The Accounting Podcast

Professor Ed Ketz of Penn State joins the show to discuss audits' current state and future. We delve into the relevance of audits and explore the value of unqualified opinions in making audits meaningful. The discussion also touches on the overstandardization of audit reports and how this can lead to investor misunderstandings. Professor Ketz brings a unique perspective, sparking a debate on whether the existence of the unqualified opinion creates value rather than the content within. The episode ends with a brainstorm on potential regulation improvements to improve audit quality and usefulness.

Meet Our Guest, Ed Ketz

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Creators & Guests

Blake Oliver
Founder and CEO of Earmark CPE
David Leary
President and Founder, Sombrero Apps Company
J. Edward Ketz
Ed Ketz, Ph.D., a member of the Penn State faculty since 1981, has authored and edited 17 books as well as numerous articles. His book Hidden Financial Risk (Wiley, 2003) examines the corporate culture and the institutional setting that engendered recent accounting scandals, informs investors how to protect themselves, and suggests improvements for the profession. Accounting Ethics (Routledge, 2006) investigates the accounting profession over the last century by scrutinizing its positions on ethics and its roles in myriad accounting scandals and by exploring how to reduce the number of accounting frauds. Fair Value Measurements (BNA, 2007), co-authored with Mark Zyla (Managing Director at Acuitas, Inc.), summarizes the FASB’s efforts in this area, supplies the conceptual ideas behind this topic, describes methods employed by valuation assessors, and reviews criticisms of fair value measurements. Professor Ketz has been cited in the popular and business press, including The Wall Street Journal, The New York Times, The Washington Post, Business Week, Bloomberg News, USA Today, and Chicago Tribune, on topics such as accounting for stock compensation, business combination accounting, accounting for derivatives, the meltdown in the subprime mortgage sector and related CDOs, and evaluations of specific corporate accounting practices at Enron, Tyco, Rite Aid, HealthSouth, AIG, CVS, Starbucks, Merrill Lynch, Citigroup, and other corporations. He also has appeared as an accounting commentator on CNBC, CNNfn, and National Public Radio. Ed Ketz provides investment and accounting advice and has consulted for Banc of America Securities, Wells Fargo, Gerson Lehrman Group, Association of Audit Committee Members, the Coleman Research Group, and several hedge funds. He also has served as an expert witness.

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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: [00:00:09] Hello and welcome back to the show. I'm Blake.

David Leary: [00:00:12] Oliver, and I'm David Leary.

Blake Oliver: [00:00:13] And we are pleased to have with us today Ed Ketz. An accounting professor at Penn State University. Ed, welcome to the show.

Ed Ketz: [00:00:20] Glad to be here. It's a privilege.

Blake Oliver: [00:00:23] Ed, you wrote a compelling response piece to my recent article in Accounting Today that questioned whether audit opinions even matter anymore, in light of a court decision related to Bdo's botched Amtrust audit. In my original article, I covered how the Second Circuit Court of Appeals upheld the dismissal of a case against BDO, essentially saying that their audit report was too generic for a reasonable investor to depend on. I used this as a jumping off point to discuss how audits have become over standardized, creating a world where investors assume if a company has a clean audit opinion, everything is fine. Ed, in your piece, you felt that I jumped the gun by declaring audits don't matter before a rehearing. But more interestingly, you dug into how Bdo's defense seems to imply that audits have little actual value or information for investors, which is interesting considering that BDO is the auditor. In this case, you would think that they would defend their audit as having value and having information for investors. So reading go ahead please.

Ed Ketz: [00:01:27] I was just going to say the surprising thing about this case, uh, is not so much the court decision as it was bdo's, uh, brief that they filed. Once you would strip out all the legalese. In essence, what they said is that the audit opinion is just too general. It, um, uh, cannot be refined, cannot be dug down into very far, and therefore it really couldn't have value. And therefore they wanted the case dismissed in legal terms. They were saying it was not actionable because it didn't say anything, which I think, as you just, uh, implied is an incredible statement for an accounting firm to make because they're basically trying to talk themselves out of a big industry.

