Are Annual Audits still “Fit for Purpose?”

Editorial Note: We are delighted to present the following editorial column by Nick Shepherd, President of EduVision. Nick currently chairs the CPA Canada Committee for developing Statements in Management Accounting.

As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

Annual reports together with various supplementary requirements and filings are important for boards, investors, rating agencies and others as a foundation to assess and determine the financial health of an organization. Historically this has worked reasonably well; up until the 1970’s most of the corporate value – an average of 80% – was reflected on the balance sheet. If the audit revealed the integrity of assets and liabilities, there was a reasonable expectation that the business was healthy.

Fast forward to today. Most corporate value for owners, investors and others is now intangible with only an average of 15% represented by financial assets. While certain intangibles can be capitalized and included on the balance sheet, the majority are nowhere to be seen, nor are they assessed or reported on through the audit. If an audit is designed to provide reasonable assurance of organizational health and integrity, doesn’t basing this on the verification of only 15% of the value seem high risk?

There is continuing criticism of auditors and the profession for failing to alert investors and others to potential risk when organizations fail – yet how can the profession shoulder the blame when its scope and mandate are determined by compliance with standards that focus principally on tangible assets and liabilities? Apparent failures in oversight and governance approaches are not attributable to the profession alone, but the profession does have a responsibility to reflect on its own role and determine whether the principles that were initially established for audits are still meeting their goals. When significant “sea change” occurs, it requires re-invention rather than improvement. Is society changing the expectations and rules that make an audit relevant? Or are we “re-arranging the deck chairs on the Titanic?”

Customers of the audit profession are increasingly asking for additional information to enhance their risk assessments; this has resulted in regulatory changes as well as voluntary supplemental reporting. In certain jurisdictions, certain supplemental reporting – such as environmental and social issues – are now mandatory. A major thrust is being implemented by those adopting “integrated reporting,” but in most cases, this is not mandatory, audited or based on strongly established standards. A “sea change” it is not! The financial profession does not appear to be front and centre in driving fundamental change, apparently believing that its focus on financial capital remains adequate. Yes, changes are being made, but progress is much too slow; thus, the risk of “surprises” continues to increase.

The profession must start asking some fundamental questions in order to drive governance and accountability changes so that audits are fit for purpose. As a start, let’s consider the drivers of sustainable corporate value creation, and try to “peel back” corporate performance in the areas that might give investors an increased visibility into risk.

From a financial perspective, two sources of cash flow are critical to a sustainable business. First, for most organizations, more than 60% of expenditures are driven by employee costs; yet employee productivity and effectiveness are hard to measure, other than at the macro level. However, we do know that most employee costs are traditionally considered period expenses that convert inputs to outputs.

This is no longer the case, with large portions of employee expense related to building “capacity,” i.e. the contribution of intellectual capital that provides history and process capacity, as well as innovation in process improvement, new products and services, and relationship building with third parties. Only “motivated” employees will do this continually and effectively. To be a sustainable business in the future, the audit should reveal:

    • The overall level of expense committed to employee costs, with a split showing (hopefully) a declining share going into repetitive conversion costs, and a growing share committed to building “intangibles for the future.” Key indicators might also include “strategic reassignments” that give perspectives on whether management is committed to redeploying staff as a result of change versus firing them (which does not create motivation).
    • Levels of employee engagement at a depth of detail that is more than just a general percentage. What is needed is visibility into alignments of individuals, teams and departments with organizational purpose, both in “task” (the work of the business) and also critically in behavior (the stated conduct of the business that is driven by its culture and its understanding of ethical compliance).
    • Leadership effectiveness. Disengagement comes from a gap between what organizations state they do, versus what employees see from leaders. The effective development of internal leadership, accompanied by the results of 360° assessments based on corporate values, would start to identify areas of concern if they exist. It might have been interesting to see what indicators of this type would have shown for some of the banks involved in recent scandals.
    • Focus on “behavioral based” internal controls. Process controls are no longer adequate in an environment where high levels of delegation take place, leading to individual autonomy (this also applies to controls and relationships with third parties. such as outsourcing providers). Stronger reporting is needed on ethical hiring, leadership values and behavior, whistle blowing, levels of employee stress, illness (especially mentally related issues), and other behavioral aspects.

Overall, what users need to know is whether approaches to the workforce are protecting human capital sustainability through effective nurturing and development of people.

