Audits Under Fire: Ex-Big Four Partner Responds to Criticisms

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Jerry Maginnis: [00:00:04] I agree with the premise that auditing is not perfect. I also believe there's opportunities to enhance the business model in a way that can make it a better experience for young professionals. Hopefully with the benefit of technology. But I'm pretty firm in my conviction that if the audit profession that we know and love today, with all its flaws, didn't exist, things would be considerably worse and we would see a lot more problems, a lot more abuses, a lot more fraud.

Blake Oliver: [00:00:38] Hello, everyone, and welcome back to the show. I'm Blake Oliver. And today we're talking with Jerry McGinnis. And of course, as with me always is David Leary, my co-host. David, how are you doing? Pretty good.

David Leary: [00:00:49] Pretty good. I'm glad. I feel like I've met Jerry in person. I know the accounting twins have been profiling his book. You've met him in person. It's nice to finally record something with him.

Blake Oliver: [00:01:00] Jerry, I'm so excited to get your opinion on a variety of topics. Big Four Audit quality. The 150 hour rule. We'll see what we get to today. And the reason I'm excited is because I think you might be the most. You are definitely the most pro, most high profile auditor we've ever had on the show. You were the office managing partner at KPMG in the Greater Philadelphia area, and you have gone on to have a career as a board member, as an educator, as an author, and now you're traveling around the country helping young accountants understand how to succeed in their careers. So welcome to the show. Anything you want to add to that list of experiences?

Jerry Maginnis: [00:01:41] No, not at all. Blake Thank you for that kind and gracious introduction and delighted to be with you today. Looking forward to the dialog.

Blake Oliver: [00:01:48] So on the show, we've been talking a lot about audit quality and so I'm really eager to get your opinion on the current state of audit quality, given that the Public Company Accounting Oversight Board, the PCAOB, recently put out a press release saying that they expect audits for 2022 to have a deficiency rate of 40%. Chair Williams calls the findings, quote, absolutely unacceptable and says audit firms must make changes to live up to their responsibility to investors. I sit here as a CPA looking at this press release. Having not worked in audit myself, I came up a different way wondering what the heck is going on. When the PCAOB says that 40% of 40% of audits are deficient, what does that even mean?

Jerry Maginnis: [00:02:37] Yeah, great question and definitely a very important topic. Audit quality is near and dear to my heart. As somebody who signed audit opinions on public companies for many years. And I also had a stint before managing partner at KPMG, where I basically ran our audit practice in Pennsylvania and kind of oversaw our service to about 75 public companies, ranging from Fortune 500 down to venture backed startups to many private. Companies as well. Water quality is incredibly important. You know, when we think about how capital gets allocated in our country, how investors and creditors make business decisions. There are many factors that enter into that. Blake and David. But sophisticated investors make use of financial statements routinely to evaluate those decisions and how capital gets allocated really matters. Because in an efficient capital allocation model, good innovative ideas get funded, jobs get created, our quality of life improves in environments where capital is not allocated efficiently, and there are many of them around the world. It's bad for the economy as a whole. So this is an interest of vital, important importance, I would argue, to all Americans. So let's talk a little bit about the Pcob and their inspection findings and that 40% deficiency rate that they're projecting. I'll start by saying I have a great degree of respect for the professionals at the PCAOB and the leadership.

Jerry Maginnis: [00:04:13] Their mission is critically important to our capital markets system, which arguably is the most robust in the world. And I think most of the people that work at the Pcob get up every day trying to protect investors and do a great job. And they're extremely well intentioned and diligent in terms of how they go about that job. Their model is arguably a pass fail model, right? So you want a firm either gathered sufficient evidential matter to support your opinion on these financial statements or you did not. And if you did not, in their opinion, you wind up in part one of the inspection report as a deficient audit, part of that 40% statistic. I just want to read you very briefly an excerpt from the PCAOB Auditing standards. This is from section 1015. The heading of that section is due Professional care in the performance of the audit. It's just a couple sentences, but I think it's really important for context. And the standard says the independent auditors objective is to obtain sufficient, appropriate evidential matter to provide him or her with a reasonable basis for forming an opinion. The nature of most evidence derives in part from the concept of selective testing of the data being audited, which involves judgment regarding both the areas to be tested and the nature, timing and extent of the test to be performed.

Jerry Maginnis: [00:05:45] In addition, judgment is required in interpreting the results of audit testing and evaluating audit evidence. Even with good faith and integrity, mistakes and errors in judgment can be made. So that's from the PCAOB auditing standards. I recently had occasion to take a look at one of the inspection reports for one of the big four firms. I won't name the firm. It's not important because they all look pretty similar, but the finding of the audit deficiency had to do with evaluating the company's ability to continue as a going concern. And the specific criticism was not enough. Work was done on the forecasted cash flows for that business for future periods. Now, as a former audit partner, I've signed going concern opinions for multiple public companies and I can tell you that is a highly judgmental area where a lot of careful consideration is warranted. And yes, testing the company's forecast is an important element of that. Obviously, with a forecast of future cash flows, there are a lot of very subjective assessments and assumptions that are made and the auditor can and should evaluate those assumptions.

Jerry Maginnis: [00:06:57] But my point is it's very judgmental. In this case, the Pcob concluded that the firm hadn't done enough work and they gave them a deficient audit. You know, I'm not here to say that was a bad conclusion by them. Maybe they were right. But the fact that they felt in that one area and not enough work was done was enough for them to fail the audit. That firm might have done a great job in all the other complex areas of that audit. So I guess I have a little bit of an issue with this pass fail system. I personally would prefer to see a system similar to when we all took exams in high school or college where you could get 100 or an eight plus, or if you got a question or two wrong, you might have points deducted. So maybe I deduct five points because I don't think you did enough work on the going concern assessment. If there's a pattern of substandard work, maybe deduct points in other areas and your overall school score winds up being a 68 and you fail. But I'm not really confident that this pass fail system is providing the most useful information for investors. I'll pause there because I'm kind of long winded in my response.

David Leary: [00:08:10] Yeah, Jerry, just for insight, for those of us that have not worked in audit, you have to sign off on an audit. Obviously, you're not doing all the work. You're depending on your team to do that, but in the end you're kind of responsible for it. So how do you know if enough work was done on a part or not done on a part? Like just at a high level. Like what goes through your brain when you do that process or what were your processes?

