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The current global financial crisis began around 2007 and is considered the worst financial crisis since the Great Depression of the 1930s. A liquidity shortfall in the United States banking system is one of the major causes. The collapse of the housing market also plays a major role that lead to the failure of key businesses, declines in consumer wealth, and commitments by the government through the use of bailouts and favorable tax policies. Many economists have debated about the role of accountants in the financial crisis. More specifically, some economists have tried to pinpoint the role of auditors. Some economists argue that the lack of transparency in companies' financial statements led to the financial crisis. Many companies and banks reach collapse or are nearly there because of weak financial audits. Indeed, one can say that financial auditors should have been much more involved in the prevention process. However, had auditors not been around, the financial crisis would have been even worse. This paper aims to explain the role of auditors in the economy and how they help to mitigate the financial crisis.
Auditing has played an important role in mitigating the effects of the current financial crisis. Had auditing not been around, the financial crisis would have been even worse.
Cause of the Financial Crisis
In order to better understand the role that auditors play, I will first briefly explain the series of events that lead to the crisis. The most immediate cause of the financial crisis was the bursting of the housing bubble. Between 1997 and 2006, the price of the typical American house increased by 124%. In pursuit of the American Dream, homeowners were purchasing homes that they could not afford. To make matters worse, mortgage brokers were giving out sub-prime mortgages and even liar loans. Liar loans refer to loans given for borrowers who have an unstable source of income, or have difficulty producing asset verifying documents, such as prior tax returns.1 Subsequently, banks would purchase these subprime mortgages from brokers in order to resell them to investors. In essence, all the parties involved were passing down the risk to the next party in line. However, these parties only benefited in the short term. In 2007 housing prices began to decline. Investors no longer wanted to purchase the securities from banks. Banks and investment companies, mortgage brokers, and homeowners were stuck with assets that were dramatically losing value. Consequentially, housing prices declined and unqualified borrowers defaulted on their mortgages. This series of events caused the downward spiral in the value of mortgage related assets to drop even further.
Furthermore, FASB released FAS 157 to define fair value, to establish a framework for measuring fair value in generally accepted accounting principles (GAAP), and to expand disclosures about fair value measurements.2 Prior to this Statement, there were various inconsistent definitions of fair value and very little guidance for application. By developing this Statement, FASB sought to increase consistency and comparability in fair value measurements and to expand disclosures about fair value measurements. FAS 157 defines fair value as the price of selling an asset (an exit price) and not the price of acquiring an asset (an entry price). This statement also emphasizes that fair value is a market-based rather than entity-specific measurement.3 This method of accounting measurement exacerbated the collapse of the economy by causing a "death spiral", in which the value of mortgage related assets fall.4 Firms holding mortgage-backed assets must mark these assets down to the market value, and consequently, as these firms try to sell their mortgage backed securities, the value of the assets fell even more.
Another cause of the crisis was the government's increasingly leniency in regulating commercial banks. This can be seen from the repeal of the Glass-Steagall Act of 1933. This act allowed the Federal Reserve to regulate interest rates in savings accounts and prohibit bank holding companies from owning financial companies. The repeal of the Glass-Steagall Act effectively removed the separation that previously existed between Wall Street investment banks and depository banks and partially caused the collapse of the subprime mortgage market that led to the current Financial Crisis.5 The government's increased leniency put more responsibility on auditors to prevent or detect any potential fraud. In other words, regulators passed down their responsibilities to the audit profession, which has become the "scapegoat" in many cases. Some economists ascribed the financial crisis to weak financial audits. For example, Accountancy columnist Emile Woolf has argued that "[auditors] have contributed to the crisis by accepting directors' "mark-to-market" valuation of trading assets, when â€¦those directors (i) hadn't the remotest clue what was in the mortgage they had acquired; (ii) were utterly bemused by the nature of the complex derivatives on which their asset valuation rested; and (iii) knew that there was no market to "mark" to."6 The rest of the thesis aims to explain the audit profession's role in the financial crisis.
