A common element in all major corporate scandals of this decade is the questionable role played by major audit firms. In the Parmalat case, such fraud lasted over 13 years, with euro 12bn account inflation. In 2003, the HealthSouth Corporation (in a case bearing uncanny similarity to Satyam), was caught overstating its earnings by more than $2bn. In 2008, according to Hayward?s annual Fraud Track, accounting misstatements contributed to 28% of the total losses attributed to fraud in UK corporations. Accounting fraud is reportedly on the rise in the US too. Of course, one must stick to the dictum that accounting firms are innocent until proven guilty, but one must also recognise that convicting a suspected entity is extremely difficult. Information (or the lack of it) is the crux of the problem.
It is universally known that firms routinely engage in ?creative accounting?? in a wide variety of forms. Some maneuverings are innocuous. The basic problem for a regulator or a judge is to distinguish such innocuous reporting from fraud. For example, a sale item could be moved backward or forward to communicate a smoothness of earnings, and unless the time lag is too wide, one would not call this fraud. On the other hand, reporting a sale that did not take place at all calls for concern. For example, the US based disk drive manufacturer Minisribe shipped off bricks instead of disks, and fraudulently recorded $4.3m in sales. Similar techniques are widely employed by the underprovision of reserves, especially in case of defaults, where the probability of repayment in future is known to a firm but is misstated in its annual report, with or without the help of auditors. Creating special purpose vehicles to hide bad debts or to transfer bad investments (as with Enron) is another means of tunneling, but it is also used to enhance efficiency in some contexts. Eliciting such information in a timely manner is the key issue.
If an audit firm (or internal auditor) fails to distinguish between the good and bad entries, over some time, then this firm is either incompetent or crooked, both being bad news from the point of view of corporate governance. The question is: who will blow the whistle on time?
One can assume that audit companies will tend to be conservative. First, there is an agency problem. The owners of an audit firm are not the ones who are inspecting the clients? book. Almost no in-house incentives exist to reward those who spot asset manipulation. Second, most of these audit firms are not traded publicly, so they are not immediately affected by loss of reputation. Third, an audit company does repeat businesses with clients and may not want to loose this by pointing out malfeasance. Finally, these companies sit on huge a monopoly over the inside information transmitted to them via company books. They may utilise information to extract rents rather than divulge it, unless the latter is in self-interest.
Relative inaction of audit firms is also confirmed empirically in an interesting study made in the context of the US by Luigi Zingales of University of Chicago and his co-authors.
While auditors contribute 14% of the total fraud detection in their sample, speed of detection is 14.7 months, which is much higher than in case of other arms-length whistle blowers, an indication of reluctance to blow the whistle harder. An interesting finding of the same study is that media (14%), industry regulators (16%) and employees (19%) are the active whistleblowers.
The lesson for financial regulators could be to use these alternatives sources (in particular, media) of information in conjunction with auditors? reports (about firms cited by media), and this could serve as a second opinion for making at least a preliminary verification of inside information. Audit firms will stay around because there is no substitute for the services they render. However, democracy also provides regulators a useful source of information via the market of print and electronic media at an extremely low cost.
?The author is reader in finance at the University of Essex