Jerry Maginnis: [00:08:33] Sure. So at KPMG, and I'm sure it's similar at most of the large firms, the audit partner was personally responsible for reviewing the work in the most critical and high risk light areas. So I definitely had skin in the game and I personally was making a judgment whether or not we had performed enough work. In addition, David, it wasn't just me. Every engagement before a report was issued got reviewed by a second independent partner who had no involvement with the day to day work. That was part of our quality control system. In addition, we would often bring in specialists to assist us with the work. So I might have one of my valuation professionals involved, for instance, with an impairment analysis. So there's a lot of people involved. There's a pretty extensive review process before opinions get issued. But the reason I read you that excerpt from the auditing standards is the standard I think that's out there now is almost one of perfection. And that's it's hard for human beings to be perfect, right? So again, not in any way criticizing the PCAOB, but I feel like sometimes, you know, it can create the wrong message. Like my personal opinion is there's a lot of high quality audits being done and the firms have been never more laser focused on audit quality than they are now. I think there's also a lot of professional audit partners that take their job very seriously and fully appreciate the responsibility they have to third parties, not just their client investors, creditors, etcetera, folks relying on their audit report.

Blake Oliver: [00:10:07] So so we have a situation so we have a situation here where the PCAOB is saying that 40% of audits are so deficient that the auditor should not have issued the audit opinion. That's a part one, a deficiency. And that's a that's a serious deficiency. I mean, that's a fail, right? And yet audits are up to incredible amounts of professional judgment, right? Like there's no hard when I look through auditing standards, I don't ever see a hard standard like a bright line for anything, it seems. It's all it's all up to professional judgment. So we've got auditors on one side using their professional judgment saying this audit is a pass. Let's let's issue this. You know what unqualified opinion. And then we've got PCAOB on the other side saying, nope, sorry. According to our professional judgment, you didn't collect enough evidence. And they're saying 40% of audits fail in that way. So who are we to believe?

Jerry Maginnis: [00:11:11] Yeah, I think you summarized it very well, Blake. And I'll just add that everything's electronic nowadays, of course, but ten, 15 years ago, depending on the size of the company, I mean, on a typical public company audit, if you had a multinational business with a bunch of foreign subsidiaries, there were thousands of workpapers. I mean, we would literally have 25 binders of work papers. And so my point there is there's an awful lot to evaluate and form judgments on. And again, if an inspector, whether it be an internal firm inspection, which was part of our quality control system or the Pcob came along and said, Hey, we don't think you did an adequate job in inventory. We don't think you did an adequate job on this impairment analysis, income taxes, you didn't do enough work. And there's a real pattern of substandard work and underperformance absolutely failed that audit. But for it to come down to one judgment. In a subjective area. I struggle with that. I'd rather say, okay, deduct five points, give me a 95, but maybe the passing grade is even a lot higher. Like we want excellence, we want rigor. So maybe it's a 90 is the passing grade. But look at the whole body of work. Don't focus on one judgment that may be subjective is kind of where I'm coming from.

Blake Oliver: [00:12:28] Now, you got a peak at some at an inspection report, but those aren't made public, so I'm sure they are.

Jerry Maginnis: [00:12:35] The PCB publishes on their website every inspection they do for all the firms they inspect.

Blake Oliver: [00:12:41] Okay. And does that say where the audit was?

Jerry Maginnis: [00:12:45] It does so in part one. A, there's a description of the finding and the basis for the PCB's conclusion. They're not terribly long. It might be 2 or 3 paragraphs, but it'll say, hey, in the inventory area, we don't think the auditor did enough work for these reasons. Right? So that's all made public. What's not made public is part two of the inspection report, which deals with the firm system of quality control. Unless in the judgment of the PCB, after a certain period of time, the firm hasn't adequately addressed those quality control findings and then they will make that public. So that's kind of their vehicle to incent the firms to really pay attention.

Blake Oliver: [00:13:24] So it sounds like you you're doubting this number, 40%. Do you think that 40% of audits are deficient to the point where the auditor should not have issued their opinion?

Jerry Maginnis: [00:13:34] I will say that I think more than 40% of audits are not perfect. So what is the standard we're assessing for here? Is it reasonable compliance or is it perfection? And reasonable people can debate that again, I think the pcob is well intentioned. I will say they have set the bar very high in terms of the level of documentation that they're looking for in an audit engagement. As we get close to football season here. You both no doubt have heard of the great football coach Vince Lombardi, who inherited a Green Bay Packer team that had gone one and 11 the year before he took over. And in his first talk with the team, he said, Gentlemen, nobody's perfect, but we are going to relentlessly catch Chase Perfection because we'll catch excellence. And that was a great motivator. And his team went on to win some Super Bowls. I think the PCB is pursuing perfection and they'll catch excellence. I think auditing has gotten a lot better. I'll give them credit because I think the auditing being done today is far superior than it was 20 years ago when they came into existence. But I struggle with the bar being set too high, and I worry, frankly, that when they publicize a 40% audit failure rate, is that a fair picture of what's happening?

Blake Oliver: [00:14:58] Yeah, because if you look at the numbers they're pushing out, it would seem that audit quality has dropped over 20 years. But you're saying in your experience, it's gotten better since PCAOB came into existence?

Jerry Maginnis: [00:15:11] Absolutely. And you know, I've been retired now for more than a couple of years, Blake and David. So I may not be entirely current, but certainly during my tenure with the firm, I can tell you that there was a laser focus on audit quality and it was made very clear to the audit partners that your compensation, your advancement is the first thing we look at is your audit quality. If you're not doing a good job on the quality front, nothing else matters. So I don't think that's changed at all. I still talk to my former colleagues occasionally. I talk to partners at other firms as an audit committee chair. I work with two national firms and I hear about their experiences with the PCAOB. So I think I'm pretty close to what's happening. And, you know, I may be a little less than objective given my background, but I feel like audit firms are working really hard to do a good job and they have a tough job to do.