The second core cash flow is “cash flow in from customers.” Areas such as retention rates, repurchasing patterns, repeat customers and others are all important, but especially critical are relationships. One factor that could be more fully implemented into annual reporting is the stability of brand value.

The attached table shows 2018 data regarding the year end and most recent brand valuations by either Interbrand or Brand Finance (we used the higher valuation). This table demonstrates that, although the “pure audit” of financials provides insight into book values (i.e. balance sheet / shareholder equity), the shareholders value of their investment (i.e. the market value) is much greater.

Several key questions should be of interest to the investor. Using the traditional audit, is the integrity of the balance sheet acceptable? Is the brand value, as calculated by independent third parties, increasing or decreasing? If so, why? And what is the impact on this for the future? For instance, was a potential “auditable” cause the diversion of human capital resources away from customer support activities to enhance financial capital results? Finally, what makes up the ‘other intangible assets’ that contribute a key part of an investment valuation, but that are not being assessed or audited?”

One key failure of the accounting profession is to grasp and modernize the assessment of goodwill. On a sale or purchase of a business entity, it is the “market value-based intangibles” that end up on the acquirer’s balance sheet that must be assessed for “impairment.” How can an auditor do this effectively if the drivers of this value have not been clearly determined?

As can be seen from the table, book values range from 5.9% of value to 24.4%, and it is these underlying valuations of “financial capital” that a traditional audit discloses. If these are examples of the impact on financial capital of the growing knowledge economy, then one can only conclude that audits that remain focused on financial capital alone are not “fit for purpose.”


Reimagining a More Ethical and Sustainable Management Accounting Curriculum

Editorial Note: We are delighted to present the following editorial column by Richard Kravitz, the Editor In Chief of the CPA Journal. As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

Furthermore, the opinions expressed below do not reflect the position of the CPA Journal, The New York State Society of CPAs, or the Board of Directors or Executives of the New York State Society of CPAs.

The accounting curriculum, while relevant 40 years ago, has lost much of its relevance today in our post-modern global economy. Accounting education fails to account for the real drivers of enterprise growth in the digital economy. This article focuses on the components of value creation within publicly traded multinational corporations. It also addresses how these valued components are all but ignored in the accounting classroom, in AACSB’s model curriculum for accounting education, and by the majority of our accounting professoriate.

Accounting is a practical discipline. It focuses on the application of skills and knowledge that enable practitioners to identify, measure, monitor, control and report on business activities. However, the real drivers of long term value creation within the modern global corporation are no longer measured by these traditional accounting tools. Financial accounting, cost accounting, and managerial accounting methodologies provide little guidance on how to accurately report on the condition and value of global business. Accounting information teaches us very little about great companies whose great products and services drive our postmodern global economy.

Similarly, accounting information ignores the dominant creators of long term sustainable value, i.e. the growth drivers of modern enterprise. Accounting rules even expense many of the value creators, such as reputational capital [brand marketing], intellectual capital [patents, trademarks, business method processes], human capital [talented workforce], social and relationship capital [infrastructure, health, education and safety], and others.

Accounting also does not account for the impact that global corporations have on society. For the past 20 years, organizations such as Ceres, the GRI, the IIRC, the UN Global Compact and others have been looking at this issue. Mervyn King, founder of the IIRC, for example, focuses on the evolution of the corporation from share value to shared values, and from a shareholder centric to a stakeholder centric perspective.

Nevertheless, the average time a shareholder in America owns a US public company, according to Prem Sika in the The Myth of Shareholder Ownership, is 22 seconds.  Even Larry Fink, the consummate Milton Friedman capitalist who heads Black Rock, now suggests a new approach to corporate earnings: “Profits With Purpose.” But accounting does not measure purpose.

Finally, the lack of relevance of accounting information was amplified by luminary NYU professor Baruch Lev in his seminal work, The End of Accounting. According to Lev, “financial information contributes only 4-5% of decision relevant information for investors.” What a loss for accounting relevance.

The Critical Role of Accountants in our Post Modern Global Economy

While our training may be suspect, the role of accountants in society is not. Accountants are even more critically important in today’s global society; they are arguably more important than ever. Indeed, accounting remains a critically important gatekeeping profession.

The obligation of accountants, as its founders passionately argued, lies in their ethical responsibility to protect the public, and to insure public trust. Accountants are the historical stewards and fiduciaries of the public interest. Indeed, accountants protect the public from corporate mischief. They help insure honesty and trust in our institutions. And they report on companies that are too good to fail, too strong to fail, and yes, even too big to fail.

