Re:Balance -- Jim Peterson

Auditor Independence -- If There's No Value, What's the Point?

The latest example of finger-pointing in the credit market turmoil is the examiner’s report placing blame for the bankruptcy of subprime mortgage lender New Century Financial upon its auditor, KPMG. Released yesterday, and available here, the report echoes the drubbing that fell upon Andersen over Enron – a no-win subject for the auditors: “By which are you more corrupted – your breadth of client relationships, or your fee levels in general?”      

Public discussion is finally beginning to focus on the reality that the familiar model for auditor assurance on large-company financial statements is flawed to the point of requiring fundamental re-structuring. Especially in the absence of coherent and achievable solutions, however, one element deserving attention is the obsolete and over-valued concept of auditor independence.

So this column, originally published in the International Herald Tribune on March 24, 2006, retains its relevance.

Setting Free the Auditors

The American writer Dorothy Parker, who never shied from afflicting the comfortable, put it this way: "If you can't say something nice, come over and sit by me."

Parker would have been aghast at the self-congratulatory atmosphere among the regulators of the world's securities markets. According to them, the problem of dubious corporate accounting has been solved by strictly limiting the kinds of services the auditors can provide to clients.

There is nothing more sacred in auditor-client literature than the notion of auditor independence, which dates from the founding of the profession in the 19th century.

Yet with auditors today stumbling under the weight of litigation - each of the surviving Big Four accounting firms having a list of cases large enough to be fatal - this unexamined burden has become yet another millstone. And a proposed solution circulating in the halls of Washington - involving a waiver of the Sarbanes- Oxley rules limiting the scope of auditor services to clients - is a political nonstarter.

So I say it is time to stop making nice and to discard a 150-year-old piece of conventional wisdom. The concept of auditor independence does not serve the interests of investors.

Audit performance - and more immediately, the survival of the large firms to serve their global clients and the capital markets - would be better achieved if the current independence requirements and constraints were scrapped altogether.

Auditors should be free to provide their clients with any services within their skills. The only thing that should be required is comprehensive disclosure of all relationships, to be evaluated and decided by the voting power of the marketplace.

Some will be scandalized by the suggestion that the sacred cow of auditor independence should be led off and humanely put out of its misery. But there's a reason it should be done.

Regulators confess to being clueless about what will happen when the next of the Big Four accounting networks disintegrates under the combined pressures of hostile law enforcement and overwhelming shareholder litigation. (Think it can't happen? After Enron and Arthur Andersen - and the $456 million fine over questionable tax shelters paid by KPMG to escape indictment? It's Russian roulette out there, and the gun is full of bullets.)

The purest argument for driving the profession back to audit-only basics has always been that as clients pay the fees, for services of any type, auditor independence is inevitably subject to compromise.

But to finish that thought, in a system so inherently subject to corruption, auditors should never take any fees from their clients. So who will pay? Inserting a government-run fee and license structure amounts to nationalizing the audit function - an idea that figures nowhere in rational dialogue. And there are no other volunteers around.

Likewise, the argument that consulting fees corrupted auditor behavior was always a bit stretched. Heady as that stream of revenue was, it was the money itself, not the source. It could be said, in fact, that auditors who depend on audit fees alone are under even more pressure to accommodate client wishes. And whenever that accommodation has turned ugly - Andersen's travails with Enron being only the most egregious example - it's the firms that pay. As recent history shows, they have neither the reputation nor the capital to bear the terrible cost.

Clearly, the accountants garner neither respect nor liability protection by complying with these enforced codes of independence. They, and their clients, would deliver better value if audits were based on a comprehensive understanding of and involvement with the business. In other words, auditors need to be closer to their clients, not farther away.

Who better to ensure that financial statements are free of error than a professional who designs, installs, operates and maintains the system that accounts for the transactions of an enterprise - the very services from which today's auditors are barred?

This does not dismiss the importance of accountability or of oversight. Regulators have their place - but only under systems of liability that address the reality of today's deadly threats.