David Leary: [00:16:02] If I'm hearing you correctly, the PCAOB, it's treating everything kind of equal, so it's not weighted. And I'm thinking of like a restaurant, like restaurants get their food service inspections and they have a plus, a minus. Obviously, there's probably some violations where it's an F no matter what. Like there's an automatic F if there's a rat on the counter, right? There's probably an F or something like that. But probably, you know, if something's on the refrigerator is off a couple of degrees or something like that, it probably it's weighted. And if I'm hearing you correctly, there's no it's all it's all or nothing type pass fail.

Jerry Maginnis: [00:16:34] It's pass fail, David, in that if they find one area and arguably it's a significant, important part of the audit where they feel that the work wasn't adequate, that sufficient documentation wasn't gathered, they can tell you on that one area. And all I'm saying is take the whole body of work into consideration. And if in 99% of the audit, I did a great job, but you maybe have a different judgment in this one area that is subjective. Take my whole body of work into consideration before you fail me. You know, Blake, I think when you and I were together, we had a conversation about the airline industry, and I said to you that, like every day in this country, thousands of airplanes take off and land safely. But you never read about those, right? You read about the plane that crashed or the the collision, the bad things that happened. And I think it's similar in our profession where, you know, there's an audit failure. It gets it gets a lot of attention and press. But you don't read about the thousands of audits that get done well and serve an important purpose for investors and creditors.

Blake Oliver: [00:17:44] I like what you said about the PCAOB inspections being not pass fail and being more graded. I feel like that would provide a lot more useful information to us. Also, you know, David's pointed out in previous episodes of our show that the specific audited companies are not identified in the inspection reports. So there's like no pressure on the audit firms to improve. If their clients aren't identified, the clients aren't going to, you know, the clients who are identified as having deficient audits might have a word with their audit partner, perhaps. What do you think about that?

Jerry Maginnis: [00:18:24] So you're right. The name of the the company being inspected is not made public in those inspection reports. But like as an audit committee chair, I asked my auditors all the time, have you been inspected? And if so, what were the results? And Chair Williams, in that most recent release, if you if you took a close look at it, actually encouraged audit committees to be asking their firms about their inspection results, about the engagement partners history. Most firms, in addition to being inspected by the PCAOB, have their own internal inspection process where they'll randomly select engagements and tests themselves, whether they believe a quality job was done or whether the firm's policies were complied with. So that's another question audit committees can be asking their their auditors.

Blake Oliver: [00:19:20] So there's a few other stats that we've discussed on the show that I want to get your take on. Sure. Three three that I'm tying together recently. So the first one we just talked about, that was the deficiency rate. Thank you for your perspective on that. The second is that average audit fees have tripled over the last 20 years. If you adjust for inflation, they've a little more than doubled. But at the same time, staff salaries have stagnated. When you adjust for inflation, cost of living, that sort of thing. So we have a situation where, you know, I'm looking at these three numbers. I'm saying Pcob says audit deficiency rates have increased. Meanwhile, the audit firms are making more money, double the money, but they're not paying their staff any better. How do we reconcile those numbers? It doesn't seem right.

Jerry Maginnis: [00:20:09] Yeah, a great question, Blake. There's. There's a lot to unpack there for sure. So let's start with audit fees. So using your 20 year time horizon, I guess that takes us back to 2003. And as you know, the Pcob was created right around that time in the wake of the big corporate failures. We had the Sarbanes-Oxley Act. And of course, it took the PCAOB a little while to get up and running. But one of the first things they did was issue auditing standard number two, which required companies over a certain size to have a separate audit of their system of internal controls and the audit firm to render a separate opinion. So now we're issuing an opinion on the financial statements and an opinion on the company's system of internal controls over financial reporting. That requirement initially became effective in 2004. I vividly recall doing my first Sox internal control audit of a public company. So if you go back to 2003, your base year doesn't have the effect of a huge expansion in the scope of the audit. So in 2004, many public companies sold their audit audit fees double. It varied, you know, depending on the size, complexity, global footprint of the client. But I would say anywhere from 60 to 100% increase in fees was not unusual, particularly because as to was very prescriptive and required the auditors to do a very lot of detailed testing.

Jerry Maginnis: [00:21:40] There was a bit of a backlash in the marketplace in the ensuing years and a couple of years later the Pcob revised the standard. They came out with S five, which was kind of a streamlined approach to auditing internal controls, took out some of the detailed requirements. Audit fees came down a notch, but when the dust settled, I think it's fair to say that the average public company audit fee had increased by at least 50%. So this is all the way back in 2006, seven time frame. Now scroll forward another 15 years. Gaap is incredibly complex. When the FASB comes out with new standards for revenue recognition or wheezing, that requires a lot of work on the part of companies. It also requires a ton of work by the auditor to audit that revised revenue recognition methodology. Every time a new standard comes out, it's a bit of a scope expansion, right? And there's a history here, right? The FASB is generally not taking anything away. They're adding the SEC is also adding new requirements from time to time. So that all impacts fees, inflation impacts fees.

Jerry Maginnis: [00:22:47] An important trend in the last 1015 years has been increasing use of specialists. So there's a lot of people that get involved in an audit these days. If I'm auditing an insurance company to get a handle on the adequacy of their loss reserves, I'm going to have an actuary involved in that audit. If I'm auditing an impairment analysis, I might have a valuation professional income taxes, very complex for a global company. I'm going to have all kinds of tax experts involved. Those specialists have high billing rates and they drive up the cost of an audit. So as the percentage of specialists involved and I would guesstimate, the typical audit today probably has 10 to 12% of total hours or specialist time that's driving up the cost of an audit. So there's a lot of factors. I mean, the regulation of the profession by the PCAOB, what we talked about earlier, kind of the bar is set pretty high on what constitutes a quality audit. Firms are spending more hours doing audits than they were 20 years ago. In my opinion. That adds to it. I'll remind you that fees are set in a free market system, right? And I've had clients.

Blake Oliver: [00:23:52] Go, Well, it's sort of a free market system because we only have four major players.

Jerry Maginnis: [00:23:56] Well, let's talk about that. So I've had clients go out to bid, and if it's a good client, guess what? Those other firms are interested in doing the work. Maybe a Grant Thornton's in the mix as well, or a BDO. So it's very competitive. I've won new business in proposal situations. I've lost it. But firms compete pretty fiercely for work, and fees are always on the table when there's an RFP process.

