In this post, I’ll argue that the global corporate services sectors like management and technical consulting, accounting and auditing, credit rating, and other similar services suffer from a serious market failure, one of accountability deficit.
A concern that critics highlight about these service providers is that they have managed to somehow or other insulate themselves from the consequences of their actions/advice. When confronted with the consequences of their advice, they have the standard cop-outs - the client did not listen to them, the information that formed the basis of the audit or rating was flawed, and so on.
Consider the case of audit firms and their effectiveness in deterring fraud.
For decades, investors have lamented how rarely external auditors uncover corporate fraud… The Association of Certified Fraud Examiners’ biennial report on how workplace fraud gets detected has typically shown auditors are the ones uncovering the wrongdoing only 4 per cent of the time… The latest report out a few weeks ago said the number is down to 3 per cent… A survey of investors by the Center for Audit Quality, a trade group for large accounting firms, found that 57 per cent thought the current system “frequently” failed to detect illegal acts… Regulators fear auditors are failing in their role as a last line of defence for investors against corporate shenanigans.
A 3-4% fraud rate would imply global corporate governance standards that are almost of biblical purity. The rates are farcical. It's similar to the institutionalised small sample audits by superior authorities in government entities that rarely, if at all, uncover any lapses.
Auditors have their reflexive responses.
Audit firms argue that company executives are responsible for the accuracy of financial statements and that the role of an auditor role is only to provide reasonable assurance — not a guarantee — that a financial statement is free from material misstatement. It is an argument that has prompted the US Securities and Exchange Commission’s chief accountant, Paul Munter, to exclaim to me on more than one occasion that he is fed up hearing from auditors what they do not do… PwC last year promised it would overhaul its fraud detection procedures and probe its clients’ whistleblower programmes more closely, among other reforms to boost audit quality. PwC boss Tim Ryan tried and failed to get all the Big Four firms to make a common pledge on these issues.
The responses get even more disngenuous
Audit industry leaders still talk of an “expectations gap” between what investors want an audit to be and what it really is, as if it is the investors that need to be educated instead of the profession that needs to change.
In response to the obvious problems in the audit industry, the regulators have started acting amidst stiff opposition from the industry.
In the US, the Public Company Accounting Oversight Board is revamping rules on how auditors must look for and deal with evidence of a client’s non-compliance with laws and regulations (Noclar, in the jargon). The intent is to force auditors to cast a wider net for matters that could have a material effect on a company’s financials, even indirectly by leading to big fines or regulatory action that threatens the business. Audit firms have responded that they cannot be expected to make legal judgments, and that the huge amount of extra work implied by the Noclar proposal as currently drafted probably will not uncover anything significant that current procedures do not already… The latest move is by the International Auditing and Assurance Standards Board, which sets rules that are used as a template by scores of countries around the world. It has proposed strengthening standards on fraud detection to emphasise that auditors must look for financial misstatements that might not be “quantitatively material” but which might be “qualitatively material”, depending on who instigated the fraud and why it was perpetrated.
The FT article has the obvious logical suggestion on how the audit industry ought to have responded to these reforms.
An alternative response to some of the current proposals would embrace them to strengthen the hand of auditors. They provide new justification to pry open clients’ businesses, push back on hostile finance chiefs and chief executives, and flag more matters of concern to directors, to investors or to the authorities — to follow through on the professional scepticism that is supposed to be at the heart of the auditors’ creed. There is room for agreement, even on the contentious Noclar proposal. Better still for auditors, there is evidence investors are willing to pay for a more robust service. The CAQ survey showed a majority would support auditors charging an additional 20 per cent or more to cover the extra work of rooting out non-compliance.
We have an interesting problem. As the surveys indicate, investors strongly believe that audit standards are broken and need fixing. They are even willing to pay for any additional work necessary to fix it.When faced with such investor demand, the market should have responded appropriately. Instead, we have auditors pushing back strongly on efforts at any reform.
In a quasi-cartelised industry like auditing where a handful of firms exercise tight control over the market and are entrenched in a comfortable self-serving equilibrium that also suits their clients, notwithstanding investor interest, reforms to change the equilibrium will naturally face resistance. This is a classic market failure, arising not due to any government intervention or regulation but purely due to the market's inherent inefficiencies and incentive distortions. It’s an example of a case where regulation has a constructive market-making role to play.
I’m not sure that the auditors will embrace the reform proposals because it would increase their freedom to do more rigorous audits. There’s a trade-off between accountability and freedom. With reforms that confer more freedom (or strengthen their hands) to auditors comes greater accountability. And that’s a problem.
On similar lines, organisations hire consultants to diagnose problems and offer recommendations. The organisations then decide to implement the recommendations. But when the outcomes don’t follow, the consultants are not held to account. Instead the consultants blame their clients for not executing them properly or for making changes to their recommendations or on confounding factors. Ironically, a consulting firm which advises an organisation on performance management does not hold itself to account for the non-delivery of its consulting objective.
Here too there’s a market failure. An industry dominated globally by a handful of firms has collectively defined the standards and terms of their service, insulating them from any scrutiny of the consequences of their prescriptions. The incentives of the corporate executives and managers of these firms are most often aligned, for a variety of reasons, to adopt the prescriptions of the external service providers. Even if they want to enforce accountability, clients struggle to overcome the entrenched industry business model. The only way out is to break the stranglehold is through careful regulation that targets the accountability problem.
Given that the vast majority of these corporate services are procured by companies with diffused shareholders and hired executives and managers, market failure also creates a principal-agent problem. How do the investors know that their capital is being deployed and managed effectively when these ubiquitous and critical corporate services suffer from an accountability deficit? Therefore there’s a public goods case for regulation.
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