Société Générale’s 2007 Annual Report – Jérôme Kerviel Is So Last Year

The recurring claim of French exceptionalism got a big boost early this month – at a price. Société Générale asserted that the only fair way to report its loss of € 4.9 billion, inflicted in January by junior trader Jérôme Kerviel, was as an event occurring in 2007.

Deep down in footnote 40 of SocGen’s massive annual report – to get the English version -- here – ou bien la VO Française ici – the bank discloses that Kerviel was in a net positive position of € 1.471 billion as of the end of 2007. His blow-up came on January 18, and the unwinding losses in the following days came to an eventual € 6.382 billion.

Over-riding the compelling guidance of the International Accounting Standards Board, that would book the effects of Kerviel’s mischief as they fell, would be rare enough under the UK’s high-level “true and fair view” rubric, much less under the American guidance of “present fairly in accordance with generally accepted accounting principles.”

But that didn’t stop the French bank – supported by its national banking and securities market supervisors, as well as the two Big Four accounting firms -- Ernst & Young and Deloitte & Touche -- who share responsibility for its audit.

There is at least behavioral history on the French side: for years the European practice of booking the effect of deliberate errors in the year of discovery rather than in the year of perpetration has avoided the litigation hazard of the American requirement to re-state erroneous financial statements for prior years.

And on the recent and highly political side, the French have been vocal and steadfast in resisting the international standard for marking financial derivatives to market – the infamous IAS 39 – arguing the difficulty of valuation models other than historical cost but also conveniently retaining the flexibility of corporate management to time their recording of results to suit their discretion.

SocGen’s tone-deaf approach starts with its footnote description of Kerviel’s trading “plain vanilla” financial instruments – a colloquialism lacking both a usable French translation and a common understanding in the industry. Nor is there any positive spin to the term, since the more ordinary Kerviel’s scope and job description, presumably the more effective SocGen’s oversight and control of his desk should have been.

As I am told by the technical accountancy wonks, SocGen may – just barely – have a straight-faced justification, that its year-end balance sheet should reflect the € 4.9 billion body blow that struck only three weeks later.

Fair enough, on a casual first glance. But the argument for evading a well-known body of international standards, under an exception so obscure and elastic that prior examples are virtually unknown, fails on three grounds – technical, strategic and political.

First, on the technical side. Moving around Kerviel’s impact cannot lessen its prominence or significance. As a post-closing event it is comprehensively discussed for three pages in the SocGen report. A pro forma balance sheet presentation right there would do as much for disclosure as the roll-back could.   

Even if it can be done, in other words, doesn’t mean that it should be.

Strategically, then, what’s the point? The known facts are so notorious that no one will be diverted or misled. Whether CEO Daniel Bouton survives – whether the bank itself survives – or how much the bank will ultimately pay out to the shareholders who are now at the courthouses with claims that the bank was running a “culture of risk” – none of these will be affected by the choice of years. So if SocGen can achieve no good for itself, what constructive purpose could there be in adopting a lightning-rod position?

And politically, the bank has succeeded only in setting back the global arguments for international accounting convergence, harmonization and improvement. If a “fair reporting” excuse can be made for Kerviel, there is no intellectually defensible line-drawing guidance by which investors can anticipate where the next similar exception will be invoked.

The size of the event can’t be a factor. A knock of € 4.9 billion is big, to be sure, but consistency in the reporting of small things is of little use if it’s the really worrisome big problems that qualify for revision and exception.

And with a French tradition to favor management’s opportunity to manage the timing of bad news, agreed by the supporting players, predictability of reporting at the global level is out the window.

So vive la difference – but let it be kept to matters of local impact only. 

The Accountancy Regulators -- Motion Is Not Progress

My last post, critical of the proposal from the SEC’s Committee on Improvements to Financial Reporting for a “judgment framework” for accounting and audit decision-making, generalizes across the lack of substantive debate on the difficult state of financial reporting and the auditors’ threatened assurance franchise.

