Accounting in Crisis, but there are Solutions

I believe the accounting profession is at a critical point, especially in the attest and assurance practice. Technology, complexity, and staffing even the very licensure of the accounting profession are just a few items threatening the future of the industry. Why is no one addressing the root causes of the issues plaguing the accounting profession nor is asking the hard questions. The situation is getting worse, but there are solutions, if we are willing to make radical changes. Below are some of the problems, my reasons for their existence and how to solve them,

Why is the audit a commodity? A commodity is something that is bought and sold and is generally useful or valuable. The more valuable the commodity, the higher the price paid. How is the audit of financial statements (the, “Audit”) a commodity? If the audited financial statements are useful and valuable, a premium should be paid, but this is not the case. Since audited financial statements are bid so the lowest or most favorable price is achieved, it stands to reason that the audited financial statements are not useful or valuable. Thus, the accounting profession produces an audit report that is a commodity and not a professional service that provides value. How is this positive? How is this not being addressed? What are the causes? Laws have been passed, accounting and audit standards have been improved, the audit report is to become more detailed (CAMs) and there is continual oversight (PCAOB, peer review, etc.) yet the commodity still exists, which means the changes are not effective. I heard the definition of insanity, “continuing to do the same thing and expecting a different result”. Until the accounting profession looks at the true causes, the Audit will continue to be a commodity. If you truly want to look at what is the cause, you need to examine what is being produced and why the item produced generates no value. The ideal item an auditor produces is a “clean” (unqualified opinion) on the financial statements. This tells the world that an independent third party, highly educated (usually Masters degrees), well trained, post-certified (i.e. CPA, CA, etc.) professional has “audited” the numbers and tested the internal controls and no material weaknesses or misstatements exist. This sounds like an excellent service, so why is that commodity. In my experience, it’s not. If it is not the auditor or the firm, you have to look at what is being audited, the financial statements prepared under US GAAP. If the work of the auditor is valuable (as is my experience), then the actual financial statements must have no value, which I believe is the case. Thus, the audit service is not the issue, it is the financial statements prepared under US GAAP. And the continual methods to “improve” US GAAP is the insanity. Eliminate US GAAP and start over with a simplified approach to financial reporting which is easier to prepare, understand and audit. This will allow the auditor to focus on providing truly value-added services.

Why don’t investors have confidence in the audited financial statements prepared in accordance with US GAAP? This is seen in two areas: 1) The continual increase in the amount of non-GAAP financial information provided with US GAAP financial statements for publicly held companies and; 2) the 2018 Main Street Survey by the Center for Audit Quality. Follow up questions are if the US GAAP based financial statements represented the comprehensive economic transactions of a company or organization, why would any non-GAAP financial information need to be included? and why is the amount of non-GAAP financial information increasing? If public companies (issuers) are providing to investors or investors (users) are requesting from companies additional non-GAAP financial information in order to make decisions about their investments and there is continual increase of this information, what does this say about the US GAAP audited financial information being provided? We know what it says. Investors have little or no confidence in the audited financial information prepared under US GAAP. This is made clear in 2018 Main Street Survey by the Center for Audit Quality, which reflects auditors still garner 81% confidence. Yet, if you read the survey in detail about the confidence in audited financial information of a publicly traded company, it reflects a very different position:

  • 35% of investors have quite a bit or a lot of confidence in the audited financial information of a publicly traded company
  • 55% have some, very little or no confidence
  • 15% did not know or had no opinion which means at best the audited financial information has no weight at all on their decision making.
  • 12% of Investors had no confidence in the audited financial information while 9% had a great deal of confidence. Why is this the case?

The most telling part of the Survey is that 40% have some confidence in the financial information and the survey seems to suggest that this is positive. How is “some” positive as it relates to a professional service? If I suggested a plumber and you asked what do you think of him, and I said, I have “some” confidence in him. Would you hire him? Some is not good, especially for a professional service.