Accounting in a Global Environment – What has changed?

This is not our parent’s world from a global corporate perspective. It is not the world that existed even 40 years ago:

• 52 of the largest economies of the world today are multinational corporations, not sovereign nations.
• The top 2000 companies generate more than 50% of the global GDP.
• The market cap of Apple, at almost one trillion dollars, even after decline, is larger than the GDP of all of the European Union Countries except for two.
• The market cap to book value of the top 5 global corporations is between seventy five to a hundred to one. US Steel, the consummate brick and mortar corporation, on the other hand, still boasts a ratio of market cap to book value of about one to one.
• Walmart employs 2.7 million people, half the population of New Zealand.
• Google uses more electricity than the country of Sweden.
• 85% of the federal government expenditures of the United States are made to corporations, including transportation, defense, and nuclear power firms, as well as various other organizations that now perform tasks that government once performed.
• Today, corporations impact societies and stakeholders to a greater extent than at any time in history.

The Exponential Growth of Intangibles

So why is there such a huge divide between traditional accounting measurements, and between book value and market caps? What has happened during the past 40 years is revolutionary. According to the authors of Capitalism without Capital, the intangible revolution has impacted society far more than the industrial revolution of a few hundred years earlier.

87% of the value of today’s postmodern global corporation [per Ocean Tomo] lies hidden in its intangibles. These hidden assets or strategic resources do not appear on the balance sheet, income statement, cash flow statement or in retained earnings. They do not appear in inventory, goodwill, or tangible long term assets. They do not appear in the pages of accounting texts.

Strategic resources [such as intangible or hidden assets] power society today. Strategic capital drives long term value creation in our postmodern global corporation. Cost accounting texts ignore them, but they are familiar to all of us. These hidden intangibles include knowledge, data, information and ideas. They are the conceptual assets and creators of corporate value today. In fact, the investment in intangibles at 2-3 trillion dollars a year is now the dominant creator of corporate value. Intangibles include intellectual property, patents, trademarks, brands, brand identify, a skilled and talented workforce, business method patents, business processes, and supply chain sourcing.

Financial accountants and auditors hide conceptual assets from the public. They are expensed or hidden from the balance sheet. Conceptual assets are buried in SG&A or Cost of Sales, with the exception of those conceptual assets which are acquired or booked on the balance sheet for financial statement disclosure purposes. This is not deliberate; it occurs because accountants have not been trained to recognize intangibles.

Realigning Accounting Education

Accounting students invest 4 to 5 years of their lives in accounting schools. They hone their skills on traditional financial and managerial accounting techniques while ignoring 87% of the value of the global corporate enterprise. What a loss for accounting’s relevance. What a huge hole, then, that exists in the education curriculum. In future blog posts, I will suggest a realignment of accounting education.

Accounting and the Public Interest

We usually begin our blog posts with a customary disclaimer that our columnists only speak for themselves, and do not express the positions of the AAA or of any other party.

This post, however, is different. Our columnist Amy Hageman does speak for us! She is the incoming Senior Editor of our section’s flagship journal Accounting and the Public Interest (API).

We are delighted to introduce her to our members with this blog post. Welcome, Amy, to your new role. And thank you for your contribution to our Section!

My name is Amy Hageman, and I have the honor and privilege of serving as the Senior Editor of Accounting and the Public Interest (API) for a three-year term, beginning in January 2019 through 2021. API has a rich history of excellent Editors, and currently has an outstanding group of Associate Editors and Editorial Board members. This journal serves an important role in our field – as it is an American Accounting Association (AAA) section journal focusing on socially responsible accounting research. The journal has a history of publishing work from leading accounting academics – and I believe this trend will continue as universities’ emphasis on showing how accounting research positively impacts society continues to grow. I am excited to take on the role of Senior Editor of API, as I want to positively influence the future of this journal by increasing its presence, quality, and efficiency, and in helping to establish API as one of the top specialty accounting journals in the field.

Currently, my primary objective is to build on and expand the tradition of excellent scholarship published by this journal, as well as enhancing the efficient administration of API. One of my aims is to provide guidance to submitting authors to enhance the quality and contribution of their work, as well as working across other AAA sections to identity potential submissions that could further our understanding of how accounting affects the public interest. In short, I am striving to continue the tradition at API of aiming to publish articles across a wide variety of functional areas of accounting using an equally-wide array of methodologies.

