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In our 400th episode, Blake and David dive into the controversial world of audit quality and Big Four accounting firms. They also discuss a listener's critical email about their audit coverage, explore recent audit failures and deficiencies, and debate the underlying incentives in the audit industry. The discussion turns to workplace culture issues at major firms and potential solutions to improve audit quality.
Chapters
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Chapters
- (01:05) - Listener Email: Criticism of Audit Discussions
- (01:59) - Reading and Responding to Connor's Email
- (05:19) - Understanding Audit Deficiencies
- (07:46) - Audit Quality and Deficiency Rates
- (13:26) - EY's Audit Deficiency and Industry Comparison
- (15:28) - The Business Model of Big Four Firms
- (19:13) - Challenges in the Audit Profession
- (19:39) - Listener Feedback and Commentary
- (35:33) - Super Micro Accounting Scandal
- (43:53) - AI's Impact on Auditing
- (44:11) - The Tipping Point: Media Coverage and Reactions
- (44:40) - Audit Issues and Historical Context
- (46:10) - The Role of Consulting in Audit Firms
- (48:04) - Materiality and Audit Quality
- (51:32) - The Future of Auditing and AI
- (53:16) - EY's Secret Drinking Club Controversy
- (01:15:35) - Addressing the CPA Crisis
- (01:19:10) - Listener Mail and Final Thoughts
Show Notes
PCAOB Posts 2023 Annual Inspection Reports Alongside Staff Observations and New Charts To Boost Transparency
Super Micro: Fresh Evidence Of Accounting Manipulation, Sibling Self-Dealing And Sanctions Evasion At This AI High Flyer
AI Spotted Super Micro Risks Two Years Before Filing Fiasco
EY's PR nightmare: A ‘secret drinking club’, misconduct allegations and resignations
Super Micro shares fall 19% on filing delay, Hindenburg Research report
Who Wants to See How Much Big 4 Revenue by Service Line Has Changed Since SOX?
PCAOB releases two new, divergent inspection reports for Canadian accounting firms
Rethinking Rankings: The Top 100 Firms — Adjusted
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Transcripts
The full transcript for this episode is available by clicking on the Transcript tab at the top of this page
Creators & Guests
What is The Accounting Podcast?
The Accounting Podcast (formerly the Cloud Accounting Podcast) is the world's #1 accounting, bookkeeping, and tax podcast! Join us weekly for a roundup of accounting news, analysis, and interviews. Plus, earn free NASBA-approved CPE credits for listening with the Earmark app. Learn more at https://earmarkcpe.com.
Attention: This is a machine-generated transcript. As such, there may be spelling, grammar, and accuracy errors throughout. Thank you for your understanding!
Blake Oliver: [00:00:04] And that's the real problem, is that the auditors do not have a financial incentive to find fraud, to find significant issues. They have every incentive to get the audit done and look the other direction. And the only thing keeping them from doing that is ethics. But we know that when you put ethics up against money, money wins in business.
David Leary: [00:00:25] Coming to you weekly from the OnPay Recording Studio.
Blake Oliver: [00:00:30] Hello and welcome back to the Accounting Podcast. The number one podcast for accountants in the world. I'm Blake Oliver.
David Leary: [00:00:37] And I'm David Leary. And Blake, today is Tuesday because we didn't record yesterday.
Blake Oliver: [00:00:41] On Monday we took Labor Day off as everyone should. It is Labor Day. The most appropriate day to take off. We did. I went to Sedona for the weekend. I did some mountain biking in Sedona, which is really challenging. I didn't realize the trails are all intermediate or advanced and I struggled, but I got through it. I didn't get injured. I'm here today.
David Leary: [00:01:01] It's good. Good? Yeah. Made it. So I try to enjoy my weekend. But we got a we got a voice, not a voice mail an email from a listener who's leaving the show because of our talk about audit. And it just made me for the last 48 hours. Just question if I understand audit at all.
Blake Oliver: [00:01:21] Yes, I read that as well. And I'm always sad when somebody decides they aren't going to listen to our show anymore. It doesn't happen too often that we get those kind of messages. So I want to read it because I think it is also quite revealing, and we'll give us an opportunity to continue that discussion from last episode. And if you are listening and you haven't heard that, go back to episode 399 and check out somewhere in the second half. We start talking about PCAOB deficiency rates and BF borgers and audit again, and you can catch up on that and then you'll know what's going on with this letter we got here from Connor. So here it goes. I'm going to read the whole thing. This is unabridged listener mail opening the mailbag. This is from Connor. Hello. My name is Connor, and I'm a manager at EA in the assurance practice and a consistent follower and listener of the podcast. I'm also a member of the transformation effort at EA to enhance audit quality that you frequently scoff at on your show. The accusations of personnel and leadership of public accounting firms during your last episode was beyond unprofessional. To liken all firms with part one A findings to affirm that was caught falsifying audit is heinous, and you should be ashamed. I can speak for the firm of which I am employed to say no one accepts or is pleased with the percentage of inspection findings. A tremendous amount of resources are being deployed to remediate and improve future results. The findings aren't acceptable and are instances that need to be remedied in the present audits and those in future periods.
Blake Oliver: [00:02:55] Moreover, partners of those audits are fined by the firm itself and subject to disciplinary action. Pcaob inspections are rigorous and challenging, and rightfully so. Passing without findings is quite difficult, and they are doing a good job protecting the markets. I applaud the enhanced scrutiny and hope to see it continue under Williams. I'm not even someone who looks to be a partner one day, and I can tell you that partners at my firm care deeply, but for you to sit on your podcast and aggressively throw stones is harmful and unhelpful. To casually claim that leadership in our regulators are buddies and are more concerned with lining pockets than audit quality is disgusting. You're constantly, consistently negative and flippant. Attitude is unbearable and it's unhelpful to your listeners. I don't disagree with the vast majority of your argument. However, the tone and accusations are simply inappropriate. I wanted to write to share my perspective and let you know that you just lost a weekly podcast listener and follower on social platforms I wish to earmark. I wish the earmark team luck going forward and all the best. Connor. And I'm not going to read his last name because I don't know. You know, if he cleared this with E. I doubt it. And he is speaking on behalf of E there. So we'll just say it's Connor, a manager at E in the assurance practice who we have now lost as a weekly weekly listener.
David Leary: [00:04:13] And maybe this question like it's I'm I'm the common man here on the podcast. Blake I'm not the accountant, not a CPA. I have not worked in audit. So I can only come across as the investor on the street or the common man and me. Do you want to see what audit means to me, Blake? I'm gonna share my screen. Okay. Describe it. This is what audit means to me. This website from the Television Academy, the Emmys.
Blake Oliver: [00:04:36] We are looking at the E accountants holding the briefcases. I take it this is from the Emmys, where they they they tally up the votes and they.
David Leary: [00:04:47] Have handcuffs on the briefcases. This is this is what I think of what it is.
Blake Oliver: [00:04:53] Well, tell me why. Why does this. How does this make you think of what it's like? This is not a financial statement audit. This is audits of votes for the Emmys.
David Leary: [00:05:00] But it's the impression, right? It's giving me the impression they have suitcases that are locked, handcuffed to their wrist because they have the utmost trust. We trust them with the Emmys and the Oscars, and it doesn't have to be right. That was just the first one that came up in Google shirt. It doesn't Google search, but we trust them. So I went on this hole and I went to Investopedia and try to understand audit there, because that's like the common man and man's investor place, the purpose of the audit. And so I'll read you the definition from there. Okay. Audits are a necessary and important part of the financial world, because a company's financial health and well-being can't be upheld without proper accounting. Routine audits ensure that companies are following reporting standards and that they are being truthful and honest about their financial position. Audits are particularly important for shareholders and lenders, as well as consumers and suppliers. The process of auditing also helps companies in other ways, including finding inefficiencies, improving production and operations, meeting compliance requirements, establishing procedures for monitoring and fraud prevention. And it goes on to talk about external auditors. External auditors follow a set of standards that are different from those of the company organization, hiring them to do the work. The resulting auditor's opinion expressed on items being audited parentheses, a company's financials, internal controls, or a system close parentheses can be candid and honest. When audits are performed by third parties, they won't affect the daily working relationship within the company. Okay. So that this implies that hey, what the external auditor says they're ensuring I can trust this company, right?