Blake Oliver: [00:24:22] And that's what I've heard. I get no argument from anyone when I say that audit fees are always under pressure because there's always some partner who will be able to underbid you. And so that's one of the explanations for why staff salaries have stayed low. It's that audit fees are under pressure. And if you're an audit partner, the only way to make money is to get your staff to work the longest hours you can to motivate them to work that unpaid overtime and, you know, hire as few people as possible. It's a that's the game. That's the business model.

Jerry Maginnis: [00:25:01] That's a great segue into the topic of staff compensation. So let's talk about that. When I was leading the audit practice for. Pennsylvania. I was intimately involved in setting salaries for all levels from new interns up to partners. And I could tell you that I was supported kind of with some firm wide infrastructure and resources. And we had, I think, a pretty sophisticated, rigorous process on how we did that. For instance, every year we had a market study that was unique to, in my case, Philadelphia. What's the market, what are firms paying? And we would study that data carefully. I may be a little dated, Blake, but during the time I was in this role, I mean, our salaries increased on average 6 to 8 to 10% a year. When people got promoted, there were additional bonuses and incentives and it wasn't a flat situation. Now, maybe. Maybe it's been a little flatter since I retired, but I'm still pretty close to the market and I believe currently the starting salary for a big four audit professional right out of college in the Philadelphia market is in the 75 to $80,000 range. I think that people often miss the value of the fringe package. Now, there are certain things like subsidized health care 401 (K) contribution that I would say any employer is providing, right? So that's table stakes. But things like certain firms have programs where they're repaying student debt. Most of the big four firms and other national firms that day you walk in the door as a brand new hire. You get six weeks off the 30 days of PTO fully compensated. You know, I don't know what the average employer gives you as a new employee these days, but I'm guessing it's maybe two weeks vacation.

Blake Oliver: [00:26:48] So the caveat that you're going to be asked to work a lot of hours.

Jerry Maginnis: [00:26:52] No doubt that extra.

Blake Oliver: [00:26:53] Certain times of the year.

Jerry Maginnis: [00:26:54] No doubt that extra time off is in part to compensate for the hours in busy season. Yeah, but also in the last, I don't know, 5 to 10 years. Most of the firms are shutting down between Christmas and New Year's and paying people for that. Most firms are giving not only Thanksgiving, but the Friday after Thanksgiving. I've seen firms shut down depending on when the 4th of July holiday falls. There's probably a couple extra days there, paid holidays. So all those things add up. And I would guesstimate, I don't know this for sure, but I would guesstimate if you did a fully loaded fringe rate for the big four firms, that's in the 35 to 40% range. So take that new hire that's making 75,000 in Philadelphia, layer on the fringe rate. And that new employee is costing the firm over $100,000 with virtually no experience. I actually think that's pretty fair and pretty competitive.

Blake Oliver: [00:27:48] I would agree with you if the hours weren't so terrible for some hires. Now we don't have data across all staff at every firm, but the ones who are talking about this on online forums and on social media are really unhappy with the amount of time they're expected to work, and it can be incredibly brutal. I personally would not want to work 60 to 70 hours a week ever, and yet we expect young people coming out of school to to do this for years on end, for months on end, for years on end. My argument against it is it's simply unhealthy that it's asking people to sacrifice their mental health, their physical health, their family time, their hobbies in service of the audit or the firm. And young people just don't want to do that anymore.

Jerry Maginnis: [00:28:44] Right. I think it's a very fair point and it's a very legitimate issue. It's not a new issue. Right. It's an issue the profession has coped with since the beginning of time. I think in some respects that doesn't mean there aren't better, more creative, more innovative solutions to it. And I think technology is a part of that, which I'll touch on. But let's back up and say, why do we have to work 60, 70 hours a week in busy season? And it's basically a function of if you're a public company, depending on your size, you have to file your 10-K within 60 days of year end, maybe 75. If you're a smaller, smaller market cap public company, 60 days after the end of the period is not a lot of time, Right? The company has to close their books, put together their financial statements. The best companies, you know, probably need at least two weeks to do that. Some take longer.

Blake Oliver: [00:29:34] And like you said, what gap has just gotten more complex over the years?

Jerry Maginnis: [00:29:39] Exactly. And and so let's say that, you know, by the time you're coming in to do the year end audit, it's at least the third or fourth week in January. You've got the PCBs. Expectations are up here. You've got a lot of things to audit in a very limited period of time. And sure, you can do work before the balance sheet date. And most firms do. They do their planning. They do a lot of their control testing. They'll do what we call interim procedures. So you might audit inventory or receivables. As of September 30th and then roll forward from there. But there's still a ton of work that has to get done in a very condensed period, and that's what drives the overtime. Now, could ferns be more efficient? Could they use technology better? I believe they can, but it's not because the firms are just saying, let's work our people to death. Right? There's a reason for everything.

Blake Oliver: [00:30:31] There's these deadlines. It's a deadline driven profession. Exactly. Same, same.

Jerry Maginnis: [00:30:35] Same thing in tax.

Blake Oliver: [00:30:36] Right. But here's the thing about audit. What do you think about this argument? I think we have as a profession, done this to ourselves or the audit profession has created this deadline driven culture itself, because who goes to FASB? Who goes to PCAOB? Who ends up moving from partner roles or director roles at the big firms into the regulatory roles? It's it's the same people. So we could change this as a profession if we wanted to. It's accountants on the regulatory side who are setting all of these expectations and deadlines.

Jerry Maginnis: [00:31:12] So the deadlines on things like ten KS, ten Qs are set by the SEC. And I'll acknowledge your point that there are some people from the profession that go to work at the SEC, but the vast majority of the SEC are lifetime civil servants who have been there for 25, 30 plus years. And really they have a commission, five commissioners overseeing them that set these kind of rules. You got to look at the big picture, right? So if you're an investor now, put on your investor hat. Do you want to wait 90, 120 days to see the year end audit? I mean, time is of the essence, right? Markets need real time info.

David Leary: [00:31:49] Why is the the overwork thing happens in Australia, it happens in the UK, it happens in Canada. Like everybody has different timelines of when financials and things have to be done. But the same work culture seems to exist anywhere big firms accounting firms are at.