Thus, investors have confidence in the auditors (81%) but many (55%, maybe even higher) do not have confidence in the audited financial information. How do you have confidence in the auditors but not confidence in what they audit? Clearly, this points to a different problem which is what is causing the lack of confidence in the audited financial information. It is clear investors do not trust the audited financial information and need additional non-GAAP financial information. Again, if the investors trust the auditors (81%), then the issue must be the US GAAP financial statements.

Where are all the qualified opinions or alternative basis of accounting such as reporting using IFRS, IFRS for SMEs (other than the obvious one, tax)? The accounting profession treats the qualified opinion very poorly. The general understanding is the audit is a pass/fail. Either an entity receives a “clean” (unqualified) opinion or the financial statements “fail” to pass the audit. The audit profession as a whole has failed miserably in this area. The qualified opinion merely means the financial statements contain departures from US GAAP. How is this a “fail”? My opinion is US GAAP is the distortion and departing from it provides a more accurate financial statement. I may be biased against US GAAP but there is no doubt that many times US GAAP distorts the true economic substance of a transaction. In 25 years, I can count on one hand the number of times I have seen a qualified opinion issued. In addition, aside from tax and cash, there are other basis of financial reporting such as IFRS for SMEs. Again, the profession has “dropped the ball” on informing clients and educating users (banks, government agencies, etc.) of these legitimate and quite useful alternative methods. I think the issue here is the professions comfort with a different basis of financial reporting. They may feel they are unable to properly prepare financial statements under a different method. They may be afraid to make a mistake causing them and/or their firm a serious problem. In addition, accountants are not generally open to significant change (No secret here). These are legitimate concerns and should not be dismissed. The AICPA, State Societies, and other organizations should take a major proactive approach to support these alternatives and put them at the forefront by educating users and issuers of these viable alternatives. Why don’t they? US GAAP. Less US GAAP, less complexity, Less money. It does not have to be this way. For me, less GAAP and less complexity translates into more opportunity and better service to clients.

Here is an idea for everyone, do not implement the new lease accounting standard. Do not attempt to assess its impact on the financial statements or bother collecting the data. Just qualify the opinion and explain it to the user. Also, read the documents requiring an audit, I would be curious to see if the document requires an unqualified opinion or just says in accordance with US GAAP because a financial statement with a US GAAP departure is still in accordance with US GAAP. If the only reason I am doing this website, results in more accountants looking at alternatives (even ignoring mine), the accounting profession would be substantially better off and have a much brighter future.

Why doesn’t the external audit catch fraud? Quite simply. It is not designed to detect fraud and it never will be. Every ACFE biennial Report to the Nations for the last 20 years has demonstrated the infrequency an external audit detects fraud. In the most recent report, 80% of companies had an external audit as a fraud detection method yet the external audit only detected fraud 4% of the time, whereas 7% of the time fraud was detected by accident. Thus, a company had almost a twice as likely chance to “stumble” upon fraud than by having educated, trained CPAs who were tasked with planning and performing the audit to ensure there is no material misstatement due to fraud. The problem with the second part of my previous sentence is two-fold. CFEs spend years honing their skills learning how to assess and investigate fraud. How can we expect a staff, supervisor or even a manager, who most likely has never dealt with a fraud, detect let alone investigate one using a checklist and their professional skepticism? The second part of the sentence is materiality. As we all know, audits use sampling and materiality. Even if the checklist and their professional skepticism lead them to a possible area of fraud, the audit procedures to vet the fraud are not like a forensic investigation. And, if the fraud is large enough for discovery, what does that say about the financial statements as a whole. If the requirement is for the audit to detect fraud, you might as well not audit. There is a better approach. Simplify financial reporting and the related audit, which lowers the risk of fraud. Reallocate some of the costs saved from financial reporting and the external audit to internal audit, which is the second-best fraud detection method after tips. Or companies can continue spending enormous sums of money on a fraud detection method (i.e. external audit) that will never detect fraud.