Blake Oliver: [00:06:46] That you can trust the numbers the company is putting up. Yes, that's the point, right? That's the key. That is the fundamental job of an audit to give investors confidence that the numbers, that the financial statements are accurate like that, they are, uh, that they can be relied upon to make investment decisions. And that's what we believe here on the show. And the reason that we talk about audit in the Pcob and these audit findings is that it doesn't feel like, based on what we see coming out of the PCAOB, that the auditors are doing a good job. And that's not that's just what I am seeing. I am just reporting what I observe. This is this is not something that we are creating. We didn't make this up right. The the Erica Williams at the PCAOB says every time she speaks, it seems like that audit deficiency rates are completely unacceptable. So I don't know why you're getting upset at me, Connor, about talking about this, like. And I just want to go through line by line through this letter and address these concerns. Right. So I, I don't know if I would use the word scoff to describe how I talk about audit quality, but I do think that it is unacceptable.
Blake Oliver: [00:08:08] And I wouldn't want to be part of an audit firm that had a what is it? 37% audit deficiency rate at UI, which is the highest of the big four, Deloitte at 21%, UI at 37%, KPMG at 26% and PwC at 18%. So PwC is doing the best, but even PwC an 18% deficiency rate. I was an A student in school all the way through school. In college too. I got A's right. I was a good student, and if you're telling me that the best you can do is like an 82% success rate on your audits like that, you'll be a student. Great. If you think that's fine. Good. Good for you. But I don't think that's acceptable. And E I mean, you're close to failing there, right? You're at 63% success rate. If you have a 37% deficiency rate, that means only 63% of your audits are passing muster with the regulator that oversees you. And of course, then we've got BDO. Just to be fair, with an 86% deficiency rate. So only 14% of their audits pass muster.
David Leary: [00:09:19] And Grant Thornton.
Blake Oliver: [00:09:20] At 54%.
David Leary: [00:09:21] But so that's a sample of ones they selected. So you could imply that it's of all their audits, only 14%. Right. Well we don't know what was selected but yeah exactly.
Blake Oliver: [00:09:31] So but it's quite a I mean hopefully it's an accurate sample. You would think that the regulator is choosing audits. You know, that that.
David Leary: [00:09:40] Are representative of a.
Blake Oliver: [00:09:41] Representative. Yeah. Like just there's this concept of audit sampling, right? You would think that if you want this rate to mean anything, you're going to select a variety of audits to inspect. But I think part of the problem is that it's just very unclear to me, even as a CPA, what a part one deficiency really means, because the way the PCAOB defines it, it indicates that the auditor had not obtained sufficient, appropriate evidence to support its opinions on the issuer's financial statements and or internal control over financial reporting. So that means the auditor should not have issued their opinion, and potentially investors should not be relying on it. So you've got a situation where a huge chunk of audits of financial statements out there had audits done. The auditor said, we give you a what's it called? What kind of opinion?
David Leary: [00:10:37] The letter they stick in the.
Blake Oliver: [00:10:39] Yeah. It's there's no there's no qualification. Unqualified. Unqualified opinion. Right. So I, as an investor, think I can rely on these financial statements, but a giant percentage of them out there? Apparently not. But we don't know which companies have had these shoddy audits done. And I don't even know if I could call them shoddy. I'll be fair with that. Like, how bad are these part one deficiencies? It seems like they are pretty significant. Uh, in this report by the pcob, they said that the most common part one a deficiencies in 2023 related to performing substantive testing to address a risk of material misstatement. So not doing enough testing, testing controls over the accuracy and completeness of data or reports used in the operation of controls. Testing the design or operating effectiveness of controls tested for testing and testing data or reports used in substantive testing. So testing, testing, testing, testing, testing it sounds like they just didn't do enough testing. And that's pretty basic. You didn't test enough to back up your opinion. They did. Let's see. Of the 59 audits inspected at EPA, 22 of those audits had part one A deficiencies, 22 out of 59. And of the 22 that had deficiencies, 12. More than half had deficiencies in both financial statement and internal controls audits. So you know, I'm just that's that's I'm just reporting the news here. This is a report issued by the PCAOB. If you think it's let's see quote let's see. Heinous. And I should be ashamed for likening firms with part one finding. Here's the sentence to liken all firms with part one A findings to a firm that was caught falsifying audit is heinous and you should be ashamed.
Blake Oliver: [00:12:38] So he's talking about the bf borgers, uh, deficiencies, right? Bf borgers caught by the SEC for falsifying 1500 public company audits. And they, of course, had a 100% Pcob deficiency rate. Well, there's lots of firms on the Pcaob's website that have 100% deficiency rates. And my question is, how do we know that these firms aren't like BF burgers and aren't falsifying audits or doing shoddy work? We don't know. So why is that heinous? With the information we have, we could speculate that there's probably more firms like BF Borgers out there, and if I'm a good auditor, I would look at the numbers and say, well, it can't just be one guy doing this. Probably more. Yeah. So now Connor goes on to speak on behalf of EY, saying I can speak for the firm of which I employed to say no one accepts or is pleased with the percentage of inspection findings. Well, I wonder if you've spoken to the tens of thousands of people that work at EA and you know, know that for a fact. I believe you that the people you work with aren't pleased with it. I don't think anybody's pleased with it. He goes on, a tremendous amount of resources are being deployed to remediate and improve future results. We saw that actually that EA is cutting the number of clients they have in order to improve audit quality. I think it was around 10%. David, do you remember the number?
David Leary: [00:14:08] I think that was in the end, it was about 10%. Yeah, it was a. 10% of the revenue maybe or no, not enough revenue. But it was it was a significant cut. So they could improve their audit quality. Yeah.
Blake Oliver: [00:14:20] Ultimately does this does this mean but I and I speculated that 10% is not enough. If you have close to 40% audit failure, then simply reducing the amount of work that your team has by 10%, is that really going to improve it. Um, let's see, what else do I need to address here? The findings aren't acceptable. Yes, I agree they aren't acceptable. Completely unacceptable. And they need to be remediated. And. Oh. He says the partners of those audits are fined by the firm itself and subject to disciplinary action. Right. But as we've discussed on the show, the fines are are small and the disciplinary action is not very meaningful. So you can keep doing this stuff because there's not a lot of penalty. Individuals are rarely prosecuted. The firm might get a fine. Very rarely do individual audit partners suffer any consequences for bad audits. Um. And why why would you change your behavior if you can make a lot of money doing low, low quality audits? The business model incentivizes this. And if we look at EY as a company, as a business, you actually see any of the big four has the most audits and they make the most revenue per employee. So what does that mean? How do you make the most revenue per employee with the most audits as a big four firm? You have the fewest people working on the audits.
Blake Oliver: [00:15:53] Right. You understaff the audits compared to your competitors and you make the most money. And I actually can prove this to you. Uh, this is from vision Dot, CPA, which is a blog by Rob. Didn't put his last name on there. Rob Valdez, who's been on the show before, and he did an analysis called Rethinking Rankings the top 100 firms adjusted. And he says, look, in this post, he says, you can't look at the big firms or the top 100 or top 400, or any of the big firms, whatever their size, based on revenue. It doesn't make sense because this is a people business. So he says you have to divide the revenue by the number of employees and get revenue per employee. That is how you decide what are the most profitable, what are the best firms, and which are the best ones to work for. And E, even though it's ranked three in terms of revenue, has the highest revenue per employee at. Get this $383,900 per employee. On his chart here, Markham is next. And then you get some much smaller firms like could.
David Leary: [00:17:10] You zoom in on this just a little bit? Yeah. Yeah, sure. Beautiful.
Blake Oliver: [00:17:15] So, you know, you got Berkowitz, Berkowitz, Pollack, Brandt. There are 51 on the top 100, and Frazier and Deeter and Holthaus, Karlen and Van Tricht and PwC is way down. One, 123456. Pwc even though they're number two in terms of revenue in the big four, they're number six in terms of revenue per employee. And let's see is where is Deloitte here. I don't even know if Deloitte is on the list on this this here in terms of revenue per employee. And so if you look at the PCAOB inspection report, deficiency rates, right. It seems that the higher the revenue per employee, the worse the the worse the inspection rate, at least with the big four is right. And there's a huge incentive to do this as an audit partner. And there's very few penalties for for doing bad quality audits. So it really doesn't matter what you feel. And I'm sorry, Connor, if I've made you feel bad about your firm. But these are the facts. What else does he say? He applauds the enhanced PCB inspection, a move what Erica Williams is doing. He says, I can tell you the partners at my firm care deeply. Well, if they care deeply, let's see them take action to improve this. Actions speak louder than words. And then here's the part that is a little hurtful to me. He says, but for you to sit on your podcast and aggressively throw stones is harmful and unhelpful. Well, somebody needs to bring attention to this if it's going to change.
