Accounting Horizons

Vol. 21, No. 4

December 2007
pp. 437–444

The Current State of Auditing as

a Profession: A View from
Worker-Owners
Damon A. Silvers
INTRODUCTION

T
he last five years have shown the deep connection between the success or failure of
our system of public accounting and the ability of our economic system to work for
all Americans—as investors, employees, and citizens. This article seeks to explain,
from the perspective of the people who ultimately rely on financial statements, how the
auditing profession got into trouble, how much progress we have made toward recovery,
and what challenges face the profession today.1
America’s 15 million union members and their families participate in benefit plans with
over $5 trillion in assets. Unions themselves sponsor benefit plans with over $400 billion
in assets. These funds are set aside to provide the good things in life to working people—
in particular the chance to retire in comfort and dignity. These assets are invested in a wide
variety of plans, but most are invested in the debt and equity securities of public companies.
While individual workers have diverse goals when investing, most worker money is invested
through institutions with very long-term horizons, and at a scale where diversification is
crucial. When workers’ benefit funds make investment decisions based on inaccurate finan-
cial disclosures, workers are hurt. And workers are not just hurt through the impact on their
benefit funds.
The employment relationship is a deep and profound mutual investment by the em-
ployee and the employer. The employee presumes that the employer is what it seems to
be—that promises of wages and benefits, not just in weeks but in years to come, can and
will be honored. Financial disclosures create the background circumstances in which em-
ployees feel comfortable making that commitment. When those disclosures are false
and companies collapse, as happened at Enron, WorldCom, Global Crossing, and dozens
of other companies, the employees are usually the most profoundly injured in the form of
undiversified losses: lost jobs, health care, and retirement benefits.

1
This article is based on a speech given at the AAA’s Auditing Section 2007 Midyear Conference in Charleston,
South Carolina, in January 2007.

Damon A. Silvers is Associate General Counsel for the AFL-CIO.

Submitted: May 2007
Accepted: July 2007
Corresponding author: Damon A. Silvers
Email: dsilvers@aflcio.org

437
438 Silvers

Keeping financial fraud and error to a tolerable level is also a vital aspect of the
competitiveness of our capital markets. Recently, a fair amount of discussion has ensued
regarding the challenge of maintaining the competitiveness of U.S. capital markets in the
face of global competition. Some have suggested that the relative transparency of our mar-
kets is a source of competitive weakness. These arguments presume that decisions by
company management are the critical issue. Of course, they have it backward—capital
markets thrive when investors have confidence in them. The resulting low comparative cost
of capital attracts users of capital to those markets. Thus, the real crisis of U.S. capital
market competitiveness occurred in 2002, when for the first time in living memory, foreign
investors began to question whether investors in U.S. companies really benefited from the
rule of law. Sarbanes-Oxley was the solution to a competitiveness crisis, not its cause.

