CSU's The Audit

Host Stacy Nick: Hi Eric and Michelle, thanks for being here today.

Michelle Draeger: Hi.

Eric: Lohwasser: Hi. Nice to meet you.

Nick: Now, if I say let's talk about the 2002 Sarbanes-Oxley act, most listeners might not have any idea of what I'm talking about. But if I say, let's talk about the fallout from the 2001 Enron scandal, now we've got people's attention. So, I'd like to start by having you explain a bit about the Sox act, what it did, and why it was enacted.

Lohwasser: If you think about a lot of ways in which companies might get in trouble for the way that they put out financial reporting or the way that they show their earnings, basically any of the activity that they have that's disclosed to the public, a lot of times you would know that you're going to rely on an auditor and you would yell at that company for it. But what was unique about Enron, aside from its severity, was that the people in charge of ensuring everything was accurate and correct were the auditors, and they were also in on the scandals. So that caused widespread concern across both Congress and all of society. A lot of people lost their jobs, lots of money, significant impacts, particularly on their investments and their portfolios and retirement.

Nick: Their life savings.

Lohwasser: Yeah, it had a lot of impact on everyday people. It also had the attention of Congress who otherwise might not want to regulate. That's why SOX was different, because instead of just looking at the ways in which they wanted to improve, the way that companies report things and fraud, they also wanted to look at how they can improve the auditors process and the people who actually try to catch everything.

So overall, SOX did a lot of things. It helped hold CEOs and CFOs accountable by telling them they must take responsibility for all the financial reports, because they would walk into Congress and say, "I don't know anything about this. I'm not an accountant. Even though I'm in charge of this company, I don't really know what's going on.”

Separately, there were a lot of things that auditors did where they were just trying to make sure that stuff was correct, but they weren't ever really trying to improve the overall process on how we did things. Fortunately, the U.S. is a leader in capital markets around the world, so we wound up being a leader in regulating and changing how we fix companies and provide information to the public.

Largely, SOX was successful. You had over 400 votes in Congress for it, and only three against, which you never hear of Congress passing anything like that nowadays. Aside from fixing things where you'd be concerned about criminal activity or holding executives responsible, there were a lot of other things in there, including auditor independence, making sure that they're independent from their client and they're less likely to have fraud going forward.

It established an entire governing board, like the SEC. So, there's another whole governing board that sits under the SEC called the PCOB, and they're in charge of auditors the same way the SEC is in charge of companies. Then the largest things that came from that are internal controls. So, to think about internal controls in a very simplistic way, not just is the right amount of cash in your bank account, but do you have a process written down whereby you track it every month and someone else checks the fact that you tracked it every month.

Draeger: A lot of these companies had lucrative contracts with their auditors in terms of Enron. They had sold to their auditor, Arthur Andersen, $27 million in consulting services. But then their financial statement audit was only $25 million. So, you can see how they might let a few things go, because they are getting a lot more dollars from the consulting side, and it was millions of dollars that they're paying their auditors just to do what's called “pristine audits.” They would go and check that the toilets were clean and make sure trash was empty and just kind of these things that now they're saying, is this a conflict of interest to have our auditors getting all these dollars from these other things and then ignoring the problems that were there.

Lohwasser: Overall, what's interesting to think about is that you have a unique situation whereby you're paying somebody to catch mistakes that you make as an auditor, right? So, the government isn't really paying people to come in or the SEC to come in and check that everything is correct as an independent organization. The same people that run the organization are paying somebody to come catch their errors and yell at them for stuff. So, there's a lot of misaligned incentives, because it's hard to call somebody out for doing something wrong when they're the ones who are paying you.

Ultimately, the legislation requires publicly traded companies to hire an independent auditor to perform these audits and report on companies' financials. On the surface, that makes sense. But Michelle and Eric, you both collaborated on some research into some of the impacts of the SOX Act that pointed to some unintended consequences. What did you find?

Lohwasser: Within that study we weren't necessarily looking at an unintended consequence of regulation as much as the way in which the intent of the regulation might have been undermined because of the way we conduct things in society. Let's say you're a company and you have really good internal controls, and you're confident that you're going to be able to put out good financial statements, and your earnings are going to be accurate, and you're not worried about the external auditor helping you find errors. Well, that's good. That was the whole point of SOX, was that we had internal controls that would help us produce more accurate financial reporting.