Blake Oliver: [00:02:14] That's right.

David Leary: [00:02:15] So BDO planted that seed. That was their argument. And then the court basically agreed with them. The court didn't just come up with this on their own. Bdo planted the seed of the thought.

Ed Ketz: [00:02:23] Exactly. It was not the court that invented this, uh, as a uh, a proposition for evaluating the case. This was an argument that was made by the defendant BDO and the court. Thought it made some sense. You can basically think of, uh, this is a bit of an overstatement, but not by much. That audit opinions are pass fail. You either get the unqualified or you don't. And uh, so verbose argument is, is that's not much of a signal to investors and creditors.

Blake Oliver: [00:02:58] So I myself as an investor and as a CPA, I've read through, uh, some audit opinions and having never been an auditor myself, I guess I don't feel too much loyalty to audit. Um, you know, I'm one of those CPAs who, in California managed to do it without getting audit hours. And I've always been on the financial statement side of things. Uh, and so I, I saw this ruling by the court, and I thought to myself, wow, somebody's finally speaking the truth. Uh, because all these audit opinions, nobody's reading them, right? They're all the same. They all say the same thing. And in essence, what we have is this pass fail system. And what I was trying to get at in, in my piece in accounting today was that, well, when we have this pass fail system where the bar is actually seemingly very, very low, um, and very few companies ever actually, you know, fail an audit. Um, we have this system that just doesn't create a lot of value anymore for investors. And, you know, if we want audit to have value, if you want the CPA to be valuable, maybe we should consider changing how we do business so that we are creating value for investors. But you, you you have a different take on that. You believe that, you know, the audit still does have value. And so I was curious, you know, let's have you on the show and talk about this and debate this, uh, you know, so.

Ed Ketz: [00:04:25] Uh, yeah. Let me uh. Uh, let me approach it this way. Uh, the researchers that have examined this question typically examine it from what happens to those companies that do not get an unqualified opinion. Uh, if you get a going concern opinion, for example, what happens. Right. And, uh, a number of papers have found that any firm that has that, um. So it's a going concern opinion. Uh, let me put this in the context of predicting corporate failure. Uh, there are models out there, financial models such as the Altman model, which has been around 50 years. Uh, and many models since then that predict corporate failure, predict bankruptcy. And the question is, does the going concern opinion assist that at all? Does it assist your ability to predict corporate failure? And the answer, interestingly, is yes it does. So, uh, whatever you can do, uh, by having a model, whatever you can do with simply looking at a number of ratios, uh, debt to equity and some other items, uh, can be improved upon if you know that the auditor says it's a going concern. And so looking at things like that, uh, it does indicate that there's value.

Ed Ketz: [00:05:43] Another way, uh, some interesting studies. And this doesn't happen all the time, but there was a, uh, very nice change in institutional framework, uh, in the UK where private firms, uh, that had, uh, let's see, it was 1 million pounds in earnings or uh, uh, greater than 1.6 million pounds in assets. Uh, even though they were private firms, they had to have audits. And then in 2004, if I remember correctly, uh, U.K., uh, dropped that law and, uh. So firms, private firms do not have to have audits anymore. But some of them chose to have audits anyway. And so some researchers looked at those firms that continue to have audits and found that, uh, uh, in terms of credit ratings, uh, they were doing much better, uh, a number of points, uh, higher. Significantly higher than what? The ones that did not choose audit. So audit served as a signaling mechanism to indicate that they were good firms. And so the audit opinion did provide value in that case. Uh, in that case.

Blake Oliver: [00:06:56] So. Is it fair to say that your argument is that the simple existence of the unqualified opinion is what creates value, not necessarily what is written in the audit report the.

Ed Ketz: [00:07:12] Way it is written now? Yes. Uh uh, it's more that because there is an absence of a variety of things in terms of, uh, consistency, uh, various changes in opinions, uh, uh, in accounting standards, uh, going concern. By not having those things, then the investor can assume that the information in the financial statements, uh, are, are, uh, not materially misstated and, uh, they do not have any material omissions.

