Continuous Auditing Continuing Corruption

The procedure that we would like to see enacted entails a government agency conducting audits on large companies prone for missteps or fraud. There are many procedures currently in place that could theoretically circumvent the need for such an agency if they were conducted properly. As we have discussed earlier, they are prone to bias and inaccuracies. Miklos Vasarbelyi, Alexander Kogan, and Michael Alles of the CPA Journal talk about the possibility of continuous auditing eliminating the possibility of such an agency being created. Well, not directly, but we can most certainly apply it to our proposal. In their article, titled “Would continuous auditing have prevented the Enron mess?”, they analyze the preventative worth of continuous auditing, a method that is conducted within a company, much like internal auditing. Unlike internal audits, continuous auditing or continuous assurance monitors transactions and compares actual results to expected or calculated ones. If there is any discrepancy, the supervisor can address the issue only hours, if not minutes after it happened, rather than in a traditional system, where several days or weeks may pass before any inconsistency is uncovered.

Graphic from http://www.accounting-degree.org/scandals/

So could it have stopped the Enron mess? Assuming that a continuous audit would pick up on the massive accruing debts of Enron, we still have to look at the subjective nature of any internal operation, which is talked about in the article, questioning its own conviction of the idea. Seeing that Arthur Andersen, one of the world’s largest audit and accountancy partnerships, was pulled into the scandal, presuming some monetary gain by the conspirators fudging the books, it is even more conceivable that one of the companies own higher-ups would have some reason for overlooking debts being amassed.

“Tighter regulation can be devised and implemented…”

A continuous auditing system seems as it has a good set of procedures that would fit perfectly with government monitoring. Obviously not every company could be monitored through this system, at least not without significant effort and technology on the government’s part. Perhaps companies at a higher risk for fraud or lack of appropriate auditing. These would include rapidly growing companies with hastily swelling stock prices and companies that have little to no physical assets, such as software companies, which we are seeing a candid rise in. Having a high margin of liquid assets as opposed to physical increases the potency of bankruptcy, as no returns to investors or lenders can be distributed.

The article itself say that times have changed and outgrown old procedures and “Tighter regulation can be devised and implemented…”, showing that this is not such a radical a new idea, simply a sensible one. Without trust in our nations economy and the companies that we see on the stock ticker everyday, we will see a striking decline in many spheres, not just the economy.

Changing the Audit Structure

The way auditing firms are currently set up goes against their main purpose of serving the public. Currently public companies financial statements are audited by for-profit organizations. This becomes a problem because this for-profit structure promotes auditing firms to focus on profits as opposed to focusing on their core purpose of serving the public interest. By creating a vested interest in profits rather than quality, you end up with unreliable figures, leading to precarious business. A business must not forget its purpose in pursuing its motive. For example, a train’s purpose is to move cargo from one place to another, while its motive is the engine and its moving parts. If we give the train the best motive by giving it a fast engine, aerodynamic frame, and state of the art wheels, but it has no cargo then it is useless regardless of how fast it moves because it does not serve its core purpose. Unfortunately, auditing firms have become so concerned with their motive, or compensation from clients, that they have lost their objectivity when looking at their clients and are too concerned about pleasing them to keep their profits coming in.

“By creating a vested interest in profits rather than quality, you end up with unreliable figures, leading to precarious business”

This for-profit structure of business works well when the company or professionals direct interest and purpose is to serve the client or customer in some beneficial way. However, auditing is different in that its direct purpose is to serve the public interest as opposed to its client. A lawyer or retail store wants to serve the client as best as it can, so the client will want to come back and the firm will continue to get its motive, money, to keep moving forward. In auditing the public, who benefits from auditing services, does not pay the firm. Therefore, the firm has an incentive to better cater to the client who provides the firm its motive to keep moving forward. This changes the purpose of the firm to serve the client instead of the public and can create some relationships that cause auditors to be less diligent in examining the company, which can lead to companies under a lot of pressure putting out misleading financial information and costing investors a lot of money.
Over the years the number of public auditing firms has declined from the big 8 to the big 4. Through these years every large firm has had its share of scandals it was involved with. Take for example Arthur Anderson that got so caught up in keeping profits high that it couldn’t avoid major scandals, including Worldcom, Enron, Waste Management, and Sunbeam Products. Although they didn’t have a direct hand in all of the above-mentioned scandals, they also weren’t as honest with companies like Enron because they were concerned for the loss of such a big client. The failing of companies like Enron due to consequences of inaccurate audits is a burden our economy just cannot handle.