These are several opportunities to improve the impact of API. A long-term goal is to see an increase in citations of published articles in API, and for more universities to positively evaluate API in making promotion and tenure decisions. One strategy for potentially increasing the journal’s impact is to consider publishing special issues, which have the potential to increase both readership and citations. One possible idea would be a special issue dedicated to a specific theme. Potential themes could include professional and business ethics, governance of accounting organizations, social and environmental accounting trends, or responsible actions by governmental and non-profit accounting entities. Another possibility would be to devote a special issue to increasing the journal’s impact beyond the United States – such as a special issue on U.S.-Canadian issues, or on accounting issues that are emerging in Europe. Such a special issue may be a way of reaching contributors who may not have submitted to API in the past. Another is to potentially hold a special conference tied to the journal.

Overall, API is an outstanding journal with a rich history and an even brighter future. As I begin my three-year Editor term, my goal is to strive to act as an excellent steward of this journal and to work to further improve both the quality and overall impact of API. Thank you for entrusting me with this role, and I look forward to working together to disseminate public interest-related research in API.

Redefining Audit Quality

During the past two weeks, our contributing columnists Steven Mintz and Sri Ramamoorti shared their perspectives on the topic of Audit Quality. This week, Michael Kraten completes the trilogy of blog posts by asking whether the profusion of unaudited sustainability data should compel our profession to modify our definition of audit quality.

As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

We are presenting this trio of articles to illustrate the rich editorial value of the conversations that you will join when you attend our Midyear Meeting. Please keep in mind that the manuscript submission deadline of our meeting is Monday, January 14, 2019.

Are you aware of the massive volume of disclosure data that is defined by the Global Reporting Initiative? A firm that fully complies with the GRI’s directives must report on 3 sets of universal standards, 6 sets of economic standards, 8 sets of environmental standards, and 19 sets of social standards.

How about the Sustainability Accounting Standards Board? Its standards encompass a set of 77 industries.

And the United Nations? It has defined 17 Strategic Development Goals.

These data sets have become so massive that organizations now require guidance to determine how to organize it all! And thus another entity has developed a framework to meet that need; the International Integrated Reporting Council defines 5 governance, 4 business model, and 6 capital factors that can be employed to structure the reported data.

Because these data sets are gigantic in size, corporate sustainability reports are expanding into massive tomes as well. Let’s assume, for instance, that we are interested in researching Coca Cola’s sustainable agriculture policies and metrics. We would begin by reviewing all 21 pages of its Sustainability Report for 2017. We would then read its 13th page on Agriculture more intently.

What next? A link on that Agriculture page would take us to Coca Cola’s full 2017 Agriculture Update. On that web page, we would find additional links to information about the organization’s Sustainable Agriculture Guiding Principles (SAGPs), Seven Steps to Supplier Verification, 5bv20 Supply Chain program, fifteen research studies, a set of climate protection goals, Field to Market program, Farm Sustainability Assessments, Sustainable Agriculture Initiative Platform …

… and the list continues.

These disclosures are clearly voluminous in length and dense with content. But how much of it was subjected to independent assurance activities?

Hmm. It’s a bit difficult to find the answer to that question. The very last page of the 2017 Sustainability Report sports a circle entitled “Assuring The Adequacy Of Our Disclosures.” A click on that icon carries us to a web page with a brief section entitled “Assurance 2017.”

That section contains a link to Ernst & Young LLP’s Review Report. How much of Coca Cola’s sustainability data was reviewed by the public accounting firm?

Four metrics.

Not much, eh? The Review Report only addressed Coca Cola’s Greenhouse Gas Emissions value of 5.54 millions of metric tonnes, Water Replenishment percentage of “More Than 100%,” Water Use Ratio of 1.92, and Lost Time Incident Rate of 0.57.

Furthermore, although the scope of E&Y’s independent review work was limited to these four measurements, it still failed to address key concerns about the validity of Coca Cola’s water replenishment and use disclosures.

We usually define audit quality in terms of assessing the validity of the information that is presented in the Annual Report. And we often expand that definition to the supplemental disclosures in the 10-K and 10-Q reports.

But should we also consider the massive amounts of data disclosures that are presented to the public outside of these traditional reports? Would it be helpful to redefine our concept of “Audit Quality” to encompass the extent to which the auditors are, in essence, ignoring other critical public disclosures?

Michael Kraten, PhD, CPA is a Professor of Accounting at Houston Baptist University. He is also the President of AQPQ Management Consulting.

