PREVENTING AUDIT FAILURE - The Limit of Rules and Regulations

PART 5 of A Letter to My Profession V - THERE IS NO CURE FOR AUDIT FAILURE

Here I am continuing the discussion on the polythematic issue of audit failure.? You will recall that in the earlier parts of this progressive serial article my position is that “there is no cure for audit failure.”? So why continue the discussion?? There are many reasons, but the main ones are that we should get used to failure because it is not avoidable.? I do not mean getting inured to failure as to tolerate it is pathologies.? I mean that failure should not shock our sensibilities to delirium and cause learning disabilities when we catastrophize it.? Confident discussion of audit failure will help us embrace it (not condone it), analyze it and improve as we learn in our ever-changing world.? Continuing this conversation is important for adjusting the doxastic states of the profession, for example, to start viewing audit failures through the prism of psychological safety and understanding that it is as an obligatory loss characteristic of the high metabolism in the cauldron of our system of markets.

Accounting/auditing is a confident profession.? We have courage to be different, a quality that helps us stand up for what is right even when unpopular.? It is one of the reasons that societies and the markets have enduring trust in audit and auditors, though not popularly spoken about. Therefore, we should not reproach our profession with being timorous in the face of failure, and yielding to the pacifying illusion that rules and rules and more palimpsest of rules with years of desuetude will cure audit failure.? I am by no means diminishing the indispensable role of rules and rulemaking in a functioning society.? I only know that nothing in the history of humanity suggests that problems like audit failure can be cured by abstract rules.

In this section I am looking at the promise of rules as a cure to failures.? My conclusion is that rules will not cure failures.? We should make rules to help us reduce the “noise” that cause failure and to be alert and attending to avert and catch predictable failures.? According to Kahneman (2021),[1] “rules have an important feature: they reduce the role of judgment … noise is always a product of failure to issue rules.”? In the human systems, there is nothing we can do about obligatory failures and vagarious residual failures.? Without them progress might stagnate, meaning that failures are part of our learning society.? Pretending that audit could be perfect is not helpful. Perfection and inerrancy are not measures of the verity of any professional practice, certainly not for audit.

To be sure, rules are necessary for society to function orderly.? In the absence of rules entropy sets in towards anomie and collapse.? From a control perspective, rules exert “purposive influence” on people and institutions of society, steering them towards desirable goals.? The significance of rules is not arguable.? However, rules need to be purposeful, relevant, measured, formative and adaptively corrective.? Rules should not simply be the result of automatic, impetuous reactions to pain.? When that happens societies run the risk of over-regulation which creates unexamined burdensome rules that lack efficacy.? Therefore, we need to also always examine the logic and economics of rules, the social impact of rules, the political impact and overall societal burden implicit in the rules we make.

However, we must admit that it is human inclination to make rules as often as there are troubles; rules are event-driven sometimes without considering if a rule was the necessary solution. The eminent law teacher Bayless Manning (1982),[2] alluded to this human tendency when he wrote thus:

“every expert, in every field of endeavor, when confronted by a problem, is seized by an urge to elaborate … With the best and purest of professional motives, we invariably propose elaboration as the answer to any problem.? We elaborate legal propositions in a dedicated pursuit of virtue, always seeking … to exorcise the demon of ambiguity … we enjoy doing it – as professionals, we relish the challenge to erect elegant logical structures that will ‘solve’ the problem.”

Manning describes our human tendency to make rules – for every problem, erect a regulation, and more of it, to solve the problem.? We do it without sufficiently thinking about the human elements, the people that make the rules, the people that enforce the rules and the people that are affected by the rules.? In the urge to make rules as a reaction to pain we tend to forget that abstract regulations cannot solve problems, only people can.? This is perhaps one of the major root causes of the failure of regulations generally.?

Accounting is one of the regulated professions now, since after the era of self-regulation.? But years of failure-driven regulation is leading us towards a tendency for over-regulation that rule-makers hope will cure audit failures by putting the system on putatively autonomous, self-executing over-broad rules and regulations that ignore practical wisdom and human judgment and decision making.? What has resulted is a “defensive society” that has bred “avoidance” experts helping organizations and individuals focus on finding loopholes to avoid micromanagerial rules and regulations, instead of solving real problems of the society.? People are no longer thinking of how to do things the right way but how to live with regulatory overload and its burdensome paperwork by deking the system - providing compliance readiness advisory support services is now a career in the avoidance industry.? In the United States there came to be so many rules creating heaps of untraceable papers all over government that the Paperwork Reduction Act was passed, “designed to reduce the total amount of paperwork burden the federal government imposed on private businesses and citizens,” (Wikipedia, 2023).[3]? Regulatory compliance overload burden drains energy and productivity from both auditors and auditees.

