How to Audit the Auditors
Why auditor oversight requires a change in culture
Lukas Löhlein - 19. Februar 2021
Auditors are the quality control agents of the market economy. They oversee the financial statements of the largest corporations as well as systemically relevant banks and medium-sized companies. Nevertheless, spectacular accounting frauds pervade the history of auditing and bring the control and efficacy of auditors into question. Based on expert interviews and archival analyses, a new study examines the introduction and historical development process of audit oversight in Germany. Conclusion: The low impact of today's oversight system is the result of historical path dependency. The Wirecard AG accounting scandal now offers a new opportunity for Germany to raise its oversight system to international standards.
In Germany, the Auditor Oversight Authority (Abschlussprüferaufsichtsstelle or APAS) at the Federal Office of Economics and Export Control is responsible for overseeing auditors. Formally established only in 2015, APAS must, however, be viewed against the backdrop of a development process that has lasted almost two decades.
Oversight as the result of historical path dependency
Historically, the German auditing profession organized itself largely independent from state intervention. Around the turn of the millennium, however, international regulatory trends and national accounting scandals put the profession – and its traditional rejection of external quality controls independent of the profession – under pressure to legitimize itself. The profession reacted and, in close coordination with legislators, established a formally independent "Quality Control Advisory Board" in 2000, which was charged with the supervision of binding quality controls. But it was not even two years before the U.S., shaken by the accounting profession's involvement in the Enron scandal, ushered in a new regulatory era. Equipped with far-reaching supervisory and enforcement powers, the established U.S. regulatory body, the PCAOB, began to set international standards for control over auditors. To keep pace with this development and ensure acceptance of the German oversight system, in 2005 the German legislature – again in close consultation with the profession – transferred the existing Quality Control Advisory Board to the Auditor Oversight Commission, (Abschlussprüferaufsichtskommission or APAK).
From the outset, the APAK was characterized by close personnel and organizational ties with the profession. One political actor recalls:
"When I first visited the regulator, I expected a powerful U.S.-like agency. And then I found myself in a small office on the fourth floor of the Chamber of Public Accountants."
Increasingly criticized by the U.S. PCAOB, subsequent years were marked by a series of “regulatory cosmetics” designed to demonstrate the oversight system's formal independence from the profession. The result was a supervisory system that had formally adapted to the requirements of international financial markets, but culturally continued to be shaped by a strong culture of self-regulation. This was also reflected in the staffing: it was (and still is) predominantly former employees of the Big4 firms who fill managerial and supervisory roles and carry out the operational implementation of inspections of audit firms.
This regulatory culture was not to change significantly with the introduction of APAS in 2015, and the regulator remained, as one observer described it, "a strange creature" – caught between the ambition to establish strong oversight along international lines without simultaneously challenging the traditional logic of professional self-governance. Against this background, it is not surprising that the sanctions imposed by APAS to this day consist mainly of reprimands and small fines; it cannot be assumed that they have a disciplinary effect on the profession.
What can we learn from this history? First, historically, the audit profession has had a profound impact in shaping the legislation of independent oversight. There is nothing wrong with this per se, but when it comes to shaping the oversight of its own profession, the question arises as to how much control emanates from an oversight that has been shaped from the beginning by a personal, structural as well as cultural interdependence with the profession. Second, despite countless reforms, supervision remains trapped in its historical path dependency, which allows reforms and promises to degenerate into symbolic politics and prevent real cultural change.
Wirecard as an opportunity for change?
Path breaks are usually triggered by exogenous shocks. The spectacular collapse of Wirecard AG therefore offers a (new) opportunity to raise the German supervisory system to an international level. What needs to change for this to happen? Germany needs a cultural change in the supervision of auditors. Specifically, the supervisory system must no longer give the impression of protecting auditors from a critical public. Instead, it must be ensured that supervision takes a more critical stance toward auditors. To this end, the assertiveness and transparency of supervision in particular must be strengthened. One example: despite the high number of deficiencies, the current oversight does not publish information on which auditors have been found to have said deficiencies. This is vastly different from its European counterparts, as for instance, in Great Britain. There, a quarter of the audits of the 350 largest listed companies were recently found to be deficient. Studies clearly show that increased transparency reduces the error rate in auditing firms and thus increases the quality of financial statements. Inspection results and sanctions against auditors should therefore be communicated by name rather than anonymously, as is currently the case. It is this transparency that disciplines both the profession and the regulator. A cultural change also requires a balanced composition of the supervisory authority: qualified auditors are not to be found exclusively at the Big4 firms.
The falsification of Wirecard AG's financial statements has exposed the weaknesses of auditor oversight. However, this is precisely why it presents an opportunity for fundamental reform of the oversight system. Only with a fundamental regulatory culture change can the public's trust in the role of auditors as the TÜV of the chapter market be regained.
Tips for practitioners
- Transparency and rigor are critical to system credibility. Look for this in the establishment and evolution of oversight and control systems.
- The DNA of systems can limit their scope for change and adaptation. Pay attention to the path dependency(ies) of your organization or industry.
- Consider the compatibility of different system goals. Clear prioritization of goals is critical to system stability and effectiveness.
- Löhlein, L./Müßig, A. (2020): At the boundaries of institutional theorizing: Individual entrepreneurship in episodes of regulatory change, in: Accounting, Organizations and Society,83.
Assistant Professor Dr. Lukas Löhlein
Lukas Löhlein is an assistant professor at the Institute of Management Accounting and Control (IMC) at WHU – Otto Beisheim School of Management. In his research, he takes an interdisciplinary, sociological perspective on accounting.