Can you fully trust the numbers contained in the audited financials of the companies you own?
The question is being raised by the fine folks at the Securities and Exchange Commission (SEC), the same people who produced and directed the blockbuster runaway summer hit "Banning Selective Disclosure." (Selective disclosure, for those who missed it, was the pernicious and totally unjustifiable practice of companies giving Wall Street analysts crucial information before giving it to the public.)
Now the SEC is looking to bring out a sequel, and the previews seem to be rubbing the fur of a pretty powerful group the wrong way. Though it carries the not-so-catchy title "Auditor Independence," it looks to be a show you should tune in.
SEC Chairman Arthur Levitt gave the details to the reasoning behind the rule in a spring speech. There's quite a bit to chew on, but for individual investors the matter is pretty simple: Auditors might be skimping on the their audit responsibilities where there are big dollars at stake on consulting fees. Auditors often offer clients consulting services, yet these are the same companies they're supposed to be rigorously auditing. And since 1993, auditing revenues have grown a feeble 9% annually, while consulting and similar services have grown at the far brisker rate of 27%.
If you're asking yourself how important a thorough audit is to your pocketbook and the security of the markets, just think about the $25 billion that MicroStrategy (Nasdaq: MSTR) investors have lost because of accounting fiascoes with its books. That's the kind of thing the SEC is looking to prevent from happening again with this rule-making.
As John Bogle, legendary founder of The Vanguard Group and index fund investing, put it in his testimony before the SEC, there are possible parallels between a potential decline in services in the auditing profession, and the tragicomedy of what has already come to pass in the mutual fund industry. Bogle stated:
"Of course there is no clear evidence on this subject, but [the] proposal says very aptly [that] studies cannot always confirm what common sense makes clear.... The stakes are high, and when consulting fees come to be many times more important than audit fees, it just must be obvious to anybody that independence is clearly likely to be impaired. I know it's subtle. I know it's a state of mind. But when self-interests predominate, trouble comes not far behind. And it seems to me it comes into special focus as a profession becomes a business.Bogle's testimony, while nicely raising the threat to the public markets inherent in the current system, keys on one of the major problems for the SEC in its attempt to convince the public of the severity of the issue. "You know, a little evidence of compromised audits would be nice" goes the argument from the auditing profession. Yes -- of course it's possible that the independence of an audit has been or could be adversely affected by the presence of other business relationships between a firm and the audited public company, but does the mere possibility of something like that require the drastic action of preventing auditing firms from pursuing reasonable (and very lucrative) business opportunities?
"In this case, the profession of accounting [has] turn[ed] into the business of consulting and cross-selling. It has potentially very adverse consequences to the public interest.... If you'll forgive me if I add a parallel to my own experience in the mutual fund business, which used to be a business of trusteeship and investment management -- and has now become a business of marketing, and the public interest, in my judgment, has not been served thereby. So I feel strongly about the divorce of outside services from the audit services." [Emphasis added.]
Well, as a former attorney, I think that the auditors' major argument against the SEC's proposal is a darned good one. It's the precise argument that I would make if I were still taxed with the millstone of defending a suspect client. But I also know the argument that I would make in response: The absence of empirical evidence is a red herring. In a situation like this you're never going to have hard, empirical evidence seeing the light of day. Any time that an auditing firm was actually facing the possibility of having "smoking gun evidence" disclosed, it would quietly settle the case and seal the record as a condition of the settlement -- preventing the SEC investigators from ever being able to publicly disclose what they know to be true.
Which is precisely what the SEC is faced with -- attempting to convince the public of the severity of a problem it gets to see up close, but isn't allowed to actually reveal the details of. The recent news that there is an investigation into Arthur Andersen's audit of Waste Management (NYSE: WMI) being compromised by Arthur Andersen's provision of non-audit consulting services is a prime example. The leak of that investigation is already causing the SEC headaches -- yet it might be precisely the kind of evidence that would demonstrate what really goes on when audits are mixed with non-audit services.
Your take on whether this is as important as the SEC argues it is will depend quite heavily on the debt you feel is owed to the SEC for its work on the selective disclosure issue on behalf of the individual investor. Because to side with the SEC on Auditor Independence, you have to take a leap of faith that the Commission has reasons for making this as high of a priority that it has, even though it can't publicly demonstrate the extent of the problem.
That leap of faith is one John Bogle is willing to take, and so am I. Is it one you're willing to take?
If so, or even if not, let the SEC know where you stand -- virtually all publicly submitted comments so far come from auditors, and the voices of some individual investors are needed. Put "File No. S7-13-00" in the subject header to let 'em know what you're talking about.
Oh, and this issue is something Rule Maker Port founder Tom Gardner will be testifying about in New York City on Wednesday, September 13. Call C-SPAN and demand live coverage!
Have a great weekend!