Caveat Emptor: let the buyer beware

I have been slowly but surely reading “Manias, Panics, and Crashes: A History of Financial Crises” by Charles P. Kindleberger and Robert Z. Aliber.  Coincidently, I am on Chapter 7, which covers frauds, swindles, the credit cycle, and Bernie Madoff.  In the book the authors ask a commonly asked question: should the governmental authorities establish ‘truth police’ to prevent the investing public from being misled, or should the public be on its own in determining which statements made by the stock sales personnel are not strictly true (1)?

One of my initial reactions when trying to answer a question as such is usually something along the lines of “who should determine what is right and wrong?”  While the implosion of a financial bubble always leads to the discovery of fraud, to include our most recent financial crises, a majority also points to acceptance of caveat emptor, which is Latin for “let the buyer beware.”  Nevertheless, most fraudulent behavior is illegal, but most can linger on an ill-defined and vague legal borderline.  Some of those ‘fuzzy’ activities may be entirely legal, yet those engaged in them would be unwilling to have their activities posted on the front page of the Wall Street Journal or Financial Times.

I believe a touch of caveat emptor will always be present in the financial industry – as it should!  However, regulation must also exist in order to ensure buyers and sellers buy and sell based on their own idea of risk and personal knowledge, not on the possibility of illegal behavior.  As discussed previously in this course, sovereign risk and protecting investors is a major factor in economic development and future investment.

What can we do to increase investor confidence and ensure accurate information is released?  I believe SOX regulations need to be intensified to include mandatory audit firm rotation.  SOX currently requires that companies rotate their audit partners every 5 years, however, there is no regulation on the rotation of the firm.  According to GAO Analytics, nearly 35% of companies in the S&P 500 have had the same audit firm for 25 years or more, about 60% of audit firm tenures for Fortune 1000 companies are estimated to be 10 years or more, and 8 companies in the Russell 1000 have not changed auditors in the last 100 years (3).

In addition, many audit firms also offer consulting and financial advisory services.  Undoubtedly, helping companies make money can be in conflict with auditing – remember the Big 5?  Deloitte, the largest audit firm in the world, grew 8.6% in 2012.  Deloitte increased revenues from consulting by 13.5% and from financial advisory by 15% (4).  CEO of Deloitte Barry Salzburg said that they are adding consulting staff at twice the rate as audit employees, and that he expects consulting to continue to grow by double digits (3).  Keep in mind: at this rate the firm would do more consulting than auditing by 2017.

Lawmaking bodies have brought up the idea of auditor rotation.  Still, the last vote on mandatory auditor rotation was shot down 321-62 for HR 1564 (5).  Should the above be stopped?  Are public accounting firms working in the best interest of the public?  Do you think mandatory audit firm rotation will help?  How about the implementation of audit-only firms?

References

(1) Manias, Panics, and Crashes by Charles P. Kindleberger and Robert Z. Aliber
(2) http://www.merriam-webster.com/dictionary/caveat%20emptor
(3) http://www.directorship.com/mandatory-audit-firm-rotation-explaining-the-key-numbers/
(4) http://www.economist.com/node/21563726
(5) http://www.forbes.com/sites/francinemckenna/2013/07/09/house-counts-on-honor-amongst-thieves-votes-against-mandatory-auditor-rotation/