It is not US GAAP, it’s the auditors and audit firms. I disagree. This is the basis of the profession’s argument. For whatever reason, we need someone to blame and it cannot be US GAAP so it has to be the auditors. We fix those auditors conducting the audit and everything will be fine. Well, let’s examine that. Let’s assume that in every profession there are always some bad apples. We will put them aside and focus on the rest. If US GAAP is the reporting framework, GAAS (along with other auditing standards) is what the auditors are required to follow to ensure the audit is planned and performed so they can issue a “clean” audit report with these 12 words “…the financial statements referred to above, present fairly, in all material respects,…”. If US GAAP changes, GAAS changes. There is no vice-versa. GAAS can be improved but it does not impact US GAAP at all. Thus, GAAS is dependent on US GAAP and the auditors are required to follow GAAS.

Assume that US GAAP and GAAS are not the issue and the audit failure is because of the auditor and/or audit firm. Either the auditors/audit firms are not following the proper policies and procedures to conduct an audit or they are letting their clients get away with incorrect interpretations of US GAAP. As many firms have strict guidelines about adherence to US GAAP and GAAS, they would have to knowingly and willingly ignore both or they are just plain incompetent. There have been and will continue to be auditors/audit firms that do not follow the auditing standards and will let clients interpret US GAAP in “creative” ways. I consider those the “bad apples”. In my experience, auditors/audit firms follow both their internal policies and procedures and the external guidelines of the profession when conducting an audit.

Thus, which is more likely, an auditor/audit firm knowingly and willingly ignoring US GAAP and GAAS or there are flaws with US GAAP and GAAS. Since GAAS is dependent on US GAAP, the simplest explanation is usually the right one, US GAAP is the problem, not the auditor or audit firm.

Why are the accounting standards continually becoming more complex? One word, Money! The top ten global accounting firms combined revenue for 2017 is approx. $160B (US) with the Big 4 accounting for approx. $133B (US). If we assume audit is 50% of the revenue (and half is US based) (a complete guess), there is an $40B (US) industry hanging on US GAAP for just the top ten. Imagine if you add in the rest of the US accounting firms. In addition, the 2018 budget for the FAF, FASB and GASB is approx. $55M (US). I had never looked at this budget before and I was not aware of how large it was. This helps explain the failure of the convergence project of IFRS and US GAAP. You start including other associations, state boards of accountancy and state society’s and the numbers really start to add up.

If this is completely obvious, I do not see anyone talking about it or writing about it. We have a multi-billion-dollar commodity industry set to fail because of the uselessness of US GAAP financial statements and the continued focus is to make accounting standards more complex and fix the audit. Thus, the goal is to stay the course and hope, like death and taxes, that an Audit will always be required by someone. I am sure many companies and organizations “hoped” for the same thing related to their product or service. May I suggest we get out in front of this before someone else decides for us. If we are proactive and willing to make major changes, I believe that any lost revenue could be replaced with significant value-added services creating a solid future for auditing.

Technology. What would happen to the US GAAP financial statements and the corresponding audit, if investors (users) could receive financial information they specify in real time from an immutable software? The answer to this question is not what but when. The Big 4 have begun implementing Block Chain including selling their versions. Do they see what I see coming?

As of today, I have not heard of any block chain or AI software that can prepare a full set of US GAAP financial statements with footnote disclosures. Thus, the technology is limited to transaction-oriented improvements. It is not able to apply interpretive guidance and application of an accounting standard, not yet at least. Thus, the profession may think it is safe for now and that they are still relevant. As for me, it is the other way around, if the immutable system can’t produce it, what confidence will investors have in it. Investors what 3 things as it relates to financial information: timely, accurate and relevant. US GAAP provides none of those three. Eventually, technology will provide all three. Once the investors realize this what would you need an audit for? I know and I know how to make the auditor a highly specialized sought-after professional.