History of Auditing
In order to better understand the role of auditors in the financial crisis, I will first investigate the history of the profession. The recent global economic meltdown has revolutionized the business world and placed new demands on accountants. More evidently, the role of auditors has evolved. This is partially due to the fact that the rules of business have changed, and accounting is more important in our society than ever. Auditing services are currently provided to a large number of business and government units, suggesting that the services themselves are valued highly by consumers. Statistics show that right before the Securities Exchange Acts of 1933 and 1934, 82 percent of firms trading on the New York Stock Exchange were already audited by CPA's.7 Even today, unregulated segments of the economy are voluntarily audited.
The history of audit extends far beyond the emergence of the SEC. Audits are identified as early as 500 to 300 B.C. in Athens, where the Greek city-state revenues and expenditures must be verified by the state accountants.8 Later, the auditing profession developed in Italy as a way of maintaining accountability of ships with riches returning to Europe from the Old World. In 1066, after the Norman Conquest, merchant guilds started to appear in England.9 These guilds sought to protect the prosperity of the merchants. The guilds were the earliest examples of incorporation. Gradually, the merchant guilds began to require annual audit for the benefit of the merchants. The auditors were selected from guild members.10 Even back then, auditors had ample reasons to be independent. They would be heavily fined for not completing the audit in a timely fashion, or if the quality were below a certain level.11 Nonperformance would also negatively impact auditors' reputation, and could possible cause auditors to lose their guild membership and share of the guild's monopoly profits. In other words, the guild auditors all owned property. In the case that they neglected their duty, the guild could easily recover damages against them.12 This provided auditors with further incentives to be independent and report any contract breach they found. Later the use of an audit committee became a popular method to encourage high performance and independence. It reduced opportunities of collusion between manager and auditors.
During the Industrial Revolution from 1500 to 1850, auditing expanded as a profession. In fact, in 1844, Great Britain formalized the already common practice of voluntary company audits.13 Directors were to keep accounts and have them audited by persons other than the directors or their clerks. Interestingly, auditors were required to be shareholders, a practice that today would certainly violate the independence criteria. This perhaps was done to financially incentivize auditors to act in the best interest of their clients. Furthermore, the auditors needed not to be outsiders, or even be a professional firm.14 Going forward, the 1933 Securities Act required corporations subject to the act to have audits by independent certified public accountants. At that time, many U.S. audit firms were started by British chartered accountants who came to the United States to audit American companies selling securities in London.15
This overview of the evolution of audit demonstrates that audit persisted through time in unregulated environments. Over time, the substitution of professional auditors for shareholder auditors occurred in both Britain and America even though the law made no such requirement.16 This trend suggests that the market forces were changing the demand for audit. As market forces changed, so did the nature of audit. The persistence of demand for auditors suggests that audit brings value beyond regulatory compliance.
Factors that Cause Audits to be Necessary
The Committee on Basic Auditing Concepts presents four conditions that create a demand for auditing. The four conditions are: conflict of interest, consequence, complexity, and remoteness.17 Conflict of interest refers to conflict between information preparer and a user due to potential biased information production and presentation. Consequence refers to the fact that all information can be of great value to a decision maker. Complexity refers to how expertise is required for information preparation and verification. Remoteness points out the disadvantage that most information users face: that they are frequently prevented from directly assessing the quality of information.18
Audit demand is influenced by factors related to the size and complexity of the organization. As the structure of an organization becomes more complex, the legal liability that directors assume also increases. Demand for audits also increases as the number of corporations in the market increases. The increased complexity changes the nature of audit. Auditing becomes more specialized to meet the demands of various industries. This specialization also enhances the growth of professional firms.19 In any organization, there are multiple stakeholders that endogenously influence the demand for controls. Each group of stakeholder has its own objectives; some may be unique while others may be shared. Shareholders' conflicting objectives increase risk, which drives demand for control.20
Another source of risk comes from information problems. Information contributes to the functioning of the economy. A lack of solid information can weaken a market's efficiency. Remoteness of information, biases and motives of the provider, voluminous data, and complex exchange transactions all cause information risk to arise.21 Some economists believe that information asymmetry contributed to the financial crisis and the recession. This can be seen from the "lemons theory". This theory points out the damage that can be caused by information asymmetry, which occurs when the seller knows more about a product than the buyer.22 In a market where quality is unobservable, buyers do not know the quality of the product they are buying and therefore will not pay the high price that would be required for a high quality product. Consequently, sellers will refuse to sell high quality products because they know that they cannot receive a fair price for the products. This causes the market to reach an equilibrium where only sellers selling the worst quality products are willing to trade and only buyers interested in buying the lowest quality product are willing to buy. This is an inefficient outcome. During the financial crisis, the market for mortgage backed securities became a "market for lemons" when the quality of mortgage backed securities was called into question. It was difficult for investors to distinguish between high quality mortgage backed securities (those backed by conforming home loans) and low quality mortgage backed securities (those backed by subprime home loans). Therefore, market prices used in fair value valuations were trades of the worst quality mortgage backed securities, just as predicted by lemons theory.