The solution is that the firms need to be structured as an independent government agency much like the SEC and the FDIC.By having it structured as a government agency firms won’t be as concerned with profits, and the public companies will still pay the audit fees to the government so that US taxes won’t increase. Another benefit of having the audit function performed by a government agency is that it will deter a lot of self-serving people from entering the profession. This is because the government salaries for executives and employees will be capped at a certain rate. Employees who enter this profession in the government will most likely have a strong passion to do this work as opposed to doing it simply for the money. Also by having the one agency perform the audits it will allow for better knowledge of the clients industries and make for better audits overall. This government agency will gain more experience working with many different areas and can provide new employees with better training, giving more assurance that financial statements out there are accurate and properly stated. This should be done sooner rather than later, it is only a matter of time before the next big scandal comes around, and there needs to be a strong agency in place to spot it before it damages the public.

“Public companies will still pay the audit fees…. US taxes won’t increase”

 

What is the real problem?

Over the next few weeks, we will be discussing the nature and issues with the auditing system in the current business environment. One of the biggest problems with our system is that big businesses often report and conduct audits autonomously. These are called internal audits. Now this seems like a massive problem to me. How can any business be asked to fairly report on the mistakes, or lack thereof, of their own employees? In a perfect world, in which big business has morals and saint like honesty, every business would report every little mistake from entry-level misclick to large scale fraud. Now we know this is not the case, with billion dollar fraud as an all too common occurrence. In 2008 Bernie Madoff ran the largest Ponzi scheme in the history of big business, which tricked investors out of almost $65 billion. You may say this is separate from what we should be concerning ourselves with, as it was an upper echelon scheme, involving millionaire stock investors.

“In 1998 Waste Management Inc. reported $1.6 billion in fake earnings”

Now what about a more accessible company, a company that many of us see and have contact with on a normal basis? In 1998, Waste Management Inc., the very same company that takes the garbage from in front of my house, reported $1.6 billion in fake earnings. Now this is not a Wall Street dignitary cooking books, this is a blue-collar company that any one of our neighbors or relatives could work for. In a service industry like the one Waste Management Inc. operates in, many of the employees depend on their job heavily. Without it, many of them would need to go on public assistance, if they aren’t already. If you were in the same position, would you risk losing your job by reporting a mistake in the books of your company? One of my close family members has been called on multiple times for auditing service. Being an employee of over 30 years in the pharmacy department of a large retail conglomerate, she has come to depend on a paycheck every two weeks. I am not saying by any means that she cooked the books on her department’s revenue, but if there had been a discrepancy, and it was either omitting the mistake or Even though the auditors are not paid on whether the records come back clean, employees may still feel pressure to protect their livelihood. Sometimes internal audits can be effective in uncovering unsavory business practices. In 2003, WorldCom’s internal auditing system caught fraud of it’s own CEO.

 

 

By and large, by giving the responsibility of auditing a business on it’s own employees, you end up with quite the conundrum. Either the employees are truthful and report any of the mistakes in the business’s books and risk losing a dependable paycheck or they value their livelihood over the legitimacy of the business that they work for. By placing a vested interest, like a regular paycheck, in the auditor giving the business a clean slate, you create a breeding ground for corruption and shady business practices. To effectively avoid this situation altogether, a third party auditing system needs to be appointed for internal revenue and performance audits. A third party, with no bias or incentive to alter data, there will be less opportunity for businesses to misreport or alter spending, revenue, or investor profit margins. As it stands, internal audits happen much more often than IRS audits. Now it would not be prudent for the IRS to conduct audits on every business that was due, however it is very reasonable for a third party accountant or accounting firm to do them. The main purpose of internal audits is to catch mistakes before a legal body catches them. With repercussions in turn with mistakes, employees again have a reason to distort numbers. The existing systems have many flaws that can be fixed. As we continue throughout the next few weeks, we will attempt to lend a helpful opinion into this issue.

Nick Clark

My name is Nick Clark. I’m a sophomore currently attending the University of Maryland. I have lived in Maryland all of my life, right in between Baltimore and Annapolis. Looking toward an Economics Major with a possible minor in rhetoric. Having a local’s perspective to the capital not only of the nation, but also the state of Maryland, I hope to bring a regional interpretation of the pressing issue facing us today. Being so close to our nation’s capital, we should be the first informed on issues facing us today.