Is financial reporting broken?
As an investor, I depend on financial statements to assess corporate performance. With the exception of “Bizarro” bond yields in Europe, no one invests in order to lose money. But there’s a problem. Companies self-report their earnings, then pay auditors to provide assurance to investors that these financial statements reflect reality. Executives might not want to air all their dirty laundry; compensation is usually tied to financial performance. And auditors that are too strict or picky can be fired. Enron’s cozy relationship with its auditors was partially blamed for its demise.
So how do we make sure that financial statements reflect reality—that companies aren’t cooking the books? One proposal is to make auditing a government function—like the police or fire departments. So could we expect the efficiency of the DMV and the friendliness of the IRS in financial reporting? No thanks. Or make auditing firms liable for misreporting? That will just speed the disintegration of the auditing profession. We used to have a “Big Ten” group of auditing firms. We’re down to a “Big Three” now.
Perhaps the solution is to make the system more adversarial, with auditors earning bonuses for finding instances of financial misreporting. But accountants need management’s cooperation to do their jobs well. Paying bounties for adverse findings would poison the well.
At present, accounting firms submit a sample of their audits to other accountants for professional review. Making these reviews public might encourage the CPA firms to improve their processes. After all, knowing another knowledgeable professional will examine your work—and make the findings public—would encourage higher standards.
It seems there’s no clear way to radically improve the auditing system. Investors who read financial statements need to know how to “speed read”—using ratios and history to detect discrepancies, or flipping to the end of a conference call transcript to get to the tough questions. For now, it’s caveat emptor—buyer beware. Enquiring investors will want to know. The truth is out there.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!