The Future of Auditing

Last week, our contributing columnist Steven Mintz led off our three part series on audit quality by addressing the topic of mandatory audit rotation. This week, our columnist Sri Ramamoorti continues the conversation by discussing the Expectation Gap, the Information Gap, the need for non-GAAP measures, and the future of auditor education.

We acknowledge, and thank, The CPA Journal’s Editor In Chief Richard (Rick) Kravitz for permitting us to repurpose and reposition content that originally appeared in the February 2017 edition of his publication. The material appeared in an article entitled The Future of Auditing: A Roundtable Discussion; it is available online in its entirety.

Rick is a friend of the AAA Public Interest Section. He is a frequent presenter at our meetings and symposia, and is a contributing columnist to this blog as well.

Dr. Sridhar Ramamoorti, ACA, CPA/CITP/CFF/CGMA, CIA, CFE, CFSA, CGAP, CGFM, CRMA, CRP, MAFF, is an associate professor of accounting at the University of Dayton. Previously, he was an associate professor of accounting and director of the Corporate Governance Center at the Michael J. Coles College of Business at Kennesaw State University. Dr. Ramamoorti was also a principal in the Professional Standards Group of Andersen Worldwide, Sarbanes-Oxley Advisor for Ernst & Young’s National Advisory Practices, a Corporate Governance partner with Grant Thornton, and was a principal leading the governance, risk and compliance (GRC) practice of Infogix, Inc. In December 2016, Dr. Ramamoorti completed a three-year term on the prestigious Standing Advisory Group of the Public Company Accounting Oversight Board (PCAOB).

Why are we utilizing our blog in this manner? We are showcasing our perspectives in order to generate interest in our midyear meeting. If you would like to present your own work about accounting and the public interest, please keep in mind that the manuscript submission deadline is Monday, January 14, 2019.


Sri, in our previous blog post, our colleague Steven Mintz suggested that mandatory auditor rotation may help address certain challenges that confront the audit profession. He cites KPMG’s 109 consecutive year audit relationship with GE as one that is ripe for rotation, in light of GE’s recent travails. What do you think?

You know, the medical profession’s lament applies to us, too—that the operation was successful, but the patient died. All we are able to assure as auditors are the standards and the processes that are the inputs to the audit. But we are unable to guarantee the outcome. Yet, the first thing that happens when there is the collapse of a company, perhaps because of poor governance or a terrible business model, is that the business failure is almost immediately equated with an audit failure. And we have to live out the consequences as a profession. I think this is also going to be part of the education of the public, that we can’t be held responsible for a mistake that is being really committed by company management and their governance.

Having said that, any century-old relationship between an audit firm and its client certainly raises questions about the lack of independence in appearance. The optics aren’t good, even if the client is growing and profitable.

But don’t users of financial statements expect auditors to be held responsible for such mistakes? And if there is an expectation gap, is there also an information gap?

On this issue of the expectations gap, as far back as 1988, the MacDonald Commission in Canada very systematically broke it down into three separate gaps. One was the standards gap, another was the performance gap, and the third was the communications gap. That’s one framework.

More recently, in 2012, the International Auditing and Assurance Standards Board [IAASB] talked about the information gap. There is a lot more information than what appears in the financial statements, and hence, the recent pressure on the profession to look in some way or the other at these non-GAAP measures. They’re just proliferating, and it’s clear that there is much more that investors and other stakeholders are demanding to know. In a world that is awash with information, I think these demands have gotten only worse. Herbert Simon, a Nobel Prize winner and a polymath, said, “a wealth of information creates a poverty of attention.” Simon perceptively noted that many designers of information systems incorrectly represented the design problem as information scarcity rather than attention scarcity. We don’t have information scarcity; we have information abundance. Attention scarcity is the real issue.

He went on to say what was really needed were systems that excelled at filtering out unimportant or irrelevant information. This is going to be one of the future jobs of the auditing profession, to serve as that filter in such a way that we define relevance to our stakeholders. That really allows us to become trusted as a profession, because people don’t know what’s relevant and what’s not. We are really becoming the curators of information in terms of its underlying quality, its relevance, and providing that decision context in which stakeholders can maximally use that information. The recent proliferation of non-GAAP measures, potentially more relevant but perhaps less reliable, is highlighting this perspective. In a way, I am merely expanding on what the AICPA’s Elliott Committee concluded in its 1996 Report.