Accounting standards, auditing standards and financial market regulations have over the years formed a palimpsest of rules that sometimes are difficult to track and comply with, some have literally fallen into desuetude and obscurity but because they are still in the books (and not specifically repealed) they continue to bear as compliance overload. A lot of the rules are event-driven, such as when the collapse of Enron generated the Sarbanes-Oxley Act in the United States.? In recent times the PCAOB announced proposed rules that will expand the responsibilities of auditors, perhaps in reaction to recent banking collapses.? The proposed rule would expand audit responsibilities to the effect that the “obligation includes a responsibility to identify and evaluate information indicating that noncompliance with laws and regulations, including fraud, has or may have occurred and to make appropriate communications to management and the audit committee about such information.”? To fulfill the audit remit implicit in this patently overbroad rule proposal would require auditors to perform executive roles in the client business amounting to conflict of auditor-auditee roles by desegregation.? It would also expose auditors to “indeterminate liability,” a notion that was rejected by Judge Cardozo in the Ultramares (1932)[4] case.?

According to the Financial Times (Foley, 2023),[5] “the world's largest accounting firms are fighting to block new rules in the US that would force them to take more responsibility for rooting out fraud at the companies they audit.? With days to go before the end of a consultation period on the proposal from the Public Company Accounting Oversight Board, they are trying to sign up their clients to oppose the plan, saying that audit fees will soar if the changes go through.”? Notice in this reporting that the new rules want auditors “to take more responsibility for rooting out fraud.” ?Rooting our fraud is a weighty and decidedly invasive administrative activity. How can auditors do that without engaging in executive roles in the entities they audit?? The profession is opposing the rules on the grounds that “proposed amendments would expand the auditor’s role to include knowledge and expertise outside their core competencies, … will substantially increase the cost of the audit without a commensurate benefit.” The main argument against these new rules should be their draining impact on auditors’ role and effectiveness, particularly diminishing independence.? We should not be worried about the cost of audits that can be handled by market forces.? It is a weak self-advocacy to advance the audit fee impact case.? In my opinion, a big issue like overbroad rules should not be approached with audit fee minimalism that does not impact public interest as much as the larger issue of making an overbroad rule that could bumble the profession to ineffectiveness with untoward consequences for the markets.? A better argument is that rules and regulations are correctives that exert purposive influence on society and its individuals and institutions, therefore, they ought not become onerous and discomfiting disutilities. This concern is seen in the thematic sentiment of Howard’s (2011)[6] argument that law might suffocate a society unless rationalized. It happens when the effectiveness of rules and regulations are hobbled by overbroad stretch and invasiveness that enervate the potential of rules, making them counter-productive to the stated objectives. Such regulatory inefficiencies do not promote the improvement of human judgment necessary to improve audit.? Howard argues that “human judgment is essential to success in government, as with any other life activity.”? Accounting and audit regulation should not ignore the truth that law, rules and human judgment and good conscience must conjoin to produce public good. ?

One of the authoritative voices in corporate governance that opined on a cure for Enron-style audit failure is Professor Jay Lorsch (2002),[7] the organizational theorist of Harvard Business School who, after Enron collapse, said that the situation “cries out for legislation to create an independent, self-regulatory organization to oversee accounting firms.”? In that year the US congress passed the Sarbanes-Oxley Act (SOX) that established the Public Company Accounting Oversight Board (PCAOB).? It is noteworthy that the SOX did not aim to cure audit failures.? The US Congress (2002)[8] in passing the law creating the PCAOB stated the measured purpose of the rule as “to protect investors by improving the accuracy and reliability of corporate disclosures …"? The purpose was not to cure audit failures, nor to make audit perfect. The evidence in the two decades of SOX shows that there have been some improvements in the journey of corporate reporting, but not perfection.? We are still inundated with stories of corporate failures, easily labelled audit failures.? These putative audit failures need to be addressed pragmatically at the root causes.

Since rules cannot be implemented by themselves, audit reform efforts should also consider the human elements of audit failure and how to address them, starting with separating the failings of governance and management from the failings of audit.? Law is limited by the degree of compliance by people.? If a people are not going to obey laws, or are going to find ways around it, the laws will be ineffective.? Therefore, good rules and laws must consider how to get people to be compliant, such as creating a conducive social context, for the greater good.? According to Stout (2011)[9] the instrumental question is “how to combine law and conscience to influence behavior … law, after all, is mostly about promoting unselfish prosocial behavior … The vast majority of people are willing to sacrifice to follow ethical rules and help others, but they are only willing to do this when the social conditions are right.” Making more rules to solve problems may be a natural inclination. But we need always remember what Howard (2011)[10] said, that “only people, not rules, can make good things happen.”? So any reform that ignores the reform of people will not be sufficiently effective.

