Why Audits Fail - PART 3 of A Letter to My Profession V: THERE IS NO CURE FOR AUDIT FAILURE

We will continue to search for the reasons why audits fail.? Over time the reasons will change, and new ones arise as society itself changes.?

Our generation knows the scourge of audit failures and financial crises from the 80s decade, including the 2008 global financial crisis.? But what piqued my interest in audit failures was the collapse of Barings Bank, a 261-years old entity renowned for “a conservatism that was deep and inert,” (Fay, 1997).[1]? At the time I was invited to speak at the Bank Directors’ Annual Conference held at the NICON Hilton Hotel, Abuja, Nigeria, where I shared my perspectives on the potential role of sedulous controls in preventing audit failures like Barings Bank – I hinted at the incurability of audit failure though, a phenomenon that we will continue to grapple with.? Ever since I have developed a keen interest in understanding why audits fail and failures generally, to the point of perhaps having become a student of failures.? Based on experience, from the perspective of accounting and financial reporting, I have decided that audit failure, unarguably, has no cure.? This is contrary to promises (some unwitting) made by auditors and regulators that audit failure can be prevented.??

Audit failure is multi-factorial.? Accounting literature and the media are replete with reasons why audits fail, such as:

·?????? Inadequate audit procedures due to ineptitude and insouciant incompetence

·?????? Insidious furtive errors and irregularities

·?????? Management collusions for which there are no controls

·?????? Brute force misstatements by stewards, with audit complicity or apathy

·?????? Also, “audit failures are the natural product of the audit-client relationship”[2]

Inadequate audit procedures may be the result of incompetence; it is professionally unacceptable.? We have seen reckless incompetence, insouciant incompetence, and incompetence because of lack of opportunity for empowering training.? Of these, the first two are unconscionable and would usually get the attention of the ethics committee of the profession. Audits also fail for predatory reasons, mostly corruption.? This happens when auditors connive with managers to falsify financial statements to achieve predetermined objectives.? Predatory failures are egregious and could be criminal. Brute force misstatements buck accounting and audit rules impudently and deke auditors.? Reckless, insouciant incompetence is professionally and morally unacceptable.? We have always had audit failures but because they were mostly in the normal bearable range the markets did not buckle.? Today we have a feral market with psychopaths, economic jackals, and economic mercenaries whose predatory motives induce and exploit audit deficiencies.? They decidedly buck accounting rules and regulation, and pressure, deke and deceive auditors for their greedy interests.? Auditors should not be unwary of this state of the market when planning client engagements.? Audit should not be on their side but on the side of the public interest where civilization inhered the role of audit.

A recent PCAOB report shows that 40% of audit contained errors and the reasons include “failures to execute the ‘basic audit steps sufficiently.’”? This is not different from what happened in the case of Kingston Cotton Mills (1896)[3] in which the auditors failed in basic audit steps of verification of inventory certificate issued by the company’s officers.? Failing basic audit steps is not new to auditing – 126 years after the Kingston Cotton Mill case audits are still failing for missing basic audit steps.? PCAOB chair Erica Y. Williams (2023)[4] said, aptly, in a recent press conference that this is “completely unacceptable,” and we ought to agree. What is interesting in this report is that one might expect that audits fail with a bang.? Now we know they fail with cumulative thuds and whimpers as basic audit procedures are incompetently missed.

It has been found that failure to executive basic audit step resulted in the audit failure that led to the collapse of Lincoln Savings and Loan collapse?in 1989.? According to Erickson, Mayhew and Felix (2000),[5] “the main conclusion of our analysis is that the most significant shortcoming in the LSL audit was the auditor's failure to obtain?and?use knowledge of LSL's business, the industry in which it operated,?and?the economic forces that influenced this industry/business. It is our view that had the auditors obtained this understanding?and?applied it to an evaluation of the substance of LSL's main source of profits during this period, sales of undeveloped Arizona land, the auditors would have reached different revenue recognition conclusions.”? Obtaining knowledge of business is a basic audit step that is codified in auditing standards and putatively applied by auditors.? Every audit procedure of accounting firms has that step that says “obtain knowledge of the business,” but doing it and doing it right is a different matter.

Another common failure in audit steps is Bank reconciliation, that basic bookkeeping and audit task that we learn early in accounting lessons and grow to take it for granted.?