Blake Oliver: [00:19:00] And what the profession has been doing isn't working. So maybe if we all, as CPAs wake up and realize that the audit profession has a big problem, we can do something about it. And unfortunately, the auditors who represent less than 20% of our profession are giving it a really bad name, because every time there's a giant audit failure, or like in the UK, where 75% Of. Of business collapses are completely missed by the auditors. You know, like it doesn't. It doesn't look good. The public says like you, David, the man on the street says, what the heck? Where were the auditors? So we have stimulated quite a bit of commentary from our live stream viewers. Thank you, livestream viewers, for coming. Before I get to that, I want to finish this to casually claim that leadership in our regulators are buddies and are more concerned with lining pockets than audit quality is disgusting. Well, that's what it looks like. It's appearance is matter. And when you have big four audit partners going to work at the regulators, creating more regulation that is unhelpful and doesn't improve, uh, financial statements, doesn't improve audit quality. And then they go back and they get higher salaries when they work at the big four. That to me seems buddy buddy. So I don't understand why that's disgusting. I think I think it is disgusting. And the fact that it's happening is disgusting. But to talk about it is not disgusting.
David Leary: [00:20:32] And to reinforce proof that that's happening. I mean, we talked about this in the past, but, uh, Canadian CPA or Canadian accountant. Com recently had an article talking about how the PCAOB released two new divergent inspection reports for Canadian accounting firms. So one was Deloitte and they actually passed four of their last five. And then Creston GTA. They actually disagree with their failed suspension. And then but what caught my eye in this article is that they noticed the letter that Creston GTA uh replied. The reply to Pcob is the exact same letter that Pkf, Ontario's professional corporation earlier this year, gave the same letter. And the reason why, and I'll quote from the article. Both replies referred to an external consultant with over ten years of prior experience with the PCAOB. Both firms use similar language and called contrary conclusions patently erroneous. So? So there's proof like people that work at Pcob go back to work and consult for the firms and like, this is exactly what you said.
Blake Oliver: [00:21:36] Exactly. Right. It's the regulatory audit industrial complex. It's called regulatory.
David Leary: [00:21:42] Capture. It's not exclusive to accounting. Know this happens FAA, the FDA yes, it happens everywhere. Right.
Blake Oliver: [00:21:48] Pharmaceuticals all that um, you're constantly negative and flippant attitude is unbearable and it's unhelpful to your listeners. Okay, I'll admit I can be a bit negative sometimes, and I'm trying to be more positive. But when it comes to audit, man, auditors make so much freaking money. I don't really feel bad about it. You know how much the partners, Connor at EY are making millions of dollars on average. Top accounting firm partners, top 100 partners make like $800,000 a year, and you can bet that at the big four, it's a lot higher than that. So they're all making millions. At least $1 million a year is my guess. And so why should I feel bad when they're doing crappy work? They're making a lot of money. They should do better work, and they should be responsible for protecting the public and not lining their own pockets. Is that too much to ask millionaires? So maybe the tone is inappropriate for the big four. Yeah, you can bet people would never talk like this in their suits and ties down at KPMG in Los Angeles, or at EY in Chicago or whatever it is. But I think people are sick of that. They're sick of the fakery.
David Leary: [00:23:06] You mean the suitcases with handcuffs?
Blake Oliver: [00:23:08] Fake suitcases with handcuffs? They can't. And was it ey that who screwed up the Oscars? They can't even do that properly.
David Leary: [00:23:14] That's right, that's true. Somebody messed up.
Blake Oliver: [00:23:16] You brought up that example of the Emmys and whichever big four firm screwed up the Oscars. I mean, that's it's almost like, um, it's so poetic because it represents everything that's going on with financial statements. So anyway, I'm sorry, Connor, that we lost you as a listener. Um, I think maybe you should stop drinking the Kool-Aid at the water cooler and think a little bit about this. And, you know, like, maybe I'm helping. Maybe bringing attention to this could actually help. And I really think this is actually the root cause of our problems in the accounting profession is that even if people don't know exactly about this, this is why we struggle to recruit people. Because when you have a system that rewards low quality work, maximizing the number of people on your, uh, minimizing the number of people on your engagement and maximizing realization and just checking the box, right? The whole business model is set up to reward doing low quality audit. Like there's definitely no financial reward if you do a higher quality audit. I mean, right, like there's nobody's nobody's singing your praises for that because we don't have a system to measure it. Um, this is what we get. And smart individuals go into school and they go into the world of of accounting and they figure it out just like I figured it out. And so if you want to get more people into audit, which is where two thirds of grads go to preserve the CPA pipeline, you got to make it meaningful. And everyone's talking about how Gen Z wants to do meaningful work. Well, if if 37, if you go to work at EY and you realize that 37% of the audits you work on were not done to standard, do you feel like that's meaningful?
David Leary: [00:25:07] Yeah, I could see in this generation, I mean, the next generation wants that's like the big part of their life. They want work to be fulfilling, right? Make a difference in the world. Et cetera. Et cetera.
Blake Oliver: [00:25:19] And I'm not just blaming the audit partners at EY. Actually, they're in a really tough position. Um, the auditors at Big Public doing big public company audits because the regulations have gotten out of control. So it's really hard to do a high quality audit because it's so nitpicky and there's so many rules. And we've made accounting so complex. So I lay an equal amount of blame at the writers of accounting standards, the FASB, of course, those are often the same people that used to be audit partners that have now gone over to the SEC and are, you know, writing rules there, and they're at the FASB and they're writing rules there, and they make accounting more and more complex. The the amount of knowledge you have to have to do GAAP, US GAAP is just insane. Uh, and it's not helpful. It's way too complex. And there's no incentive, though to simplify. So it just gets more and more complex. And they also completely missed a fundamental change in our economy, which is that since the 70s, since the computer revolution, we have flipped from an economy that's based on physical, tangible assets to an economy that is based mostly on intangible assets. 90% of the market value of the S&P 500 is intangible assets. Yet our accounting is still rooted in tangible assets railroads, factories, widget making. And so when a company like Netflix reports results and they're a subscription company, like the financials are not nearly as useful as they were for GE when it made air conditioners, I think it still does. But you know, like when it was the industrial might it used to be. So yeah.
David Leary: [00:27:00] So you have this you bill by the hour. You got to get your your your your overworked. You're in the weeds of all these regulations. You got to track that. Like why would you pursue any big picture things that could actually be wrong with the company and report it up the ladder because there's just not enough time. You're not resourced to do that and you're not incentivized to do that.
Blake Oliver: [00:27:20] There's no incentive to to find problems. Actually, if you find a problem, it just makes the audit take longer. So you're better off looking the other way as long as you possibly can, which is apparently what happens. You look at the results in the UK. Great example, 75% of these companies that collapse, there was no hint of anything from the auditors. Do you think that they may have seen something that could have warned the public?
David Leary: [00:27:44] Oh good news. We have a story that came out this week that's going to obviously reinforce that argument, but I'll let you catch up on some of the comments. People are very fired up today in the comment thread. And then after that we'll do our ad, I'll let you do the ad and then I will get this next story. This next story ready?
Blake Oliver: [00:28:00] All right. Boring accountant. Welcome. Boring accountant. Our number one fan. Boring says I am surprised anyone who pushes shady audits or toxic leadership in accounting would listen to the accounting The Accounting Podcast negativity doesn't like the spotlight, corruption doesn't like accountability, Goebel says. You didn't even say that you were asking the question. Does this mean they are operating around the same lines as Borger's? Yeah, I didn't I didn't say the same, but I said, could there be more BF borgers out there? There's there's dozens and dozens and dozens, maybe even hundreds of firms inspected by the Pcob with 100% deficiency rates. And so did Borger's. Borders had one. Oh, and by the way, BF Borger is still a licensed CPA in the state of Colorado. I just want to point that out, even though he was disciplined in Canada. Did you just mention that, David, or am I hallucinating?
David Leary: [00:28:48] I did not mention it, but yes, he was disciplined in Canada because he never registered to practice by CPA Ontario.
