Re:Balance -- Jim Peterson

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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Re-Structuring the Audit Profession: The UK's Competition Commission Hunts the Woozle

 After the United Kingdom’s Competition Commission issued its report on February 22, asserting that the Big-Four-dominated audit services market is non-competitive, I sought to raise a flag of warning that, unless de-railed, its rush to fait accompli would soon inflict mandatory auditor rotation or at least re-tender on global-scale companies.

Diligent digging through the Commission’s augean piles of paperwork makes clear that its ostensibly supportive “research” ranges from the shallow and irrelevant to a results-driven reflection of its confirmation bias.

Comes to mind A.A. Milne’s 1926 fable of Winnie-the-Pooh and his pal Piglet, earnest and naïve, circling their own tracks around a spinney of larch-trees, and befuddled in their speculation that they might be tracking a Woozle.

 

Despite a forthright bias in favor of “auditor switching” – reflected in the finding that “incumbent auditors … face less competition for their ongoing engagements than they would were the company more willing to switch thereby reducing rivalry” -- the Commission fails to elicit any evidence-based impact of auditor tenure on audit quality.

To be sure, the Commission’s inquiry into the rate of “switching” is voluminous – building elaborate calculations in search of relationships among such elements as client size, audit complexity, geographic spread, client evolution from private to listed status, length of tenure at the start of the measured period, etc.

Yet, it does not attempt to examine, much less resolve, these two related but distinct questions:

• With the considerable number of long-tenured auditor-client relationships where the record of non-controversial financial reporting is unbroken, is there any identifiable relationship between the length of auditor tenure and the incidence of diminished quality or “audit failure”?

• As to the extremely small population of actual “audit failures” – compared to the huge number of non-problematic audits – is there any identifiable relationship between the length of auditor tenure and such failures themselves?

Nor is the integrity of the Commission’s history of the profession any better than that of their economic research. Their lengthy discussion of the early audit requirements, evolving from the Joint Stock Companies Act 1844 through to the superseding Act of 1856, omits essential facts:

• First, the terms of the 1844 Act were met by “auditors” chosen from among the company shareholders – non-professional co-investors engaged to examine and report on their company’s results, with interests not independent but precisely aligned economically with their fellows. 

• Second, it was not until the dawn of the next decade that these amateur “auditors” reached out to the nascent profession for assistance – e.g., William Welch Deloitte, then aged 32, joined Messrs. John Dickinson and Richard Atkinson, the shareholder auditors of the Great Western Railway’s accounts for the six months ended December 31, 1849, in the terse opinion dated February 8, 1850 – “Audited and Approved.”

• Third, therefore, by the Act of 1856, developments in the market for independent audit had surged forward, making that legislation essentially reactive, in the same manner as today for government regulators typically late to the party. 

Shortcomings in the Commission’s approach include a rose-tinted survey of the mid-tier firms’ “self appraisals of their capability and willingness to audit FTSE 350 companies” – noting, however, that as of 2010, the Big Four audited 99 companies of the FTSE 100, and 96% by number and 99% by fees of the entire FTSE 350.

In that context, asking a mid-tier business developer about his firm’s capability to audit a global-scale FTSE 100 enterprise would be like asking a sophomore in a fraternity house how he’d like a date with the Sports Illustrated swimsuit cover model. What possible response could be expected?

My graduate-level course in Risk Management uses a reading exercise in what legitimate, non-ideological research ought to look like – drawn from the very Victorian era when independent audit was invented, on whose history the Commission is so dim.

It’s the 1855 diary of physician John Snow, whose meticulous tracking of epidemic cholera cases around the publicly-accessible water pump at Broad Street in central London ranks among the origins of forensic medicine.

Dr. Snow’s techniques made inquiry in both directions: Not only who got sick, after drinking water from the pump – including both residents and casual visitors to the neighborhood. But also, who lived and worked in the vicinity and yet stayed well – such as brewery workers who preferred their own product to pump water, and factory hands in a facility with a separate and independent well.

By so doing, Snow avoided precisely the trap of disregarding the “absent evidence,” into which the Commission’s ends-serving inquiry falls headlong.

Confronted by Christopher Robin’s challenge that they had been chasing their own footsteps, rather than the imaginary Woozle, Pooh had the grace to concede:

"‘I see now,’ said Winnie-the-Pooh.

‘I have been Foolish and Deluded,’ said he, ‘and I am a Bear of No Brain at All.’

…. And then he brightened up suddenly.

‘Anyhow,’ he said, ‘it is nearly Luncheon Time.’

So he went home for it." 

 

Commission group chairman Laura Carstensen and her fellows should do no less.

 

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Mandatory Auditor Rotation: The UK's Competition Commission Stirs the Pot

For a charm of powerful trouble,

Like a hell-broth boil and bubble.

Double, double toil and trouble;

Fire burn, and caldron bubble.

            W. Shakespeare, “MacBeth,” 4.1

The simmering caldron of accountancy regulation was brought to a rolling boil in the United Kingdom on February 22, when the five-strong Audit Investigation Group of the Competition Commission issued its provisional findings.

No less sweeping than its assertion that the supply of statutory audit services to large public companies is rife with adverse effects on competition, the Group's suggested “remedies” would be draconian – among them, mandatory re-tendering for audit engagements every five to seven years, and mandatory rotation of audit firms after seven to fourteen years.

Remarkably, while the UK press treated these landscape-altering proposals as a one-day story (e.g., the Financial Times, BBC and Independent), attention in America beyond minor pick-up from the news services has included not the first word of either reporting or commentary.

Which had better change, and quickly too – not just because the basic impracticality of mandatory rotation is a long-standing barrier to its implementation (here, here and here). It’s because Group Chairman Laura Carstensen and her coven of non-accountants are working to the accelerated timetable of March 21 for comments, and publication of a final report by October 20 of this year.

By then, under the typical regulators’ effects of both momentum and inertia, their “provisional” hell-broth is likely to be fully cooked.

And a toxic brew it is indeed.