Blake Oliver: [00:32:04] We have people dying at their desks in extreme circumstances in Australia, for instance, there's a big scandal going on right there about the work culture. I mean, how how can we as a profession claim to look out for our people when we allow things like that to happen? And yeah, that's a rare case, but it's a symptom of a big underlying problem.

Jerry Maginnis: [00:32:27] Yeah. And I'm not sure I'm familiar with all the details of the case you're alluding to, but I think it might have involved an employee of a firm in Australia who was working and then went out for some drinks with their colleagues and then came back and they found them at their desk later and who knows what was going on. That's obviously not a good situation. And to your earlier point, Blake, I, I think the firms don't want to contribute to an unhealthy lifestyle, right? Yeah. The firms, I think, are keenly aware of this issue and they're working very hard to address it. They have that fundamental challenge of the deadline driven business. But I alluded to this earlier. I do think technology is going to help us get better, be able to maybe do more work before the balance sheet date, maybe do more kind of online auditing where we're actually getting into the system and looking at transactions real time on a continuous basis. So we don't have this crunch at the end of the year. I can tell you if it's helped you at all, it probably doesn't. But like it has gotten better for when I entered in the profession when I started, I mean, the mindset of the partners was we're going to do whatever it takes to serve the client. And if that means working 24 over seven or all weekend, that's what we're going to do. When I was running a audit practice in Managing Partner, we were very focused on kind of quality of life considerations for our people, and we tried really hard to be sensitive to these issues and to make it better to the extent we could. I'm not going to declare victory and say we solved it 100%. We definitely lost people who felt like this is not for me working 60, 70 hours a week. But it's a bit of a journey and I think the firms are focused on making it better. It is a legitimate issue.

Blake Oliver: [00:34:06] So perhaps if we're going to talk about solutions, we can look to simplify creation of the accounting standards because like you said, they've only gotten more complicated. If you look at the past 100 years of accounting standards, they have only gotten more complicated and financial statements have only gotten longer. Silicon Valley Bank's financial statements were over 180 pages long, and it's hard to imagine any human being reading every set of financial statements for every public company that are issued. I just don't believe the analysts are doing it. And. The evidence suggests that they aren't. A set of financials is downloaded from the SEC website maybe a few dozen times at most. So here we are. We're doing all this work to produce financial statements that very few people are actually reading. They may be looking at that bottom line number, that earnings per share, you know, or that net income number. But all this other stuff that we're doing in between that number, you know, and starting the audit, like I don't know if investors actually care.

David Leary: [00:35:12] Arguably, they're not even looking at that number because they're investing in Amazon and Tesla and Facebook. And none of these companies have good numbers at all. Right.

Blake Oliver: [00:35:21] Well, because and that goes to a deeper issue, which is that any business that is based fundamentally on intangible assets as the primary revenue driver is not captured by GAAP. Well, because GAAP does not understand intangible assets, it's still built on this industrial economy that it was founded on, right. Railroads, factories work great for that. But you know, when it comes to a Netflix or an Amazon subscription based businesses, it's terrible. You know, the thing that people care about with Netflix is subscribers and we don't track subscribers as a GAAP metric. It's all non-GAAP metrics when it comes to subscription businesses. And so, you know, I look at this situation where you've got these audit firms working their staff and it's great to hear it's gotten better, but, you know, it's still it's still it's still pretty. It can still be pretty bad, right? And yet what we're delivering is just not what investors necessarily want or need. And it seems tragic, you know, that that we've got. This massive, multi-billion dollar industry. That is is kind of missing the point.

Jerry Maginnis: [00:36:30] So you covered a lot of ground there. And I want to react to multiple points that you made. Let me start with a positive kind of I agree with you response, which is the accounting model for intangible assets I think is broken has been for a long time. I'll give you a great book recommendation, Blake and David. It's called The End of Accounting.

Blake Oliver: [00:36:55] Love that book.

Jerry Maginnis: [00:36:56] Trying to remember the other. You've read.

David Leary: [00:36:57] It.

Blake Oliver: [00:36:58] Baruch Lev. Yes.

Jerry Maginnis: [00:36:59] They make some great points in there. And furthermore, you know, we kind of have a mixed attribute model for intangibles, meaning if I buy company ABC as part of my purchase accounting, I'm going to value their intangibles and put them on my balance sheet, including things like the customer base. But if I develop that internally, it gets expensed as incurred. It's not on my balance sheet and it makes no sense. That can create real challenges, particularly when you're looking at some of the tech companies like you guys alluded to a moment ago. Again, I'm a product of my experience, so I may be a little biased, but I'll defend audited financial statements as being a useful tool. And I think sophisticated investors do make use of them. If you read some of Warren Buffett's writing, you'll see that he routinely reads every footnote, and that's one of the things he believes has given him a competitive edge and has helped him to really stand out as an investor. Most sophisticated Wall Street investors read financial statements closely and rely on them. Main Street investors don't. I was in a meeting a couple of years ago where the speaker said to the roughly 400 people assembled, Has anybody in this room made an investment in the last year, whether you bought a stock or a bond or you invested through your 401.

Jerry Maginnis: [00:38:19] K plan? Every hand in the room went up. He then said, How many of you read the audited financial statements before you made that investment? And 1 or 2 hands went up? So relevance is an issue. But I think if we had a system where audits weren't required anymore, it would become the wild, wild West very quickly. There's a deterrence factor from auditors and from audits. And the other thing you don't see behind the scenes is what about all those financial statements where material adjustments are made as a result of the audit before the financial statements go out or the auditor does give the client a going concern, opinion or resigns from the account because there's fraud going on. Those things don't get reported, but they happen more than you would think. So I think our capital market system would suffer greatly if we didn't have the independent audit function. Just a personal opinion.

Blake Oliver: [00:39:10] Yeah, I agree with you. We need audits. And this is the tricky part, is that we need audits, but the value of them has is questionable in many situations, right. Like it could be better when I when I look at an audit opinion. And actually, if people aren't reading the financial statements, what are the odds they're reading the audit opinion? How many people actually read the audit opinion? There's not that much in there that's useful to me as an investor, right? It's what's useful is that I know that the company managed to get somebody to sign off on it. Right? Right. That's what I need. That's what I need to know. But that standard, that pass fail standard, like you said, is incredibly subjective and in many cases. Right. It's totally false. The company was a going concern warning or in the case of Wirecard with in Germany, they weren't even confirming bank balances. So the audit was completely useless. So for me, just sitting back as an investor thinking, you know, what is this audit really provide me? It doesn't really I don't feel like it gives me a lot of assurance because I don't get that much information out of it. It's like if every health inspection report at every restaurant I go to was just pass fail.

