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Is It Time for Auditors
To Give Out Grades?
By Art Berkowitz and Richard Rampell
October 23, 2002

Is it time for auditors to give investors more information than a simple pass/fail grade?

That's what Mark Cheffers, CEO of accountingmalpractice.com 1 , thinks should be done to restore investor confidence.

After analyzing the impact of the accounting scandals and the response by the accounting profession and politicians, Mr. Cheffers believes that it will take more than Sarbanes-Oxley Act ( see the act 2 ), which created an oversight board for auditors earlier this year, to restore the confidence of investors. In his proposal for an alternative to the standard auditor's report he says, "External controls over the people who are supposed to operate with the highest levels of integrity may prevent some auditing failures, but that is not the same as restoring confidence." ( Read Mr. Cheffers' proposal 3 .)

As the corporate scandals have spread, investors' confidence in the value of the "unqualified" auditor's opinion has declined. Bond-rating companies like Moody's and Standard & Poor's have used a graded system for years, and it was the downgrade of Enron's bond credit rating that was a major factor in exposing the energy trading firm's wrongdoings last year. Influential players in the accounting profession are now asking if a similar system can be used to rate a company's stock.

The Six Cs

Samuel DiPiazza, CEO of PricewaterhouseCoopers, suggests using what he calls the Six Cs. Financial statements would be graded against a set of standards on their completeness, compliance, consistency, commentary, clarity, and communication, either in whole or in part. He asserts, "More expansive audit opinions would provide a greater level of assurance to stakeholders, while creating an incentive for companies to improve their corporate reporting practices."

This leads us to ask two important questions:

If the standard auditor's report were replaced with a grading system, could that have prevented corporate scandals like Enron and WorldCom? And would such a system be less or more confusing to investors?

Let's look at Enron with those questions in mind.

Certainly, it has been shown that Arthur Andersen knew about the aggressive accounting for several years. Carl Bass, a member of the firm's national technical support group, had been holding a running battle with the engagement partner, David Duncan, over the off-balance sheet debt, partnerships, and special-purpose entities. We know that in February 2001, fourteen members of the audit team held a meeting to discuss these exact issues. While there may be questions over how Andersen was sufficiently satisfied to continue their audit relationship and issue an unqualified opinion, it would have been considerably more difficult to justify issuing the company an AAA or A+ rating. Imagine the discussions that would have taken place at the management and board of directors' level if the company's rating was downgraded because of the lack of clarity or completeness of its financial-statement disclosures.

For those who are skeptical about the negotiations that might take place, we can look at the large number of public companies that have bond ratings below the top grade. Certainly negotiations go on today that affect the company's ratings. The relevant question is whether such a system is better than the current pass/fail system where a company could just as easily be closer to a D- than an A+.

Which leads to the second question. If a company were to receive an expanded audit opinion that included a grade (or multiple grades) on its financial statements, would that provide better information for investors?

Mr. Cheffers asserts that the playing field has changed because of the numerous corporate scandals. While in the past, investors may have been satisfied that the underlying financial information could be rated an A, their confidence has been so shaken by the numerous scandals, they now look at the financial statements and attached auditor's opinion wondering what information is hidden or disguised in financial doubletalk.

According to Ellen Masterson, global leader of audit methodology and value reporting for PricewaterhouseCoopers, the bottom line is "whether a rating against a set of standards will actually reduce the expectation gap. Sarbanes-Oxley should actually help in market receptivity by companies, but will investors have a better understanding at the end of the day?"

As accountants, we are still concerned about the potential liability. Is it realistic to think that such a grading system won't initiate a wave of litigation every time a company chokes in the marketplace?

Ms. Masterson doesn't think so. "We don't see rating agencies suffering the same litigation costs as the accountants," she says. "If the 6 C's, or whatever framework is used, are backed by standards against which we evaluate companies, then ratings are feasible."

Early Warning System

Besides, all one has to do is look at the newspapers or speak with their malpractice insurer to realize that suing accountants is already the standard procedure when anything goes wrong. With the speed that companies go in the tank today, a more relevant question might be, would a grading system provide management, boards of directors, stockholders, and the auditors with a much needed early warning system?

We also want to know about its practicality. Can accounting firms who rely on less experienced staff to be their first line of defense implement such a system?

To efficiently perform the audits, accountants must make much of the work systematic. As such, developing tests, checklists and an internal grading system that can be implemented by junior staff should be possible.

One of the most important issues that has come out of the peer-review process is the need for earlier intervention and increased involvement by more experienced auditors to help identify potential problems. After all, wasn't the early detection of potential risks the original point of risk-based auditing? (See our Aug. 9 column, "Drive-By Audits Have Become Too Common and Too Dangerous" 4 )

There are still lots of details that need to be considered before such a fundamental change could be made. But with influential supporters like Mr. Cheffers, Mr. DiPiazza, and Ms. Masterson, the idea deserves a full and open discussion.



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