The Group did give the market-dominating Big Four tetrapoly a back-handed compliment, by exonerating them from the most malign charges of the profession’s fiercest critics:

“The CC also considered whether the market conditions are conducive to coordination or that Big 4 firms engage in tacit collusion; that they bundle audit and non-audit services together in order to raise barriers to expansion to other firms; that they target the customers of Mid Tier firms with particularly low prices; or that they are able to exercise undue influence over the formation of regulation or on regulatory bodies through their extensive alumni networks. To date, the CC has not identified sufficient evidence to support these other theories of harm.”

Scant comfort, indeed, as they went on to “find” an entire menu of ostensible reasons for a dramatic re-structuring of the audit services market:

            “Companies face significant hurdles in comparing the offerings of an incumbent auditor with those of alternative suppliers other than through a tender process.

            “It is difficult for companies to judge audit quality in advance due to the nature of audit.

            “Companies and firms invest in a relationship of mutual trust and confidence from which neither will lightly walk away as this means the loss of the benefits of continuity stemming from the relationship.

            “Company management face significant opportunity costs in the management time involved in the selection and education of a new auditor.

            “Mid Tier firms face experience and reputational barriers to expansion and selection in the FTSE 350 audit market.

            “Auditors have misaligned incentives, as between shareholders and company management, and so compete to satisfy management rather than shareholder demand, where the demands of executive management and shareholders differ.

              “Auditors face barriers to the provision of information that shareholders demand (in particular, from the reluctance of company management to permit further disclosure)."

Beyond these mostly unexceptional characteristics of a properly-functioning market for specialized professional services, of course, the unresolved and gaping logical gap in the Group’s entire approach is two-fold:

• First, Big Four dominance of large-company audit is a natural-market result of client demands for scale in geographic coverage, expertise and exposure tolerance – all of which are beyond the capabilities of the smaller firms.
• Second, at the same time, the widely-shared dissatisfaction of the user community -- that the standard and commoditized auditor’s report is grievously obsolete and provides no value -- is destined to be unrealized by the attempted re-engineering initiatives of such standard-setters as the PCAOB or the IAASB.

Nor is either of these root difficulties touched at all by the asserted but unsubstantiated claims of benefit to audit quality to be wrought by mandatory tendering or rotation.

Instead, within what the FT described last fall as the Commission’s “sheaves of working papers,” there is not a single research under-taking, much less a scintilla of evidence, showing an actual link between the length of an auditor’s tenure and the quality of either its audit work or its client’s financial reporting.   

Put in summary, the fundamental dysfunctionalities in the reporting and assurance models are untouchable by the “solutions” urged by those having the authority (if not the evidentiary basis) for their mischief-making, while mandatory re-tendering and rotation remain as “remedies” in search of problems yet to be grounded in reality.

But if not stopped, the Competition Commission is likely to work its will.

A regulator on a results-oriented mission is dangerous enough. But undiluted by the flavoring effects of the facts, the Commission’s recipe for a reconstituted audit structure will leave a foul taste all around.

Those obliged to sup at this devil’s banquet are advised to bring very long-handled spoons.

 

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Happy New Year -- What's On the Accounting and Assurance "Worry List" for 2013?

For the financial information community – issuers, users and gate-keepers -- what looms ahead for 2013? Now that we have survived the end of the Mayan calendar, crawled back from the edge of the year-end fiscal cliff, dodged briefly the threat Greece poses against the Euro, and crowned Alabama as the champions of college football? 

For starters, in a very target-rich environment, three potentially malign influences may be in retreat:

First, on the everlasting postponement of converged international accounting standards, the combination of political antagonism and absence of a sensible rationale desirably signals the end of the endless charade.

IASB chairman Hans Hoogervorst did temper his usual bellicosity at the AICPA’s annual December knees-up with the SEC and the PCAOB – not that his sabre-rattling had ever done the cause any good. The SEC lacks a head cheerleader, being populated these days by lame ducks, ghosts and placeholders – so with newly-designated chief accountant Paul Beswick’s deputy Julie Erhardt the nearest to a champion, the diffidence in her understatement amounted to a punt from the regulatory end zone.

While across the Atlantic (see the always-informative Edith Orenstein for the FEI), the ICAEW in the UK bailed out. Its report, The Future of IFRS, calls for non-adopters with “strong national GAAP” to take their own convergence “option” – an unmistakable message to the US to go its own way.

Second -- if finally game-over for convergence, it’s no less so for mandatory auditor rotation – never more than an unachievable notion in futile search for evidentiary support (here). Reality has taken hold in Europe in a climb-down from proposed six-year rotations and “audit-only” firms, despite a fervid pro-rotation residue unrelieved by the complete lack of factual basis. And an important voice of reason is heard in the US -- PCAOB member Jay Hanson – conceding at the AICPA conference that he “doesn’t know” what a “reliable study … would conclude with respect to audit tenure’s effects on audit failures and deficiencies…” and expressing skepticism “as to whether we would ever be able to make that connection.”

Third – the always-fraught issue of auditor liability remains challenging, if unlikely to be existential.

The manipulators of short-term statistics did nobody a favor by asserting in December that “things have changed” for the better from the post-Enron wave of auditor liability claims – a hostage to fortune disprovable at the time and subject to immediate invalidation (see below).

On the contrary, the Big Four in the UK fell all over themselves to emphasize their litigation exposure, in resisting the Competition Authority’s suggestion of a benign environment. True enough, that official proposition dangles from two illusory hooks – that short-term calm portends a longer-lasting trend, and that the large firms have available insurance remotely adequate against potential claims measured in the billions – neither of which is sustainable.

The real problem is that the large firms have never succeeded in carrying the burden of their message – dating back to 2008 and the embarrassing inability of the US Treasury’s fractious Advisory Committee on the Audit Profession even to agree that life-threatening litigation was an issue.       

In this tangle among the confused, the perplexed and the unpersuasive, three recent items are informative:

First, Ernst & Young’s agreement to pay C$ 117 million to settle civil litigation in Canada relating to its work for the failed Chinese company, Sino-Forest, does not approach the calculable limit of E&Y’s financial tolerance. But it is amply big enough to exceed either E&Y’s local Canadian resources or its global-scale nuisance value. And an upward re-set of the liability record in any developed economy cannot bode well in the hands of aspirational plaintiffs’ lawyers.

