Back in October I wrote here that a very long list of sophisticated investors including my ultimate boss, Rupert Murdoch of News Corp., and business partners like Walgreen’s made the decision to invest hundreds of millions of dollars in the private start-up Theranos but didn’t insist on seeing audited financial statements first. From its incorporation in 2003 to its shutdown in August of 2018, Theranos operated on a cash-basis and distributed unaudited and allegedly made-up financial information to investors.
Such boldface-name investors as Mexican billionaire Carlos Slim; Betsy DeVos, now secretary of education [and married into the Amway family]; Oracle founder Larry Ellison; the Walton family of Walmart fame, who invested $150 million in Theranos; Greek shipping heir Andreas Dracopoulos; and members of South Africa’s Oppenheimer family, which controlled the diamond company De Beers Group, lost their entire investments.
These investors did not believe that an audit provided useful information when they made personal multi-million dollar investments despite most also being majority owners and chairs or CEOs of public companies that are mandated by stock exchange listings and, in the US, SEC rules to hire an external audit firm and pay for an audit according to Generally Accepted Auditing Standards that is conducted by firms registered with the PCAOB, the audit regulator.
The Theranos investors decided that an audit wasn’t worth asking for, even if the cost of this laissez-faire attitude was some “immaterial to them” fraud losses.
This week, after attending the American Accounting Association Audit Mid-Year conference in Nashville, I came back with tons of academic research I can write about at MarketWatch.
One set of researchers is keenly focused on issues related to audits and earnings releases, mostly because auditors are not required to audit earnings releases and, yet, earnings releases are so influential to investors’ activity and the market’s reaction.
From the Standing Advisory Group Meeting, June 21-22, 2004, Potential Project – Auditor’s Responsibility for Communications to Investors Containing Financial Information
Existing standards address an auditor’s responsibility for interim financial statements included in an issuer’s quarterly report filed on Form 10-Q or Form 10- QSB. Consistent with SEC requirements for timely interim reviews of financial information, the standards require the auditor to perform certain limited review procedures in connection with the quarterly statements. Neither the auditing standards nor the SEC requires the auditor to issue a written report on a review of interim financial information. However, the SEC requires that a written review report be filed with the Form 10-Q or Form 10-QSB if, in any filing, the issuer states that the interim financial information has been reviewed by an independent public accountant. (To be clear, the SEC requires that the auditor perform a timely interim review. By filing a Form 10-Q, the issuer implicitly asserts that the auditor’s required review was complete at the time of filing. However, the SEC does not require the auditor to, and most auditors do not, issue a review report at the conclusion of every review.)< However, existing auditing standards do not address an auditor's responsibility for financial information provided by an issuer in other types of investor communications, such as in a Form 8-K. In most cases, an auditor is not associated with such information; thus, having no responsibility for it is appropriate.< In other cases, however, even though an auditor is not directly associated with such information, he or she often is indirectly associated with it, particularly when an issuer makes its earnings release on a Form 8-K. Existing auditing standards do not address the auditor’s involvement in an issuer’s earnings releases. However, as a practical matter, most auditors are involved to some extent with quarterly earnings releases. This and other practice issues have led to questions about whether an auditor should have some responsibility for this type of financial information and whether he or she should be required to report on that information in some way.
I wrote about a new study from Assistant Professor Joseph Schroder and his colleagues at Indiana University, Assistant Professor Lori Shefchik Bhaskar and Professor Patrick Hopkins, in MarketWatch this week that says investors would rather have any information now even if the audit is only 80% complete:
Many of the annual earnings results companies are releasing will arrive without an auditors’ signature, and a study suggests that could be a problem.
A majority of companies announce annual earnings before auditors sign off on the numbers, but new research suggests the practice increases pressure on auditors to stick to the announced numbers rather than suggesting any final corrections or adjustments.
Approximately 70% of U.S. public companies announce annual earnings prior to the completion of an annual audit, by about 16 days on average. The practice has exploded in the past 15 years: Prior to 2004, approximately 75% of annual earnings announcements were released on or after the audit report date, but the Sarbanes-Oxley Act of 2002 added additional audit requirements related to internal control audits and audit workpaper documentation that resulted in audits taking 16 days longer to complete, on average, according to other research published in 2010.
What is the point of the audit if the market moves on unaudited information every quarter and even at year end, and auditors feel pressure not to make adjustments once companies release unaudited results, typically crowded with non-GAAP metrics that are also unaudited?
Would investors still pay for an audit if it weren’t legally mandated? Are regulators and exchanges perpetuating a government-mandated oligopolistic exclusive franchise for the Big 4 and a few additional firms that produces information investors now ignore?
Eliminating the audit mandate altogether is an idea that has been floated as the ultimate solution to the problems that plague the profession.
Turner argues that, for the system to work and investors to get the information they’ve paid for, major changes must be made. His first suggestion: provisions of the Securities Act of 1933 and the Securities Act of 1934 should be amended to remove the requirement that companies be audited. The audit firms are a “subsidized industry, like the credit rating agencies,” Turner told me, and companies are required to pay for “audits no matter the quality.” Instead, he recommends that every three to five years, investors vote on whether they want an audit. Turner says that would require auditors to “justify their existence to investors,” and this could “alter the behavior of auditors, as they would now be beholden to investors.”
Theranos was a wolf at the door, looking for pigs, that the accounting profession is, for now, ignoring.
Given that most investors seem to be just fine with buying and selling trillions of private and public company shares based on unaudited earnings information filled with unaudited non-GAAP metrics, is it only a matter of time before the wolf —complete relief from all audit-related regulatory burden and expense — blows the whole house down?