With rising social anomie and polarization in society, individuals become more egoistic.? It is in this environment that auditors live and work, and it is impossible to completely insulate them from the consequences of the formative influences of the social environment. Rulemaking needs to become more instrumental in promoting prosocial behavior.?? Efforts to reduce audit failures must include deliberate attention to auditors.? We need to recognize their humanity and its fallibility.? Restoring high trust, the social capital of the auditing profession, will increase compliance with rules and regulations.? Concluding that “law can help develop conscience,” Stout (2011) opines that:

“a healthy, productive society cannot rely solely on carrots and sticks.? It must also cultivate conscience, and tap into the human potential … to ethically refrain from harming [others] … the conscience is the cheapest and most effective police force [read as most effective regulator, emphasis mine] one could hope for.”?

The demon of audit failure cannot be exorcised by mounting regulations.? As the Igbo people of Mbaise town in eastern Nigeria say, “nguchi uzo anaghi ahi amba mmoo.”? The sentiment of the proverb is that running into a room or closet and securely locking the doors does not protect you from the evil spirit.? To alleviate audit failure needs profound improvement of auditors, not just constraining auditing rules and systems. We need to regenerate the ethical Zeitgeist of the profession and rehumanize the auditor, with emphasis on ethical intelligence and competence for financial reporting decisions.? Lockdown rules will not save the markets from the demon of audit failure.? Rule makers, auditors and auditees should shift focus from return on investment (ROI 1) to return on integrity (ROI 2).

Nevertheless, it behooves the profession to raise a magisterial voice in self-advocacy and explain very eloquently to society, from a public interest perspective, that overbroad rules that stretch auditor responsibilities will be harmful to the public interest in several ways. As already noted by the PCAOB and other regulators around the world, audit is grappling with performing basic audit steps properly; now it is being squeezed into Procrustean rules that will require expertise beyond our traditional training.? Our argument should be reframed to show the risk to the protection of public interest of foisting overbroad rules on auditors and the profession.? That public interest perspective should resonate with the public more than framing our argument around safeguarding and minimizing audit fees.? In my opinion, audit fee security is not how the accounting profession should frame its case against overbroad rules that expand the spectrum of audit duties: it should be that the procrustean rules undertow progress, and not communal for the common good.

A look at major audit failures shows me that we do not need new rules or high expertise to avoid “missing basic audit procedures” that result in the failures – basic booking knowledge and expertise could help an auditor perform basic audit procedures like verifying bank accounts.? According to Jacobs (2004),[11] “a vigorous culture capable of making corrective, stabilizing changes depends heavily on its educated people, and especially upon their critical capacities and depth of understanding,” and not on rules. We need to recognize the limits of rules and regulations in addressing audit failure.? We need to recognize the role of human judgment and expertise; we need to improve our judgment and decision-making capacity.? We need to learn how to operationalize our judgment intelligence continuously in action to notice and avert basic errors that precipitate huge adverse audit consequences. Making more and more rules without figuring out what is wrong with auditors that is making them fail basic audit procedures frequently will be like a doctor increasing the number of prescribed medications to treat the side effects of earlier prescriptions and the vicious cascade continues. ?We need to understand the forces affecting auditors today, we need to critique our entire audit armamentarium (including our skills and personalities), we need to improve the human element, not just rules, to minimize failures.

Finally, no one should think that an unruled accounting regime is an option for society.? Nevertheless, an overruled regime, resulting in defensive pretentious compliance surrogation, is a prescription for more audit failures.

As I lead this conversation with your peer reviews, I will next be thinking in the direction of what novel steps should be taken to improve audit further and minimize failures.? I am not thinking of a cure for audit failure because it does not exist while our system is operational. ?Only dead systems can have cure for audit failure, namely, the death of the systems.

[1] Kahneman, D., Sibony, O., & Sunstein, C. R. (2021). Noise a flaw in human judgment. Little, Brown Spark.

[2] Manning, B. (1982). HYPERLEXIS AND THE LAW OF CONSERVATION OF AMBIGUITY: THOUGHTS ON SECTION 385.?The Tax Lawyer,?36(1), 9–15. https://www.jstor.org/stable/20768441

[3] Paperwork Reduction Act - Wikipedia

[4] Ultramares Corporation v. Touche, 174 N.E. 441 (1932)?

[5] Foley, S. (2023, July 31). Audit firms fight to block expansion of fraud detection role . Financial Times.

[6] Howard, P. K. (2011). The death of common sense: How law is suffocating America. New York, NY: Random House Trade Paperbacks.

[7] Lorsch, J. (2002). A cure for Enron-style audit failures. Retrieved August 5, 2023, from https://hbswk.hbs.edu/item/a-cure-for-enron-style-audit-failures

[8] United States Code (2002). Sarbanes-Oxley Act of 2002, PL 107-204, 116 Stat 745 Codified in Sections 11, 15, 18, 28, and 29 USC.

[9] Stout, L. (2011), Cultivating Conscience: How Good Laws Make Good People, Princeton University Press: Princeton, NJ

[10] Howard, P. K. (2011). The death of common sense: How law is suffocating America. Random House Trade Paperbacks.?

[11] Jacobs, J. (2004). Dark age ahead. Random House Canada.