Second, the slow-moving litigation machinery in Iceland has ground out not only prosecutions and now jail sentences for senior members of its renegade banking sector, but also new claims against PwC in both Iceland and the UK, on the non-trivial order of $ 490 million, relating to its audits of Landsbanki, added to a prior claim for $ 2 billion over its work for Glitnir Bank, commenced against the firm in the US in 2010 and re-started in Iceland in 2012 (here).

Third, the HP-Autonomy fiasco in the UK saddles the Deloitte firm with years of runaway defense costs and disruptive diversion of senior management. Even if Autonomy CEO Mike Lynch’s robust defense of his company’s accounting proves entirely vaporous, however, or substance emerges in the announced investigation by the US Justice Department, Deloitte’s exposure is wrapped in several layers of insulation:

• The reluctance of the UK system to impose death-threat damages.
• HP’s reluctance to proceed adversely against its own alliance partner.
• The high threshold facing HP shareholders attempting to sue Deloittte derivatively in the company’s name.
• And the hostility of American courts to claims having a foreign nexus and one step removed from HP’s own financial reporting.

Auditor regulators in the United Kingdom not having a record of aggression, timeliness or ferocity, the Autonomy debacle is unlikely to tar Deloitte, either at all or at least within a time span occupied by anyone currently in positions of authority or responsibility.

So much for what may pass as good news. There’s a good deal more of concern, in this new year – but not today – so please watch this space.

 

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The Pre-Election Mood: Enervation Over Innovation

 I awoke last night in the cold sweat of nightmare terror – my own version of Bill Murray in the 1993 film, “Groundhog Day”-- that CNN moderator Candy Crowley saw her shadow, and we were cursed with six more weeks of Presidential debates.

And PCAOB chairman Jim Doty kept scheduling “public meetings” on the exhausted topic of mandatory auditor rotation – the last in Houston having dragged through October 18 with no observable contribution to our wisdom – until he held one in the junior high school gym in Punxsutawney itself.

A tour of media, commentators, and those knowledgeable, confirms the prevailing sense of lassitude and ennui – owing much to the nationwide American paralysis ahead of its November 6 elections, but also to the absence of any credible display of energy, much less urgency, around the issues overhanging the accounting profession.

The usual crabbing continues, of course – ranging from the ineffective if age-old grousing about auditor skepticism -- vented by the PCAOB chair himself, webinars from the private sector, and such bloggers as the Grumpy Old Accountants – to the commenter on my last posting, about the British regulator’s new policy on re-tendering, stating mistakenly that I “ask for ‘proof’ that lack of auditor rotation is a cause of fraud,” when I want no such impossible thing, but only recognition, as I have often said (see here) of the absence of “any evidence of a link between auditor tenure and audit quality.”

In the gathering gloom and darkness of late autumn, then:

Nothing good can be expected from the Securities and Exchange Commission in Washington, where Chairman Mary Schapiro is said to be packing for her post-election departure, having in her light-touch tenure realized nothing of effect on the structure or stability of the assurance function. 

On the globalization of accounting standards, the dialog is if anything more sterile than ever: The SEC has only an interim chief accountant in place; the griping about non-convergence includes the hand-wringing of IASB trustee chairman Michel Prada and the sideline irrelevancies of AICPA president Barry Melancon; while FASB chair Leslie Seidman should be plainly tired of the censorious Dutch-uncle utterances of her counterpart at the IASB, chairman and non-accountant Hans Hoogervorst.  

While on the auditing standards side, the intellectual heft brought by the International Auditing and Assurance Standards Board to its project on Improving the Auditor’s Report is unmatched by the political skills or horse-power necessary for action in the face of entrenched resistance. At the same time, the PCAOB’s parallel Concept Release, going back to June 2011 – which by rights should be cooperative and complementary – wallows becalmed for lack of any readiness to re-engineer a reporting system in which all interested parties are invested in preserving the status quo.

Even what should be a bright spot – the launch earlier this month by seven joint sponsors of an assessment tool for audit committees, “Annual Evaluation of the External Auditor” – designed to support “an informed recommendation to the respective board of directors whether to retain the auditor,” has the taste of very thin gruel.

That is, it says precious little about the skill level of an audit committee, to think it requires such an anodyne checklist as these “get-to-‘yes’” examples: 

• “Was the cost of the audit reasonable and sufficient for the size, complexity and risks of the company?”

• “Was the audit engagement partner able to explain accounting and auditing issues in an understandable manner?”

Enough with the softball treatment. For a committee obliged to justify itself, why are there not such substantial questions as:

• “What qualifications and training does the audit committee itself have in the exercise of skepticism and the avoidance of bias?"

• “If forced to rotate or re-tender the audit, does the company have a realistic alternative choice?” 

• “What other or different forms of assurance, beyond the current standard audit report, would company management and its community of information users find useful and valuable?”

Historians of the evolution of knowledge teach that systems on the cusp of obsolescence – inherently resistant to the disruptions of fundamental change – evolve only when those contributing to the prevailing inertia are forced into confrontation. 

But that when they are, the realignments are highly disruptive, in ways unpredictable in advance.

Meaning that the groundhog’s looming shadow is long, dark and ominous.

 

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Mandatory Auditor Rotation -- The British Regulator's Latest Spin

The endlessly tiresome proposal that mandatory auditor rotation would improve audit quality – a mis-perceived solution long and desperately in search of a problem – approaches its defining moment – taking one of the forms I predicted last spring. 

The Financial Reporting Council – regulator of accounting and auditing standards and practices in the United Kingdom – on September 28 slipped this subtle sentence into section C.3.7 of its Governance Code: 

“FTSE 350 companies should put the external audit contract out to tender at least every ten years.”

Called “limited changes” by the FRC, this stealth provision has been little remarked at home and virtually ignored in the United States. But the impact and effects – once the dust settles – will be profound, if difficult to predict.