CRISIS IN THE AUDITING PROFESSION

Auditing, like law, is a gatekeeper profession in our corporate governance system. The
experiences of the last five years have given many long-term investors new respect for
professions, not just as repositories of expertise but as necessary cultures of an ethic of
responsibility that must function if our capital markets and corporate governance systems
are to work.
The idea of professional principles extends far into the past. Evidence from ancient
Egypt indicates that architects sensed that their work was a calling, subject to standards
they were honor-bound to uphold, standards that overrode both greed and fear of the
pharaoh.
As Europe and the United States moved into the age of modern business in the late
nineteenth century, it became increasingly clear that a well-managed and well-regulated
market economy required strong professions, with clearly defined intellectual standards and
principles of conduct. Pure market incentives were simply not enough to ensure that build-
ings were built to stand safely, that patients were cared for properly, that the law was
followed respectfully, and that the financial records of business enterprises were kept
accurately.
Between the Civil War and the Depression, great efforts were made to found, define,
and develop professions in the United States. At the heart of this effort was the idea that
professionals—doctors, lawyers, architects, accountants, and others—were dedicated to
serving their clients and upholding standards of intellectual excellence and moral integrity.
While professionals certainly made good money—ultimately their judgments and loyalties
were not supposed to be for sale.
As a result, as state and federal governments tried to bring order and integrity to
financial institutions and financial markets during the Depression, they looked to the legal
and the audit professions in particular as allies in this effort. Congress structured the se-
curities laws to essentially require public companies to use outside professionals more
extensively in preparing disclosures to the investing public. The Securities and Exchange
Commission (SEC) looked to the accounting profession itself, organized through predeces-
sors to the Financial Accounting Standards Board (FASB), to make the accounting rules.
To ensure that public companies complied with these rules, the FASB predecessors ruled
that public companies must have independent public accountants audit financial statements.
This system, which worked to provide the United States with arguably the most trusted
capital markets in the world, began to come under serious pressure beginning in the 1980s,
pressure that escalated in the 1990s and reached a crescendo in the market delirium just
preceding the 2000 tech collapse.

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The Current State of Auditing as a Profession 439

All sorts of accounts have been given for the origins of the corporate lawlessness of
the Enron period. Unquestionably, a key moment in the path to crisis came in the 1980s
when investment banks began to look to law firms and audit firms as a source of human
capital, and to compete with professional service firms for business school graduates.
In the 1980s and 1990s, audit firms increasingly viewed their goal as profit maximi-
zation in a world where consulting and work related to mergers and acquisitions (M&A)
provided far more lucrative opportunities than the traditional auditing work of the profes-
sion. As a result, the then-Big 6 wallpapered the departure lounges of airports with adver-
tising proclaiming that they offered comprehensive business solutions to companies.
The result was not just the specific and egregious conflicts of interest that came from
marketing consulting services to audit clients. These unmanaged conflicts were symptomatic
of the growing deterioration of the professional ethic itself and its replacement by the view
that like investment bankers and bond traders, auditors were profit maximizers.
Along with this view went a change in the profession’s view of who the customer was.
The professional ethic of auditors had at its core the idea that the profession served the
reader of the financial statements—a group so large and amorphous as to be in a sense
the public as a whole. The new profit-maximizing mentality unavoidably replaced the cen-
trality of the reader with the centrality of the preparer—and the goal was not to ensure the
accuracy of the audited financial statements, but to facilitate the achievement of the pre-
parers’ goals—closing the M&A deal, hitting the quarterly earnings target, keeping the
stock price above management’s options strike price.
This commodification of the audit function was paralleled and reinforced by two legal
developments affecting the profession. The first was the highly symbolic battle over stock
option expensing, where the considered judgment of the profession that options should be
expensed, embodied once again by FASB, was essentially overridden by a Congress captive
to CEO interests. The second was the well-known Central Bank of Denver case, where the
Supreme Court found no private right of action for aiding and abetting securities fraud.2
Because auditors and other external gatekeepers have relatively little direct contact with
investors, this case was understood to mean that investors could not, as a general matter,
sue auditors and other outside professionals to recover their losses resulting from securities
fraud at a company those professionals advised. The SEC could still pursue civil penalties
against aiders and abettors, but these penalties were relatively small amounts compared
with civil judgments that sought to make the victims of fraud whole.
The first event suggested that the profession was unable to stand up to political pressure
from the preparer community. The second event suggested auditors had little to lose if they
ignored their duties to readers of financial statements.
In the end—and the end came quickly—this cultural shift proved disastrous: disastrous
for investors and the public, disastrous for companies, and disastrous for the profession.
The symbol of the disaster was of course the death of Arthur Andersen, the firm named
after the individual most responsible for the professionalization of auditing in the first place.
Accompanying that disaster was a political environment where investors and auditors
were effectively at war. When the SEC seemed to be refusing to act, companies collapsed,
and confidence in the integrity of our markets reached post-Depression lows—com-
mentators inevitably pointed to then-Chairman Harvey Pitt’s ties to the audit firms. As
Congress took up what would become Sarbanes-Oxley, the Washington Post reported almost
meeting-by-meeting the collaboration between auditing industry lobbyists and members of

