October 7, 2005
The Function of Auditors
Floyd Norris, the fine commentator for the NYT Business Section, writes today about the draft of a new "White Paper" from the American Institute of Certified Public Accountants (AMICPA). According to Norris, the White Paper instructs auditors to refuse to answer questions from underwriters on whether the auditors had uncovered "instances of fraud or illegal acts." Auditors are told to refer the underwriters to company management. The White Paper is yet another illustration of the uncertain role of auditors, something one would assume we had well worked out by now.
If auditors had their way they would describe their role this way: We are under contract with a company to check their books for compliance with GAAP and report to the company our results. The company passes our report out to others. We do not owe any duty to investors or the market in general, we owe a duty solely to the company to do our job in accordance with the contract, which incorporates trade association standards of auditing (GAAS). If our report is incorrect, it is the company alone that should sue us for breach of our obligations. If anyone asks about the reports contents, we refer them to management for it is management that can choose whether or not to disclose the contents of the report, subject to their obligations under the federal securities acts.
Investors, however, if they had their way would describe auditors role this way: Our company hires auditors to verify company accounts and to report to shareholders (and other interested market participants) that company management is properly disclosing the use of investor funds. An auditors report is a public seal of approval on which the pubic expects to rely. If a report is false, the public is aggrieved and has the right to sue for damages. Any investor, or investor representative, should have free access to the report.
The law vacillates in a narrow range mid-way between the two extremes, never fully embracing one extreme or the other. Auditors harbor and defend their view and investors (who are not lawyers) hold theirs. Ironically, the investor view, although false to auditors, makes audits more valuable than they would otherwise be and enable auditors to enjoy the value in fees charged.
The overriding problem with audits is the inherent conflict-of-interest that no amount of federal regulation can solve: Auditors are chosen and paid by the people they are policing, firm managers. It is analogous to the home team choosing and paying the referee for home football games based on past performance. Federal regulation cannot negate the inherent conflict of interest; it can only stop the more outrageous instances of favoritism (and even here some would disagree). The best reform proposal would have each group get its way: firms could hire auditors, if they choose to do so, with limited contractual duties and shareholders also could choose to hire auditors will duties to report directly to them. Any company could have one or the other system of auditors or both.
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