Consider first the global market for audit services. The largest 100 and second 250 British companies span the globe in their size and reach – from the agency giant WPP to BP in the energy sector to consumer leaders Diageo, SABMiller and Unilever to global bankers HSBC and Lloyds – with dominant business operations, dual stock listings and deep capital market participation across the world’s developed economies.

Audits of their financial statements are, with a handful of exceptions, the exclusive province of the Big 4 firms – 99 of the largest 100 and 234 of the next 250, when last surveyed (here and here). For reasons of cost and efficiency in any process of re-tender, the CFO’s and audit committees of those companies will invariably seek either the retention of the incumbent auditor, or the ability to transfer to another single provider. So choices made in London will be reflected in the structure of the audit market across the globe.

But, given the spotty and unequal world-wide distribution of audit competence and technical expertise, it is predictable that any auditor shifts resulting from the FRC’s dictate will, if anything, further tighten concentration at the top of the market.

Will any real changes actually emerge? The debate on mandatory rotation has been conducted in a vacuum of either evidence or intelligence on these two fundamental questions:

1. Why is there a total absence of facts even suggesting a causal connection between audit quality and the length of auditor tenure?

2. And, are choices for auditor replacement truly constrained by either disabling scope-of-practice conflicts or the firms’ unwillingness to surrender the value of such other services as tax, banking and consulting?

Two competing assessments are offered. One would be reluctance to tender – with the audit firms unwilling to invest the considerable time and expense to build sufficient size, expertise and geographic presence to pursue the uncertain process, especially when obliged to forego the certain revenue streams now generated by their non-audit work for these global giants.

In that case, the non-incumbents will take a pass; the result of re-tendering will only be the rationalized re-engagement of incumbents – a public relations exercise in “comply or explain” that may buy a decade or two of rhetorical peace but little else.

A second scenario rests on the hypothesis that large global companies now concentrate their non-audit services mainly in a single alternate Big Four provider. That firm might be a rotation candidate, assuming a “shadow cabinet” of existing skills enabling it to switch over to the audit with minimal disruption – and likely resumption of the non-audit status quo ante when it yields back the audit brief a decade hence.

A skeptic would be entitled to question whether professional skills are so fungible and transferable, much less available; or that the large firms’ current client relationships organize into such neat duopolies; or that, indeed, such a “pass-the-parcel” exercise is quite what the proponents of mandated rotation have in mind.

It is sure that London is already a-flutter. Fund manager Schroders has announced a re-tender after forty years of audits by PwC, for one example – despite no indication of either dissatisfaction or impaired quality.

About the only certainty is that the UK initiative will finesse both the already speed-bumped path to rotation urged by EU markets commissioner Michel Barnier and, in the US, PCAOB chairman Jim Doty’s extended series of hearings -- the latest, set for Houston on October 18^th which shows Doty’s willingness to pursue out-of-town try-outs in the futile search for an adult witness with a fact-based case in his favor.

Put another way, the FRC has now kicked down the road of mandatory rotation a can that bears the label, “Made in the UK -- for world-wide consumption.”

 

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Inaction Prevails Again -- The European Parliament Defers on the Auditors

My work trip to London this week confirmed the moderate spring temperature of the bureaucratic climate – the regulators of the accounting profession are not about to disturb the status quo structure and business models of the large firms. 

That news had crept stealthily through the cracks last week in a news cycle bracketed by the on-going European financial crisis driven by Greece, on the one hand, and the holiday season of Memorial Day in the US and Pentecost elsewhere.

Giving usual credence to Reuters for May 24, the European Parliament will climb down from Commissioner for Markets Michel Barnier’s aggressive program to impose mandatory (if unworkable) rotation of auditors, and to force the audit firms to divest ancillary practices of any form, not just for clients. 

Announced as a “delay,” the Parliament’s exercise in can-kicking -- the wrong direction on a road to any change -- is in ostensible deferral to the expected report on the state of the audit market and profession in the United Kingdom, by the country’s Competition Commission.

That body’s provisional findings, in an undertaking started in October 2011 at the behest of the Office of Fair Trading and with an announced two-year deadline, are vaguely tipped for November – here – although anyone tempted to rely on a reliable English timetable is reminded of the protracted extensions for completion of the Eurostar connection or the O2 arena – not to mention the Godot-like wait for the third runway at Heathrow. 

Cover for the EU’s inaction is perfect. The ploddingly deliberate British timeline, by an agency famously “where disruptive marketplace initiatives go to die,” has shown no appetite to fracture the system for independent financial statement assurance that was invented on its home ground in the Victorian era.

It strains belief that positions advocated with passion on the Continent, for the break-up of firms with roots at the dawn of the Industrial Age, will have traction with the competition boffins in London. Rather, traditional British fair play provides the rationale for leaving well-enough alone: The absence of evidence of malign influence or effect in the concentration of the Big Four tetrapoly matches squarely with the lack of research or basis in experience that mandatory rotation, dual audits or restricted scope of services make any positive contribution to audit quality.

Meanwhile, inaction is also the order of the day in America – the third of the world’s audit markets large and mature enough to matter – between PCAOB Chairman Jim Doty’s commitment to further roadshows on his own set of much-derided proposals, and the over-riding political paralysis inflicted by the endless diversions of the national election cycle. 

Which, to be sure, does not make the auditors’ future out to be all cakes and ale.  New shenanigans in the financial marketplace erupt as ever – from Facebook’s botched and “unfriendly” IPO process to the wrong-way derivatives bet in the London office of JP Morgan Chase that overnight reduced CEO Jamie Dimon from global banking wizard to Oz’s little man behind the curtain.

Facing a slate of continuing existential threats ranging from hostile liability regimes and death-threat litigation exposure to the very vitality of their core product, the large-firm audit franchise is no more robust or sustainable than it was a decade ago when Arthur Andersen’s blinkered leadership drove it over the cliff.

So the predisposition to delay embedded in the functionaries’ DNA in Brussels and London and Washington may offer yet another respite to the auditors and their business model.

But anyone thinking that a “solution” is presented would probably also counsel the European Central Bank to welcome Greeks bearing gifts.

 

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Mandatory Auditor Rotation: Will What Goes Around Come Around?