Jerry Maginnis: [00:40:25] Well, let's talk about that. So again, you laid out a lot there. I'll give the PCAOB some credit here, right? For decades, all audit opinions did look the same and it was pass fail and it was. Your financial statements are fairly stated or they're not right. Several years ago, as I'm sure you guys know, the PCAOB came out with a new standard that required the auditor to talk about critical audit matters and to add language that was unique to each client to their audit report discussing those most challenging areas, most subjective areas. That was new information for investors that I think differentiated the typical audit report. You know, you referenced Silicon Valley Bank earlier. I'll just comment briefly on that.

Blake Oliver: [00:41:08] And that's a great that's a great thing to talk about in context of the critical audit matters, because the question is, I believe it was KPMG that audited SVB. Should KPMG have issued a critical audit matter about this interest rate risk with these bonds that that SVB was holding at historical cost on their balance sheet when they very clearly, in retrospect, should have been written down?

Jerry Maginnis: [00:41:31] Yeah, I think the key words there are in retrospect, right? Yeah. Hindsight. Hindsight's 2020. I'm not in a position to kind of weigh in on that and I probably shouldn't given my former firm's involved, I should probably recuse myself. But I will make one point because I've heard you talk in some prior podcasts about how the Silicon Valley 10-K was 180 pages, and there's so much in there who could possibly get through this and figure out what was going on. And all that's indicative of the complexity of GAAP. But all you had to do was look at the balance sheet and it states very clearly on the balance sheet that they're held to maturity. Securities were valued at X. Parenthetically, it disclosed the market value, which was 20 some billion dollars less. You could do that in five minutes, right?

Blake Oliver: [00:42:16] You could, but investors did not. Analysts did not. And my response.

Jerry Maginnis: [00:42:21] To that is shame on investors and analysts. Right. It doesn't take too long to look at a balance sheet.

David Leary: [00:42:27] But but the market the this is the bigger issue, right? The big firms, we are doing the audit. We are there to protect you. We are protecting the fundamental financial markets that we all live in.

Blake Oliver: [00:42:41] The whole system, and.

David Leary: [00:42:42] Everybody just assumes you're doing your job so they don't have to do their job. It's like I assume the fire department knows how to put a fire. If my house catches on fire, I'm not I don't know how they do it. I'm not paying attention to how they do the work. I'm just assuming that's true and the market assumes this. So you can't really say shame on all of you for not looking at the numbers. They're assuming you're looking at the numbers.

Jerry Maginnis: [00:43:04] Actually, I can and I will again, like if I'm an investor, I've got a responsibility to evaluate that company's financial performance. It's nice to have the peace of mind, David, to know that those numbers were audited and verified by a third party. But I should still understand what those numbers are telling me, right? What's going on in that business? Do I want to continue to hold this stock? Do I want to buy more? You need to look at the numbers and not just the numbers. Like pay attention to what's going on. What's the CEO saying, what press releases, what new products, etcetera. But astute, sophisticated investors are paying attention. They're not just relying on third parties. I would also take issue with the notion that the audit firm is telling you everything's fine. Like read their opinion. What they're telling you is the financial statements are fairly stated. That's not the same as everything's fine or this is a good stock to own.

Blake Oliver: [00:43:55] Yeah, but like, investors do not understand what that means. Well, when they when they see that a bank got a clean audit opinion, they think that means I can trust these financial statements that the bank's not going to go out of business a month after the financials are issued.

Jerry Maginnis: [00:44:12] Yeah. So let's talk about investors for a minute. Blake. A fair, fair point. Investors come in all different shapes and sizes, right? There are very sophisticated investors out there that I believe are reading those financials, paying attention, making decisions based on them. Then there's what I call the main street investor who has money invested via a 401 K plan, or maybe just on the side is buying some stocks and bonds. And I would acknowledge they're not paying attention to financials. They're assuming everything's okay. They're probably more influenced by what's on NBC or whatever they're listening to or watching on social media or maybe what their buddy told them about the latest hot stock tip, like buy crypto, you know, buy, buy Tesla, whatever it is. Right. And that's been going on for hundreds of years. Right. Speculation is basically what that is. That's not investing.

Blake Oliver: [00:45:02] Yeah, well, I wouldn't I would give them a little more credit than that. I think that they would look at financial statements if they weren't so complicated and so difficult to understand. And you had to have a master's degree and five years of experience at PwC to even understand what this footnote says. It's not written in plain English, and it's very difficult. I mean, I'm a CPA, and when I tried reading through SVB financial statements. I couldn't make heads or tail of most of it. I had to put it into ChatGPT ChatGPT to translate it for me. So I guess my feeling is that like the audit profession, the accounting profession, the CPA world has kind of lost sight of our mission. It's not to protect big financial institutions, it's to protect investors. And when most investors are Main Street investors these days, you know, like. Why were we created? Why was why was the audit profession created? It was because of the Great Depression. Right. And you know who got hurt in that? It was everyday people. And I just. I feel like we've gotten so wrapped up in all of these intricacies of of Gap where it's it's so complicated. You have to be a specialist in just one balance sheet line. You can spend your whole career just doing one thing on the balance sheet. That just seems messed up to me. You know, like it just seems like. We could be doing a lot better. We could simplify things and make financial statements useful to people.

Jerry Maginnis: [00:46:36] So again, I'll react. He covered a lot of ground there. No argument gap is complex and perhaps in certain areas, unnecessarily so. Over the years, the FASB has had different projects to simplify their standards. I'm not sure they've made that much progress in that regard. I think they keep getting more complex. But in fairness to them, Blake and David, business is complex, right? And some of the products that investment bankers come out with are increasingly complex, sophisticated. They have derivative instruments. Is it debt? Is it equity? So some of these rules that are written are written to address the evolving business landscape where new products are coming out, and we need to figure out how to account for them. I agree with you on intangible assets. We need more guidance there. But, you know, as the economy continues to evolve, GAAP needs to keep pace. And and you know, I'd love to simplify it, but it's hard because business is not that simple. I want to come back to one other thing real quick.