Blake Oliver: [00:07:44] See, I would have more comfort in, uh, going along with that if we hadn't seen in. The past years and decades, numerous audit failures, such as this one in which an audit opinion was issued as unqualified, and yet there were massive errors in the financial statements or outright fraud. An example that comes to mind is the audit of Tingo by Deloitte in Africa, in which $450 billion simply does not exist, and apparently the auditors did not confirm cash balances and there were only $50 in the bank account. The entire company was a total fraud for years. So like, it doesn't give me much confidence as an investor to know that there's not an opinion when there's also a chance that the auditors might not have done their job. And and there's nothing in that audit opinion that tells me how they did it or, you know, what exactly they tested. And I just have to take their word for it.

Ed Ketz: [00:08:42] On the other hand, you do have a tort system that allows you to penalize these guys big, big time. In addition to the example that you just mentioned, I think of the colonial Bank example, and I think of that one because that court case is finished. In that case, PwC was sued by the FDIC, and uh, FDIC refused to settle the case. So we actually have the court opinion out there. And the judgment is in, uh, uh, the public domain and reading Barbara Rothstein, uh, the judge's opinion, uh, you can see her chastisement. But more to the point, you can see the over $600 million judgment she gave against PwC. And, uh, by holding the auditors to the fire by the SEC, uh, PCAOB and by the tort system, uh, you can try to, uh, have quality audits.

Blake Oliver: [00:09:48] We can try. But you mentioned the PCAOB. Um, they've got a report coming out. It was supposed to come out at the end of last year. I think about 2022 audits. It still hasn't come out formally yet, but there was a press release that they issued saying that they expect over 40% of audits that they inspected had part one A deficiencies, which mean for those who don't know what a part one A deficiency is, um, that the auditors failed to collect sufficient evidence to support their opinion that they should not have issued the opinion with the evidence that they collected 40% of audits. So I look at that, and then I look at these audit reports that really don't contain any useful information. And I think to myself, is it really the case that 40% of audits are so deficient? The auditors should not have issued the unqualified opinion? Is that the situation we're in?

Ed Ketz: [00:10:41] Yes and no. Uh, it does point to the fact that while audits, uh, matter, the quality of the audits may be so impaired that we are not having as much value as we could have had. Uh, we had better performances in the audit, uh, process, and, uh. This does point out the need for monitoring what auditors do, not simply relying on their, uh, what are we going to say? Their own conscience to decide the matters? I use that because that was a famous phrase that came out of the, uh, congressional hearings that created the Securities Exchange Act of 1934. I'll mention that since I brought it up. Uh, Congress originally was going to have government auditors, um, audit the corporate, uh, reports, and the profession made a strong argument for, uh, letting them do it instead. And, uh, there was one senator who questioned them when they said they could audit the thing, and the senator asked, who's going to audit you? And the response by the, uh, presenter was our consciences. And so we want to what we want to do today is to make sure there's consciences are working.

Blake Oliver: [00:12:03] Right. But but it doesn't seem like it is working that well.

Ed Ketz: [00:12:08] Certainly not perfect.

Blake Oliver: [00:12:09] Right. So. David, it sounds like you had some.

David Leary: [00:12:13] I have a question. So you said obviously as an investor there's tort, right, I can sue. And you said this has been done. Do you think Bdo's real argument in this is not about this case and it's about setting a precedent. So all future audits, they all big firms that do audits cannot be found and sued. Right. Found lack of better word guilty.

Ed Ketz: [00:12:32] Thing is that they don't lose money and the Amtrust case uh, but I don't think that they would mind at all if this became a more generalized concept. Yeah. Now, as it was, the second court's ruling was that it applied only to this particular case. Right. But, uh, if it stands, you could see this thing being brought up in other cases as well.