 Could there be a plausible explanation why James Doty, chairman of the Public Company Accounting Oversight Board, would promote such a protracted timetable for decision on the notion of mandatory auditor rotation?

It’s been a mystery, ever since the PCAOB’s August 16, 2011 concept release revived this much-discussed and long-discredited idea. Nor was any clarity brought to Doty’s thinking by the parade of 47 witnesses during the two days of hearings on March 21-22.

The comment deadline has been extended, following receipt of a record number of letters, 95% negative, and Doty has announced a travelling road show of further hearings.

One of my good sources, versed in the ways of Washington agency politics, offered as a rationale for Doty’s stalling efforts the growing list of smaller-county regulators who are stumbling toward mandatory rotation.

Why would Doty get behind this array? I’d be reluctant to buy the hypothesis that by postponing long enough, he could claim to fall into line behind an artificially-created “consensus” – which would look less like global leadership from a US regulator than weak-spined passivity.

But consider the hedge in Doty’s reticence – it being likely that the collective short-term experience will collapse in misguided impracticality.

Here is the country list, with their varying and mutually inconsistent deadlines:

• Italy – and its nine-year rotation schedule, despite scholarly criticism and even after the 2003 debacle at Parmalat.

• South Korea – rotation after seven years, under rules in place since 2006, although the academic research concludes that “mandatory auditor rotation increases the cost for audit firms and clients while having no discernible positive effect on audit quality.”

• Brazil – five years, extendible to ten for companies that establish credibly functioning audit committees (here).

• Netherlands – and a newly-imposed eight-year schedule (here).

• India – under the new Companies Bill of 2011, rotation will be imposed after five years for individual practitioners and ten years for audit firms (here and here).

Plus the increasing possibility that instead of requiring rotation, the UK will go instead to either audit engagement re-tendering or “comply and explain” for extended auditor tenure (here). 

Taken together, the aggregate GDP of the countries involved approaches that of the United States itself.[1] But such measures would understate the impact of a disparate set of rotation timetables.

That’s because large players in whole industries would have operations in all the affected countries – e.g., the petroleum majors, the large auto and truck manufacturers, the global airlines, and the big banks.

Picture the next decade of rotation-driven challenges to audit committees and chief financial officers – obliged to engage new firms of auditors, from outside the network of their main firm, for significant country-level audits on six or seven different and irreconcilable cycles and deadlines.

Administration of the very basics of engagement performance would be horrifically complex – deployment of replacement firms nearly every year, each with its own culture, personnel and methodology, and the upstreaming of country-level results for global consolidation. And that’s without a thought for the impossibility of achieving uniform standards of quality and execution.

A comparison worth noting is the annual task faced by American major-league baseball, to deploy four-man crews of umpires across a season of 162 games played by thirty teams. That data-management challenge for the “national pastime” has been addressed in recent years by ground-breaking innovations from a university professor specializing in complex scheduling software (here).

For baseball, there are said to be “a host of constraints such as union-mandated vacations and league rules that regulate, for example, coast-to-coast travel and potential overexposure to individual teams.”

Child’s play, by comparison. Putting teams in the field to call balls-and-strikes in the global audit market makes baseball’s difficulty look like Little League.

It could be inferred from the PCAOB’s March hearings that Doty lacks the votes for rotation. So enough frustration and implementation difficulties in foreign jurisdictions would provide him with political cover under which to retreat.

And well he should – but right now, on a well-formed record, and without further delay. 

Mandatory auditor rotation is an unambiguously bad idea, unsupported by any evidence of a link between auditor tenure and audit quality. As the growing list of local rotation obligations will soon make clear, it will prove unmanageable for complex global companies.

More important issues confront the issuers and users of financial information – such as the basic content and value of corporate and auditor communications to users, under scrutiny by both the PCAOB and the IAASB. The energy devoted to the misbegotten effort on rotation would be better used elsewhere.

 

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[1] Data from the International Monetary Fund indicate a global total of $ 78.9 trillion, with the US accounting for $ 15.1 trillion. The five countries add to $ 10.88 trillion, to which the UK would add $ 2.23 trillion.

Mandatory Auditor Rotation -- The PCAOB Bites Off More Than It Can Chew

            “The unspeakable chasing the uneatable.”

Oscar Wilde’s description of English fox-hunting captures the spirit of the two days staged in Washington on March 21-22 by the Public Company Accounting Oversight Board – in aide of illumination on mandatory auditor rotation.

(The PCAOB’s release of August 2011 announced its initiative; it links to the overwhelmingly negative public reaction. My own long-standing pessimism is partly here, here and here.)

Thankfully unable to attend, due to classroom commitments, I salute those brave and durable enough to have done – although the tedium of the webcasts accuses anyone without handsome compensation of not having enough to do.

Which is to say, the offerings from the 47 speakers crammed into the panel sessions were entirely predictable. The maxim was reinforced conclusively that the amount of intelligent substance in any agency proceeding is an upwardly-bounded constant -- the only variable being the number of witnesses among whom it is thinly spread.

Examples included the panels of academics and “investor representatives,” whose perfervid but anecdotal pro-rotation rhetoric was untroubled by the continuing absence of any relevant empirical evidence associating auditor tenure with audit quality; Paul Volcker’s plangent if irrelevant reminiscence of his brief and inconsequential association in 2002 with Arthur Andersen’s terminal state; and Jack Ciesielski’s attempt to revive the notion that insurance might backstop the auditors – a fantasy lacking credibility and long discredited (here) by the insurance industry’s manifest lack of interest.

Careful assessment of the PCAOB house-party reveals neither an empirical case for mandatory rotation nor the supportive votes among its members – leaving this question:

What will political pressure oblige the PCAOB’s members to bring forward by way of action?     

Between the poles of the speakers' antagonisms, there are the faint outlines of plausible mid-range approaches:

To start – noting a plain truth by former SEC general counsel David Becker, that individual cases for mandated auditor rotation are “intensely situational”– support now emerges for the PCAOB’s use of enforcement-based mandated rotation (e.g., Harvey Pitt).