On one hand investors want as much information as possible, yet in many situations they have reason to doubt the quality of the information. Assurance service improves the quality of information for decision makers.23 An audit promotes confidence and reinforces trust in financial information, especially during a time of financial crisis. This can be demonstrated using agency theory. In a corporation, an agency relationship arises when the shareholders (principal) engage management as their agents (or steward) to perform a service on their behalf. In order for this process to happen, the principals must delegate decision-making authority to the agent. This sharing of risk and delegation of responsibility and authority helps to promote an efficient and productive economy. On the other hand, such delegation also means the principals need to place trust in the agent and assume that the agent will act in the principals' best interest. The dilemma arises when the principals become concerned about the motives of the agent and question the trust they place in them. The delegation of responsibility and authority inevitably leads to some form of information asymmetry. As a result of information asymmetry and self interest, principals can lose their trust in their agents and may try to mitigate potential harm by using mechanisms that would coordinate the interests of agents with principals and to reduce the extent of information asymmetries and opportunistic behavior.24 An audit is one mechanism that can reduce information asymmetry. It aligns the interest of the principals and agents and assures that the financial statements are fairly presented.
A recent survey by The International Federation of Accountants (IFAC) and The Banker magazine confirms the role of audit in reducing information asymmetry. The survey was conducted on global banks that to small and medium-sized enterprises (SMEs) in order to better understand how the accountancy profession can best support both SMEs and lenders. The survey shows that lenders highly value audited financial statements. In fact, two-thirds of the respondents indicated that their lending policies require some form of assurance on the entity's financial statements from an external accountant.25 In addition, another 60 percent of respondents said that auditor involvement in an SME's business would significantly and positively influence their lending decisions. The survey results confirmed the critical role that auditors play in reducing information risk that influences lender decision making.
Literature in accounting has utilized the "insurance hypothesis" to highlight the increasing importance of audit.26 This hypothesis argues that managers and other professionals look to auditors as a source of insurance. Nowadays, auditor's involvement is so ingrained in a society that the absence of attestation may be interpreted as negligence or even fraud on the part of management. In general, management becomes the ones to be blamed in the event of financial loss from business failure, misleading disclosure, or any overall poor performance. Auditors provide protection from business risk of investment since the courts tend to assume that the auditor is the guarantor of the accuracy of financial statements.27 As mentioned earlier, higher risks lead to higher demand for insurance, and auditors become the best sources of insurance.
Role of Audit in the Crisis
In the previous section, I have pointed out the importance of audit in the modern capital markets to reduce information asymmetry. The crisis would undoubtedly have been worse were it not for auditors. However, auditors did make mistakes during the recent financial crisis. An auditor's role is not to predict the future but to ensure that companies' financial statements give a true and fair view of the fiscal year performance.28 As L.J. Lopes of the Appeal Court famously states in ReKingston Cotton Mills, the auditor is "a watchdog but not a bloodhound".29 The primary role of auditors is to determine if an entity's financial statements are free of material misstatements. Their role is not to detect fraud, but to determine if the company's financial statements are true and fairly presented.30 In order to accomplish this, auditors must have an accurate understanding of asset valuation. However, many auditors failed to recognize the bad lending practices that led to the housing bubble and collapse.