Blake Oliver: [00:12:56] Yeah. It just seems kind of nuts to me that BDO could have no liability in this case to the investors when there were flagrant errors in this audit. Right. To call it a botched audit is almost an understatement. Um, reading the reading the case. And they could escape liability. I mean, you know, if auditors can escape liability, then. And the only thing that holds them to account is PCAOB fines, right? That's not much of a of a of a penalty to worry about last year.

Ed Ketz: [00:13:26] Yeah. They are not giving they're not giving strong enough fines to do that.

Blake Oliver: [00:13:31] Right. Yeah. So we we saw last year the PCAOB doled out $11 million in fines, which sounds like a lot of money to you and me. You know, I don't make $11 million a year. Uh, but you're right. But Deloitte made $20 billion a year on their audit, uh, audits last year. And I think in, across the whole, you know, profession, it's it's a lot more than that. So $11 million in the context of hundreds of billions of dollars is not much.

Ed Ketz: [00:14:00] Right. The example I like to use is the waste management case. It goes back to the 1990s. Uh, but when the SEC, uh, came up and, uh, had their charges, uh, they basically fined the different individuals 4000, I think several of them 4000, one individual, $6,000. And then I ask if, um, Ken Lay is looking at this. Okay. This came out in 1996. If Ken Lay and Andy Fastow is reading The Wall Street Journal and they see fines of 4000 to $6000, do you think they give a crap if they are even discovered what they're doing at Enron? I don't think so. I'm sure that they thought that they would always get away with it. But their next step was, even if we get caught, who cares? It's a speeding ticket for us.

Blake Oliver: [00:14:52] So. How do we improve this situation? Professor Katz, we have this situation where we've got pass fail audits, right? We've got auditors who are hired and paid by the companies they are auditing, which seems to me.

Ed Ketz: [00:15:13] Ludicrous.

Blake Oliver: [00:15:14] As a. Yeah, as an obvious conflict of interest that, you know, we claim as a profession can be mitigated by ethics training and, and other controls, but it doesn't really seem to have improved the situation. Right. Um, we had Sarbanes-Oxley after Enron, but we continue to see massive audit failures. Wirecard in Germany comes to mind as well as when we haven't mentioned yet. There were a bunch in the UK. Um, we're surely going to see more here in the US. Uh, it seems inevitable. So, you know, what can we do to to make audits matter more? I guess I just want to say I don't think that they don't matter. I just think that because it's a pass fail system, and the auditors have so many inherent conflicts of interest that we've created a system where, like quality is very low, it's much lower than it could be otherwise.

Ed Ketz: [00:16:10] It's lower than it could be. Yes. Um, you packed so many questions in there. Let's see if I can unpack a couple of them anyway. Um, as far as the, uh, corporations, uh, uh, involved in accounting scandals, uh, I think the immediate thing to rely on is the tort system, uh, because the SEC and the PCAOB are not doing quite enough. Uh, can.

David Leary: [00:16:35] You see that system again, Ed? I didn't catch that.

Ed Ketz: [00:16:38] Says the courts.

David Leary: [00:16:39] Oh, courts. Courts. Okay. Uh.

Ed Ketz: [00:16:41] The word I use was tort. Uh, and frauds are a type of tort. Tort? Uh, but it is the court system, uh, involving, uh, uh, accusations of fraud. Uh, the problem there, of course, is that you have a high hurdle to pass in terms of getting into the system, and it's also a costly way of going, but nonetheless, that's probably our most effective, uh, tool at the moment. Uh, it would be nice to get the SEC, uh, on fire. I think that they could do more in terms of enforcement and PCAOB. I think I would like them to start naming names instead of just giving out reports. About 40% of failures. Name the names. Name not not only the firms, but name the partners who did these things, uh, and who were signing off when they shouldn't have, uh, some embarrassment would be good. Uh, and then, uh, raise the fines. You have to raise them to something where they are hurting the firm. That the firm has something. Um, and then back on the audit itself, instead of the pass fail system, you could be thinking of, uh, perhaps, uh, wanting the auditors to fill out details in terms of naming things. Now, we already have something that they're supposed to name some critical auditing matters that can can have come up. But I don't think that, uh, they've done as much, uh, there as I would like them to. I would like them to explore that, uh, further and be able to tell the investors more about what's going on there.

