Volume 24, No. 8: Can Regulators Make Audits Matter More? Three Proposals Offer Some Hope

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Investors care about the inputs to earnings: the revenues, the costs of production, and the taxes. They’ll agonize over changes in the cost of wheat, or steel, or labor, and torment their earnings models endlessly to calculate the effect of an input’s price change on earnings per share. Usually, there isn’t clear visibility into what the inputs may be in the first place; auto makers, for instance, don’t divulge the tons and dollars spent on steel each year. Consulting firms don’t release the different classes of employees, with pay rates and head counts. In the end, many investors and analysts are simply making educated guesses about the different inputs and the effect of price changes on them.
There’s one input incurred to directly benefit investors, yet they rarely examine it – and that’s the cost of the annual financial statement audit. It’s an important function that engenders confidence in the financial statements and the capital markets, a function nobody misses until it’s too late – like in the early 2000’s. Investors don’t pay attention because it’s not like audit fees are so great that they put earnings at risk; you don’t hear of companies missing earnings forecasts because of “unexpected increases in audit fees.”
One reason investors care little about fees is the auditor’s opinion itself. The auditor’s opinion is the financial reporting equivalent of a horseshoe crab – a living fossil, little changed since prehistoric days. The auditor’s opinion has changed little since the 1940’s – almost the Stone Age given the pace of change in the investing world. Essentially a rubber stamp, the audit opinion says nothing about the work and thinking behind it. Three early-stage proposals from the Public Company Accounting Oversight Board and the Securities & Exchange Commission might provide much more quantitative information about the audit and make investors take notice.

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