The Mother of All Conflicts: Auditors and Their Clients

By Kaplan, Richard L. | Journal of Corporation Law, Winter 2004 | Go to article overview

The Mother of All Conflicts: Auditors and Their Clients


Kaplan, Richard L., Journal of Corporation Law


I. INTRODUCTION AND CONTEXT

From 1980 through 1991, I taught a semester-long course entitled "Accounting Issues for Lawyers." I dropped the course for several reasons, the most pertinent to this Conference being a concern that financial statements were so meaningless that lawyers did not really need to be all that familiar with their interpretation. This was long before "special purpose entities" became the preferred way to hide corporate debt. This was long before corporate tax shelters became so commonplace that the tax expense on a corporation's income statement bears no discernible relationship to the corporation's financial net income. This was long before related party rules were disregarded with an abandon that would shame a televangelist. It already seemed that financial intermediation in general, and mutual funds in particular, had largely eliminated the need to scrutinize a company's financial statements directly. If financial statements did not matter, why bother learning how to read them? The world looks very different today, but this central point seems unchanged.

Actually, my disenchantment with financial reporting began many years earlier, when I worked as a junior auditor for one of the (then) Big Eight accounting firms. In that milieu, did we actively ferret out fraud? Did we seek to bring integrity to financial statements? Did we hold management's feet to the proverbial fire on the proper accounting treatment of corporate transactions? Not as far as I could see.

My world was a series of steps grandiloquently styled an "audit program," the primary purpose of which was to generate files of audit "workpapers" that looked like last year's workpapers. Moreover, the procedures for generating these workpapers were set forth with time budgets for each discrete step, often in increments as small as half an hour. Completing the assigned tasks within the specified time budget was absolutely critical. Exceeding the time allotted meant that the audit might run behind and "bust" the budget that was formulated when the quoted audit fee was determined. In that circumstance, the accounting firm might have to "eat" the excess costs. This the firm most certainly did not want to do, and auditors were regularly admonished about the critical importance of meeting the prescribed time budgets.

In the context of these time budgets, uncovering some squirrelly accounting treatment was an unwelcome and unrewarded experience. If further research or additional checking were required to resolve a problem, the auditor in charge of the fieldwork would fret that his (in those days, it was always "his") time budget would be "blown," and that his evaluation by the manager in charge of the audit would reflect such apparently incompetent stewardship. Such an eventuality could impact the "up or out" progress of his own career.

The staff auditor's situation was similarly precarious. Spending additional time to resolve audit irregularities put an unwelcome spotlight on one's competence and diligence. Self-doubt would inevitably rise: Why do you think that you are seeing something that your more learned predecessors (often including the senior auditor now in charge) missed in prior years, or did not find problematic back then? The predictable response was poor evaluations by the senior auditor, and a reputation as a "budget buster." Being so labeled meant that other seniors would ask that you not be assigned to work on their audits, since an inability to meet time budgets could jeopardize their own careers. Enough such requests, and you were soon re-entering the job market, this time as damaged goods.

Given this reality, what could a conscientious auditor do? Basically, there were two options. Option One would be to work the additional hours to resolve the issue but not record the extra time spent. This practice, known informally as "ghosting," meant that the time budget would be "met" on paper but would not reflect the actual effort expended. …

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