Blake Oliver: [00:28:53] So he's doing audits in Canada for Canadian companies, never registered. Yeah. Um, by the way, uh, yes, BF Borgers is still a licensed CPA in Colorado. I just want to point that out. It's kind of insane to me. You know, there's no I can't even find any, um, you know, actions taken against him recently. The last one was, yeah, March of 2024. And it was something else. I looked it up in the past. Um. Let's see. David, David says. David Scully says. Is there a substantive difference between type one A they did nothing and type one A they didn't test enough. Same result. Audit opinion is unreliable. Right. I mean, the way the Pcob has defined it, it a part one a deficiency is so significant that the auditor should not have issued their opinion. And I don't understand why the PCAOB doesn't just like rescind the audit opinions of public companies where this happens like or publish the names of these companies. Investors should should know if the financial statements were not audited properly, that might change behavior. So to me, doing nothing and not testing enough, I mean, they're both not doing enough and we don't know what the difference is. So when I say like BF borgers made up work papers, right? That's very different than a firm that just didn't test enough. But how different is it really if you. Right. If if you don't test enough, it still means we can't rely on the financial statements or we shouldn't rely on the opinion on the financial statements. It's so nitty.
David Leary: [00:30:39] Gritty. Ultimately it's output, right? You're just you're pumping out a result and you're like, we got to get this audit done. We just have to get it done. Because if we don't, they can't release their numbers to the street. And this whole domino happens. So there's this pressure to get it done. Tons of pressure. So if you don't see some things you're okay, which is. And not seeing or skipping things, even if it's unintentional, it's really no different than just making stuff up. You might as well make it up at the end. It's the same invalid opinion.
Blake Oliver: [00:31:06] Exactly. And we have heard this from listeners. Multiple people have told me that when they worked at big firms and they brought matters to the attention of the managers and the directors and the partners, they were slapped down many times because nobody wanted to know about it, because it would just make more work for everybody. They just want to issue the opinion, do the minimum you can. If you think about it, the culture of the CPA is sort of built around this. We even tell people like, just get a 75 on the CPA exam, don't try any harder than that. And that seeps through. The 75 is the minimum passing score. That's the number one advice you hear. Don't try to get more than a 75. And then, you know, we basically are doing the same thing when we actually do our jobs aiming for sea level work, right. That's how you attract people into a profession. Uh, let's read a let's read the ad, and then we'll get back to the listener feedback.
David Leary: [00:32:10] You didn't do it.
Blake Oliver: [00:32:11] I'll do it. Okay. Thank you to Onpay for sponsoring this episode of the accounting Podcast. Forbes and CNBC rank Onpay number one for small business payroll, and we use it ourselves. Onpay really knows how to get payroll done right for every client you serve, no matter how complex their software is, easy to use and backed by outstanding service levels, and I can attest to that. I get responses within like hours or minutes even. They handle new client onboarding for free and have experts on call to keep you and your clients on track. The system includes multi-state payroll, local tax filings, integrated HR tools, and more with no hidden fees. When you join on Pace Partner program, you get a custom dashboard to easily manage all clients in one place, plus gain exclusive perks like revenue sharing or discounts, free payroll for your firm, co-branding opportunities, premium swag, and more. Onpay helps you run your practice efficiently while providing exceptional payroll that your clients can count on. To learn more about using Onpay for your firm and clients, that could be farms, start ups, restaurants, bars, doctors, nonprofits, gyms, franchises, or even dentists. Head over to The Accounting Podcast dot promo slash Onpay that is The Accounting Podcast dot promo forward slash onpay. And now let's continue on with our live listener commentary. Allison says should there be a ratio or upward limit on the number of audits conducted versus number of employees a firm has? This feels loosely like 19th century factory work in some regard. I mean, that's what the entire business model was built on. Arthur Andersen created the pyramid structure of accounting firms and likened it to a factory, believe it or not, and went around and taught all the other accountants how to do it.
Blake Oliver: [00:33:52] And that made a lot of sense when work was very rote and manual, which it still is in many Big Four audit teams. You know they've got Excel now, but they're still doing all the work by hand in Excel really in a lot of ways. Right. So I mean you could try to do that. The only problem is if you try to set a limit, technology is going to change all that right. It reduces the number of employees you need. Um, but I still don't think it gets rid of the incentive to look the other way. That's the problem. That's the real problem is that the auditors do not have a financial incentive to find fraud, to find significant issues. They have every incentive to get the audit done and look the other direction. And the only thing keeping them from doing that is ethics. But we know that when you put ethics up against money, money wins in business. So you have to create a system where you financially incentivize ethical behavior. And that would mean having somebody else hire the auditors and incentivizing the auditors to find problems. And you might say, oh, well, it's the investors who hire the auditors because it's the board of directors and the audit committee that does it. But a lot of times, these audit committees and these boards of directors, they are so invested in the success of the business, they don't want to find issues either. Right. So like I and I think the real problem is it's not necessarily the reporting to the audit committee. It's just that the auditors have so much work they need to get it done. They don't want to find problems. And so they avoid it and they they cut corners.
David Leary: [00:35:21] But I think we are at the tipping point. Blake, what happened this week really is made worse because I figured it out two years ago. So we will go off of that. But I don't know if you saw this week Supermicro accounting, which is I'm sorry, Supermicro computing had an accounting delay and their stock went down. Um, the founder lost $800 million. The stock went down 19% because they said they had to, uh, we'll need additional time to assess its internal controls and delay its annual filings. This is one day offer after your good friends, the Hindenburg Research released a report. So Hindenburg Research, I'll let you give that quick background on that short seller. Why open up the next article?
Blake Oliver: [00:36:08] Well, so Hindenburg is just super well known short seller. They do these reports. They aren't always right, but they have had some big wins in the past and I can't remember off the top of my head who they have shorted. But they've, they do, they have they have a track record.
David Leary: [00:36:22] Yeah. And mind you they're a short seller. So keep this all in perspective. But they did a three month investigation.
Blake Oliver: [00:36:27] And what that means is for our listeners who aren't familiar, it means that Hindenburg takes a short position in a stock that they think they've found some information on that is not publicly well known. Then they release a report sharing it, and they hope the stock will go down.
David Leary: [00:36:40] Exactly.
Blake Oliver: [00:36:41] And then they make money.
David Leary: [00:36:42] And the the vibe of the report they released on Super Micro Computer Inc. is dubious accounting. That's the vibe of the report. It's all about dubious accounting. So they did a three month investigation, which included interviews with former senior employees and industry experts, as well as a review of litigation records, internal corporate and custom customs records. And they found glaring accounting red flags, evidence of undisclosed related party transactions, sanctions and export control failures and customer issues. So they had this huge list. But here's three bullets that I think are more in the accounting space.
Blake Oliver: [00:37:18] Yeah, I want to know what did Supermicro do? Like what? What was the the gist of it.
David Leary: [00:37:23] The gist of it is, um, uh, I lost the word sales stuffing. Hold on. Let me. I have it in another article.
Blake Oliver: [00:37:32] So I'm seeing I'm seeing related party transactions like $983 million paid over the past three years to suppliers. A, Bill.com and Compuware, which are partly owned by the CEOs. Brothers.
David Leary: [00:37:44] Yes. So we'll get into to that a little bit. So, uh, a lot of the issues are not recent. So in 2018, they were temporarily delisted from Nasdaq for failing to file financial statements. And then August of 2020, the company was charged by the SEC for widespread. Quote unquote, widespread accounting violations, mainly related to $200 million of improperly recognized revenue and understated expenses, resulting in artificially inflated sales, earnings and profit margins. And then, less than three months after paying the $17.5 million SEC settlement, they began rehiring all those top executives at the company again, even though they were involved in the accounting scandal. Litigation records with former employees. Right. They rehired them. And the former CFO, Howard Haijima, left the company in January of 2018, was later individually charged by the SEC with accounting violations in May of 2023. He was hired by a key related party party owned by the Supermicro CEO's brother. So. So the guy was bad news over here gets rehired by the different company by the CEO's brother. So a lot of it is dubious accounting. A lot of family brothers, businesses buying and selling back and forth type stuff. Questionable transactions in countries like Russia and Iran. You have Turkish shell companies, stuff about competitors, customers leaving to competitors. Right. And their summary at the bottom, which is really tight paragraph here. All told, we believe Supermicro is a surreal recidivist. And I'll define that serial.
Blake Oliver: [00:39:21] Recidivist.
David Leary: [00:39:21] Recidivist which I to define that a convicted criminal who re-offends especially repeatedly.
Blake Oliver: [00:39:27] They do it over and over again, over again. So go ahead.
David Leary: [00:39:31] Yeah. So it benefited as an early mover. It's rewarding to the eye space. But they still face a significant accounting, governance and compliance issues and offers an inferior product and service now being eroded away by more credible competition. So of course what would I do? I'm what goes through my head. Who's the auditor? How could they? How could a company find. Oh, it just goes on and on of all the things wrong, right. How could they.