2
Central Bank of Denver V. First Interstate Bank of Denver, 511 U.S. 164 (1994).

Accounting Horizons, December 2007

440 Silvers

the Republican leadership who promised not to let any reforms through. The civil litigation
surrounding Enron immediately centered on the role of Arthur Andersen in that company’s
collapse. And, of course, the dramatic events surrounding the auditing profession’s self-
regulatory structures gave investors the sense that the auditing profession was at war with
those within it who had the most integrity—people such as Bevis Longstreth and Charles
Bowsher.

RECAPTURING A PROFESSIONAL ETHOS

This somewhat painful history is worth revisiting because of the light it sheds on issues
the auditing profession faces today. Five years after the dramatic events associated with the
collapse of Enron, the auditing profession has made substantial strides toward recapturing
a professional ethos and toward realigning itself with investors—with the readers of finan-
cial statements. This realignment is by no means complete—as anyone who has attended
a meeting of the Standing Advisory Group of the Public Company Accounting Oversight
Board (PCAOB) can attest. But it is real, and investors need to support the leaders of the
auditing profession when they act in accordance with the highest ideals of the profession.
In this regard, investors and the general public should give enormous credit to Sarbanes-
Oxley and to the leadership of both the SEC and the PCAOB over the last five to six years.
Sarbanes-Oxley did three things that together have helped reorient the auditing profession.
First and most obviously, it drastically reduced the provision of consulting services by audit
firms to audit clients. Second, it created the PCAOB, with standard-setting and inspection
authority over public company audits. Third, through the creation of Section 404, the fa-
mous internal control section, the Sarbanes-Oxley Act made clear that the audit as a whole
is not a perfunctory exercise and cannot be approached wearing blinders. Section 404 did
not just increase audit fees—it made companies and audit firms take more seriously the
integrated audit as a whole.
Of course, Section 404 and its implementation turned out to be enormously controver-
sial. At one level, this development is astounding. Some in Washington are actually willing
to be publicly associated with the proposition that companies with inadequate internal
controls should be allowed to sell securities to the investing public. It seems hard to imagine
anyone could say this with a straight face. Fortunately, for investors and for our country
that point of view, while common among lobbyists, is not shared by Chairmen Cox, Olson,
Frank, or Dodd.
But here the proposition that investors and the auditing profession are finding common
ground has been sorely tested. As irresponsible elements of the business community or-
ganized their attack on Section 404 more than a year ago, the potential was very real for
conflict between investors and the auditing profession. Investors were not satisfied with the
way internal controls audits had proceeded—the costs appeared to be too high, and investors
were deluged with anecdotes about auditors making unreasonable demands on companies—
the ‘‘count-the-coffee-filters’’ stories. But investors were also adamant that while the details
of Auditing Standard 2 were up for discussion, the core principles of Section 404—all
companies must have a real annual independent audit of the adequacy of their internal
controls—could not be touched. Some investors feared that auditors would be willing to
allow exemptions for smaller public companies, or conversely that auditors would insist on
protecting unreasonable practices or fee gouging.
In the fall of 2006, as it appeared that exemptions from 404 were off the table, investors
became concerned about the possibility of a sinister bargain. In this proposed bargain, audit
firms would acquiesce in the gutting of Section 404 that was being marketed under the
notion of a ‘‘design only audit,’’ in exchange for a promise from someone (not clear whom)