Blake Oliver: [00:47:37] I just want just the complexity thing, right? The problem with complexity is that smart people can use complexity in GAAP, in the tax code to basically do what they want to to make the numbers come out how they like it. And that's what I've my takeaway I'm reading the the big book about Enron. Right. And my huge takeaway from the whole Enron era, that whole that whole thing is that basically, if you know what you're doing, you can manipulate the numbers to get what you want because it's so complex and people don't understand it. And so if we simplified accounting standards and went back to our roots, if we took a radical approach, right, we might actually clear things up, you know, like.

Jerry Maginnis: [00:48:22] So are you suggesting we go back to cash basis?

Blake Oliver: [00:48:27] Well, I guess what I'm suggesting is that we we like SVB, is a great example. Right. The problem with SVB is that I could decide as the as people running SVB if I want to hold those bonds at cost or if I want to mark them to market. And it's all based on my discretion. Essentially, I can choose and it's based on my intent and it's all very ambiguous and gray. And many accounting standards are that way where I can manipulate the numbers. And it's hard for my auditor to question that because it's a matter of my judgment and it's a matter of their judgment, and it gets all very squishy. And so maybe we take accounting standards back to something that's more hard and measurable, right? And if we're not going to do that, then at least we make it more broadly principles approached and not so rules based. And then we give auditors more freedom to to actually exercise their professional judgment. Yeah. I mean, it's the current situation. Just. The path we're on is a path where we're going to keep making accounting standards more and more complex, and they're going to provide less and less useful information. And FASB is just obsessed with these like least accounting was the most useless thing that ever happened. Can you can anyone defend the lease accounting rules? It doesn't add any value to investors. I've never heard anyone say that it creates any more value, but it adds tremendous cost for businesses. You know, so and.

Jerry Maginnis: [00:49:52] So this is an important discussion, right? I mean, the standard setters have an important responsibility and an important job. They also have a complex job. You know what you're really getting to at the core here is. How much regulation do we need or should we have? I probably lean a little bit to the right. But, you know, I asked my students at Rowan, I'll purposely ask the question this way Is regulation a good thing or a bad thing? And I'll get a bunch of students that will jump up and say, regulation is horrible, it's bad for business. We shouldn't have any regulation. Then I'll get others that say we need regulation to protect abuses. Et cetera. And I'll say, well, you're both right. Right. But what's the right amount of regulation? That's the fundamental question. Most reasonable people would agree We can't let people run wild and be totally unregulated. And I think a lot of people would subscribe to too much regulation is bad. So let me flip it around and ask you guys a question. Do you think we have too much regulation in the accounting profession today, whether it be the SEC, the FASB, the PCAOB or not enough? Because you referenced things like Wirecard and silk bags. So what do you guys think?

Blake Oliver: [00:51:02] I feel like we've gotten lost in the weeds because there are so many rules. Like this is just my take as an outsider because there's so many rules. It's so complex. It's easy to lose sight of what the purpose of the audit is, which is not to tick and tie, but is to actually determine to protect investors. You know, are these financial statements accurate? Are they, you know, can we can we trust them? Right. To provide that trust in the space? And, you know, SVB is a perfect example of how. We did not protect investors. Now, whether that's our fault is another question, but.

Jerry Maginnis: [00:51:46] I think it's also a fair question, Blake, whether SBB was a business failure or an audit fail.

Blake Oliver: [00:51:53] Well, and couldn't can't audits shouldn't audits anticipate to some extent like a collapse.

Jerry Maginnis: [00:51:59] Of crystal balls? They can't predict the future. Right now they are. No.

Blake Oliver: [00:52:05] But interest rates started rising 12 months before SVB collapsed. There were there were at least four reporting periods in between when the Fed started aggressively raising interest rates and when SVB went under. And those were all opportunities for the auditors to point out this rising risk. Yeah, and they didn't.

Jerry Maginnis: [00:52:24] Well, and I'm sure they were aware of it and they may well have evaluated it and they may have concluded that we think the company is going to survive. You know, a lot of companies face major issues that their existence is threatened by. Right. But a lot of times they survive. So that's a great example of a judgment was made. You could come along after the fact and criticize that judgment with the benefit of hindsight, and people love to do that. But you weren't sitting in the chair real time trying to make that decision. And by the way, certain information came to light after that opinion was issued. Right. The failure to get the capital raise done. Et cetera. So all I'm saying is, you know, it's hard to predict the future for anyone. And auditors mostly are reporting on the past, but they do have that responsibility to consider, is the company going to continue in existence?

David Leary: [00:53:17] I mean, I can't answer your question. If there's too much regulation, there should be less or any of that. But I think we're going to start getting natural experiments telling us what the world is like for people that don't get an audit. I think the accounting shortage is going to cause small townships, cities, counties that can't get their financials audited, but they need to get a loan or they need to issue bonds and they're going to do it without audited financials. And then the next one is a Fortune 500 companies. I mean, that auto parts store, right? They they had to delay their financials because they couldn't get accountants either internal on staff or not. So I think we're going to get natural experiments. That's going to tell you what the market really thinks about the value of an audit.

Jerry Maginnis: [00:53:57] Right. I think you're right about one of the solutions.

Blake Oliver: [00:54:01] I was going to throw this out there. Jerry, can I get your take on this? Right now, we require 100% of public companies to get audited every year, right? Maybe one way that we solve this and doing a little experiment is we say not every company gets audited every year that a percentage of companies get audited. And that way we can spend our time focusing on fewer audits. Right. But doing higher quality audits.