Blake Oliver: [00:39:56] Do this and the auditors not know about it or report it?
David Leary: [00:39:58] So then I'm like, all right, let's go to the Supermicro computers investment page. And I looked at the 2022 earnings 2023 earnings. And it's Deloitte right. And Deloitte uh they had to sit there little letter to shareholders. It's exactly the same in both of them. And they only call out one critical audit matter description. And it's identical word for word two years in a row when they sign off on this essentially they're talking about inventories. Excess and obsolete. Obsolete. License reserved reserved reserved to notes one and five inches the financial statements. The company's inventories are stated at a lower of cost using weighted average cost method or net realizable value realizable value. The company evaluates inventory on a quarterly basis for excess and obsolete obsolescence and a lower cost and net realizable, realizable, realizable, realizable, realizable value as necessary. Writes down the valuation of inventory based on inventory aging, forecasted usage and sales, anticipated selling price, product obsolescence, and other factors. The exact same paragraph was in the the next year. So same letter. All they did was change 2022 to 2023 and signed it. And it was interesting. So Deloitte signed this Deloitte and Touche LLP and they they underneath their signature they said we've served the company's auditor since fiscal 2003. So so they've.
Blake Oliver: [00:41:27] Been the auditor the whole time 20 years. And they didn't identify any of this stuff. The critical audit matter doesn't seem like had anything to do with the actual issues that were found there.
David Leary: [00:41:37] You know, their fees are in there, $4.5 million about every year it's been going up. But that's pretty good fees for not finding anything. Now what's interesting? This is really the when I say this could be a tipping point. So this is in Forbes. Apparently I spotted these risks two years before the filing fiasco.
Blake Oliver: [00:41:57] Really?
David Leary: [00:41:57] So there was a company called Hudson Labs. They built a large language model using 800,000 FCC filings a year. So they're mining millions of pages and billions of words. It plays super microcomputer in the top 100 companies with the highest risk, and is able to figure out how that you mentioned those two companies A Bill.com and Compuware. Right. So they did that round tripping, right. And they say Hudson Labs even blogged about this in February of 2022. They actually put this in their blog. So a Bill.com is ran by um Smc's brother. So super microcomputer brother and his wife is on the board and Compuware both distributes and manufacturers goods for Cmci. So they're all.
Blake Oliver: [00:42:47] Together. They're all related party companies. And the auditors didn't flag this?
David Leary: [00:42:51] Yeah, and they're selling things to each other. But the I detected it the I took all the filings because there's words and notes about this stuff and yeah, all these, it found all these and bubbled this up. But the takeaway in this paragraph that really kind of summarizes all of this for audit. Right. External watchdog seem unfazed. The only critical audit matter raised by Deloitte in last year's annual report related to the excess and obsolete inventory reserves, as the major public accounting firms pour billions into, I won't, investors reasonably expect better, deeper and quicker assurance. That's the first of likely of many questions. This might be the tipping point if I can surface these, audit these problems with these companies before the audit firms can do it, people aren't going to want to pay $4.5 million for an audit.
Blake Oliver: [00:43:43] Yeah, they'd rather pay 10% of that to a company selling an eye audit. They can do a better job because the eye is unbiased. The eye does not make more money when it does a worse audit.
David Leary: [00:43:59] So this is the tipping point I think this this. Because there's going to be lots of stories about all the stuff Deloitte missed right over the next two, three, four, five, six weeks, maybe longer. Is this the tipping point? Because I've already seen this story from Forbes get picked up in a lot of other media outlets within the last 4 or 5 hours. Like that's going to be the narrative of this. I found major audit problems and Deloitte missed them. That's going to be the headline 2 or 3 weeks from now.
Blake Oliver: [00:44:27] That has to be the headline of this episode. Hey, guess who the new auditor of Supermicro is. Ernst and Young? Yes. Uh, Amazing.
David Leary: [00:44:40] And this is all important because this goes back to follow up on the Mike Lynch story right from his yacht sank two weeks ago. It was the same stuff backdated contracts, round trips, channel stuffing. Channel stuffing was that word I forgot before. Channel stuffing? Yeah, channel stuffing is.
Blake Oliver: [00:44:54] Channel stuffing is where you you get your customers to, like, buy in advance, but you claim the. You claim the sales now.
David Leary: [00:45:02] Yes. And that's always great for like if you're trying to sell your company or meet a bonus deadline. Those things are very helpful. Deloitte was the auditor on that right. And this is all real. Like HP said, they're still going to pursue the $4 billion from the civil lawsuit of his grieving family that he died. His daughter died. They're still going to go after that $4 billion. So audits are super important. Like it is the briefcase, right? With the handcuffs. That's how important it is. But this is we're in a new world. If audits are going to be. I'm sorry if AI is going to beat the firms for audit, I think things have tipped like this is going to be the one that that this is the Enron of I. I think this is going to be the one. You think.
Blake Oliver: [00:45:42] So? Yeah, I think I think it's going to get worse before it gets better. I think we will have oh, I think we will have another Enron. I don't think that the underlying conditions that caused Enron have gone away. If you think about what the profession did after Enron, it's they put in CPE requirements and they put in additional ethics training requirements. And then there's all this, like nitty gritty stuff about independence. But we've seen firms figure out how to get around that. And consulting, you know, went down briefly. The big four split off some of them, split off their consulting practices, but they just rebuilt them. And now if you look at the breakdown of revenue for these big four firms since socks, it's gone way up here. I'll share it on the screen here. So this is from Going Concern. Who wants to see how much Big Four revenue by service line has changed since Socks, the Sarbanes-Oxley act that was passed in response to Enron to regulate the profession, which also created the PCAOB. Here it is. Here's the chart. So we see here. Oops. Wrong screen. There we go. So look at advisory right. Advisory dipped down to very low way below tax and assurance and has just climbed since 2003 2004. And in 2022. It's like bigger than it's it looks like it's almost bigger than tax and insurance combined now. So like the big four firms are not audit firms. They are consulting firms that happen to have audit teams. And that just seems wrong to me that consultants control the firms that are doing the public company audits, because the consultants definitely do not have the ethical rules to follow that we do. They work in service of their clients, not in service of the public. And we're back in the same situation we were in before. And you know why? Because money.
David Leary: [00:47:40] Disclosure. Right. So obviously they disclose who does their audit and how much they paid for the audit. But if they're getting consulting services from Deloitte they're not. That's not disclosed in the financials. Right.
Blake Oliver: [00:47:50] Uh, I don't know. I mean, there's rules about what you can or can't do, right? If you want to do the audit, you can't do the consulting and all that stuff. But then it gets fuzzy when it comes to the tax stuff. And I just think that, like the issue, this is the same issue we have with private equity coming in and buying these top 400 firms and controlling them is they take the assurance practice and they split that off into its own entity, and that's the CPA firm. And then all the rest of it is now in a new entity that is not a CPA firm that is not run by CPAs. So you want to talk about marginalization of the profession. That's the definition of it. When you take the CPAs and you just stick them in a little box. That's the assurance practice. And and and what's going to happen is long term, if CPAs don't do a good job of auditing, the public will figure it out. What I'm saying will become common knowledge, and I will disrupt, audit and take away all the audit work. And we will lose the one thing that we have as CPAs that we have a monopoly on, which is assurance.
Blake Oliver: [00:49:03] It's selling out the profession. Jonathan says this feels like the entire profession. Stay within hourly budget, get work done by deadline. Take on 1 billion clients so partner maintains yacht the bare minimum to get the work done. Yeah, it's the factory model, right. Which is not conducive to work life balance, which is yet another problem in the profession. Another big reason why we can't attract people is because the only way under the current business model, to make money as a partner is to overwork your staff And like Chris Vanover said in his LinkedIn post that we talked about last week, you know, work them 3000 hours in audit every year and just, you know, churn out the churn out the returns. Joseph said says it was PwC that handed the wrong envelope at the 2017 Oscars. Thank you Joseph. Um, and Deborah says happy 400th episode bosses. Thank you Deborah. We appreciate you. Uh, Heather said nice spotting. Deborah. Congratulations. Amazing achievement 400. That is a lot of candles. It's crazy. We've gotten to 400 400 episodes, and now we better read another ad because we are getting, like, close to the end of the.
David Leary: [00:50:10] Episode, and we'll just do them back to back. So if you want to grab that.
