The Big Short and Curlies

By The Professional Asshole


Auditing is bunkum.

Quoth the Yoda, “insane you are.”

No, really. The entire public auditing side of the accounting profession is wackadoodle.

Many libertarians are also disciples of the Austrian school of economics which teaches that central bank’s involvement in credit creation creates credit bubbles, fueling the boom and bust cycle. But, there is another major threat to financial markets that even many Austrians are not aware of: auditing.

Since the formation of the Securities and Exchange Commission (SEC) in 1933 publicly traded companies have been required to provide independently audited financial statements done by a CPA (Certified Public Accountant). Most public companies go with large accounting firms, like the Big-Four, or a large regional firm. They have internal auditors (usually non-CPA accountants) who do most of the accounting year-round for both management and eventual external auditing. But external auditing is required of financial statements for publicly traded companies. Auditors provide an opinion on the veracity and accuracy of financial statements which aid in investment decisions.

The company being audited is required, however, to pay for its own audit. This creates a perverse conflict of interest—the ones paid to be skeptical of a company (auditors) are being paid by their prospective enforcement subjects. How can auditors be skeptical of their paycheck? As Upton Sinclair said, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!” Big problem.

You might think auditors aren’t aware of this problem, but second to actual auditing procedure these economic perversities are the thing about which we learn the most in school. The counter-balance for them is an extremely forthright, honest culture of duty to the public interest. They really think of themselves as public servants. For the most part I have to congratulate auditors for not being far worse than they are given their economic incentives. I sure wouldn’t trust my life to “culture,” though I admit that culture can compensate for a lot of bad things.

As relatively impressive as auditors are, they did have a major failure in the early 2000’s. The Houston office of Arthur-Andersen allowed obviously suspicious practices to WorldCom and Enron because both companies paid very well for few man-hours of work. Both had little in the form of inventory or physical product to audit—just tons of data.

This failure lead into the Sarbanes-Oxley Act (SOX). Auditors now had to separate their auditing profession from the more profitable advisory aspect of accounting. This means if you audited a company you couldn’t give them advice on how to improve. This creates another perverse incentive (no, duh). Now auditors have no economic reason to find errors upon which the company could improve. To do so would only help competition.

Oddly enough, almost all of the actual accounting regulation is done by private companies whom the SEC simply signs-off on the regulations they develop. Those organizations existed before the SEC, police their own, and continue to act privately, though now as adjutants of the SEC, much like how the American Medical Association is “private.” It’s not perfect.

Better would be if the public (i.e. the interested party) paid for the audits in the form financial publications or investor information reports, which already exist. Companies would likely allow these audits of their books without government prompting because it would raise the price of their stock by boosting investor confidence. The audit firms would simply sell the reports themselves. Auditors would have an incentive to be honest to ensure sales, fair because companies could choose new auditors if they thought the reports were unfair, and investors would be more confident of auditor’s independence. The only catch? Government would have to pull out of regulating and requiring auditing.

Fat chance.


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