Re:Balance -- Jim Peterson

KPMG's Independence, Herbalife's Stock Price, and the Game of Name Blame

What does this say about the value placed by investors on the independence of outside auditors: 

Two trading days after KPMG withdrew its audit reports on the financial statements of its Los Angeles clients Herbalife and Skechers, because of inside information shared by its promptly sacked and criminally charged engagement partner Scott London, the stock price of both of those stocks has actually risen!

The consequences of London’s passing on, to the million-dollar benefit of his golfing pal Bryan Shaw, will be swift and nasty:

• Ratted out by Shaw, London will cut the fastest plea deal the prosecutors will offer.

• KPMG will hurl its checkbook at every dollar of costs incurred by its ex-clients to obtain replacement auditors.

• Aggressive plaintiffs’ lawyers will fashion some theory of shareholder harm – despite the stock price upticks – doubtless spinning a conspiratorial connection with the long-running spat over Herbalife between raider Carl Icahn and shortseller Bill Ackman, and eventually coercing a nuisance-level settlement.

• And the American securities and accountancy regulators – the SEC and the PCAOB – will vie with each other in a pell-mell rush, recalling the unseemly post-Enron haste with which the Sarbanes-Oxley law was passed in 2002, to push a requirement that auditors of US public companies identify by name their partners signing client audit reports.

This last has been opposed with intensity by the American accounting profession, although long in place in much of the world without measurable adverse effects.   

Nor, it should be noted, with measurable benefits either – as client managements and audit committees in the US have never lacked access to the decision-qualifying information necessary about the engagement personnel at their audit firms.

In the wishful search for magic bullets aimed at the structural weaknesses in the auditor-client business model, “partner naming” is a distinctly small-bore and ineffective weapon. 

But London’s downfall does require re-framing my opening question, this way, heretical as it may seem:

What value to the operation of the capital markets – if any -- is actually delivered by the entire structure of auditor independence? 

London’s professional position was destroyed, and his liberty put in jeopardy, not because he violated the elaborate dictates of the auditor independence rules, but because of his multi-year violations of the insider-trading prohibitions of the American securities laws.

And on the other hand, despite KPMG’s immediate and apologetic resignation and report withdrawals, the stock market has given credence to the assertions that the substantive content of the Herbalife and Skechers financial statements are unaffected (even given the charges hurled in the Icahn/Ackman dust-up).

In short, the indifference of equity investors to the state of KPMG’s independence speaks volumes.

I’ve long been saying (here and here) that – under the “client pays” business model for financial statement assurance, invented back in the Victorian era – the accounting profession has gained nothing positive for years, by way of reputation, stature or risk and exposure mitigation, from the intellectually unsatisfactory edifice of “appearance of independence.”

Now, the stock price non-event of Scott London’s misadventures equally shows the converse – that investors impose no downside price penalty on even a slam-dunk independence violation.

Conclusion: the time, energy and cost of maintaining the outmoded and anachronistic structure of “independence” should be re-directed to the long roster of topics legitimately worthy of the effort.

 

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Re:Balance Takes a Spring Time-Out -- Will the Silliness Please Take a Break Too!

For the first time since launching as a blog in 2008 after its run without a break from 2002 as “Balance Sheet” in the business section of the International Herald Tribune – “Re:Balance” is going to be dark for several weeks. 

Intense and nearly unbroken travel on three continents will impede staying current on all the mischief within the capabilities of the inter-locking participants in the structure by which assurance is provided on the financial statements of the world’s large companies: issuers, the large accounting networks themselves, users in the capital and investment markets, agencies of law enforcement and politicians and regulators.

Developments in this troubled world are likely to be consequential but cannot be predicted with any level of confidence – so there will be catching up late in the spring.

Three items in the last week head the list of topics to be monitored, however:

• The PCAOB announced consideration of a proposal for the reorganization of its auditing standards – something on absolutely nobody’s list of priorities -- while the agency has failed to get off the snide on either auditor rotation or the content of the auditor’s report – reinforcing the unavoidable conclusion that this body has lapsed into terminal inconsequence. 

• The vote of the European Parliament’s Economic and Monetary Affairs Committee to scrap a proposed requirement for mandatory auditor rotation, in favor of a less binding “directive” on periodic re-tendering, has potential to inflict a dose of reason and reality on a topic long threatening to float away on clouds of fantasy. 

• And the news from the UK -- that the move by Schroders to replace long-time auditor PwC with KPMG has foundered on the inability of the putative successor to satisfy the independence requirements -- provides early validation that even aspirations limited to periodic re-tendering are subject to the realities of a market for audit services too constrained to function under legislated mandates.