What we have in the U.S., which is a little strange, is that whenever you hear a company get on the news, maybe they're on the Wall Street Journal or New York Times, and they announce their earnings, and they say they made a certain amount of money at this period, they're putting out those earnings but they're doing it before the audit is actually done, which most people don't realize. Even among people that do financial research or even accounting research, not everyone is quite aware of that fact.

How does that work?

Draeger: It's concerning to us as the auditor when you're doing audit procedures, and they say our earnings call is tomorrow. Tough luck if you're not done.

Lohwasser: It's weird. It puts a lot of pressure on us. We were both auditors before we did research on it as academics. We both found this to be strange. When you looked at the averages and ran the data, it was over two weeks ahead of time on average, which is a pretty long time.

Draeger: A significant portion — I think around 70% of companies, if not 80% — are doing that before the audit is complete.

Lohwasser: You'll effectively have companies that are trying to meet market expectations on the fact that they want this disclosure right away, even though the audit is not done. So, there's kind of this informal conversation that they have with their auditors where they're saying that they're pretty comfortable on what the numbers are, but they're not fully done with auditing all of the disclosures and details, even though they could find errors in those disclosures and details. So, what we show in our study is that it's true that internal controls did help improve that financial reporting and improve earnings, but it gave them the confidence to release their earnings even earlier, further before the audit was done.

Because we allow that in the U.S and we don't say that the audit has to be done when you release your earnings, it had an indirect effect of actually creating more earnings announcement revisions because the auditor was finding things after the earnings were disclosed, and they're more likely to have to revise those earnings. So, it achieved its overall goal. But -- it's not really an unintended consequence -- it's more that we didn't really think about the background of the environment in which we're operating when we're doing that, because it undermined a lot of the regulations intended purpose.

Draeger: That is kind of an area, too, that is contentious. Do we want auditors to verify or are we going to require auditors to verify these earnings information? Because that's technically outside of the scope of what we're currently doing, which is our year-end financial statements, or quarterly. But at the year-end, and that's already kind of taking a while. We're also going to require auditors to look at these earnings numbers. Well, how long is that delay going to be? Because there is this huge demand from investors that want this timely information, and they just don't have the time to wait for it, really. We saw that recently in the news, right? Lyft's, I think it was CEO he added an additional zero on his earnings projection and that the stock price skyrocketed.

How are businesses going to be able to deal with I mean, what's the backlash or are we kind of like, well, it's not Enron level, so...

Draeger: There are some ramifications in terms of, a lot of times the management might get fired. I know he apologized. I don't think there's anything that came out of that, at least for that one. A lot of times it depends on whether you're intending to deceive versus just having a clerical error, which is what he alluded to, that it was just a clerical error. But that could have very real effects, because the stock price is supposed to be following net income essentially, or what they're expecting shifts in net income to be. So that actually doesn't happen. Then you have that disconnect between your share price and what the company's actually performance looks like.

Lohwasser: Market drops when that sort of thing happens. So, we'll see share prices drop simply because they're having to revise their earnings and they weren't stable to begin with, particularly within the case more recently where there was the clerical error. Without getting into complex terminology, there's quant funds that were just automatically trading with computers because that stuff came out and immediately just started buying shares, trying to get ahead of everybody else. So, you're going to have a lot of market manipulation that happens related to that.

You also found that companies are more likely to fire their auditors when they list an earnings expectation. How does that play into all of this? Seems a little wonky.

Draeger: For a while now, we've known that you can make accounting judgments and decisions where the market's expecting you to, let's say, have a certain amount of earnings for a quarter. Let's say it's $0.34 a share. There's a lot of literature that shows that what companies want to do is meet or beat those expectations, and it helps boost that stock price. Sometimes they walk the analyst down to where they can make it so that they can beat it. A lot of times those are made up by accounting decisions for accruals.

A lot of the ways that we look at the quality of an audit and how well the auditor does themselves is whether they're meeting or beating those expectations at an abnormal rate. We show in this study that when companies are just missing their earnings, they're more likely to actually fire their auditor and then hire a more lenient one. That has a lot of different implications. Not only is that opportunistic potentially, I mean, you can't see it on an individual basis, but when you run 30,000 observations, you see it's there. But it also calls into question some of the independence concerns. Because this company is paying you to provide assurance over their financial reporting, and you're trying to call out errors from them, and you're trying to make it so that you have accurate reporting.

If they're really close to just meeting earnings, it kind of implies to them, potentially, that the auditor was stopping them from using some sort of minor accruals manipulation to get there. So, in the fact that they would lose all their revenue if they were fired for just basically doing their job, that's pretty important when it comes to auditor independence, because the entire concept of this is that they're supposed to remain independent of management and not be coerced by it. It kind of has both sides of that feeling where it looks like auditors are actually standing up and holding people accountable and doing their right job, but many of them might not know that they could get fired for that at an abnormal rate.