Well -- “right on,” but also “about time.” Having written to this effect way back in August 2011 (here), I put it this way:

“…In a specific case, if the PCAOB can sustain its proof that long audit tenure was causally related to its definition of “audit failure,” it could include rotation in its toolkit of post-inspection sanctions.

“Since the PCAOB looks annually at a sampling of engagements for each of the large audit firms, and claims to target its inspections on the basis of perceived engagement risk and exposure, the agency’s experience base should bring to light cases – if any – where audit quality might be affected by length of tenure.  

“In which case, rotation could be proposed, and if necessary, imposed.” 

The other way forward comes in two flavors – either of which would allow PCAOB chairman James Doty to declare victory; would be tolerable to the profession; and, unlike mandated rotation, would actually be achievable in the large company audit market.

The first would be by way of periodic mandatory re-tender, with the incumbent auditor eligible to be re-engaged. The estimable Bob Pozen, one of chairman Doty's "rock stars," proposed 14 years (here), so as to allow for three individual partner rotations. Others proposed far shorter periods, although five or seven years would be too short, causing the profession to spend endless time and waste prodigious sums in a musical-chairs chase for business.

Compromise should be possible. If potential replacement auditors had the commercial choice of giving up ancillary services for their clients – tax, consulting, valuation – in order to be eligible to take up the audit, the market itself would determine the range of choice and competition. That has to be better than leaving such bright lines to be drawn under the dim vision of the regulators.

The second alternative places focus on the responsibilities of corporate audit committees – supported by former SEC chairmen Richard Breeden and Harvey Pitt among many others. That body would be obliged periodically to justify the continued engagement of a long tenured auditor – a process of “comply or explain” -- not difficult for a good quality committee.

Failing which the PCAOB, challenged to focus its inspection attention on long-lasting relationships, could determine that a dysfunctional audit committee amounted to a material corporate control weakness, justifying the requirement of a re-tendering.

I have crawled out on numerous shaky limbs, and survived. So I am prepared to predict here that some variant of these ideas will emerge at the seemingly endless end of the PCAOB’s process.

(Other and deeper problems would remain untouched, much less unresolved by this outcome, unfortunately, such as the basic value and usefulness of today’s accounting and reporting model itself, the relevance of audits, and the very existential viability of the private audit franchise – all subjects postponed to other days.)

Meanwhile, audit committee leadership on either re-tendering or “comply or explain” would not cause the world of audit to come crashing down. The actual effect would be modest at most.

Which in a world of knee-jerk critics and short-sighted regulators would be no small thing -- and one the community of financial statement users could very well live with.

 

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PCAOB Chairman Doty Takes His Mandatory Auditor Rotation Proposal On Tour

 

Boone: “This is ridiculous.”

Pinto: “What are we going to do?”             

Boone and Otter: “Road trip.”

 -- Animal House, 1978

 Of all the goofy reasons for government inaction, the Public Company Accounting Oversight Board’s new tactics on mandatory auditor rotation may take the prize.

A release on March 7 from Chairman James Doty announced the extension from last December to the end of this April, for still further comments – along with public meetings in Washington on March 21–22 and, according to his interview with “Accounting Today,” a roadshow of “meetings of similar importance in at least three or four cities around the country.”

Those searching for sense are left agape.

Doty continues to flog the idea of mandatory rotation, re-raised in the agency’s concept release of August 16, 2011, despite its lack of evidentiary support and its long prior history of rejection (here, here, here and here), and in the face of uniform opposition from those knowledgeable enough to be worthy of attention.

Exhaustively discussed for decades, and deservedly consigned to the dustbin of bad ideas, mandatory rotation cannot be revived with credibility through either of Doty’s attempts to troll for support.

First, the announced list for the Washington meetings reveals a pre-loaded attempt to pimp the agenda. Jamming a two-day program with 47 speakers, mainly old-timers well used to hearing their own pontifications on the panel-and-symposium circuit, guarantees that most of the time will be spent in chair shuffling, self-important CV recitations and bathroom breaks.

The positions of the panelists are all well known and require no further display: stale recycling of four former SEC chairman plus various agency alumni, predictable sanctimony from such “investor advocates” as ex-TIAA-CREF head John Biggs and Vanguard founder John Bogle, automatic resistance from the Chamber of Commerce, and sitting-duck defensiveness by the large accounting firms themselves.

Perhaps least credible is the callback of the leaders of the Treasury Department’s Advisory Committee on the Auditing Profession -- convened as a bearding exercise by Bush-era Secretary Paulson and, to its embarrassment, so riven by division that its 2008 valedictory could not even agree that there really was a grave challenge to the audit function (here and here) – and whose singularly brainless idea, advanced from aloft by Paul Volcker, was the implausible notion of management replacement contingency plans by the large private accounting partnerships if falling into Andersen-like distress (here).

As for Doty’s out-of-town tryouts – what else but a further source of delay and inaction?

That any wisdom will be garnered from beyond the Washington Beltway clashes with the record -- successful delivery of over 600 comment letters, from (as Doty seeks) “communities across and up and down the axis of the United States”– none indicating need of his outreach because all are evidently well-connected to the nation’s capital by e-mail and standard postal service.

Indeed, Doty concedes the can-kicking. As he put it, “We’ll be working on this at this time next year …. This is a protracted process, and should be for an issue that is this fundamental.”

Fundamental it may be – and protracted for certain. But not persuasive. Those like my friends Tom Selling, Dave Albrecht and Caleb Newquist, who support mandatory rotation if only because they recoil by instinct from the large firms and others who oppose it, are urged to consider:

• Weakness in an antagonist’s position, however apparent, is not affirmative support for the soundness of the opposite.

• Human nature consistently underestimates the cost, disruption and unintended consequences of acts taken for the politically motivated sake of “doing something.” 

• Finally, the PCAOB still has no answer to this central question, which should be posed to all the panelists and should lead the agenda of all further dialogue:

Where is there any empirical evidence that the incidence of “audit failures”– however defined – correlates at all with the length of auditor tenure?

The same tired script of clichés, recited by the same dumbshow cast, will not answer.