It sounds like you’re calling for the development of Integrated Reports that include both GAAP and non-GAAP measures. Are we adequately educating auditors to perform assurance activities on such reports? Or do we need to modify our education practices in creative ways?

I’ve always wondered why ours is probably the only discipline—I won’t say profession—in which the word “creative” is a bad word. Creative accounting is not a bad thing. After all, as Albert Einstein famously remarked, “Imagination is more important than knowledge.”

H. G. Wells maintained that it is nature’s inexorable imperative that you either adapt or perish. One may choose not to change, however, because survival is not mandatory. Given all the change that we’re seeing, if we remain in the status quo, we’re finished. We have to be grabbing at these opportunities to become more relevant in a fast-changing world.

In my opinion, we are facing a human capital crisis in the accounting profession. However, the problem is not with the young people who are entering the profession. They are actually very smart. There are these very advanced and sophisticated technologies that are really putting the lie to what used to be big problems. They can be solved, but you’ve got to be creative. And you need to master some of these new technologies.

For instance, let’s think about the classic problem of finding a needle in a haystack. Pretty difficult, isn’t it? And yet, some of our young professionals might suggest that we wave an industrial grade magnet over the stack, and the needle will simply jump up.

To me, the need for being creative is fulfilled by having a diversity of experience, curiosity, and the ability to learn continuously. These are the kind of people we’re looking for, and the profession should be able to attract them. The worst type of auditor we could have in today’s world is the gullible auditor. We want the skeptical auditors who will not accept answers at face value. They’re always going to dig deeper. We want to attract these kinds of insatiably curious kids into our profession.

I think it’s going to require a different skill set, a different kind of ability among young people. I’m not sure we want the types of students who did really well only in accounting, as in the olden days.

Are we, as a profession, up to this challenge?

We started by talking about the past, the present, and the future. And that progression, to me, gives us the opportunity to use hindsight to get insight, which hopefully will allow us to get foresight.

Sigmund Koch, a very famous and distinguished professor of psychology at New York University, in 1985 observed that the mark of maturity of a profession is its ability to do soul-searching. And so the fact that we are doing this kind of [discussion] is itself evidence that this is a profession that has that capacity, that is willing to look at itself critically. The profession is a prestigious one with a glorious history. You cannot have true accountability without proper accounting, so I have tremendous hope for the future.

Should Auditors Rotate Every 109 Years?

Independence. Integrity. Objectivity. Professional skepticism. These concepts are bedrock principles of audit quality.

As audit failures continue to plague the accounting profession, the Contributing Columnists of the AAA Public Interest Section offer different perspectives about preserving these principles.

During the next few weeks, a number of our Columnists will present an online conversation about this critical issue. Steven Mintz will kick off our series (below) by addressing GE’s recent travails while raising the suggestion of auditor rotation. Sri Ramamoorti, Michael Kraten, and others will then approach the issue from different directions.

Why are we utilizing our blog in this manner? We are showcasing our perspectives in order to generate interest in our midyear meeting. If you would like to present your own work about accounting and the public interest, please keep in mind that the manuscript submission deadline is Monday, January 14, 2019.


We are delighted to publish this “opinion piece” by Dr. Steven Mintz, a frequent contributor to our social media blog. As always, when you read his contribution, we ask that you keep in mind that the opinions expressed therein are those of the author. They do not represent the position of the AAA or of any other party.

A new rule adopted by the U.S. Securities and Exchange Commission requires disclosure of the tenure of a public company’s external auditor in the annual report. KPMG recently reported that it has audited GE since 1909. This raises the question whether there should be mandatory audit firm rotation after some period of service. Right now, other than the tenure disclosure, there are no requirements for mandatory audit firm rotation.

The fact that KPMG has audited GE for 109 years is coming under greater scrutiny, given that the SEC disclosed on January 24, 2018 that it was beginning an investigation of the company’s accounting practices. The regulators are investigating a $6.2 billion insurance loss from GE Capital, the troubled financial service business that the company is trying to wind down.

The SEC is also looking into “revenue recognition and controls” for the company’s long-term service agreements including insurance reserves. GE restated its 2016 and 2017 quarterly numbers to reflect new accounting standards. The company lost $9.8 billion in a single recent quarter. With the company’s stock down more than 40 percent during a recent twelve month period, the uncertainty of the accounting investigation raises troubling questions.