It's so strange to think that actually doing your job well could get you fired.

Draeger: And poorly. So, what do you do? Liz's paper has similar findings with internal control opinions.

And you're talking about your colleague, CSU professor Liz Cowle.

Draeger: Yes.

And Liz's research found that the accounting firms with more lenient auditors grow faster than stricter more by the book auditors. There was also some research that she did that showed that big accounting firms are beginning to shift to offering consulting services rather than audits, as those are a little bit more lucrative. What does that tell you about the ramifications of the SOX Act? I mean, is there a way to get a truly independent audit? This feels like a little bit like a rigged game.

Draeger: I think that's very challenging. For the paper that Liz looked at for her consulting and to your point, that they are shifting because these are more lucrative and we don't have kind of these rigid requirements and oversight of the auditors because, as Eric mentioned, the organization that was formed, the PCOB, comes in and inspects these firms and make sure that these audits are performed correctly.

There's a lot of regulation around the audit side where we don't have that necessarily around the consulting side. It's more lucrative financially for them to be able to do and alleviate some of this pressure. We did see one of the big four, EY, recently wanted to split apart its consulting arm from doing the financial statement audit, because of that prohibition that SOX created initially, to try to help with some of those independence issues.

Truly some of the other items that came out of SOX were to look at the governance side of it. There was a lot that was done around audit committees, which are intended to be the guardians of the auditors, because now we have this business model where the company itself hires the auditor. So, as Eric mentioned, you're supposed to then tell the company when they're doing things wrong, which is very difficult. Each company has a board of directors that's responsible for overseeing that company and overseeing management. Then a subset of that board of directors that we have various committees. The audit committee specifically oversees the audit.

What came out of SOX was requiring all of the audit committee members to be independent, meaning they don't work for the company. That's intended to help somewhat because previously if you have the CEO or CFO on the audit committee, again, you're still reporting to the person that hired you and kind of tattling on them, so to speak. That was one attempt to get more independence. Essentially, if this is the current business model, I think we're going to have to do the best we can. But at the end of the day, you are still supposed to be reporting on management when they're doing things incorrectly.

I do have a separate paper that does look at audit committees and the power dynamics specifically between management and the audit committees, because again, they're the ones the audit committee is supposed to be protecting and fighting against management. We do find when the audit committee does have these higher power levels compared to management, the auditor is freer to issue what we're calling a “going concern” opinion, which is an undesirable opinion. So, we do see some improvements in independence, which I think is really the goal. I don't know if we can get to 100% independence because of how the business model is, but I think we are going to try to improve upon it as much as we can to help assure the capital markets that we can rely on these financial statements.

Right. You haven't seen, there hasn't been another Enron.

Lohwasser: Right. So, everyone thinks that is an unregulated one, right? It's always this other company that's not regulated.

Draeger: Yes, I think Enron/Anderson at least scared the auditors quite a bit. None of the firms want to be the next Anderson. So, they are hyper vigilant to the extent that they can be. Again, they're really trying to do the best they can; they do take their jobs very seriously. We have a lot of firms on campus all the time. I think with the additional regulation, we have to really think about the costs of it and if that's really doing what we would hope that it would do.

Lohwasser: And I would hope that everyone thinks about the importance of some of this because it has so much impact, even though it's one of the less ... the things people don't think about as much, or not one of the sexy things that's in the news all the time. It is important that we have reliable financial information. Everybody uses it. Just because it's not something that you might necessarily want to spend your time working in or checking -- a lot of the most boring things are sometimes a lot of the important things that we have to make sure that we keep going. It's a profession, though, that does seem to have continuous improvement, which is good.

Draeger: Yes, always room for improvement, which makes our lives interesting because we always have things to look at.

Lohwasser: What's good is that a lot of your research winds up getting cited in business news articles. We have people who are particularly prevalent within our discipline that testify in front of Congress and really inform them about things. And because it's not contentious issues -- it's “boring” issues -- they listen a little bit more. So, it really does make a difference.

Well, thanks so much for being here. I really appreciate your time and for talking with me about this.

Lohwasser and Draeger: Thank you so much. It was great to be here. We appreciate it.

That was CSU assistant accounting professors Eric Lohwasser and Michelle Draeger, talking about their research into the SOX Act. I’m your host Stacy Nick and you're listening to CSU’s The Audit.