who pays the auditors?

how the pcaob could assure real independence.

by kayleigh padar
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is the u.s. ready to move to a third-party payer system for audits?

the author of an article in the influential new york state society’s cpa journal magazine says the time has come to bring the discussion into the open.

in the article, michael doron, ph.d, cpa, an associate professor in the department of accounting and information systems at california state university in northridge, examines relationships between auditors and the public in countries which have more regulation, the results of an experiment with a third-party payer and how the united states government handles similar regulation in other industries.

although he recognizes changing this process could be seen as “politically radical,” evidence shows it could work. organizations such as the public accounting oversight board (pcaob) already regulates the american auditing profession. in addition to being seen as radical, he acknowledges the shift would be a “tremendous change.”

regardless, he says this discussion is an important one to have since it’s very rarely talked about.

“the united states has never witnessed a real debate over the role government should play in the audits of publicly traded companies’ financial statements,” doron says.

even in countries with stronger regulation than the united states, auditors are still hired by and compensated by clients, he says. for example, in france and germany where auditors are seen as “arms of the state.”

however, in south korea, the financial supervisory service (fss) can assign an auditor to a company deemed “problematic.” a company can receive that label if it experiences financial distress, poor leadership, or other factors the fss addresses. in this system, the auditor determines the fee and remains assigned to the client until the fss decides the company isn’t a problem anymore. research has found both auditor independence and financial reporting improves under this system, according to doran.

although the united states’ financial system is more complicated than south korea’s, doran argues there are similarities in the way the u.s. handles medicare and the way it could handle the auditing process.

hospitals become eligible to receive medicare and medicaid patients by getting accredited by a private body, the joint commission on accreditation of healthcare organizations (jcaho). most hospitals choose this private accreditation over government inspection.

criticism of this system is similar to criticism about a third-party auditing process, doran argues. people criticize the jcaho for being too friendly with hospitals and say the jcaho accredits nearly every hospital it inspects.

since the government outsources this process to the jcaho, doran says it’s reasonable that the auditing process could also be outsourced to a third party.

the 1933 security act — which set up the current auditing system — was passed quickly and without much discussion or research because a number of other important bills were passed at the same time. in future years, congress addressed making adjustments, but nothing came of these.

“overcoming skepticism about increasing the government’s role in the audit process may be the biggest hurdle any third-party payer proposal faces,” doran says. “perhaps now is the time to have the debate that should have taken place in 1933.”

if the pcaob acts as a third-party auditor, it could help ensure auditor independence and rotate auditors more frequently, but not randomly in order to preserve their expertise, according to doran. the pcaob could also increase competition among auditors by assigning more second-tier firms to audit larger companies.

however, it would be important that the pcaob would remain unbiased in its decisions and not make influential relationships with the players in the auditing process.

another risk would be that the auditor might lose the incentive to complete accurate work because he/she’s not directly connected to the client anymore. this could be solved by reassigning auditors with subpar work, doran says.

while some quirks may still need to be sorted out in order for this transition to take place effectively, doran says the real obstacle is convincing lawmakers and the public this change is necessary.

“while a range of operational issues would need remediation, the greatest obstacle to that debate may be political rather than empirical,” doran says.  undertaking major reforms requires acceptance of the idea that the status quo is suboptimal.”

posted on april 2, 2019