5 radical ideas to reform the $150 billion auditing industry: DB

Reuters / Neil Hall

• A new report from Deutsche Bank challenges conventional
  views of auditing, and argues there are several improvements
  that can be made to the industry.
• Research analyst Luke Templeman lays out five “radical”
  suggestions for how the auditing industry can be changed for
  the better.

Auditors can be intimidating.

In the corporate world, their role is to make sure financials are
compliant with accounting standards. And as a result, they’re
often viewed as rigid, if not infallible, purveyors of accuracy.

While Deutsche Bank doesn’t
necessarily disagree, it argues that there’s clear room for
improvement in the roughly $150 billion industry.

In a recent report, the firm invokes the infamous auditing
failure at the 2017 Academy Awards. That was when PricewaterhouseCooper (PwC) — tasked with guarding
the show’s results — accidentally handed the wrong
envelope to Warren Beatty, which resulted in the wrong winner
being announced.

Sure, the Oscars snafu didn’t cost anyone money, but it did dent
the credibility of gatekeepers like PwC.

Going beyond that high-profile example, Deutsche Bank finds that
two-fifths of analysts covering Europe’s biggest companies think
there are “risks and opportunities” in their audit functions.

Luke Templeman, a research analyst at Deutsche Bank, has five
“radical” proposals for improving the audit process. They are as
follows:

(1) Auditors should be appointed and paid by the company
regulator

Templeman says that, on rare occasions, the fact that companies
pay their own auditors can create a conflict of interest. He
notes that this arrangement can increase the risk of “aggressive
accounting.”

His solution is for companies to pay a fee to a regulator, who
then negotiates with multiple potential auditors for the job.

“This arrangement would not amount to a nationalization of
auditors,” Templeman wrote in a recent client note. “Rather,
it could sharpen the focus of auditors and ensure a closer
line of accountability to stakeholders outside company
management, and go some way to eliminating the perception of a
conflict of interest.”

(2) Introduce auditor disclosures

The purpose of Templeman’s second proposal would be to create
more differentiation between audit reports, which often look
nearly identical, even if there are vast discrepancies across
companies. In particular, he wants to convey the quality of the
audit.

In order to do this, Templeman proposes that auditors publish the
average amount of experience incurred by its auditing team — or
perhaps delineate between the time spent by more highly qualified
staffers, versus their junior colleagues.

Other disclosures proposed by Templeman include: naming competing
companies the firm has also audited, and discussing the prior
positions of senior auditors.

(3) Merge consulting divisions with audit

Templeman argues that combining the roles of these two
departments could make auditors more responsible for the
financial models they’re tasked with checking. In his mind, the
more involved auditors are with these models, the better off a
company will be in multiple ways.

“The auditors will then have greater certainty as to its
accuracy, and a potential conflict of interest will be
eliminated,” said Templeman. “This arrangement could be
buttressed with the threat of serious banking-style fines for
nefarious behavior.”

(4) Focus management incentives on return on assets

Templeman points out that one of the most controversial pieces of
regulation that stemmed from the financial crisis was the
accounting rule that measures assets at fair value. He notes that
this has created a situation where companies inflate their asset
values, then pressure their auditors to sign off on it.

In order to address this, Templeman says corporate managers
should be compensated based on return on assets. After all, as
assets rise, the return on them falls — so that would
theoretically eliminate the conflict of interest outlined above.

“If shareholders required management incentive packages to be
more weighted towards return on assets, it would diminish the
incentive for managers to argue for fair-value asset increases,”
he said.

(5) Five-year audit tenure

Templeman’s idea here is that it eliminates the possibility of an
auditor getting too comfortable with one of their clients — a
situation that can breed complacency and an eventual lack of
rigor.

“When new auditors learn about the business from scratch, it
is easier for them to ask simple questions (which are often the
most on-point) without the baggage of having conducted the prior
year’s audit,” he said. “Processes that have ‘always been done
this way’ are suddenly given a fresh degree of scrutiny.”

Templeman also notes that this could challenge the dominance of
the so-called Big Four firms: Pwc, Deloitte, Ernst & Young,
and KPMG.

“If tenders arise too infrequently, there is little incentive for
second-tier firms to build the capabilities required to compete,”
he said. “Additional opportunities to tender could fix that.”