The obvious question is: Where were the auditors during the accounting scandals? The answer is: Nowhere To Be Found. In fact, two shareholder watchdog groups – Glass-Lewis and Institutional Shareholder Services — urged shareholders not to ratify KPMG as GE’s auditor at the company’s annual shareholders meeting last April. GE shareholders approved KPMG for another year, but only after overcoming substantial opposition in the wake of GE’s accounting issues. Only 65 percent of shareholders supported GE, an historically low percentage of support. Last year 94 percent of shareholders supported GE.

Let’s examine the potential costs and benefits of auditor rotation. The costs should be obvious. There is a learning curve during which time the audit may not be as efficient and increase the costs to the client. Moreover, a relationship of trust between the audit firm and client builds up over several years and any forced rotation may make it more difficult to build trust simply because of the lesser passage of time. In that regard, GE defended its decision to stick with KPMG, noting that the benefits of a “long-tenured auditor” include “deep expertise” and “familiarity” with the company’s vast business empire. GE also highlighted “independence controls” on KPMG, including “thorough” oversight from the board’s audit committee and requirements that the lead partner be rotated every five years.*

The benefits of forced rotation are subtler. After a period of service (say, 20 years), the auditors may become too complacent and close to the client, creating a familiarity threat to independence. Audit independence and objectivity may fall by the way side. And conflicts of interest may develop over time, making it more difficult for auditors to exercise professional skepticism in gathering and evaluating financial data to ensure that the financial statements do not contain any material misstatements.

The benefits of auditor rotation may also include getting a fresh look at the company’s accounting methods and financial reporting techniques. The new firm may not be biased by past audits, and may critically challenge accounting techniques that smooth net income or create earnings to meet or exceed financial analysts’ earnings consensus estimates. Glass-Lewis chimed in when it wrote to GE shareholders, saying that GE shareholders must beware that “a long-tenured auditor can become too close with a client,” while a new auditor can “uncover problems previously unidentified.”*

The accounting profession contends that the mandatory rotation of principal audit partners sufficiently protects the public interest and builds in the “fresh look” critics are looking for. The Sarbanes-Oxley Act created a five-year auditor requirement. The SEC enforces it through the Public Company Accounting Oversight Board (PCAOB). Critics contend that this is not enough, and that mandatory audit firm rotation is necessary to compensate for years of influence by audit clients over their auditors.

The key factor in evaluating the net benefits of mandatory audit firm rotation is the public interest. The problem is there hasn’t been sufficient research on this issue because the mandatory partner rotation requirement under Sarbanes-Oxley is relatively recent, and less time has gone by since the European Union first required a 10 to 20 year firm rotation.

I have a different perspective. The PCAOB conducts inspections of public company audits every year or so. Why can’t the PCAOB look at the retention issue based on noted deficiencies in audits examined? It’s true that the Board may not look at the same client each year. Still, some kind of overall evaluation of the ethics of the firms, based on audit inspections, might add value to the process of determining when audit firms should be rotated. Noted deficiencies such as a lack of independence, integrity, objectivity, and professional skepticism, the bedrocks of audit quality, should raise questions in the minds of shareholders about whether a firm should be rotated.

The presence of these factors suggests ethical failures in the audits. By making the evaluations public so that shareholders can consider them in their annual retention votes, the firms may take the noted failures more seriously. This may not be the perfect solution, but it does begin the process of holding audit firms accountable for their audits by having meaningful consequences for repeated failures in ethics, and it protects the public interest.

* Source: Matt Egan, GE pressured to fire auditor after 109 years. April 24, 2018.

Robin W. Roberts, Accounting Exemplar

Editorial Note: We are delighted to publish this interview of Professor Robin W. Roberts, our Accounting Exemplar. As always, when you read his comments, we ask that you keep in mind that the opinions expressed therein are those of Professor Roberts. They do not represent the position of the AAA or of any other party.

On Sunday, August 5th, Professor Robin W. Roberts of the University of Central Florida received the 2018 Accounting Exemplar Award during the Accounting Exemplar Luncheon held during the American Accounting Association Annual Meeting in Washington, DC.

The Public Interest Section’s Accounting Exemplar Award is given to an educator or a practitioner who has made notable contributions to the professional and ethical health of the accounting profession. The Exemplar represents a role model who has contributed to our profession in a manner that serves the public interest. Previous winners of this prestigious award have included Abe Briloff, Stuart Chase, Cynthia Cooper, Ralph Estes, Harold Langenderfer, Arthur Levitt, Eli Mason, Tony Menendez, Albert Meyer, Carl Devine, Tony Puxty, Bob Sack, Prem Sikka, and Art Wyatt.

