VIEWPOINT : While Auditors Watch Clients, Who Should Watch Auditors? : Strict Oversight by State Board Can Reduce Sloppiness

How well are accountants doing their jobs?

This basic question is at the heart of the current controversy surrounding the responsibility of accountants in auditing financial statements.

The question is not a new one. The history of the accounting profession is littered with cases in which companies and their shareholders have sued auditors on grounds that they have not done their jobs even as auditors maintain that their jobs continue to be misunderstood.

Today, however, the dollar amounts involved are unprecedented. When even a small savings and loan firm goes out of business, millions of dollars are at stake and the entire life savings of shareholders can be wiped out. The nation’s largest accounting firms--known as the Big Eight--collectively have paid more than $175 million during the last five years to settle lawsuits or to avoid them.

Congress currently is holding hearings to determine if accountants have adequately fulfilled their role in auditing public companies. Corrective legislation has been suggested.

Regulation from Washington is an inadvisable solution. In each state, there is a board of accountancy that has the power to revoke an accountant’s certificate to practice, if circumstances warrant. This is where corrective action should begin.

State’s System Effective

California is one of very few states to undertake an effective program to improve the reliability of audits, to pinpoint auditors who perform substandard work and to institute educational programs aimed at correcting deficiencies. If necessary, under extreme circumstances, practitioners may be supervised during a probationary process or have their license revoked. Unfortunately, several other large states such as New York, New Jersey and Illinois have failed to follow suit.

The challenge now confronting accountants is two-fold: Accountants have to do a better job of educating the public on what the auditing role is all about and they have to assure high-quality work.

- Public perception. Apparently, too many shareholders base investment decisions on information found in annual reports because they believe that an “unqualified” auditor’s letter is equivalent to the Good Housekeeping Seal of Approval.

This simply is not so. Auditors do not search out fraud nor guarantee against bankruptcy. As stated in the auditor’s letter, we conduct “such tests of the accounting records and such other auditing procedures as we consider necessary.” This means that the auditor is simply conducting a statistical sampling of transactions to see if they support the company’s financial statements; it is not possible to check every single transaction for inaccuracies or fraud.

Although accountants believe this statistical sampling to be thorough and adequate, the nature and size of businesses today make it impossible to review every single element of a company’s financial statements.

The profession as a whole is faced with a major educational task so that the public understands exactly what auditing means. Perhaps part of that solution should be to actually change the wording of the auditor’s opinion letter to more clearly reflect the work performed and the responsibility assumed.

- Quality of accountants’ work. We must recognize that bad auditing does exist, and we must take steps to assure that auditors comply with standards of the profession.

Many of the larger accounting firms have instituted exhaustive checks and balances to maintain a high quality of work--and even have competing firms periodically review the quality of their audits. However, a much broader program is needed. All accounting firms, whether large or small, should have their auditing performance reviewed.

The California State Board of Accountancy, which has had a “positive enforcement program” in place since 1981, provides an excellent example. (The state has 45,000 licensed accountants, and the state Board of Accountancy has the responsibility to assure that the public is protected in its dealings with them.)

Initially, under its positive enforcement program, the California board reviewed only a small segment of all accountants’ work, namely reports that are in the public domain, such as those involving school districts, cities and counties.

Substandard Reports

I was involved with that pilot program, and our findings left us aghast. An appalling percentage of auditing reports reviewed were found to be substandard.

We wanted to make certain that practitioners whose reports were reviewed could learn from the process. The thrust was educational.

Every practitioner who was reviewed received a comprehensive analysis of the findings that arose from all the reports examined. More important than the list of deficiencies, the analysis gave a source of authoritative professional literature where the correct reporting approach could be found. Practitioners also received personalized letters detailing specific problems discovered in their own audit reports.

A year later, the process was repeated. As part of that, the board followed up on the performance of practitioners whose performance had been found substandard. We learned that about half of the reports previously considered substandard had improved. On the other hand, this second overall review revealed that the percentage of substandard reports had essentially not changed.

The California board recently expanded this program to include audit reviews of financial institutions such as savings and loan firms and insurance companies. We are now examining a sample of those audits just as we did for the government entities. Likewise, our findings will be reported and a comprehensive analysis will be sent to the specific auditors involved.

Sample All Audits

The third, most ambitious, and potentially most effective step in this program will permit review of samples of reports for all audits conducted in the state.

The California State Board of Accountancy is considering draft rules and regulations to make this possible. Only with this final step will we be able to effectively test the quality of auditing in California. Several other states have undertaken similar programs, but not enough.

All 50 states should be encouraged to implement a program of positive enforcement as the most direct method of minimizing and, one hopes, eliminating bad audits.

The National Assn. of State Boards of Accountancy is currently developing a standard model for all states to follow in this process of review, education and enforcement. The key force in improving auditing standards should be the Board of Accountancy--the agency that licenses accountants to practice and that has the power to rescind that license.