Blake Oliver: [00:50:13] Okay, you put that link on the screen and I will read Zoho Introducing Zoho Practice. Thank you, Zoho for sponsoring this episode of the Accounting Podcast. Zoho practice is the all in one practice management platform built to streamline accounting firm operations. Soho practice saves you time chasing clients by automating reminders and requests to get you the documents and clarifications you need when you need them. Staff and clients stay connected through a centralized communication hub to resolve accounting queries faster. Seamless timesheets and billing translate billable hours into invoices with just a few clicks, and robust document management means no more digging through piles of paper to find what you need. Beyond workflow efficiency, Zoho Practice also enables real time financial visibility across clients thanks to seamless integrations with Zoho's accounting tools, allowing you to gain actionable insights to identify and resolve reporting inconsistencies quickly. Whether ensuring tax compliance, monitoring cash flow health, or simplifying collaboration. Zoho practice is the unified solution to manage all aspects of an accounting practice. To explore how Zoho Practice can save time, enhance oversight, and help your firm work smarter for free up to five users. That's crazy. You get it for free. Up to five users. Head over to The Accounting Podcast Dot promo slash Zoho. That is The Accounting Podcast dot promo forward slash Zoho.
David Leary: [00:51:41] And I'm going to go ahead and just back to back to our maker sub ad. So as well. So maker Sub thank you for sponsoring as an accountant. You know that accurate cost tracking is the key to your construction and manufacturing clients success. But tracking costs precisely can bog down your team with never ending data entry. Say goodbye to those headaches and hello to Makers Hub, the ultimate tool for eliminating the nightmare of manual build data entry with its unparalleled scanning capabilities. Makers hub captures over 100 data fields from incoming bills, including items at the SKU level, Po numbers, payment terms, discounts, and vendor details. It scans deeper than any other solution on the market, but Makers Hub doesn't stop there. It seamlessly syncs all that valuable data to QuickBooks automatically. Automatically allocating costs to proper customer jobs, projects and classes. Bid farewell to the tedious task of entering line items one by one and say hello to accurate, real time visibility into your clients costs. With Makers Hub, you can empower your construction, manufacturing and other clients the insights they need to bid on new jobs with confidence, plus streamline their entire accounts payable process with the ability to collect, manage and verify w-9 forms as well as handle bill and payment approvals effortlessly. Head over to The Accounting Podcast dot promo slash makers hub that is The Accounting Podcast dot promo forward slash m a k e r s h.u.b. Thank you.
Blake Oliver: [00:53:09] So what should we close out here? How about a tax story? Unless we've got more Big Four stuff? I mean, I could talk about e secret drinking club in New Zealand, but I feel like we've dished on the big four so much. I don't know. Maybe. Maybe we just keep going. I'll let you choose. David. Secret drinking club or Congress putting the wrong tax date in the law. Companies making millions.
David Leary: [00:53:35] Club. Because I feel like we covered a story in the past where, um, a Big Four employee was seriously injured. They had a bad head injury because they were forced to drink and they fell off a curb or something, and half the skull was removed. So now these drinking clubs have become secretive.
Blake Oliver: [00:53:51] So, uh, well, I think they're always like, I wouldn't say they put them on their website. Right. So they're they're never exactly public. But this was reported in, uh, stuff in May, and it details it's an article that details controversies and investigations surrounding E New Zealand, a branch of the global accounting and professional services firm EY, formerly Ernst and Young. Um, so apparently this this followed the Oceana Oceania branch issue, where they had. In August 2022, a 27 year old auditor was found dead at the Sydney office after a work function. And, um, there was a survey that was done across Oceania, including EY New Zealand, that of 4500 staff that revealed a culture of profit over people. I didn't say that. That's in the report, people. 15% of UI people surveyed in that area experienced bullying. 15% experienced bullying. That's a shockingly high number. 10% experienced sexual harassment. 10%. 1 in 10 experienced sexual harassment. And I bet you if you like, filtered that for just women, it's probably a lot higher, right? Um, many employees didn't report issues due to a lack of trust in the processes for dealing with complaints. Uh, God. What? Let me just read this. Let's see. Is there an example here in this story? Basically, it just sounds like a toxic culture, and it's not anything unusual. It's funny. Australia and New Zealand have been getting hammered recently for this and the UK as well. Maybe we're just better at like, keeping this under wraps here in the United States or the HR teams like know how to keep people quiet or something like that, but like this. I don't know, this doesn't surprise me. I don't know if I have anything else to add. The personal stories are always sad.
Speaker3: [00:56:04] Yeah.
Blake Oliver: [00:56:04] The people who are whistleblowers, who get pushed out and just like, demonized by the, the firm and and the the HR people. I don't think there's anything worse than HR people who work at, like, companies like this. Right? Because your job is like covering up the sexual harassment that a partner did, like to a manager or something like that. That's your job. Like what? You must just be an off. Like to to go and rationalize that. Like go home to your family after you do that all day, like how.
David Leary: [00:56:36] Your job is to protect the assets of the company, essentially.
Blake Oliver: [00:56:39] Right. Your job is to protect people who are basically recidivists in a lot of cases and keep doing it over and over again. You know, I mean. Here's the example. I found it the secret drinking club, right, I mentioned this.
David Leary: [00:56:53] Yeah.
Blake Oliver: [00:56:54] Um, so this is in the report. It's about a drinking culture described as, quote, extraordinary, unquote, by one former employee and quote, horrific, unquote by another. Um, there's one client relationship in particular where overuse of alcohol was raised by numerous sources. His biggest account, Fonterra, Braden Dixon was one of the head e figures on the Fonterra account. Stuff has been told of a secret drinking club involving senior people from Fonterra and E, which would take place at various venues in Auckland and Hamilton. Drinking is, of course part of the entertainment culture at plenty of corporates, but questions are being asked by current and former staff about whether the tight relationships led to lines being crossed. How can Fonterra and E people who are meant to be negotiating and managing projects be out drinking together several times a week, often until the early hours of the morning? Asked one insider from various industry sources. Stuff understands e! Was recently selected as a design partner on a major Fonterra project. If the contract continues as proposed, it will be worth in the hundreds of millions over a period of years. Stuff has seen documentation, which shows an internal audit team at Fonterra is now looking at the major project. There were concerns raised at Fonterra saying hang on, did E have the best bid? Said a source. Fonterra did not answer questions about an audit or the secret drinking club. O'connor says he is not aware of any such club and that any entertainment spending is closely monitored. So this goes to the buddy buddy kind of thing. But this is with development.
Blake Oliver: [00:58:22] Yeah. Yeah. Um, some of the EA names involved in the club are well known to whistleblowers who have been talking to stuff. Stuff is aware of three complaints against one senior male employee and that there were EA partner level discussions about him, but ultimately he was kept on. You produce, you sexually harass, you get to stay. There's another one. Another example, a former female employee described keeping a folder of inappropriate messages from the man, usually complimentary comments on my appearance, requests to join for drinks or comments along the lines of I'd have more fun if you were here. She said she didn't lodge a formal complaint about him, but felt her folder was another example of females having to take action to safeguard against actions of their male senior leadership. Another described the man as a predator. He is just disgusting. There you go. I didn't write it. I just report it.
David Leary: [00:59:15] That's, uh. We usually do. Usually. Very rarely do we report anything. Usually something's already out there or people have been saying it for a very, very long time before we discuss it on the podcast.
Blake Oliver: [00:59:25] And Heather says, I think it's pronounced Oceana, probably. I apologize to everyone in that part of the world. I am ignorant, I am American, so you must forgive me.
David Leary: [00:59:38] You probably cost us another listener. Thanks, Blake.
David Leary: [00:59:42] Well, all the air people aren't going to listen anymore.
Blake Oliver: [00:59:44] Like, I hope we don't have air people listening. I, I hope we never have an Air Department. I mean, I have not had good experiences with air.
David Leary: [00:59:54] I thought this comment from Allison was interesting. I wonder what would happen to audio quality if partners were held personally liable for failed audits.
Blake Oliver: [01:00:05] Right. And the argument is, oh, they are, but the fines are like tiny. It's pales in comparison to their compensation. You know, not a partner might get fined like 100 K. It sounds like a lot, but they're making millions of dollars. Yeah, I maybe it would go up, but I'm I'm not in favor of a stick approach. That's the approach we have. We have an approach where the auditors do their job. The pcob comes in and says, you did a bad job and slaps him on the wrist. And yeah, you could make the fines more. But ultimately, if you want audit quality to go up a lot, you've got to create a positive incentive, a financial incentive like to incentivize like a you need a system where people make more money when they do good audits, or at least one that doesn't punish them for doing good audits. I argue that the system we have now, if you do more than the bare minimum, you get punished financially because you have to hire more people to do a good job. So we need to create a system where that isn't the situation And I don't know what that is exactly, but nobody's even talking about it. Um, none of the.