In a forum of experienced professionals made up of accountants and auditors a conversation about generational gap in audit efficacy came up and literally everyone mentioned recently encountering auditors who could not competently do bank reconciliation, a classic example of “basic audit steps.”? We are not talking about audit neophytes here. I have personally encountered many auditors who do not comfortably understand double entry principles and could not pass certain transaction journals properly – one passed a journal entry as if he was in the books of a vendor, instead of the books of the buyer where he worked.? In my outreach program to incite young interests in accounting I took along a young chartered accountant.? As I was teaching double entry principles he got confused and said to me, “we did not learn this detail in college;” he couldn’t properly journalize a store receipt we used as an example.?

I have seen an audit done by a team of professional accountants in which the bank reconciliation statement showed large amount of money in/of uncredited lodgments (deposits), but what made it worrying is that the line read “uncredited cash lodgments,” a long list, with some of them over 24 months old when aged.? Basic bookkeeping would teach you that one could not have cash lodgment uncredited by a bank for more than 24 hours unless it was a weekend (just to allow that).? To a trained audit mind, that would be a put-upon-inquiry situation, a coruscating red light telling you clearly that there is fraud here, not just error. But the auditors focused on checking the arithmetics and “balancing the bank reconciliation statement.” Basic bookkeeping teaches us that balancing anything – the trial balance, bank accounts, the balance sheet - is no assurance of proper accounting. Upon investigation of the bank reconciliation statement in question, massive fraud was uncovered that was concealed in the legacy reconciliation item named “uncredited lodgments.”

If I were not in this professional peer group and knew the people talking, and if I had not experienced it myself, I would insist that it was all hyperbole.? But the recent WireCard case now proves it is not hyperbole - it is flagrant egregiousity.? According to Olaf Storbeck of Financial Times of London (2021),[6] “’for years’ EY had failed to request crucial account information from Singapore’s OCBC Bank — where Wirecard claimed it had up to €1bn in cash. Instead, the auditors relied on documents provided by a Singapore-based trustee which have been labelled “forgeries” by prosecutors in the city-state.”? Apparently, they were just doing conversational audit, as in, do you have bank reconciliation, is it balanced, is it the right cut-off date, yes, yes, yes, etc, etc, etc, and then tick mark, tick mark, tick mark and sign offs by a senior, manager, partner, audit quality assurance reviewer, etc. None of these had the keen audit eyes necessary to detect the failure of a basic audit procedure; they also failed in audit judgment, a guardrail for audit procedures.? When basic audit steps failed to detect that the €1bn said to be in the bank account in question was fiction, good audit judgment ought to have prevented that fiction from ending up in the balance sheet. ??The failed basic audit procedure, though a thud, produced a bang in the collapse of WireCard, showing how audit fails with whimpers that we ignore. It is the state of our profession today.

The consensus of my peer group conversation is that we know how we got here with rush-to-solve accounting education and credentialism in which candidates now only read constrained study packs and PowerPoint slides and do electronic questions and answers to become ACA or CPAs, just to get the badge.? In my generation we read tomes of accounting literature that contained the wisdom of accounting (computareprudentia) and the nuances of practice designed to inculcate and imbue accounting knowledge, dexterity, “foresight, wisdom, discretion, sagacity, … and practical judgment or reasoning” into the student.? Starting a career at any medium to large accounting firm began with training sessions, which included giving you a bag containing accounting and audit reference literature that you carried to the field (we had no Internet then). Falling standards in foundation accounting education and training are among the main causes of weakening competence in basic auditing; it represents a vulnerability for audit failure.?

What the above peer group conversation reveals is that there is a lot of low visibility, seemingly immaterial audit failure going unreported, literally a pipeline of looming audit failures waiting to happen. Over time they will accumulate and result in a major audit failure. Audit failure is rarely the result of a one-time event such as a brute force misstatement. It is more of cumulative effects of furtive errors, inefficiencies, irregularities and insouciant incompetence, even when unwitting, that blows up in the face like a volcano.

Also, society has been affected by the scourge of aliteracy and accounting/auditing is not immune to that.? With all the electronic access to information, instant in most cases, we are still discomfited by the endless noises reverberating in the society, coupled with distraction from popular entertainment culture, which combine to make us disinclined to read – that is aliteracy.? According to Pope Francis (2015)[7] “… the market tends to promote extreme …? compulsive consumerism … an unethical consumerism bereft of social or ecological awareness … which makes it difficult to develop other habits. We are faced with an educational challenge.”? Among the “other habits” difficult to develop in modern times are reading attitude and intellectual life, the absence of which result in weak knowledge and expertise.