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The Current State of Auditing as a Profession 441

that auditors would be given protection from investor lawsuits. The fear of this particular
deal was centered on a group of mostly financial service company executives and some
academics that called themselves the Committee on Capital Market Reform. This group
was sometimes referred to in the press as ‘‘the Paulson Committee,’’ because Treasury
Secretary Hank Paulson issued a supportive statement (Labaton 2006). Secretary Paulson
subsequently denied they had any particular imprimatur from him.
But at the end of the day, this committee did not recommend a radical weakening of
Section 404, though it did recommend a number of other very bad ideas. And credit for
not weakening Section 404 goes in substantial part to the representatives of the audit pro-
fession on this committee, which in the end rejected the sinister deal they were being offered
by those who wanted to roll back investor protections.
More recently, the Treasury Department has announced the formation of a committee
to look at issues associated with accounting and auditing, to be co-chaired by former SEC
Chairman Arthur Levitt and former SEC Chief Accountant Donald Nicolaisen. Once again,
in statements connected with the establishment of this committee, Secretary Paulsen and
other Treasury Department officials have raised the issue of limits to auditor liability. The
auditing profession will be faced it seems, for some time, with the temptation to engage in
this sinister bargain. The most likely outcome, should the profession yield to this temptation,
is not the actual enacting of liability limitations, but a reversal of the profession’s recent
gains in terms of its standing with investors and the public.
I think that the American Federation of Labor and Congress of Industrial Organizations
(AFL-CIO) and most investors are relatively satisfied with the changes to the implementing
regulations regarding Section 404 that the SEC and the PCAOB announced at the end of
2006, and that have been released in final form now by both bodies. Investors do have
some concerns about the extent to which those regulations allow audit firms to rely on the
work of others, and we think the SEC should make clear that, to the extent companies
perform inadequate internal controls assessments, they will bring on themselves more ex-
tensive and expensive external audits. But with these changes, all public companies should
come to accept the internal control audit as part of the necessary routine of running a public
company—as most large public companies have already done.

CURRENT ISSUES
Investors and auditors now face three immediate issues that are emblematic of these
issues of professionalism.

Limitations on Auditor Liability

The first is the issue of whether there should be limitations on auditor liability to private
parties in cases of fraud or other malpractice. Here, the auditing industry seems to be
arguing something like this—we have only four big firms; each audits companies with
collectively trillions of dollars of market capitalization; it is not right that we should be
answerable as firms for whatever misconduct occurs throughout this universe of activity.
Investors look at this argument with some skepticism, particularly after the history of
the weakening of professional standards that followed Central Bank of Denver. The audit
firms appear to be seeking the protections that nonprofit or public institutions enjoy, without
being similarly limited in their conduct. And by the way, the idea that a professional service
firm is involved in issues that could give rise to liabilities many times that firm’s net worth
is nothing new—law firms have always had to function that way.
But there is no getting away from the fact that, as the number of very large firms has
shrunk from eight to six and then from six to four, it increasingly feels as if the Big 4 are

Accounting Horizons, December 2007

442 Silvers

providing a quasi-public service. Investors should be willing to look at the liability regime
in that context. On the other hand, it seems unlikely that audit firms will be able to suc-
cessfully push their argument here so long as their own operations are as opaque as they
are with respect to their own financial picture and the earnings of their partners.
It is hard to look at this issue and not think that to some extent an apples-to-oranges
analysis is at the center of the issue. Audit firms complain they cannot receive liability
insurance, and then they go on to say that they need limitations on the really big judgments.
But liability insurance does not generally protect firms against the possibility of a cata-
strophic award—rather firm liability insurance typically enables firms to monitor the ebb
and flow of expenses related to more mundane litigation liability. To the extent firms have
difficulty obtaining insurance, it would appear to be the result of problems in the market
for liability insurance that might be susceptible to solutions other than depriving investors
in situations like Enron and WorldCom from recovering from auditors who participated in
a fraud.
Ultimately, the audit community’s desire for legal immunity, or something approaching
immunity, will continue to put the audit profession in the position of having to decide
whether fundamentally it wants to align itself with investor or preparer interests.