David Leary: [01:01:15] If we have more short sellers like Hindenburg research out there that are making money on the short, that would essentially that could be the model. Like, we don't we don't have to have independent auditors because there's companies out there that are watching for opportunities to short sell somebody. So if, if, if all these short sellers aren't writing up stuff about company, why.
Blake Oliver: [01:01:36] Yeah.
David Leary: [01:01:37] Well, the why is safer than company J.
Blake Oliver: [01:01:39] But the problem is you'd have to for the short sellers to do a good job, you have to give them access to the company's books. That's the external auditors have access to all this information. I still think that the best solution would be if the stock exchanges hired the auditors and assign them out to the different companies and rewarded them based on, like, the quality of the audits, the what they find, right? If they find something material, like they get an extra bonus, like incentivize the auditors to find problems rather than cover them up.
David Leary: [01:02:14] That makes sense because the stock exchanges themselves are businesses, and you want to be able to say like, look, we have the most reputable businesses on our exchange. Come, come use our exchange.
Blake Oliver: [01:02:24] That's one idea. Um, it's certainly better than the system we have now. Boring. Accountant says partners have said, quote, we don't guarantee the audit quality. We manage risk, right? They're managing their own risk. The risk of the firm. Right. And so how do you maximize the money you make? I keep saying this over and over again, but I feel like accountants don't understand this, so I have to keep saying it. You want to make a lot of money doing audits. You tell your team, do the bare minimum required, like do as much prior year. Like you create a system where they do as little work as possible to pass. Just pass. So that's why you get low quality, because the people who are doing the best audits are basically just passing. They're getting the C grade, and then the people who are lower down are failing. So if you want to improve audit quality, you need to get the high performers to do A audits not C audits. That'll bring everybody up. It'll force everybody to up their game.
David Leary: [01:03:29] So this is in my head I was going through this so supermicro, uh, computers. I'm the auditor, and I'm. I'm a young auditor at Deloitte. I see something weird. I was like, that's weird. Like, they basically have $1 billion going back and forth between a company his brother owns. Like, like. And I bring this up the ladder and this is a concern. So, Blake, you're my senior partner. You're the one that's going to sign off on the audit. I bring you up this concern, which. How do they not see this if everybody else is seeing it? Because they're not looking that.
Blake Oliver: [01:04:02] They're not looking for it.
David Leary: [01:04:04] But what if I found it? Now I go up the ladder.
Blake Oliver: [01:04:05] What would happen is your manager might say something like, don't worry about it. Thanks. Got it. And then they don't do anything about it. And it has to go through all these layers, right? Nobody wants to make more work for anyone else. So at some point it it doesn't get to the partner. And if it does and the partner is unethical, the partner might say like, oh, well, let's not worry about it.
David Leary: [01:04:26] It's immaterial because did you know that that's going to cost us as a company, $4.5 million in fees, because they're going to be like, forget you guys. I don't need to bring up these headaches.
Blake Oliver: [01:04:37] David, did you know that auditors and companies don't have to disclose their materiality standards? So one of the arguments, like one of the reasons why frauds don't get reported in audits is because they're immaterial, meaning that it's decided that the amount of the fraud or the amount of the inconsistency or the misstatement is not enough to change the mind of an investor. And the question is something like and I apologize, auditors, if I don't get this exactly right. But the question is essentially would this would would this information change how an investor views the stock right, or views the company? And if it's small enough like then no. Right. Like, David, if there was a $10,000 fraud at Microsoft, would you care? Would that make a difference? Probably not.
Blake Oliver: [01:05:33] No, but it should.
David Leary: [01:05:34] Be reported like the street should make that decision.
Blake Oliver: [01:05:36] Well we don't we can't report everything.
Blake Oliver: [01:05:39] So you have to have a materiality standard. But what I'm saying is that we don't know what that is. We don't know what that number is. The auditors don't even have to tell us what the materiality standard is. So all it takes is somebody at the audit firm to say it's immaterial. Now in their documentation, they're supposed to have this. It's very easy to cover up something you don't want to see with materiality.
David Leary: [01:06:06] You just raise the bar. Well, on this, on this audit engagement, we had the bar set at this number and that didn't meet that number. So we can ignore it.
Blake Oliver: [01:06:13] Yeah. And it's very discretionary. So even the pcob has trouble questioning materiality because it's up to the audit partner. There is no definition of what is material. Now there's rules of thumb right. Many audit firms use 5% of pretax net income as a materiality threshold. Um, the SEC's new climate rules suggests a 1% threshold for revenue expenditures or assets. Right. And it's very complicated. And there's both materiality for individual transactions, but also for an account and for the financial statements as a whole. There's all sorts of different materiality levels. And this is all highly discretionary. So it's very easy if you don't want to see something, to not see it, because you can simply put on darker sunglasses, right? Raise your material threshold until you can't see the problem.
David Leary: [01:07:04] It's managerial accounting 101. You're just changing. You just make the numbers be what you want them to be.
Blake Oliver: [01:07:08] Well, in this case, it's. That's what the. That's what management does, right? Make the numbers what they want them to be. And then in this case, it's, uh. Yeah. Change the tint on your. Change your standard. So like your filter so you don't see those issues. Right. Yeah. I don't think people understand just how, uh, like, much discretion auditors have and management has. There's, like, so much. And that's why this stuff doesn't ever get surfaced until it's too late. It's a system we've designed which is designed to reduce the risk to the firms, to the auditor.
Speaker3: [01:07:42] It's a good way.
David Leary: [01:07:43] To put that that the reducing the risk to the.
Speaker3: [01:07:46] To the firm. Right.
Blake Oliver: [01:07:47] The audit firms are extremely profitable and have very low risk because you can simply ensure away all the risk. You just go buy insurance for your eventual audit failures, which are going to happen. You're going to have botched audits and you're going to get sued, and you just buy insurance and you're very profitable, you know? So it's a cost of doing business literally built into the business model. Um, Hunter says, do you think these low quality audits exist are as prevalent in small business and private industry? Big Four you've talked about a lot, but what about the rest? So sadly, Hunter audit quality is lower among the small firms. The big four actually have really good PCAOB inspection rates other than our friend at EY, which is a 37% deficiency rate. You know, the others are like in the 20 percentile, but you go to like small firms and they might have like 80, 90, 100% like and the pcob, to be fair, only might inspect one audit but then they fail it. So like how do we know what the quality is? My guess is it's going to be lower, that you will probably even have lower audit quality at small firms because they have fewer resources and fewer experts. And, you know, they're not as good at managing risk. But that's speculation. I'd be curious if any of our listeners know for sure. David says audit is fairly commoditized, right? The exchanges being the gatekeeper and creating their own audit roulette should help decouple the bad incentives we are trying to fight today. Good idea. Thanks, David Scully. And that's not my idea. It comes from Ron Baker. He has floated that idea. I don't know where he got it, but yeah. Why don't exchanges hire and roulette? And it could be a roulette system, right. And, you know, obviously you don't want to switch auditors every year. That's a lot of work. But you could certainly switch them up more frequently than now where it's like, you know, some companies had the same auditor for decades and decades.
David Leary: [01:09:46] So to put a button on all of this, I'm the street. I'm the common man investor. Every day. There's earnings announcements. There's earnings releases. You know I'm not going to read the super microcomputers. You know 172 pages 160 pages I can't read all that. I just see that X company signed off on the audit. So the numbers in that report are probably good. Like how do.
Speaker3: [01:10:11] I wouldn't I wouldn't necessarily how do I.
David Leary: [01:10:14] Move forward as the common man when it comes to trusting audit?
Blake Oliver: [01:10:17] Well, you'll do what many investors have done, which is they have reduced their reliance on financial statements. If you look at studies of investor behavior, less than 14% of financial decision making by investors now, investment decisions is driven by the traditional financial statements. And that is not I don't mean to, you know, insult our friends who are making financial statements or auditing them. That's just the situation we're in. And like I've said before, the reason is that our accounting has not modernized for intangible assets. And so the primary drivers of value, the success of businesses is not in the financial statements as much as it used to be. And so investors look to other sources of information like short sellers, or they look to non-financial metrics, subscriber numbers. We have this world in which the most important numbers are not in the financial statements anymore, like the number of subscribers. If a business is a subscription business, should it not be required to report the number of subscribers it has? If a business is a software as a service business, should it not be required to report in a systematic way its annual recurring revenue, which is the number that is the most important for determining its health? There is get this there is no common definition for RR or MRR monthly recurring revenue and companies use different ones. This would be so easy for FASB to standardize and require the reporting of. And yet they spend their time doing lease accounting, the most useless accounting standard we have ever encountered in in my brief lifetime. I don't know what they are thinking. They are like, completely out of touch. I tried to get somebody at FASB to like, talk to me. They, you know, don't respond to that.