Equally important is the attitude of the market towards quality audit.? It raises the question “what does the market want?”? Coffee (2019)[8] notes that “the deeper problem that clients (or their managements) may not want aggressive auditing, but rather prefer a deferential and perfunctory audit;” auditors responding in a market sense would like to do what clients want.? Therefore, reform should also be beamed at the market to limit the negative effects of its poor desires on audit performance.

Another culprit is the irrational pursuit of efficiency.? We know that capitalism in all circumstances prioritizes efficiency and profit, not resiliency.? Audit firms pressured by the shortage of accounting graduates and restive audit fees cannot hire extra hands to provide slack in their stable.? The result is that everyone is overworked.? There are studies that show evidence of systemic overworking in the profession as noted in an interview by Deveau (2023)[9] with professor of accounting Merridee Bujaki, co-author of the study:

“The culture of accounting is one that is characterized by long hours. Some talked about putting in up to 100 hours a week during the busiest time of the year. … What is concerning, however, is that we are hearing from people that they had no opportunity for downtime or to reset from these long hours and their work has only become busier and busier. We were told that in some cases, vacation plans are not being respected, and people are expected to be available at any time.”

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Network Rail, the British rail infrastructure managers reported that “when we’re fatigued, we struggle to understand complex situations because our mental capacity is impaired … fatigued people are poor communicators, … take more risks and make poor decisions.[10]? Grissinger (2009)[11] observed that “an exhausted workforce increases the risk of errors.” The profession has been groaning under the pressure of talent scarcity and starvation audit fees for years now.? The overworked few are making multiple audit judgments under pressure, making them vulnerable to avoidable errors, avoidable decision fatigue, that lead to audit failures.

Besides auditors “missing basic audit steps,” or being incompetent, or corrupt, Bazerman, Loewenstein,?and?Moore (2002)[12] asserted another reason for audit failures thus:

“Given the vast scale of recent accounting scandals and their devastating effects on workers and investors, it’s not surprising that the government and the public assume that the underlying problems are corruption and criminality—unethical accountants falsifying numbers to protect equally unethical clients. But that’s only a small part of the story. Serious accounting problems have long plagued corporate audits, routinely leading to substantial fines for accounting firms. Some of the errors, no doubt, are the result of fraud. But to attribute most errors to deliberate corruption would be to believe that the accounting profession is rife with crooks—a conclusion that anyone who has worked with accountants knows is untrue. The deeper, more pernicious problem with corporate auditing, as it’s currently practiced, is its vulnerability to unconscious bias. Because of the often subjective nature of accounting and the tight relationships between accounting firms and their clients, even the most honest and meticulous of auditors can unintentionally distort the numbers in ways that mask a company’s true financial status, thereby misleading investors, regulators, and sometimes management. Indeed, even seemingly egregious accounting scandals, such as Andersen’s audits of Enron, may have at their core a series of unconsciously biased judgments rather than a deliberate program of criminality.? Unlike conscious corruption, unconscious bias cannot be deterred by threats of jail time.”

Auditors today seem to have been taken by the acquisitive spirit of modern society, forsaking their shepherding role that helped nurture modern civilization.? We do not seem to love the shepherding servant role of audit because it lacks the allure and glamor of Wall Street stockbrokers’ highrolling lifestyle.? Auditors are financial information homemakers, shepherds to the market, a leadership role that is sacred, requiring modesty, self-control and measured ambitions.? According to Adair (2010),[13] Prophet Muhammad once said that “a good shepherd guides his sheep, unites them, works for their welfare without taking advantage of them and cares for each individual.”? Whenever auditors abdicate this responsible oversight role and abandon the pursuit of public interest and protection of the client and the greater good, audit begins to fail. This is what happens when soldiers abandon the solemn duties of the army to engage in “commercial activities” of the world – the battle is lost.?