David Leary: [00:18:11] And when you're preparing your students to go out into the working world and become auditors, like Blake likes to say us all the time, we live in the golden age of fraud. Do you have them approaching this as don't trust anything and attack things this way? Or do they just get caught up in the system and it's just like pump out the work as fast as possible. Like how do you how do you prepare them for this?

Ed Ketz: [00:18:28] I teach two courses at Penn State these days. In the fall I teach, uh, forensic accounting, which basically the way I teach it is, uh, looking at financial statement frauds. And then, uh, the what happens to them either by the SEC or in the court systems. And then, uh, I also force them into a trial like situation where they have to be expert witnesses, some for, uh, the, uh, plaintiffs and some for the defendants, uh, on real life cases. So I try to find cases that are ongoing now, uh, probably more than anything else. Students, uh, run to find what the answers are. And I like them not to have the answers to. So force them to come up with some real arguments on their own. I do worry sometimes that maybe in the fall when I teach this, that I. It's just possible I'm teaching someone how to be a criminal rather than how to catch them. But hey, that's a risk. I have to take. The course that's harder for me to teach. Is the one on, uh, accounting ethics? Because how can you teach ethics when you have all these ethical failures? It's, um. It's discouraging.

Blake Oliver: [00:19:39] What about the idea of having an outside third party hire select, hire, pay auditors? This idea has been floated by a number of people. Um, perhaps the stock exchanges could do it.

Ed Ketz: [00:19:52] I think there's a number of changes. I will say that, uh, a paper that I wrote a couple of years ago, I'm very fond of and, uh, that was published in CPA Journal, and it's entitled The Impossibility of Independence Auditor independence. And the major thrust is indeed what David said earlier. Uh, I think it was David, uh, that, uh, the person that is, um, uh, getting the audit is the one paying the auditor. And, uh, I have raised in professional settings, uh, the situation what if I have a student in my, one of my classes, intermediate or advanced accounting, and he or she is paying me $100 an hour for tutoring lessons, and I give them some sample exams and so on. And that student ends up getting an A in the class. Have I been objective? Have I provided a service? And if you are another student in the class, what would you think? Let me just indicate that CPAs don't like that example.

Blake Oliver: [00:20:51] But it's a very it's a very appropriate example because that seems to be the situation we've created in our regulatory system.

Ed Ketz: [00:20:58] So, um, I don't know what the solution is. Uh, there are a variety of possibilities. Uh, what you mentioned is one, uh, another possibility is. Is having financial statement insurance. This was a proposal that Josh Ronen made a number of years ago. And his idea was let the insurance companies get the auditors, and so it would not be the company themselves, it would be the insurance companies that would handle that. And then the auditors total responsibility is to satisfy the insurance companies. And the insurance companies, of course, would decide who they're giving insurance to and how much they would charge for that. So I actually like that system. I will say the one alternative I would never choose is, is having government auditors. Uh, all I have to say is just look at the IRS and you have every reason that you need to keep the government out of, uh, doing that sort of thing.

Blake Oliver: [00:21:55] Ed Ketz, it has been a pleasure speaking with you. Professor Ketz is at Penn State University. You said teaching two classes, one in fraud, the other in. What was the other one? One in forensic accounting, the other in ethics. So, um, if folks would like to follow you online, is there is there a do you have a social media platform that you prefer? Do you like for people to email you? What is the way I prefer?

Ed Ketz: [00:22:23] Uh LinkedIn. So, uh, Ed Katz at LinkedIn, uh, would be good. They can email me as well at Katz at Penn State University, at PSU. Edu. Uh, alternatively, I have an alias, uh, Uh, I have Twitter, but I'm not active on that, so, uh, I don't get on there enough to make that worthwhile.

Blake Oliver: [00:22:47] Professor Katz, thanks for your time. It's been a pleasure.

Ed Ketz: [00:22:50] It has been. Thank you.