Dr. Robin W. Roberts serves as the Al and Nancy Burnett Eminent Scholar Chair in Accounting and Pegasus Professor at the University of Central Florida (UCF). His research interests focus on accounting and business ethics, regulation, and social responsibility. Dr. Roberts serves on the Executive Council of the Center for Social and Environmental Accounting Research, which is housed at the University of St. Andrews, and is past editor of Accounting and the Public Interest. He has been instrumental in the development of the AAA Public Interest Section Emerging Scholars Colloquium and in promoting public interest scholarship in accounting.

We are delighted to publish this interview with Robin.

When you learned you were receiving the Accounting Exemplar Award, how did you react?

Pat Kelly emailed me and asked if we could talk by phone. I said of course, thinking, however, that I was about to commit to doing Pat a favor. I was so pleasantly surprised when Pat told me I was receiving the award. After finishing my talk with Pat, I called my spouse Sherron. During my call with her I got surprisingly emotional (and continue to be). The Public Interest Section has provided such a supportive and nurturing environment throughout my career. Receiving this honor is a very personal, significant career achievement for me.

I want to thank the Accounting Exemplar Award Selection Committee and my colleagues who conspired behind my back to nominate me, particularly Lisa Baudot, Charles Cho, Joseph Johnson, Pamela Roush, and Dana Wallace. And I have to give tremendous credit to my favorite colleague and life partner, Sherron. Sherron is an education professor and has been my personal teaching coach, professional advisor, and my editor for over 35 years. My career successes are due in large part to her counsel and encouragement.

How did you become interested in public interest accounting scholarship?

Like most public interest accounting scholars, my interest grew as I became more familiar with the AAA Public Interest Section and with public interest research. My original research interests were in governmental accounting and auditing, spurred in part by Dr. Michael Granof assigning our undergraduate class to read Aaron Wildavsky’s book, The Politics of the Budgetary Process. It was the very first time I found accounting really interesting.

Over time this evolved into a stronger interest in political science and in studying the politics embedded in the profession and practice of accounting. Researching and teaching accounting ethics, professionalism, and the public interest rescued me from a much more mundane and less satisfying academic career and I am grateful.

Why do you think you were chosen to receive the Accounting Exemplar award?

First, I will repeat how honored and grateful I am to receive the award. I know there are many others who have devoted significant time and effort to advancing ethics, professionalism, and the public interest in accounting. So, for one thing, I was lucky.

I view the award as a career achievement award. I don’t have a defining life episode when I faced tremendous pressure to stand up against unethical practices. I so admire our award recipients who took such personal risk to blow the whistle. Although I have published public interest accounting research, I think the award primarily reflects my interests and efforts in developing new public interest accounting scholars.

I served for 10 years as Director of the University of Central Florida’s Accounting PhD Program. Our program valued and supported doctoral students interested in public interest research. Also, I helped start the PIS Emerging Scholars Colloquium that is held in conjunction with our section’s mid-year meeting. The success of these two endeavors means the world to me.

What advice would you give to emerging public interest accounting scholars?

I believe that choosing to focus on ethics and public interest accounting research and teaching is a vocational calling. Dedicated ethics and public interest scholars are passionate, caring, and intellectually interesting people. We are the moral conscience of the accounting discipline and the accounting profession. Ethics, professionalism, and the public interest should be key aspects of our collective work as an accounting academy—in our teaching, in our research, and in our service to practice—and it is not. So, work to help these topics find their rightful place.

I will offer three pieces of advice. First, research without regret. Let your curiosity and passion drive your research program. If I had continued to study aspects of accounting that don’t resonate with me as a person, I would have failed miserably. Stand proud as an accounting researcher who cares about solving social problems such as discrimination, income inequality, access to health care, and environmental degradation.

Second, be bold in pushing the ethical envelope in your classes. Accounting is much more than a technical practice. It is a social practice that affects the lives of employees, customers, suppliers, citizens, and all living things. Bring the ethical aspects of decision-making and reporting into all of your classes. I have found students very receptive. Collectively, we can make difference, and it starts with you.

Third, become involved in the AAA Public Interest Section or another group of like-minded scholars. It is very difficult to go it alone as a public interest accounting scholar. If you become involved, you will find encouragement, support, and potential collaborators. Reach out if I can do anything to help!