Why Aren't Audit Reports More Like Movie Reviews?
When Roger Ebert reviews a movie, he communicates his opinion in three ways. First, he gives a "thumbs up" or "thumbs down" to indicate whether he recommends people go see the movie. Second, he uses a four-star scale to distinguish the good (three star) movies from the oscar-caliber (four star movies) and distinguish the mediocre (two star) movies from the truly abysmal (one star) movies. Finally, he writes a brief narrative describing what he liked and didn't like about each movie.
Would movie reviews be valuable if Mr. Ebert did not award stars or write narratives but merely gave a "thumbs up" to every movie that met the bare minimum standards of filmmaking? I don't think so; yet that is precisely the reporting system auditors use to communicate their opinions about clients' financial statements. Auditors do nothing more than give a "thumbs up" (unqualified opinion) to every client that meets the minimum standards of GAAP.
In most of the recent accounting scandals (e.g., Sunbeam, Enron, Waste Management, W.R. Grace) the auditors knew about questionable accounting practices or even blatant GAAP violations, but still reported a "thumbs up" because the problems were "immaterial" (i.e., even though the plot was contrived and the acting was poor, the movie still met the minimum standards of filmmaking).
Maybe auditors should adopt something similar to Roger Ebert's four-star rating system. A company whose financial statements reflected the economic substance of its transactions and included informative disclosures would earn three stars. A company that structured transactions to avoid accounting requirements and refused to record "immaterial" adjustments would get two stars. Only companies that went beyond the minimum requirements of GAAP and made additional voluntary disclosures would earn four stars. The rating would be accompanied by a two-three page narrative describing the auditor's opinion about the client's internal controls, risk management processes, and accounting practices.
To use another analogy, most of us assign grades using an A through F scale that distinguishes the highest performing students from the middle performers from the lowest performers. This system (though admittedly flawed) gives employers and graduate schools information about each student's capabilities and performance. Auditors, on the other hand, use a pass/fail grading system. They make no distinction between companies that practice "A" financial reporting and those that practice "D-minus" financial reporting.
My experience with pass/fail grading has been that too many students, rather than striving to excel, perform the least amount of work necessary to earn a passing grade. This is what appears to be occurring in accounting. Companies are competing in a "race to the bottom" to see who can disclose the least and manipulate earnings the most while still earning a "D-minus" grade from their auditors. I can't help wondering if a different grading scale would lead to different behavior.
When I have offered these observations before, people have often responded, "That will never work because the auditors will give everybody an A/four stars. The auditors will never say anything bad about their clients for fear of being fired." I am not convinced that would happen. Granted, there are some movie reviewers who claim that even the stupidest movie is "the funniest movie of the year." These reviewers are quoted frequently in advertisements for bad movies, but I don't think they have any significant influence over people's behavior. People quickly learn to discount these reviewers' opinions. What would happen if Roger Ebert began giving every single movie four stars? People would stop reading/listening to his reviews and he would soon be unemployed. I think the same would happen if Deloitte & Touche gave every single client four stars and a glowing report. Audit reports are public information and it wouldn't take long to figure out which audit firms were the "easiest graders." I believe that, in the long run, financial statement users would discount the opinions of lenient accounting firms the same way graduate school admission offices discount grades from colleges with the worst grade inflation.
Please consider what the following people recommended to reform the current system of audit reporting.
David Hatherly, in his article, "Company auditing: a vision of the future?" (Accountancy, July 1992) wrote:
- My vision is that the audit report of the future will be a commentary on the operating and financial review, highlighting points of contention, uncertainty and difficulty. As a commentator, the auditor has considerable reporting freedom and the opportunity to communicate the subtlety of his own judgments in full.
- Investors and other use groups would find this type of report far more useful than the present one. It would therefore add considerable value to the present audit, not necessarily for management, but for those in whose name the audit is carried out. Since the audit report would no longer be standard in style, content or wording, there would be competition between audit firms to be seen to deliver the added value in the most accessible fashion. Thus we would have competition on the basis of product quality as well as on price…. Investors would take a much keener interest in the appointment of auditors and the adequacy of their remuneration.
Similarly, Robert Mednick in his article "Reinventing the audit," (Journal of Accountancy, August 1991) wrote:
- Under today's definition of the attest function, the auditor is responsible only for opining objectively on the board's and management's periodic reports to stakeholders, based on established standards and rules for such reports (such as generally accepted accounting principles). Ideally, a future auditor should be directly responsible to the stakeholders for all knowledge gained in an engagement they would find useful in their decision making.
- As a first step along the road to the ideal, the profession will probably merely supplement the traditional opinion on management's assertions-for example with an independent financial analysis of the entity and early warnings of potential problems, communicated in most cases to the stakeholders' representatives.