The accounting scandals of the early 2000s destroyed lives and reputations and prompted a veritable conga line of perp-walking CEOs from companies like Enron, WorldCom, Tyco and others. As the gravity of the criminality unfolded, many wondered how these companies and their executives managed to swindle, cheat and manipulate numbers for as long as they did. And many looked with a furrowed brow at the auditing companies, whose primary responsibility was, and is, to ensure accounting ethics, legality and accuracy.
Thanks to folks like Kenneth Lay and Bernard Ebbers, we now have Sarbanes-Oxley, a comprehensive law governing accounting rules and regulations so strict and suffocating some publicly traded companies have privatized just to avoid having to deal with it.
Among the many problems SarbOx was designed to address was the relationship between auditor and company. The new law attempted to remove conflict-of-interest scenarios and also required that companies put their audit business up for bid every five years.
Glance at the audit market today and it’s not unreasonable to have cause for concern. The current environment, where four major companies conduct a majority of the auditing work, harkens a woebegone era before the trust-busting days of Theodore Roosevelt and the Progressive Era where oligopolies and monopolies were rampant and competition lay low. This benefits no one, as evidenced by the recent analysis conducted by the U.S. Public Company Account Oversight Board (PCAOB).
In its annual inspection of the country’s largest auditing firms, the PCAOB reported an increase in the overall auditing deficiency rate from the prior year. The oversight board saw a 23% increase in deficiencies from KPMG and found 47% of Ernst & Young’s audits to be problematic, as well. Moreover, the PCAOB warned that nearly one in three of audits they inspected had deficiencies in testing of internal controls.
The Need for Clarity
The manufacturing industry is in particular danger of running afoul of audit standards into significant deficient territory, as the industry has a number of unique and audit-burdensome characteristics. While manufacturing is similar to most other industries in its basic need for financing and investment for growth, the sums of money involved in the manufacturing sector are often much greater. This is particularly true as it relates to the large amounts of capital investments required for plant and equipment funding, as the fast pace of change can easily result in obsolete machinery.
Given the post-meltdown capital market crunch, access to these finance options has become harder to obtain, particularly in cyclical and volatile industries like manufacturing. Where funding is available, it is usually at higher margins and with tighter contingencies, presenting an extra level of complexity to financial accounting. Adding to the industry-specific audit burden, manufacturing contracts are often large, complex deals hallmarked by uncertainty and risk. Manufacturing companies, and more importantly, their auditors, need clarity into the nuances of complex contracts to ensure they are properly invoiced, tracked and recorded.
Manufacturing finance executives must also deal with dynamic and geographically-stretched supply chains which present an added burden of foreign currency risk to the audit process. Finally, forecasting future cash flows reliably is challenging due to fluctuations in demand experienced by companies in this dynamic sector. Disclosure of these uncertainties in financial statements, without emphasis on the steps being taken to remedy the situation, can cause immediate adverse responses from partners, clients and funding providers, making the manufacturing audit process a nuanced and delicate one, ripe with potential for deficiencies and errors.
Absence of Choice and Competition
While questions about audit quality arise—both within and outside of the manufacturing sector—the U.S. Congress is considering a bill that would eliminate the audit rotation mandate in SarbOx requiring publicly traded companies to tender their audit business every five years.
The absence of choice and competition in the audit market is, in and of itself, enough to raise questions. Eliminating a mechanism that helps to keep auditors on their toes is just a bad idea. Is five years the optimum time for an audit tender? Sure, this is a good question. In the UK, ten years has been set as the maximum before a tender should occur.
But simply removing the requirement that publicly traded companies review their auditor and open their business for bidding may create too high a level of comfort, potentially reducing the stimulus an auditor should have to keep improving quality and thoroughness.
Eliminating the rotation rule would also reduce opportunities for smaller, perhaps hungrier, auditors to compete for new business, further stifling competition.
Those who support the elimination of audit rotation argue that tendering is time-consuming and costly, that long-term relationships with auditors are a best practice given the time it takes a third party to understand the nuances and complexities of a large corporation, particularly in the more complex audit industries like the manufacturing sector.
Maybe sometimes that is true. But it is also true that change, or even just the prospect of change, can be a motivational tool and a crucial element in upholding the financial accountability that necessitated the creation of SarbOx in the first place.
The tendering requirement creates a forum where both the auditor and company can review not just the quality of service provided but process and efficiency, taking into consideration that needs and business habits may have changed in five year’s time. For the manufacturing industry, this is a particularly critical element given the constant need for change in that dynamic sector, which makes the need for an audience with auditors with varied specialties of particular importance.
The Audit Cost Conundrum
The current SarbOx provisions provide the opportunity for organizations to better manage their auditor and force change, where necessary. This is a good thing, particularly for nuanced, complex sectors like manufacturing, where companies need auditors with the ability to address an ever-changing business landscape, a skill set that may become more important than entrenched industry experience.
Competition, as a result of the tendering requirement, may also begin to answer the new audit cost conundrum, which is having a significant impact on cash-strapped industries like manufacturing. As if the audit process weren’t already burdensome enough, it’s now become increasingly expensive. According to data from Financial Executives International (FEI), the average audit of a public company took almost 17,000 hours of work in 2012. The cost was about $4.5 million on average and has been rising between 4% and 5% a year.
Auditors have, by and large, defended their price increases by noting the additional complexities and burdens caused by recent PCAOB deficiencies. The oligopoly is, in essence, making firms pay for their poor performance. It’s a situation that can only occur absent competition. By forcing the audit market to expand beyond its current oligopoly, companies can create a marketplace where such deficiencies and cost increases don’t have to be tolerated. Companies—like those in the manufacturing industry for whom audit fee increases can have a huge impact on an already overly-cash stretched company and for whom deficiencies can be the norm—would benefit from a larger pool of audit candidates required to compete on a fairly regular basis.
While auditing is a complex task requiring specialized training and a unique skill set, in many respects, auditors are still suppliers to an organization, just the same as the office supply or bottled water companies. And from our own experiences with both complex and commoditized suppliers, improved management of third-party providers and external costs can yield greater results all around and improve efficiency and profitability.
As such, it’s time to apply a more sophisticated sourcing agenda and review process around how audit services are bought and managed. And it’s time for manufacturing companies—those that are already familiar with a complex supply chain of partners—to help lead the charge.
Guy Strafford is the chief client officer for Proxima, an international procurement and sourcing consultancy. Proxima operates across the U.S. and Europe, and manages over $10 billion in operational spend from clients across a broad range of industries, including consumer products, healthcare, media and entertainment, and retail.