Chairman Doty should recall that in the old days of Broadway theater, revival productions failing their previews in the provinces of New Haven or Philadelphia never made it to the big stage. The third-rate slapstick comedy, “Mandatory Auditor Rotation,” deserves the posting of its closing notice.

 

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Audit Reform in the European Union -- Michel Barnier Delivers A Holiday Turkey

On November 30, European Union markets commissioner Michel Barnier released the biggest turkey of the Thanksgiving holiday. 

His “final” proposal to re-engineer the structure and business model of the large accounting firms (here) is much revised from the draft leaked in September, resembling the original no more than does turkey hash its original hormone-injected source – “fowl” though they both are.

Press reports, speculating about its parentage and legitimacy, hinted darkly that delays reflected the heavy-handed influence of the large firms or other, unnamed lobbying interests – here and here.

But the Big Four firms should only be so effective as to deserve such finger-pointing. Contrasted with lobbying experts Fannie Mae and Freddie Mac, Big Tobacco or the National Rifle Association, who have all the political access that unlimited money can buy, the poor accounting profession has been consistently rolled over – without a real legislative success since passage of the American securities laws in 1933 and 1934.

A neutral observer could only be offended by the tendentious tone of Barnier’s unsupported assertions, of which an abbreviated sample (emphasis added):

• “The lack of regular tendering of audit services and periodic rotation of audit firms has deprived audit of its key ethos: professional skepticism.”

• “(T)he prohibition of the provision of non-audit services in general would effectively address the need to reinforce independence and professional skepticism.”

• “(T)he introduction of mandatory audit firm rotation would contribute to higher quality audits.”

• “The appointment of more than one statutory auditor … would … contribute to increasing audit quality.”

A full list of the howlers in Barnier’s proposed regulation defies reasonable length limits here. But for a partial catalog: 

• No single client could sustainably represent more than 15% of a firm’s total annual fees (Art. 9) – a limitation with nasty if unanticipated potential consequences for the ability of smaller firms to ramp up their competitive scale at the upper end of the client size range.

• The broad prohibition of Article 10 on non-audit services to clients – the full range from expert services to valuation, technology consulting and legal and brokerage – would extend to network members and to client parents and foreign subsidiaries – thus clashing with permissible scope-of-services in the entire non-European world. 

• The further obligation of the large firms to hive off all their non-audit capabilities (Art. 10, § 5) would apply to their non-EU networks’ operations within the EU, thus forcing any ex-EU company to incur the cost and disruption of dividing its otherwise-permitted non-audit service engagements between a Big Four firm and another, unrelated niche provider.

• The requirement that statutory auditors provide their own annual financial reports would oblige those to be audited themselves, at both the firm and network level (Art. 26.2 and 26.3(d)).

• Not only would rotation be mandatory under Article 33 – every six years (extended to 9 years for optional joint audits). But invitations-to-tender would be required from at least two non-incumbent choices (Art. 32.2), of which one must be such a small firm that it could derive not more than 15% of its audit fees from large companies, as defined (Art. 32.3(a)).

Therein lies a recipe for paralysis for large-company audit committees. Audit competence is built on both scale and industry expertise – so the small-firm ceiling would assure that an invitee to tender would lack the size and breadth of experience to provide adequate service, while outreach to two other Big Four firms would clash against the global-level disqualifications of networks serving a client’s ex-EU needs.

• “Contingency plans” are to be required from the large firms to address life-threatening events (Art. 43) – as if there could be disruption avoidance from the impact of a “black swan” litigation or law enforcement sanction.

That’s because, unlike a corporation’s ability to continue in supervised on-going operation as debtor-in-possession, the private accounting partnerships have no retention hold on their partners or staff, whose rapid departure – proved in the case of Arthur Andersen in 2002 – would make Barnier’s “orderly failure” an oxymoron beyond his irony-deficient comprehension. 

• The revised requirements of a re-designed audit report (Art. 21) would include 23 sub-sections, adding such new information as the length of audit tenure (§ e), the extent of direct balance sheet verification (§ h), the details of materiality (§ j), and the identity of each member of the audit team (§ q).

Potentially useful and worthy of debate, some of these may be -- yet quoting § 22.4, “the audit report shall not be longer than four pages or 10,000 characters (without spaces).”

This one is a real pip – in a different league from Barnier’s quest to impose mandatory rotation. Because it is routine that a large-company audit team has a headcount above 100 members, Barnier’s four-page limit would be exceeded by a list of personnel all by itself! 

What explains Barnier’s inability to grasp the complexities of the matrix of relationships among financial statement users, auditors and users? Perhaps it’s a simple matter of provincial bias, and lack of vision flowing down to reach its own level.

Else it’s the basic principle taught in nursery schools: 

Give a toddler a hammer to play with, and expect breakage in the toy room. 

 

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A Case for Mandatory Auditor Rotation? Sharp-Eyed Students Have a Look

With comments due next month, the concept release on mandatory auditor rotation, issued by the Public Company Accounting Oversight Board on August 16 (here), provided an irresistible mid-term assignment for my class in Risk Management. 

It’s been stimulating this fall, to be with a group of students from the law and policy schools of the University of Chicago. We examine the sources of bias, misperception and flawed analysis in the behavior of those charged with governance and leadership – in business, politics and regulation. PCAOB chairman James Doty’s promotion and affection for auditor rotation was a natural.

Ask a group of inquisitive students to find the three central themes in an assignment, and collectively they will find all six – but in this exercise, their insights are on target.

First, in the venerable economics-oriented tradition of the U of C, where the words “opportunity cost” could be etched on a microchip installed in the frontal lobes of new arrivals, it’s no surprise that the PCAOB’s sketchy attitude toward the costs of rotation caught their attention. An example:

“The PCAOB’s proposed new rule and request for commentary seems to be based on a paucity of actual hard evidence and numbers.  (T)he trigger is …“financial scandals at Enron, WorldCom, and elsewhere,”… (but) the PCAOB does not attempt to estimate (even roughly) the costs of those failures, but they acknowledge that any increases in regulation will impose added cost to the financial system.  It might have been helpful for PCAOB to try to offer some way to balance the likely costs and benefits from alternative approaches.”

