WORLDVIEW: With auditors & other watchdogs, trust but verify

By Felicity Duncan.Among the many disturbing facts emerging from the Ethiopian Airlines disaster, one stands out – and holds an important lesson for the current debate about the role of auditors..The fact is this: Under rules intended to streamline the aircraft safety approval process, the Federal Aviation Administration (FAA) outsourced some of the verifications and checks to the manufacturer of the aircraft, Boeing..___STEADY_PAYWALL___.In other words, Boeing was effectively certifying its own aircraft as safe – at least, for some parts and systems. It should be obvious that Boeing has a conflict of interests here – it's supposed to be asking tough questions about safety, but it's asking those questions of itself..This must surely create a system something like the one we've all experienced when we decide to lose weight. We obviously want to eat right and work out. But we also want to eat sweets and watch TV. So, we tell ourselves a few useful little lies from time to time. Maybe we do the right thing six days in a row, but we cut ourselves a little slack on the seventh..Read also: Games auditors play to reflect 'true and fair' accounts – FT.It's not hard to imagine something similar happening at Boeing – most of the time it will stick to the rules, since it does want its planes to be safe. But every now and then, when deadlines are biting and bosses are stressed, a few small details will slip through the cracks..This is why we generally agree that entities should not be allowed to monitor themselves with no external input. Politicians are watched over by journalists and voters. Employees are subject to managerial review. Kids' homework is supervised by their parents (ideally)..So, what does this have to do with auditing? After all, auditors are supposed to be the "external input" when it comes to companies' financial statements and financial management..But here's the problem with this – while auditors are supposed to be providing independent and objective verification of companies' financial statements, the evidence is that they are, in fact, not doing so..I'm not going to dive into a litany of auditing scandals – you probably already know about Carillion, Interserve, Patisserie Valerie, General Electric, KPMG's leak scandal in the USA, the relationship between auditors and the Guptas in SA, and a dozen other disasters. Rather, let's focus on the implications..What these scandals have in common is that the auditors in question seemed unwilling to do their jobs and ask tough questions of the companies they were auditing. Why is this so?.Well, the answer is simple: The companies are the ones paying them! It's very difficult to speak truth to power when the ones in power are the ones who hired you and can fire you if they don't like what you have to say..What's more, all the big accounting firms earn only a small proportion of their revenue from auditing – they make the big bucks from lucrative consulting gigs. If you're angling to be hired for a juicy consulting contract at a company, you're certainly not going to make uncomfortable waves when you're doing that company's audit..You may draw the line at outright naked fraud, but why would you make a fuss about creative or aggressive accounting practices that could, from a certain angle, look good enough to pass muster? You have every incentive to look the other way and keep cashing the company's cheques..Well, you may respond, there are external oversight boards..Sure, but in many jurisdictions, those boards are made up of auditors themselves. Indeed, in many places, auditors largely regulate themselves, with only the most egregious misbehaviour prompting external authorities to get involved. Even in places like the US, where an independent board, the Public Company Accounting Oversight Board (PCAOB), is responsible for overseeing and evaluating audits, the volume of audits is generally too great for meaningful oversight. The PCAOB can only review a sample – and it finds plenty of problems when it does..In other words, an overworked and underpaid external oversight board is not going to solve the problem when the rot is this deep (although the UK is going to give it a bash)..Read also: Masters of the universe: Why Big Four auditors like KPMG get away with murder – FT.The core problem is that the incentives for auditors are all wrong. Their incentive for doing a good job of auditing is basically just avoiding the remote chance that they will get into trouble with some external regulator. Their incentive for holding their nose and signing off on whatever financials they are shown is basically a gigantic pile of cash. It's not a tough choice..What we need to do is realign incentives. It's clear that, right now, auditors are frequently acting entirely on behalf of the company they're auditing – we're effectively seeing companies signing off on their own accounts (through the cat's paw of an external auditor that they hire, pay, and oversee)..If we want an actual external oversight process, we need an external overseer. Auditors should not be paid by the companies they audit. They should be paid and hired directly by those whose interests they're meant to serve – shareholders (in the case of companies with shareholders) or the general public in the form of the state (in the case of private companies). Auditors that uncover bad accounting and other issues should enjoy generous cash rewards. And audit functions should be entirely separate from consulting functions to avoid conflicts of interest..Capital markets cannot function effectively without good information. The stock market is supposed to channel money to the best companies. But if we're all looking at cooked books, how on earth are we supposed to know which companies are the best? We need transparent and accurate information to make informed choices as investors. And today's audit profession is failing to provide this..I'm sure many auditors are fine, upstanding people with no thought for dishonesty. But when the incentives are stacked against honesty as they are in auditing today, that's just not going to be enough. Change is needed.

WORLDVIEW: With auditors & other watchdogs, trust but verify

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