David Leary: [01:12:09] So going by what you're saying, if I'm going to make an investment based on all these other numbers that are not in the financials and not as part of the audit, the only thing valuable from the audit, then is going to be the detection of fraud. And so if you're not detecting fraud, does this have any value at all.
Blake Oliver: [01:12:27] I'm not saying it has no value, but I think the value is getting lower and we actually can't quantify it. And if we can't quantify it man, like where we're seeing it is in the salaries. Right. Market forces dictate salaries and the value of an audit. If the value is going up, salaries should be going up because some of that wealth would trickle down to the staff. But all we've seen is partner profits increase, which to me just means they've figured out how to game the system. How many companies would get. How many companies would get audits by external auditors if they weren't forced to do it? I would love to know the answer to that question. Audits are required by law if you're a public company in the United States. Yeah. What if we exempted a certain percentage every year and said, you can choose whether or not you want to get audited this year? How many would do it? That's an indicator of the value as well.
Speaker3: [01:13:28] In theory.
David Leary: [01:13:28] It's the board.
Blake Oliver: [01:13:29] Right. So does the board care.
David Leary: [01:13:32] And the board. Yeah. Maybe they. Maybe you do it every 3 or 4 years just to keep a check on the company, make sure it's not out of control. But if you're the board, you're probably also thinking like, do I want to spend $4.5 million on an audit. We could just keep that and split it up between US board.
Speaker3: [01:13:48] Members and increase.
Blake Oliver: [01:13:49] Our profit. Right. So.
David Leary: [01:13:54] Well, hopefully we don't get another letter this week, but.
Speaker3: [01:13:57] Oh, I.
Blake Oliver: [01:13:57] Like I mean, this is great content. Thank you, Connor, for your letter. Um, I would love to extend you the opportunity to come on the show and tell us what you feel. Let's talk it through. Hey, and if there's anyone at EA who's a partner that wants to talk about this stuff, we never get anyone from these big four firms reaching out to us to talk about this stuff. I wonder why. Uh, maybe it's just because they don't want to talk about it, right? Just business as usual. Let's make the money. Let's print the money. Let's not let this be an issue. And this is also, I think, why you don't see anyone at the AICPA or state societies talking about this, either because it conflicts with the business model. Right? Nobody wants to disrupt that. But it's also creating the problem in our profession. It's why we have a CPA crisis. I really believe fundamentally that this is the root of it is until we increase quality, we're going to have trouble attracting quality candidates. So I mean, at some point we got to recognize the emperor has no clothes. At some point we have to. Make changes. The rest is just, you know, talking and not doing, which is what we see, all these groups that are trying to solve the crisis, do they just talk, talk, talk. They don't really do anything, do anything meaningful. They don't even quantify the problem or quantify the ability of their recommended solution to solve the problem. They're not even doing basic accounting for the problem that we're trying to solve.
Speaker3: [01:15:33] Yeah.
Blake Oliver: [01:15:34] You know, so anyway, uh, for those listening who are considering a career in accounting, I want to make it very clear. You don't have to do audit. You don't have to go work for the big four. There are so many great jobs out there doing accounting for small businesses or for mid-sized businesses. Even in corporations like corporate accounting is great. It can be really good. You don't have to go do audit, and you can do something meaningful if you want to do client accounting services, outsourced accounting work in a small firm. There are so many startups and small businesses that need your help navigating both the accounting and the taxes. All the compliance, all the advisory. It's a great career. I just think that, uh, there's this big chunk of it that is kind of turning everyone off. And we need to we need to make people aware of the other options. And the professors who point everyone to the big Four are complicit in this. The universities, traditional education, many of those departments are complicit, and they take money from the big four. And so that's why they do it. It's money drives people, it drives unethical behavior. And I think the thing that I dislike the most about it is that you have people who are doing all this stuff, and then they're espousing how ethical accounting is and how important it is to financial markets. And meanwhile, the other hand, is taking the money and being unethical. And I've never liked hypocrisy. It's my least favorite thing. It's the thing I love to hate is hypocrisy. So that's what we have a lot of, unfortunately.
David Leary: [01:17:18] We need one of those, uh, somebody that's very creative and is good with Photoshop. You know, like they have those Instagram like, oh, what it's like on Instagram. Then you go to the vacation spot and the reality, like, you could take the briefcase photo like, this is the what you think it's going to be like. And here's the reality of the audience. You could edit that up and give us a little meme.
Blake Oliver: [01:17:37] My hope is that if the pipeline of Big Four folks you know dries up, then they'll be forced to kind of change their ways. We'll see. I just I just feel like it's it's our duty to make make students aware of what they're getting into so they don't go drink the Kool-Aid and regret their decision.
Speaker3: [01:17:54] And I don't know.
David Leary: [01:17:55] If it's duty. It's just like it's okay to have the public conversation about this. Like, why not? This is super important. Like, of course we should be discussing this. It's The Accounting Podcast. We're not supposed to talk about audit failures.
Speaker3: [01:18:10] This is the biggest.
David Leary: [01:18:11] Accounting.
Speaker3: [01:18:11] Firms in the world. Well.
Blake Oliver: [01:18:14] I would like it if we didn't. You know, there they would really prefer if we don't talk about it. But guess what? I'm now that now that it's been brought up by a listener, I think we'll just have to keep on this. We'll see what their inspection rating is next year. If dumping 10% of their clients actually improves audit quality.
Speaker3: [01:18:33] Well, it's pretty.
David Leary: [01:18:34] Clear 150 hours is going to change, So you don't even have to talk about that anymore. Blake. It's done. Now you have your new soapbox, which is to fix audit.
Blake Oliver: [01:18:43] The thing that really matters.
Speaker3: [01:18:45] Everyone tells me, oh.
Blake Oliver: [01:18:46] 150 isn't going to actually change anything. And I don't think that's true. I think it will help, but I think the bigger issue is this. Yes, it's the overwork. It's the unethical behavior. It's the bad business models. That's the fundamentally hard thing to fix because there's so much money wrapped up in it. But we will continue on in our mission of modernizing, revitalizing the accounting profession here on the show. And if you want to send us listener mail, whether you like what we're saying or disagree. And I love hearing other opinions. I'm more than happy to hear those. If you want to comment on any of this, please seriously email us at The Accounting Podcast at earmarked me. Join our community at Earmarked Community. You can send us your message either way. The community is a great place though because you can get more people commenting on it and more people will see it other than just me. We read every email you send us and we often read them on the air.
Speaker3: [01:19:41] Yep.
Blake Oliver: [01:19:42] Um, Blake Steele says great convo to hear two weeks before I start in Big Four audit. Blake, I want to hear. I want to hear, uh, how your how your experience goes. I would love to know if anything we are saying fits what fits, what doesn't. And I want to say before we close out, I'm not saying like every audit team is like this. I'm sure it goes partner by partner. And you have great audit partners who are super ethical, who really care, who love the work, who believe they are defending investors and probably are. But you also have a system that incentivizes really bad actors. And I've met I've met a couple of shady partners, and now I see how there could be quite a few. And you rationalize the behavior. The fraud triangle is there. Um, that's all I got, David.
Speaker3: [01:20:34] Yeah.
David Leary: [01:20:34] We should wrap.
Speaker3: [01:20:35] Up. We'll wrap.
Blake Oliver: [01:20:35] It up. See you around here next year. Thanks, everyone who joined us live. And don't forget, you can subscribe on YouTube if you're listening to this on the podcast feed. Hit the bell icon. You'll get notified when we go live, and you can earn free continuing professional education for this. If you made it to the end of this episode, you really deserve a CPE credit. Seriously. Thank you. Good job. Download the earmark app and you will find this episode on there in a few days after it airs on YouTube, and you can register for the course. Take a quick five question quiz and earn your CPE since you already watched the episode, so why not do that? It's free. You can earn one credit for free per week on the earmark app, and you can support us by subscribing on the earmark app as well. That's all I got, David. See you here next week. Thanks, everyone.
Speaker3: [01:21:26] Bye bye everyone.