Why does there continue to be a constant shortage of staffing in the public accounting profession? This question perplexes me the most. In every annual Journal of Accountancy survey, locating, hiring, and retaining qualified employees is at the top of the list of issues facing accounting firms. From what I understand, the number of students entering accounting continues to increase each year, the entry level salary out of college for accounting graduates has been increasing, the 150 hours requirement has been out for many years and many colleges have a special five-year master’s program strictly for accounting. Over the years, I have read article after article of ways to find, court, hire and retain employees. Some companies have created amazing programs and solutions, but yet the problem continues to exist for the public accounting profession as a whole. What is the real cause of this continual shortage? Based on my experiences, discussions, articles and observations, I have the following comments:

  • Students are entering the accounting program but not completing the Master’s program. The only reason I can see this happening is the outrageous cost of college and the debt burden placed on the student. They literally can’t stay for whatever reason. The profession needs to abandon the 150 hours requirement. I know people are already talking about it.
  • Completing the Master’s program but not acquiring the CPA designation. This one is very puzzling. I have encountered multiple staff over the years who are not CPAs but have been working in public accounting firms. I would have assumed that this was a prerequisite to staying at an accounting firm. If accounting firms are retaining staff who are not CPAs or are not requiring their staff to obtain that designation, that says something about the market.
  • A large number of Managers. I have seen firms that have a glut of managers. These managers end up doing supervisory and staff work because of the lack of staff. In addition, many of them do not want to be a partner or there is no partnership track for them. Thus, the supervisors and staff do not see a road to management or partner/director.
  • Working the good employees harder. Because firms are desperate for staff, they may take less qualified candidates or not hire at all. The more qualified employees are “fought” over by managers and partners. Thus, they are overworked and burn out.
  • The fear of making a mistake or missing something. Complexity of the accounting and auditing standards and tax code and regulations. These are ever changing and add to the stress.
  • Compliance oriented work and firms. Compliance tax returns and audits. Minimal to no value-added work. In addition, any value-added work is usually retained by a select group of partners/managers and rarely are staff allowed to work on these engagements as they are inexperienced.
  • Chargeable hours and chargeable hour goals. The 800 LB gorilla of the industry. I see firms trying to correct this but it continues to be a serious issue. I believe it is one of the primary reasons people leave the profession.
  • Budgets and fixed fee engagements. Since compliance audits and tax returns are commodities, clients do not see the value and will bid the work to achieve the lowest or most favorable price.
  • Compliance services pay the bills. As this work dominates a practice, it is used to pay the bills.

It seems like a giant catch-22. The compliance work dominates because it pays the bills which requires a significant number of personnel and long hours. The value-added work takes a back seat and when it is available, usually performed by a select few. The staff leave because of the hours, the compliance work and they are not shown a better future. Something has to give. If we reduce the role of the compliance work as a profession, there is more time for the value-added work. Continue to increase the compliance-oriented work (i.e. US GAAP financial statements and tax returns) and the public accounting profession will continue to suffer a shortage of staff.

For a firm, here are my suggestions, abandon the chargeable hour (not new), alter your compliance-oriented work (if you don’t know how, get creative, for example, subcontract it out) to make room for the value-added services, and embrace technology as best you can afford. As an example, learn an alternative reporting framework like IFRSs for SMEs or use mine and become the expert in it. Then convince your clients and users this reporting method is better and less expensive. If the profession will not be proactive, be the firm that is.

What amazes me is the accounting profession continues to focus on improving the audit including using AI and Block Chain as tools when the underlying problem is US GAAP. The accounting profession’s solution is if we “improve” the audit and make the auditors better, the problem will be solved. I have analyzed almost every issue I can think of related to an audit and every time the same result appears as the cause of the problem, US GAAP. In order to make auditing relevant (i.e. value added), the profession must stop believing “improving” US GAAP is the solution.

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