Stock Option Abuses

The second issue is the very large issue today of stock options abuse. We are all aware
of the academic studies that have shown implausible correlations at more than 1,000 public
companies between stock option grant dates and low stock prices. According to Bloomberg
News, as of June 22, 2007, over 200 companies had announced either external or internal
investigations of possible options misconduct. As of March 19, 2007, the SEC had over
160 open investigations into possible options abuses (McTague 2007; Soong 2007).
But investors are increasingly suspicious that we are not getting the whole story about
options abuse and the corporate governance implications of that abuse. Obviously, the
number of investigations represents only a small fraction of the companies identified in
the academic studies. Now there may be many reasons for this, some benign. But we are
deeply concerned.
The AFL-CIO has been meeting with very senior partners of each of the Big 4 firms
to discuss what the firms have learned about the options scandals generally and what steps
they are taking to see that this sort of thing does not occur again, and to disclose to investors
what exactly took place at the companies they own.
As a result of this process, the AFL-CIO has concluded that many companies that
engaged in options backdating are making Herculean efforts to avoid telling their investors.
These efforts include arguing that the board had authorized the backdating, making it proper
even when the option plan adopted by shareholders makes no mention of the board having
that power.
These situations, blending as they do financial and legal disclosures, can be challenging
to auditors. They typically also involve interwoven conflicts, where executives, board mem-
bers, and lawyers may all be implicated in the underlying conflict. Investors, however, are
looking to the audit firms as the best hope for getting some level of transparency out of
these situations.
Unfortunately, the SEC staff is not supporting the audit profession in this regard. Here
we see the extraordinary spectacle of the chief accountant of the SEC issuing a letter to
Financial Executives International (FEI) on September 19, 2006, telling preparers they do
not have to disclose the practice of spring-loading—which is managing the release of

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The Current State of Auditing as a Profession 443

material positive information so that when the options are issued and priced, that infor-
mation, while known to company insiders, is not known in the marketplace. Economically,
it is straightforward insider trading. But the chief accountant says that technically the op-
tions are issued with a strike price equal to the market price on the date of issue, so those
spring-loaded options do not have to be expensed under APB 25.
The chief accountant’s position is a straightforward attack on the profession’s integrity,
because it invites the profession to give clean opinions to financial statements that rest in
the key area of executive compensation on a market manipulation, in clear contradiction to
FASB Concept No. 5, which states the fundamental requirement of good faith measurement
lying at the heart of Generally Accepted Accounting Principles (GAAP).
This letter also has met with a fundamental challenge from the Delaware courts. In two
recent cases, In re Tyson Foods, Inc. Consolidated Shareholder Litigation, 2007 Del. Ch.
LEXIS 19 (February 6, 2007) and Ryan v. Gifford, 2007 Del. Ch. LEXIS 22 (February 6,
2007), the Delaware courts have dealt a profound blow to the forgiving view of options
spring-loading held by the Commission’s staff. In these two cases, the Delaware Chancery
Court found that spring-loading without explicit disclosure to shareholders and shareholder
authorization is a per se breach of fiduciary duty, and arguably outside the authority of a
Delaware company board. There are clear accounting implications of these rulings, to wit,
that spring-loading should be disclosed in the financial statements as an unauthorized is-
suance of securities, and yet as of this writing, the Office of the Chief Accountant is silent,
apparently standing by its September 19, 2006 letter.
Now the question is, what will the auditing profession do. What kind of disclosures
will we see in the coming months about backdating and spring-loading? Will investors learn
who did what? What was the role of executives, boards, and lawyers, and at how many
companies? Will auditors defer to lawyers and regulators who appear indifferent to the
standards they are supposed to be upholding? And will the profession be strengthened or
weakened as a result?

