Sounding the financial alarm
The Sarbanes-Oxley Act of 2002 requires annual reviews of public companies' financial reporting controls by their independent auditors. But as far as we know, only one of the big auditing firms actually sounded an alarm before a series of financial-services companies collapsed or required bailing out in recent months. (The lone firm was PricewaterhouseCoopers, in the case of AIG.)
In fact, just weeks before the credit-market collapse, management of several of the largest companies involved (including Bear Stearns, Fannie Mae, Lehman Brothers, Wachovia and Washington Mutual) reported that their operating policies and procedures were good enough to reliably prepare financial statements - findings supported by each of their external auditors.
How is this possible? As bankers, investors and regulators continue to struggle with valuing billions in subprime loans and exotic financial instruments, we wonder how these executives and their independent accountants missed what appear to be glaring deficiencies in these companies' financial reporting.
We acknowledge that predicting a global financial meltdown may be impossible, and these large auditing firms may have prevented some reporting failures. But we remain puzzled as to how they could have missed the dangers of increasing leverage, declining asset quality, complex derivative valuation, and the liquidity risks that ultimately plagued these firms.
Complicating matters, many of the Big Four auditing firms are still facing numerous lawsuits related to recent audits. These legal pressures create huge incentives for them to focus on short-term survival strategies, rather than long-term solutions to provide the market with the high-quality auditing it desperately craves.
In fact, the Big Four continue to aggressively lobby legislators and regulators for liability caps. It's particularly troubling that many regulators now view these large auditing firms as "too big to fail" because there is no auditing alternative.
Clearly, the status quo is not acceptable. The magnitude of the recent global market meltdown and government bailouts requires a serious rethinking of auditing's role and standards. The Public Company Accounting Oversight Board also needs to seriously reevaluate its role in monitoring auditing quality and setting standards.
In addition to reviewing the work of the Big Four firms, perhaps the board could emulate the National Transportation Safety Board: When a financial-reporting disaster or audit failure occurs, it could send in a team of governmental experts to investigate how it happened and what could prevent a recurrence.
A fresh look is needed. Legislators and regulators should answer a few questions: How can we get a "real" audit for a publicly traded company? How can we encourage accountants, auditors and executives to look for financial-reporting fraud? Can we design a compensation scheme that rewards these firms for detecting weaknesses and deficiencies?
We simply cannot accept another "too big to fail" argument to justify support of a profession that promises oversight but delivers much less.