All of these challenges reinforce the over-arching need for fundamental re-engineering of the reporting and audit functions in their entirety. But this process is unlikely to advance in any significant way during my brief absence. 

Instead, there is every reason to be confident that these problems will all be here and awaiting attention when I return.

 

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The PCAOB’s Inspection Reports Nibble at PwC -- A Reader Asks, “Where’s the Beef?”

Food beyond compare

Food beyond belief

Mix it in a mincer

And pretend it's beef

Kidney of a horse

Liver of a cat

Filling up the sausages

With this and that

-- Thénardier, “Master of the House,” Les Misérables

The Public Company Accounting Oversight Board – overseer of the accounting profession in the United States – got in a snit recently, perceiving that PwC was lax in its efforts to remediate the “significant audit performance deficiencies” that the agency asserted in its 2008 and 2009 inspection reports.

Expressing pique as it only could, on March 7, the PCAOB released to an indifferent public the previously undisclosed “Part II” portions of those reports.

Did it arouse the aforesaid public to care? Or even to notice?

A predictable handful of the large accounting firms’ most reliably ardent critics did weigh in (here and here).

Meanwhile a measured comparison comes to mind – the teapot-scale tempest aroused in Britain and Ireland this winter, over the discovery of equine DNA in samples of meatballs and ravioli – not, enforcers emphasized, because of any actual consumer health hazard, but over alleged deficiencies in labeling and transparency.

On which my perspective takes from the attitude of my daughter, a situational vegetarian who, on assignment this last year in Southeast Asia, has extended her palate and appetite to include crickets, dog conch and scorpion.

In the European kerfuffle, a libertarian-oriented omnivore – believing in both cultural differences and regulatory intervention only to the minimum necessary – would favor a simple modified label: “May contain horsemeat”. 

As for the PCAOB, the question has to be asked -- How can an oversight function claim either legitimacy or effectiveness, that:

• Decides for itself how to define and identify not a legal or professional standards failure, but an elusive “significant audit performance deficiency.”

• Keeps score under its own methods and incentives, like a traffic meter maid sent on patrol with a book of tickets and a daily quota.

• Must under cover of confidentiality conceal both the names and the detailed particulars of its self-defined offenses.

• And then in a burst of ill-temper, decides for itself whether the undisclosed substance of a remedial effort is satisfactory within unmeasured and unarticulated standards.

It’s no wonder, for two reasons, that PwC saw no reason to pursue its right of appeal to the Securities and Exchange Commission.

First, because PwC negotiated the ability to append to the PCAOB’s release a pronouncement of its commitment to virtuous conduct, positively radiant with unctuous platitudes.

But second and more especially, because under the current model for compliance with the securities laws, under which there is no available alternative, the Big Four-dominated market for large-company audit services is armor-plated against the PCAOB’s pop-gun arsenal. 

Law enforcement, rules compliance and social norm-setting in general -- in contexts that are controversial, subjective and incomprehensible to the laity -- are subject to credibility challenges and diminution of the authority of their arbiters:

• The Supreme Court’s obscure definition of obscenity, “I know it when I see it” (Stewart, J., Jacobellis v. Ohio, 1964).

• The theological search for distinctions between mortal and venial sins.

• The nuances and complexity of sport, from soccer’s off-side and cricket’s leg-before-wicket to hockey’s high-sticking and baseball’s rules on balks and infield flies.

• The subtleties of line-drawing between shrewd and informed investing and insider trading, or the bribery of officials and accepted business facilitation.

Here -- the mutual hypocrisy in the whole sorry audit regulatory environment is pervasive:

The PCAOB gets to pretend it is engaged in a meaningful exercise, worthy of being taken seriously in the capital marketplace.

The audit firms are obliged to pretend that they take the cost and impositions of the inspection process as something more than the de facto license fee paid as a nuisance to maintain their franchise.

And to the limited extent they really care, financial statement users can only search elsewhere for meaningful assurance, beyond the model unchanged since the Victorian era and long since degraded into obsolescence. 

Critics of this dysfunctional structure are entitled to their finger-pointing cynicism. But their bile is misplaced – until and unless they unite in advocating an achievable effort to re-engineer the entire system of reporting and assurance that today only fosters ambiguity, inconsequence and disrespect.

Until which, at the foot of each PCAOB inspection report should be appended an adapted version of the suggested European meat label – “May contain horse-sh*t.”

 

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