Conceptual Challenge
Finally, and perhaps most importantly, the auditing profession is facing a broad con-
ceptual challenge. This challenge does not come from managerial misconduct or the temp-
tations of self-interested lobbying. Rather, it comes from the major effort underway at FASB
to rethink the conceptual underpinnings of public accounting, and to move from the long-
standing approach of historical cost accounting to an approach increasingly based on mark-
to-market, or ‘‘fair-value’’ accounting.
Why does this matter from an auditing perspective? Two reasons. First, mark-to-market
accounting, while appropriate for items where the market is liquid or for items that can
readily be priced with respect to benchmarks for which the market is liquid, can be ma-
nipulated by issuers when such markets do not exist. And FASB is moving aggressively in
the direction of allowing preparers to estimate mark-to-market values for assets and liabil-
ities for which there is not really a liquid market. This presents an enormous risk of ma-
nipulation, and thus will certainly increase what is demanded of auditors.
Recently, offerings by several money management firms, firms such as Fortress and
Blackstone, have brought these issues to light in very practical terms. Blackstone sought
in one version of its initial public offering materials to use fair-value principles to capitalize
future interests in pools of securities, some of which are not publicly traded, without dis-
closing sufficient information for investors to assess the credibility of the valuations being
asserted. Then Blackstone sought to run unrealized ‘‘fluctuations’’ in the ‘‘fair-market

Accounting Horizons, December 2007

444 Silvers

value’’ of securities that had no market through the Blackstone IPO entity’s income
statement.
But the implications of FASB’s mark-to-market initiatives do not end there. FASB’s
initiative seems likely to make operating company financial statements more correlated with
a handful of key financial market indicators, and to look more like a liquidation analysis
than a portrait of a going concern. Auditors will then be asked to pass on these financial
statements, presumably as an accurate account of the financial performance of businesses
as going concerns. In the end, we run the risk of less accurate, less relevant, and less
auditable financial statements. The long-term result, if the profession does not exert some
further influence over the process, could reverse some of the progress made in this area
since 2003.
As long-term investors, the labor movement is very troubled by this trend at FASB.
We fear at the end it will lead to financial statements that are fundamentally less helpful
in judging the operating performance of companies, and will likely encourage management
and investors to think in shorter time frames than is really best for our companies, our
pension funds, or our country.

CONCLUDING REMARKS
In conclusion, auditing as an honorable profession matters to investors. Post-Enron
reforms have gone a significant way toward restoring investor confidence in auditors and
the audit profession’s alignment with investors. But we live in a world that will always
challenge auditor independence and integrity. These issues—liability caps, options abuses,
and the implications of a shift to mark-to-market principles as opposed to historical cost
accounting—are serious challenges and, if mishandled, will reverse much of the progress
made since 2002. Set against these threats, we hope, are the increasing commitments of
many leaders of the audit profession to maintaining and strengthening the integrity of the
profession. Investors’ task is to make sure that the investing community provides clear
support to the auditors and the academic community who are engaged in that critical effort.
That is the only way investors’ goals can be met, and it is the right thing to do.

REFERENCES
Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994).
Financial Accounting Standards Board (FASB). 1984. Recognition and Measurement in Financial
Statements of Business Enterprises. Statement of Financial Accounting Concepts No. 5. Nor-
walk, CT: FASB.
Labaton, S. 2006. Businesses seek new protection on legal front. New York Times (Late Edition,
National Desk, October 29): 1.
McTague, R. 2007. SEC looking at subprime, Thomsen says; Agency probing 160 options abuse
cases. BNA.com (March 26). Available at: http: / / subscript.bna.com / SAMPLES / srlr.nsf /
9e8cc926334ffad885256d05005abdfd / ae67c20eba200530852572a70074ebc0?OpenDocument.
Soong, W. 2007. SEC probes Activision, clears ArthroCare: Options scorecard. Bloomberg.com
(June 22). Available at: http: / / www.bloomberg.com / apps / news?pid⫽newsarchive&sid⫽
acKi5zGedvHY.

Accounting Horizons, December 2007