Counting on Trouble (Part 3)

So how do we fix accounting?

Someone once said that free elections are meaningless as long as the politicians control who counts the votes. In the same way, accounting reform is meaningless as long as management controls the accountants. At present, audited financials are the responsibility of the firm. You can’t list a company without hiring an auditor to look at your books.

But the independence of such audits is a fiction. If the auditors come up with an opinion that differs dramatically from management, they risk getting fired. It’s a lot like the “issuer pays” model with bond ratings. When the rated entity hires the rater, there is an inherent conflict of interest. And in both cases, you have an oligopoly: there are three major bond ratings firms, and only four major accounting firms.

At least bonds investors have the option of hiring an investor-paid rating agency like Egan-Jones or Kroll Ratings. Auditor independence can only be assured if auditors are paid by investors. Issues like adopting European accounting standards or pushing for more market prices in the balance sheet are just academic side-shows. The real issue is testing management’s performance.

Accounting should focus on whether management is providing an appropriate economic return for investors, but there needs to be a way for investors to call the shots. You get what you pay for, and as long as management pays the accountants, the accountants will serve—not test—management.

Douglas R. Tengdin, CFA
Chief Investment Officer
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