Furthermore, the audit process is increasing its use of the check list method. Whereas this approach helped to determine if loans were recorded, it did not force auditors to look beyond the given number to test the validity of the numbers. In the process of understanding the business, the auditors should have realized that this type of lending practice did not have a solid foundation. Many of the companies that received an unqualified opinion may not have deserved a clean opinion upon closer examination. However, since the financial statements of those companies were "fairly presented" according to Generally Accepted Accounting Principles (GAAP), their lending practice flaws were not brought to light. Audits might have been a better lever to prevent the wrong course of some companies' financial situation if its professional standards were more effectively applied. The economic and financial world needed more transparency in revealing the basic of financial information.31
Recently, many rules and standards with regard to accounting activity and reporting systems were issued. The International Federation of Accountants (IFAC) issued the International Standards on Auditing (ISA) to provide guidelines to financial auditors. To assist professional accountants in addressing issues related to the global financial crisis, IFAC and the International Auditing and Assurance Standards Board (IAASB) have mainly focused on three activities: to increase awareness among preparers and auditors of existing and newly developed guidance that can assist them in reporting on financial instruments; to encourage further convergence in reporting standards on financial instruments, while at the same time strongly supporting (the continuation of) fair value accounting since reducing transparency is not in the interests of investors; and to participate in and promote discussions of best practice with respect to the audits of financial institutions and other organizations that are affected by the current crisis.32 Concurrently, many countries have issued recommendations to all economic and financial organizations on improving their accounting system by enhancing transparency. But more importantly, these recommendations and guidelines need to be applied consistently to be fully effective. Many problems encountered in the audit professions do not arise from the professional standards themselves, but rather, how they were applied.
Just recently, the House of Lords Economic Affairs Committee has called for a broad investigation of the UK audit market. It accuses bank auditors of being "disconcertingly complacent" about their role in the financial crisis. The auditors' defense is that their audits of major banks are "legally sound and that [they] are not in a position to raise alarm in markets about their clients' business models.33 It appears that the auditors have carried out their duties properly in the strictly legal sense. But in the wider sense, they did not do so.34 The committee points out auditors' complacency as a contributory factor to the banking meltdown. Their criticism draws attention to the disadvantages of the box-ticking approach to audit. This approach enhances efficiency but not so much effectiveness. It makes an audit rigidly mechanical and formulaic.35 Auditors exert tremendous efforts to box-ticking rather than actually checking the validity of client's business. Their attention is easily constraint by the instructions on a checklist. Therefore, the audit system needs to be strengthened to the extent that prudence is reasserted as a guiding principle for auditors.
The current crisis and global shift has brought on new demands for auditors. Consequently the role of auditors needs to change. Auditors should look beyond the numbers presented on financial statements and spend more time assessing whether the company is doing sound business. As mentioned earlier, sub-prime lending obviously lacked business validity, yet auditors still gave clean opinions. But regardless of the flaws of the auditors, no other professions could have done a better job in determining whether a company is doing well. Auditors have the knowledge and experience to perform the necessary tasks. Above all, they are independent, which enables financial statement users to trust the validity of the information presented.
Audit is an old and powerful institution. It reduces information asymmetry and improves the quality of information for decision makers. Modern financial markets could not function without it. Despite these benefits, auditors made mistakes during the recent financial crisis. The "box checking" approach is a mistake that prevented auditors from recognizing bad lending practices. Had they been more conscientious, they could have called into question the bad lending practices that led to the housing bubble and crash that precipitated the crisis.
The auditors' defense is that their audits of major banks are legally sound and that they are not in a position to raise the alarm in markets about their clients' business models. It appears that the auditors have carried out their duties properly in the strictly legal sense. However, in the wider sense, they did not do so. (House of Lords, 2010-2011, P40) The committee points out auditors' complacency as a contributory factor to the banking meltdown. Their criticism draws attention to the disadv
antages of the box-ticking approach to audit. This approach enhances efficiency but not so much effectiveness. It makes an audit rigidly mechanical and formulaic. Auditors exert tremendous efforts to box-ticking rather than actually checking the validity of client's business. Their attention is easily constraint by the instructions on a checklist. Therefore, the audit system needs to be strengthened to the extent that prudence is reasserted as a guiding principle for auditors.