the function was invented in the Victorian era. That direct financial relationship—the only successful model ever—has colored the concept of “independence in fact” for 170 years.
Auditor obligations to nonclients have been imposed under laws, regulations, and litigation, but these have not re-defined the auditors’ “true clients.” Instead, what has accreted has been a too-complex structure of codes, rules, and constraints, under the rubric of “appearance of independence.”
Cognitive biases and principal/agent concerns may exist, which are not different than for other advisors and gatekeepers such as lawyers, bankers, and rating agencies—none of whom labor under the auditors’ burden, although all are also compensated directly.
Second, if accepting the presence of such biases, no benefit attaches among the “solutions”—listed briefly below in Ketz’s order:
- Proponents of mandatory rotation, rejected by the PCAOB although implemented in Europe, bring heated rhetoric, but no evidence; no study of large-company audits has shown a causal relationship between long audit tenure and diminished quality. Moreover, limits on auditor choice increasingly constrain companies in Europe looking to fulfill their rotation obligations.
- Although the large U.K. firms are formalizing the “operational separation” of their assurance and advisory practices, the authorities sensibly show neither movement nor appetite to force full legal separation or to reduce the firms to “audit only.” Nor could those succeed, if the firms are to access the multidisciplinary expertise required to deliver the value of large-company audits at a global scale.
- As for increased legal liability, defending a claim of audit failure is today a career-ending event for an individual auditor, whose incentives already suffice without further threat. Moreover, increased liability would further harm audit market stability, as the firms already face judgments far exceeding their limited financial capability. Arthur Andersen’s litigation-driven collapse in 2002 reduced the then–Big Five to its critical minimum; another disintegration would have a catastrophic effect, as there is no serious argument that a Big Three model would be sustainable.
- Use of the emerging tools of technology and Big Data proceeds at speed, with consequences to be determined. That said, Ketz himself makes no argument that technology alone will alleviate independence concerns for the professionals who would own, operate, and apply those tools.
- Neither audit performance nor auditor selection by government are realistic, while both are fraught with political influence and agency inefficiencies. The mere suggestion that government might manage actual execution—or even the complexities of auditor proposals, selection, and monitoring—reveals its lack of legitimacy.
- Finally, long-pending proposals for insurance supported by some form of additional assurance have never acquired traction. If the business proposition were supportable, it would long since have appeared. The insurance market has never shown interest or capacity to provide the skills, methodology, or actual coverage capacity. To the contrary, the industry has declared the large accounting firms effectively uninsurable at the multibillion-dollar level of their most threatening exposures.
There is an available solution, although not on Ketz’s table. Recognizing the broad set of skills required to perform a complex audit—appraisal, valuation, actuarial, technology, and systems, as examples—it is time also to recognize that the current requirements are remnants of a bygone era that are now outmoded and unfit for purpose. Instead, the independence concept no longer serves the interests of the public, and should be scrapped altogether, to enable auditors to offer their clients all services within their skills.
Expert assurance on large-company financial information is a valuable resource. Ketz has that right, and has done a service. If the door were opened to a full, fact-based dialogue among the participants in the capital markets, optimists would hope that—as attributed to Winston Churchill in the 1930s on the evolving American attitude toward the looming threat of war—regulators “will eventually do the right thing, only after they’ve tried everything else.”
The Author Responds
Jim Peterson offers two criticisms against my essay “The Myth of Auditor Independence.” He claims: 1) my view that the independence problem is mostly a manifestation of unconscious biases is flawed and 2) as none of the recommendations enumerated in the essay are workable or beneficial, we should jettison independence.
Peterson offers no evidence that cognitive biases are not present. Indeed, he cannot do so as the evidence of their existence is overwhelming. In addition to the citations supplied in my essay, Dan Ariely’s “The (Honest) Truth about Dishonesty” describes many experiments over a variety of contexts and demonstrates the reality that humans exhibit cognitive biases. Instead, Peterson states that these biases are also prevalent among lawyers, bankers, and ratings agencies. I agree, but this fact does not obviate the influence of cognitive biases on the decision making of independent accountants; it merely says other professionals are also infected with this malady.
The larger deficit of Peterson’s position is that he does not distinguish the function of auditing from the roles played by lawyers, bankers, and bond-raters. Auditors offer representations on a business’s financial reports to the investment community, and these opinions gain greater credibility when the auditors are independent of the business. It is similar to how Consumer Reports operates; its independence is why consumers place faith in the reports.
Peterson dismisses all the possible solutions I proffered in the essay. My purpose was not so much to choose a superior arrangement, but to start a serious conversation. Given the quantity of violations in recent years, and how egregious some of them are, this topic is ripe for investigation.
Peterson’s solution is to scrap independence. He might as well have suggested the abandonment of auditing. If we are going to slight investors, we might as well do it whole-heartedly. His perspective reminds me of a debate on how to combat high rates of crime. One “free-thinking” academic suggested that we decriminalize all behaviors. Doing that will drive the crime rate to zero, but what kind of society would we have? So, yes, we can eliminate independence rules and regulations, but would users appreciate what was left? I doubt it.
Auditing is a valuable service to society. If business enterprises did not have independent auditors performing objectively and with professional skepticism, the capital market would flee to other profit-making ventures. If CPAs bagged independence, the profession would metamorphose into mere consulting practices. I urge a more serious discussion about the profession and a more serious investigation into ways to strengthen independence. The profession, and the investment community, greatly needs this. And now.
This reflects the author’s opinion and not necessarily that of Pennsylvania State University.