What’s an audit worth?

From time to time, disappointment is expressed about what some people see as the declining quality of financial audits – in terms of accuracy, competence of auditors, types of auditing procedures used, and of course, the number of corporate frauds that are prosecuted after the auditors of a company in question issued an unqualfied opinion.

A couple of examples:

  • In April 2014 a survey by the International Forum of Independent Audit Regulators focused on issues such as how “fair value” asset measurement or valuations are audited; testing of internal controls for adequacy; and the way information is being presented on financial statements;
  • A couple of years later, in October 2016, in a speech to the Cayman Investment Forum, Harry Markopoulos went even further and called for a “complete overhaul” of the way audits are being conducted. He claimed that the current audit procedures aren’t structured to detect fraud, that young auditors are often inexperienced, poorly trained and simply follow checklists.

Markopoulos was described as a whistleblower on the Madoff ponzi scheme and used that case as an example of the need for massive change to the auditing regime. But is Madoff alone a valid example of the shortcomings of auditing?

There are two general types of accounting frauds in the world of public accounting. One type consists of frauds perpetrated directly on investors by fraudsters who lie and trick people to get them to invest money (the Madoff model).

The other type of accounting fraud is indirect – corporate employees manipulate a company’s accounting records to produce financial statements that will show desired results (the earnings management model). Often this is done to conceal losses or declines in the value of assets that could have a negative effect on the company’s stock price and on investors holding the stock who are unaware of the company’s undisclosed problems.

These two types involve different means and methods of deception – should they also call for different types of audit procedures, depending on whether the investment is offered directly to individual investors by issuers and promoters where the due diligence is the individual investor’s own responsibility; or an investment offered on an exchange where the investor might assume that others, including auditors, have access to the company’s records and have done substantial due diligence.

Markopoulos seems to be saying that all audits should have a forensic element. Maybe this is true, especially for the Madoff model. Would that approach also be worthwhile on audits of large listed corporations?

And what about situations where a company conducts an “internal investigation” by hiring an outside law firm, rather than accountants, to review accounting records in the case of a possible fraud? Where does that leave the company’s auditors? What about the growing number of internal whistleblowers who reveal a corporate accounting problem or fraud “undetected” by auditors?

One thing the critics all seem to agree on is the need for better anti-fraud training for all auditors before they start the job. Markopoulos argues that preference should be given to auditors who have experience with fraud cases. And of course, we still have the old divide between members of the public who believe that auditors should be actively looking for fraud and auditors who say that’s not their primary responsibility, that auditing is about determining whether a financial statement “presents fairly” a company’s financial situation for the relevant date and reporting period.

But from the outsider’s viewpoint, what does it really mean to “present fairly”? Is this something of value to the readers of financial statements (such as investors, creditors, and market analysts)? What’s an audit worth to them?

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