Since we just looked at this abstract game, what implications does this have for financial statement auditing? And one thing to think about is, do you think public companies could develop a reputation for accurate or fair financial reporting to the extent that the market no longer demanded an audit? There was almost 12 years ago now, dating myself for sure, but that doesn't seem very long to me, there was a move among some Congressional Republicans. Let me oversimplify things, but it is generally the case that Republicans are going to be looking for less regulation and sometimes Democrats will tend towards more regulation, or is an idea being floated of, let's get rid of the requirement, this archaic requirement from the 1933 and 1934 Securities Acts that required for initial public offerings of a company's stock, an audited set of financial statements, that's the 33 Act, and then the 34 Act, an annual audit by an independent auditor. So, some Republican said, why don't we just move this to every three years? It seems like these audits are not cheap, they're costing money, auditors are breathing down the necks of management. Or let's just let the shareholders decide. For any public company that is out there, do you want an audit, and if so vote yes. That's some of the real world in which we live. There's also been a very different type of proposal in the last decade or so, right after... so more like 20 years ago, right after a spate of frauds, in alleged audit failures of companies like Enron and WorldCom, there's a company called Global Crossing, there's a variety of these companies, Waste Management, out of this bubble of 10 to 15 very clear cases of corporate malfeasance and fraudulent financial reporting and alleged audit failures, in some case pretty clearly audit failures. Legislation called Sarbanes Oxley originated which created, for the first time, a federal oversight body instead of a self-regulated audit profession, you had a federal oversight body emerged that was going to come and set the standards for auditors and inspect their work. You also had a more extreme proposal originate by someone named Dennis Kasinach, who was the person who's behind this, and he said, the public, the Big 6, the Big 4, all the Big 8, they have audit firms, they have blown it, and he actually wanted to create an FBA. He said, we have an FBI, a Federal Bureau of Investigation. We need a Federal Bureau of Audits where we get those governmental auditors, who are truly working for the best interest of the investor. Well, that one did not... It actually had a little bit of perception but it didn't help them have the legs that the Sarbanes Oxley Act had, which generated the Public Company Accounting Oversight Board in the United States. So the question I'm teeing up here is something that you can tee up in this real world with all of these social and political forces bubbling up and equilibrating. The answer seems to be that, if you look at private companies, a lot of private companies who are not going out for widespread investment by a bunch of different heterogeneous investors, a lot of those private companies do not get audits. All public companies, I'm of the opinion, would get an audit, just because of the diversity of their investor base. It'd be awfully hard to have a sufficiently high reputation for financial statement quality to no longer get an audit. Because one reason you have that reputation, as everyone in society knows, you have those auditors watching over your shoulders. Another way to think about that is, what is the base rate of dishonest companies today, despite pretty rigorous audits? Suppose there are 1,000 public companies. How many dishonest companies would you need before an endogenous demand for auditing would exist? Again, endogenous is the academic parlance for bubbling up within the economy. Right now, we have clearly an exogenous demand for auditing and that the Feds say you have to have an audit if you're a public company. The 1934 Securities Act requires that. But suppose that went away. Well, right now even though auditing is required, a recent estimate of the base rate of fraudulent financial reporting was little over seven percent, close to eight percent per year of U.S. companies. So, if you think about that, if there were a thousand, you're talking about 70 or 80 of these public companies each of which have a huge investor base are actually just completely being dishonest about their financial results. And the problem with that is, of course, is somebody ultimately gets hurt. Sometimes, these frauds occur, a company gets an infusion of capital and the fraud perpetrators leave, they go away, and they live the dishonestly gained happy life, and the company is thereafter someone honest. That's not, by far, typically what happens. If you think about that base rate of fraud being eight percent per year, which, by the way, when I was in your shoes studying audit for the first time, over 30 years ago now, the base rate estimate at that time was one half of one percent. So something has gone wrong in society, or our ability to catch fraudsters has gone up, such that we have a much higher estimated rate of fraud.
