The Financial Times kicked off what promises to be a great series of articles on accounting this week with an excellent piece by Madison Marriage, titled “The big flaw: auditing in crisis“.
The basic question is, with the big four dominating the scandal-hit market and big company bosses ‘making the most’ of the “fair value” system, what can the sector do to improve standards?
The article seems to have struck a chord with lots of accounting professionals everywhere, judging by the interesting comments, posted beneath it. One observer had this to say:
“Good article and on point. I am a qualified CA though moved on into investment many moons ago and am currently having a stand up battle with a big four firm insisting on something called ‘straight line revenue recognition’ on a certain financial instrument which has the effect of significantly overstating current income beyond what the counter party contractually owes us, is in complete breach of ‘true and fair’, the ‘matching concept’, nor has it anything to do with either the fair market value currently realisable on the instrument (let alone cost) and is completely divorced from both the contractual reality and common sense. It is an absolute absurdity and frankly offensive to anyone that understands finance or accounting for that matter.”
Such is the consternation buzzing around the profession at the moment, the FT has been promted to produce a hard-hitting editorial comment that kicks off thus: “Bad audits and beleaguered auditors are symptoms of a cancer in the body corporate. The … investigation into the flawed audit market suggests accounting standards may be part of the disease.”
Structural dependency
It continues… “Structural dependency on four big firms is one problem. Another is auditors’ seeming inability to prevent investors being misled or to curb aggressive, even criminal, reporting practices. It suggests the rules are no longer fit for purpose. Accounting standard-setters have at least two laudable aims: to align rules globally and to close loopholes to abuse.
“Thirty years ago, it was easy for a bank to manipulate its profits by valuing loans and setting aside provisions for loan losses with little heed to economic reality. Some investors were delighted at the consequent smoothing of profits and dividends through the credit cycle.
“But the scope to minimise tax, inflate bonuses or simply obfuscate a decaying financial situation was great. Indeed, out-of-date numbers in US banks’ balance sheets were partly to blame for the savings and loans crisis of the 1980s and 1990s.
Boost share prices
Concluding that… “A key underlying principle of modern accounting is fair value… Unscrupulous managers, increasingly rewarded with equity incentives linked to accounting measures, have exploited the system. By writing up asset values in line with market values — whether real or estimated — they could book profits, distribute dividends, boost share prices and make incentive payments.
“Fair value accounting is clearly based on logic. But for it to work in practice it requires auditors to play the crucial role of arbiter. Straightforward market valuations are one thing. But when models and estimates are used as proxies, an auditor’s judgment is crucial to the credibility of company accounts. Yet the Big Four auditors have used their considerable lobbying power to hollow out their role, rather than accept that responsibility.
“The audit market needs to recover its original purpose of assuring investors and the public of the truth and fairness of accounts. Reforming the rules would be a critical first step.”
This is an issue that is clearly reaching a tipping point. As ever, if there’s going to be any significant action, it will depend on any campaign’s momentum. And vested interests.