More public meetings are on the calendar – specifically, the US Treasury’s Advisory Committee on the Auditing Profession meets on March 13 (here), the CiFIR itself meets the next day (here), and the US Chamber of Commerce's Center for Capital Markets Competitiveness holds its next annual summit on March 26 (here). The hot-air potential is high -- the optimism level is not. A catalog of inter-related issues remain completely unresolved, without any visible progress against an agenda laid out in this still-relevant column that ran in the IHT on April 22, 2006:   

Solutions That Are Not

There's no finding solutions without a proper focus on the problems. Think of the guy in the dark of night, searching under the street lamp for his keys. The beat cop asks, "If you say they were lost over in that dark alley, why are you looking here?"

"Because the light's better here," the poor guy responds.

Which pretty much describes the January, 2006 report of the U.S. Chamber of Commerce, joining the dialog on the survivability of the large accounting firms under the stunningly obvious title, "Auditing: A Profession At Risk" -- here.

With its heart in quite the right place, the group says "action must be taken" so that companies might retain "access to high-quality, reasonably priced auditing services."

Whereupon, sadly, the report loses its focus and its way, bumping dimly down the dark streets from one missed opportunity to another.

Here are six of them:

First, the chamber gamely recognizes that the audit profession has become effectively uninsurable in the face of litigation costs that threaten immediate destruction of partners' limited capital and their long-term inability to hire and retain personnel.

Yet its limp observation that legal reform "may be needed" misses the crucial point. Auditor insurability requires the ability to predict, quantify and limit the insured risk - conditions impossible to fulfill under unlimited liability hazards.

Second, the chamber repeats the familiar if unhelpful refrain that auditors should not be held liable for failure to detect or prevent cleverly designed collusive fraud.

That's fine, as far as it goes. But what about the many corporate frauds that aren't that clever or well concealed, but that repeat shenanigans perpetrated for generations? And what about all the "fraud" that consists of aggressive use of permissive accounting standards set under the influence of corporate interests themselves?

Also, what about auditors who, faced with a crushing liability overhang, are forced to settle their mega-cases without going to trial?

Third, the chamber proposes that the Public Company Accounting Oversight Board, the U.S. industry regulator, should promulgate a "safe harbor" standard for fraud detection, to protect the auditors if they can show they fulfilled steps issued by a bureaucracy.

Yet it is this very "check the box" approach to the control assurance requirements that is the Achilles heel of the Sarbanes-Oxley law. Companies whose stock trades on U.S. exchanges, and therefore must register with the U.S. Securities and Exchange Commission, are furious at the escalated cost and diminished effectiveness of auditor performance because of the Sarbanes-Oxley requirements - to the point of avoiding or fleeing U.S. listings altogether if they can.

Fourth, the chamber serves its own broad constituency of small businesses by suggesting that the audit profession's doubtful viability is not helpful to new companies that may be innovative but unfamiliar to the capital markets.

Trouble is, that's not where the real threats lie. It's not the unknowns with the biggest and most costly claims in this decade, but household names: Enron, WorldCom, Adelphia, Xerox and Parmalat.

Fifth, understandably exercised over the mortal blow of the indictment of Arthur Andersen over its work for Enron, the chamber calls for legislation to "rein in" the process of indicting whole enterprises.

Here the problem is that unless world trade and commerce unexpectedly achieve an as-yet unknown state of grace, society will expect its law enforcement officers to indict and prosecute where indicated by the facts.

Sixth, the chamber joins a chorus of concern over the shrinkage down to the Big Four, who together audit virtually all of the world's largest companies. But the relocation to smaller firms of non-audit work is once again off point: Those are not statutory compliance services, where the real legal risks and fatal exposures lie.

To be fair, though, the chamber may be so turned around because it started from a faulty bearing - that auditing is central to public confidence in the capital markets. When the next big auditor disintegrates amid litigation, it will become obvious that the delivery of services by a noble profession in the process of collapse will not be something anyone will be able to preserve.