Recalling what Pope Francis complained about, “compulsive consumerism … an unethical consumerism bereft of social awareness makes it difficult to develop other habits.” ?The habits weakened or lacking in society today are the very ones that make ethically diligent auditors who would not lead society to trust the untrustworthy.? The culture that it breeds is a substrate for audit failures.? But when you look at our recent reforms none has been directed at improving the auditor, they all focus on improving rules and regimen.? In a society that values extreme freedom, it is difficult to make rules that direct the personal life of individuals without causing social angst.? My thinking is that progress in matters like this is naturally event-driven.? Before 911 individual privacy was considered extremely sacrosanct, community policing that needed to invade privacy was not tolerated.? Well, 911 was the dynamic.? Society was forced to choose between extreme freedom/privacy, and safety; we chose the later.? Now we live in a literally surveillance society, acceptably, in our own interest.? Perhaps we need big bang audit failure that shocks and shifts our sensibilities to the changes that we need, fundamental changes in the auditor and his dexterity with expertise.? According to De Geus (1997),[14] “when change is demanded for survival … the only way for this to happen is through pain – deep, prolonged pain … The corporate equivalent of pain is crisis. … There is no denying that many a fundamental change had a crisis at its roots.”

I am thinking about what society should learn from failures in other aspects of life such as medicine, engineering, law and justice, whose imperfections have been tolerated by society forever.? Our confident society should be able to tolerate audit failure the way it has tolerated, say, medication errors as medicine progressively improves, and the way it has tolerated death.? What a confident society should do is consider inevitable failures risk calculations.? There is failure in everything, I will talk about these next in this ongoing conversation.

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[1] Fay, S. (1997). The collapse of Barings. New York, NY: Norton.

[2] Bazerman, Max H., Kimberly P. Morgan, and George F. Loewenstein. 1997. The Impossibility of Auditor Independence.?Sloan Management Review?38: 89–94

[3] In Kingston Cotton Mill Co. (No. 2) [1896] 2 Ch. 279.

[4] Shin, R. (2023). 22 years after the $63 billion Enron collapse, a key audit review board finds the industry in a 'completely unacceptable' state. Retrieved July 29, 2023, from https://fortune.com/2023/07/26/pcaob-audit-completely-unnacceptable-error-rate-enron-big-4-consulting/

[5] Erickson, M., Mayhew, B. W., & Felix, W. L. (2000). Why do audits fail? evidence from Lincoln Savings and loan. Journal of Accounting Research, 38(1), 165. doi:10.2307/2672927

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[6] Storbeck, O. (2021). EY and Wirecard: Anatomy of a flawed audit. Retrieved July 28, 2023, from https://www.ft.com/content/bcadbdcb-5cd7-487e-afdd-1e926831e9b7

[7] Pope Francis. (2015).? Encyclical Letter, LAUDATO SI’.? Retrieved June 4, 2023 from https://www.vatican.va/content/francesco/en/encyclicals/documents/papa-francesco_20150524_enciclica-laudato-si.html

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[8] Coffee, J. C. (2019). Why do auditors fail? what might work? what won’t? Accounting and Business Research, 49(5), 540–561. doi:10.1080/00014788.2019.1611715

[9] Deveau, D. (2023). Long hours, deadline pressure take toll on accountants: Study. Retrieved August 12, 2023, from https://www.cpacanada.ca/en/news/accounting/the-profession/mental-health-study

-??????? Bujaki, M., Himick, D., Paquette, S., Touchburn, H., Mawko, J., & Bourgeault, I. (2021). Accountants' Mental Health in Canada: Some Preliminary Findings and Concerns for the Future [Infographic]. Healthy Professional Worker Partnership – Accounting. https://www.healthyprofwork.com/accounting/#preliminary-findings.

[10] Network Rail. (n.d.). Fatigue reduction: How fatigue affects your decision making. Retrieved August 17, 2023, from https://safety.networkrail.co.uk/wp-content/uploads/2021/11/Fatigue-Fact-Sheet-Fatigue-and-decision-making.pdf

[11] Grissinger M. (2009). An exhausted workforce increases the risk of errors.?P & T : a peer-reviewed journal for formulary management,?34(3), 120–123.

[12] Bazerman, Max H., George Loewenstein, and Don A. Moore.?"Why Good Accountants Do Bad Audits."?Harvard Business Review?80, no. 11 (November 2002).

[13] Adair, J. E. (2010). The Leadership of Muhammad: On a Journey the Leader of a People Is Their Servant. London, UK: Kogan Page.

[14] De Geus, A. (1997). The Living Company: habits for survival in a turbulent business environment. Boston, MA: Harvard Business School Press.

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