Jerry Maginnis: [00:54:26] Yeah, that's an interesting proposition. I don't see the requirement that publicly held companies get audited changing anytime soon. I mean, that kind of exists in a mini way today in that if you're a privately held company, let's say you have a great strong balance sheet, you don't need any bank debt. So there's nobody requiring you to have an audit because the SEC doesn't require it, the bank doesn't require it. There's a lot of private companies that don't have audits. Some voluntarily choose to have audits. I guess if I had to summarize this conversation, guys, for the last 20 minutes, I would try to do it like this. I agree with the premise that auditing is not perfect. Much like my airline industry analogy earlier. I also believe there's opportunities to enhance the business model in a way that can make it a better experience for young professionals, hopefully with the benefit of technology. But I'm pretty firm in my conviction that if the audit profession that we know and love today, with all its flaws, didn't exist, things would be considerably worse and we would see a lot more problems, a lot more abuses, a lot more fraud. Audit serve a major deterrence factor. Just the fact that the client has to get ready for the audit and knows somebody's coming in to look is huge. If you took that away, I think there'd be a lot of abuses.

Blake Oliver: [00:55:44] And Jerry, I'm totally with you on that and I really appreciate you standing firm under fire. We asked tough questions on this show. And man, you know, like we made you.

David Leary: [00:55:55] Defend the whole audit industry. Yeah, 20 years of practices.

Blake Oliver: [00:55:58] We didn't we didn't give you quite the heads up that we were going to do this. It just happened. And I really appreciate you taking this on. I just want everyone to know, you and our listeners, to know that I'm a big proponent of accounting as a career. I'm a career changer myself. It changed my life. And I still think that even with the long hours, a career in the Big Four is great. There's so many opportunities in accounting for everybody and you are out there explaining how to succeed in the accounting profession with your book Advice for a Successful Career in the Accounting Profession How to make your Assets greatly Exceed your liabilities. Jerry, do you have a top tip for young wannabe auditors as to how they can succeed in their careers?

Jerry Maginnis: [00:56:46] Yeah, that's a great question, Blake, and thanks for bringing up the book. Maybe I'll just briefly mention to your audience that the catalyst for writing the book was when I retired from KPMG, I got involved at a local university called Rowan University. Kind of helping out on a volunteer basis to support their accounting program and, you know, did a couple of things, gave guest lectures, got involved with their accounting advisory board. But one of the really fun things for me was to get to meet a lot of the students and the university was kind enough to give me an office on campus. So the students sort of figured out you're there and they wander into your office, you know, How can I get that first internship? Should I take the CPA exam? What about public versus private accounting? So a lot of great conversations with like dozens and dozens of students and one day met with a student and we're talking about should he take the CPA exam and 150 hour requirement. And they left my office and I thought to myself, gosh, I've had this conversation like dozens of times now. Maybe I should try and put down on paper some of the advice and counsel that I'm trying to share with these young folks in a way that could be leveraged a little bit broadly. So that's kind of the background. On why I wrote the book. It wasn't financially motivated or anything like that, just trying to create a resource for this next generation.

Jerry Maginnis: [00:58:00] So to answer your question, like advice for a young auditor, I mean, honestly, throughout the book I tried to give advice in a variety of areas for any young person starting a business career. So there's there's a chapter in the book. It's called Have a Value Creation Mindset. And in there I talked about the fact that every day, every interaction is an opportunity to create value for the people you're interacting with, whether that be your client, your colleagues, a third party, my young people today, they have a task orientation mindset. Let me make up my to do list and get through these 8 or 10 things I have to do. Kind of almost like a robot, right? Don't get me wrong, it's great to be organized. It's great to have a to do list and prioritize it. I do it every morning. But as you think about those tasks, what can I do to make make things better for whoever I'm serving here? If it's an audit client, you know, maybe it's not just blindly executing the audit task, but maybe it's sitting down with your client afterwards and saying, Can I share a couple of thoughts about your processes and systems here and the way you're using technology? Have you thought about how to optimize the use of the data that's being generated by your accounts payable, disbursement cycle, things like that? So that's just one small example. But really the book has a lot of those types of tips and suggestions.

Blake Oliver: [00:59:18] Everyone should give it a read. We'll have the link in the show notes where you can buy it. And if you're watching this on YouTube, check out the description for the link to the book.

David Leary: [00:59:29] And Jerry just didn't write a book. Like Jerry is like he's a man of the people. Like it's very I could see somebody just who just stumbles upon this like, oh, great. It's another typical old 60 some odd year old white guy that was a partner in an accounting firm. But no, Jerry's out there going campus to campus to campus, filling up auditoriums, talking to students like he's a man of the people. He's out there. What I'd love to see Jerry Now, after you go on tour, you mean you're like Taylor Swift? You're on your tour, right? Going everywhere, Like when you're done creating economic impact.

Jerry Maginnis: [01:00:00] David, the Taylor Swift.

Blake Oliver: [01:00:01] Multi-billion dollar economic impact, as we've discussed on the show, because.

David Leary: [01:00:04] You're going to push people into the firms and big firms for billions of dollars of impact over this. But what I'd love to do after you get all this knowledge from all these young people is write the other the second book, which is for firm owners and partners, how they should be treating young people. That would be the second half.

Jerry Maginnis: [01:00:21] That might be a really good suggestion. David, My publisher has asked me if I want to do if I have anything else in mind, so that might be a good topic. I will share with you very briefly that one of the things I'm doing in this next phase is I'm serving as an advisor to an accounting firm here in the Philadelphia area called Century, and they're having a lot of growth and success. They all do audits. They don't do taxes. They're more an advisory firm, but they've also got a great culture. And so some of the things we've talked about on this podcast, like not working your people to death, they're very good at and they can do it because they're not doing audits. They don't have a lot of those same deadlines. But it's been a lot of fun working with them and kind of seeing what they're doing. And before we sign off, I do want to say one other thing. If you guys will bear, bear with me. I've become a regular listener to the accounting podcast. Thank you. And I really enjoy the shows. You guys cover a lot of ground, but I want to say that it's great that we have people being provocative and challenging the status quo. I think that's good for our profession. Keep asking the hard questions, keep pushing, keep challenging, because that's going to make us better.

Blake Oliver: [01:01:30] Thanks so much, Jerry. It's been an honor to have you on the show. It's been a privilege, a pleasure, and I hope to see you around again soon.

Jerry Maginnis: [01:01:38] Thank you guys for having me. Have a great day. Thanks, Gerry.

Creators and Guests

David Leary
David Leary
President and Founder, Sombrero Apps Company
Jerry Maginnis
Jerry Maginnis
Senior Advisor, Board Member, Audit Committee Chair and Author
Audits Under Fire: Ex-Big Four Partner Responds to Criticisms
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