In the small pool of light cast in this darkness, that much is right out in plain sight.

Accounting and Audit Judgments -- Please, No More Standards!

A new one-liner in the cultural vocabulary was introduced when the hit comedy, “No Sex Please, We’re British,” opened in London in 1971.

Today’s plea – with the Securities and Exchange Commission’s proposal to inflict an analytic structure upon the making of accounting and audit judgments – would be “No Standards Please, We’re American.”

On February 14 the SEC presented for public comments the interim progress report of its Advisory Committee on Improvements to Financial Reporting – here – which among its suggestions was that the Commission should adopt a “judgment framework” in the accounting area, and that the country’s audit regulator, the Public Company Accounting Oversight Board, should do the same for audit judgments.

Responses to the SEC are due the end of this month. Meanwhile, the PCAOB sponsored a panel discussion on February 27 by its Standing Advisory Group – summarized here by Edith Orenstein of Financial Executives International.

The signal achievement of this day-long effort was that the competing interests in the debate managed at the same time to expose both the hazards and the vacuity of the whole idea.

As co-presented to the PCAOB group by a managing director of Moody’s – yes, the credit rating agency – the notion is this:

•    Preparers of financial statements would be assisted by yet more pages of codified bullet points, in choosing and applying among the myriad of alternatives for selecting and implementing accounting standards, quantifying estimates, evaluating evidence and all the rest.

•    Auditors, likewise, would be similarly enlightened across the spectrum of judgments required to choose audit procedures, to evaluate the likelihood and impact of fraud and other risks, to conduct audit sampling, to evaluate controls and – layering the irony – to assess management’s own judgments.

Wait.

In the century and a half since the emergence of independent accounting early in the Victorian era, preparers of financial statements and their auditors have been striving get their judgment processes right. So who are these bureaucrats, with their presumption of assistance?

This is, after all, the same SEC that was caught flat-footed over the pervasive extent of executive options back-dating. The same PCAOB that in its sixth year has no more than a pilot program for constructive engagement with non-US regulators and inspection beyond the samples taken within its own borders. And the same Moody’s whose involvement in the subprime mortgage fiasco, along with the other major credit ratings agencies, finds them to be central in the still-spreading credit markets turmoil.

Put another way, taking advice on the process for judgment-making from this crowd could be viewed like hiring Noah to give flood-control advice to the city of New Orleans.

As for the parody that passes for debate, the self-interested and antagonistic participants are circling the topic and each other like stray and wary dogs around a hydrant.

The accounting firms at the PCAOB’s table gave cautious endorsement to the framework idea, despite the obvious hazard: By getting it right they would obtain no more credit, safeguard or protection than is available today under existing guidance. Instead, they would only have one more procedure to get wrong, and therefore increase their already debilitating litigation exposure.

The large accounting firms remain muzzled on their fragile and threatened state, unwilling out of either fear or denial to acknowledge the shockingly low litigation impact that would cause their disintegration (which I've calculated and discussed here).

As a result, they are inhibited from insisting that the only realistic usefulness of yet more regulation on the exercise of their judgments would be under a “safe harbor” within which they could explore and apply new modes of working.

But on the other hand, investor advocates among the profession’s critics make plain the political reality that no adjustments in the American legal liability framework that entraps the auditors today are about to be forthcoming.

Exposing the sterility of the discussion, even the regulators themselves are in full self-protection mode, making clear that nothing in the application of the suggested framework process would inhibit the SEC or the PCAOB from examining and criticizing the judgments made by issuers or auditors.

For British theatre-goers the farce of “No Sex Please” ended when the nightly curtain came down. Because a new "judgment framework" would offer benefits that range from elusive to non-existent, would impose costs of extra work and documentation that are extensive, and would inflict potential litigation hazards that are considerable, the farce now playing out in Washington deserves a closing notice.   

For other aspects of the PCAOB’s meeting last week, see my friend Francine McKenna at Re:The Auditors -- here.