Going far beyond their skepticism about the doubtful extent of the PCAOB’s economic savvy, however, these samples of the observations of a classroom of curious students show their shared grasp of the agency’s pursuit of a preconceived agenda:

“By framing the issue as a problem with professional skepticism and objectivity, the release seems to ignore other possible explanations for auditing failures, even in the absence of any empirical evidence linking audit failures to the influences it believes is responsible.”

“It appears the conclusion has already been reached that errors and failures are a result of the relationship between the auditing firms and their clients, where relationships and failures are positively associated. This anchoring or early commitment to the source of the problem changes the entire frame of the argument…. The induction that because clients and auditors have long relationships, and there are issues, does not mean that there are issues because of the length of their relationship.”

“Failures of auditing accountability have not been decisively linked to auditing tenure.  There is something of a problem of absent evidence here—though the linkage might seem intuitive, there have not been reliable studies performed to examine alternate explanations.  Thus, the agency is reasoning from a lack of disconfirming evidence.”

“The primary flaw made in the Concept Release is an assumption of causality between audit company tenure and audit failure … likely induced by availability bias, confirmation bias and shortsighted shortcuts… Investigators see numerous longstanding relationships—this has led to an availability bias and confirmation bias—since longer relationships are a norm in this industry.”

“The WorldCom and Enron scandals are the “black swans” that … should be considered when creating policy decisions. However, it would be a mistake to believe that all swans are black because you have seen a black swan.” 

The well-observed “absence of evidence” is only the beginning, however, as put this way:

“The flaws of the Concept Release are not only limited to frame blindness; … the fact on which they relied are biased with the more common traps: anchoring, availability, representativeness, lack of evidence and confirmation bias.”

And the unproven issues of relating to competition and auditor choice were flagged:

“If the market for auditing services is not “competitive” in the economic sense, this should diminish the expectation that a policy of forced rotation would leave businesses with adequate substitutes available for each “round” of auditing.”

One student even got to a nuance on incentives that the PCAOB itself has breezed right on by – the flawed assumption that “Rotating auditors is preferred because an auditor would be incentivized to ‘clean up’ the books knowing another company would look at them when they took over.” Instead, “knowing they will be leaving…the auditing firm could be less incentivized to ‘clean up’ the books, as it would no longer be their responsibility.”

This last insight wanted only the next step, that a successor auditor under a rotation mandate would have no more incentive to raise issues with its predecessor than the other way around, since it will have inherited the obligation to resolve the issue and be responsible for it – the classic deterrent to quality that “If you raise a problem, then you become the problem.”

I could not conclude any better than as one student most pungently put it:

“The remedy (of mandatory rotation) comes not from informed research about the problem but from a formulaic dealing with problems of integrity and a Band-Aid based in biases.”

 

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The PCAOB Wants to Name Audit Engagement Partners: Would Its "Red A" Really Matter?

As if it didn’t have real work to do, the Public Company Accounting Oversight Board in its October 11 release has revived its 2009 project, looking to require audit firms to disclose the names of their responsible engagement partners.

 With its persistent instinct for the capillary, the PCAOB presses for information that is:

•  Of no consequence to financial statement users sophisticated and informed enough to appreciate the complexity of a large audit.

• Of indifference to the bulk of the investor population already hard pressed to identify the firm auditing their portfolio companies.

•  Of interest mainly to the unremitting critics of the profession, for whom access to individual names would only fuel their continued antagonistic and unproductive axe-grinding.

Here’s a message for both sides: It’s a bogus issue, and not worth the distraction from serious matters.

Such as, first, the PCAOB’s own release of June 21, re-visiting the scope and content of the recognizably obsolete standard auditor’s report. A substantial discussion is now ready to start, that should include the responsibilities of issuers’ management and audit committees (some 150 comment letters are accumulating here). If only the PCAOB could align with the parallel undertaking of the IAASB, a truly coherent and comprehensive international dialog might constructively emerge (see here).

Second, it may be that the division in views of the PCAOB members on mandatory auditor rotation means that this time-worn subject was served up yet again, on August 16 (here), only to be killed off once for all. Here the problem is that, as selectively leaked, EU markets commissioner Michel Barnier has not only tabled mandatory rotation himself; in his enthusiasm, he threatens also to require joint audits with responsibility shared among multiple firms, and would also strip all non-audit services from the firms’ business models (here).

Time enough, when the details of Barnier’s proposals emerge for public scrutiny next month, to probe the fanciful and unrealistic nature of his expectations. That will also be the time for more vigorous and effective responses than are usual by all those concerned – large and small audit firms alike, along with their clients with whom in this area they have common cause -- to the destabilizing and dangerous effects of Barnier’s combined naïveté, ignorance and political zealotry.

Meanwhile, back to the naming of names:

Those charged with auditor selection already have access, on request, to the details of personnel identity and qualifications.

While over on the side of public “transparency,” branding individual auditors with the scarlet letter “A” might give satisfaction akin to that of the censorious townsfolk around Nathaniel Hawthorne’s Hester Prynne.

But to what end? As recognized at least by PCAOB member Lewis Ferguson (here), any engagement partner whose work is caught up in multi-year civil litigation and regulatory enforcement effectively suffers the end of his productive career – even if judgment-proof and indemnified – not only because of the overwhelmingly distracting time demands but because the emotional toll of defending even high-quality performance is ruinous to the capacity to exercise complex professional judgment.   

Which does not, on the other hand, mean that the US profession’s resistance to partner identification is a “hill worth dying on.” Partner signature is the practice around Europe, and some European filers so disclose in their NYSE filings, as chairman Doty has noted (here). As the world is not coming to an end thereby, a proof-seeking skeptic might well ask this: Are European shareholders really so “favored” over their American counterparts, as Doty suggests, or is it rather that the markets have compared the availability of partner names, and yawned with boredom?

Beyond partner names, the PCAOB goes off into another disclosure area, although reflection may suggest it has left a major hostage to fortune – namely, the proposed requirement that auditors disclose the names and work efforts of other firms, in their networks or otherwise, participating in their engagements.

Again, this is a matter on which investors have shown indifference – it being impossible to imagine that they are really engrossed on the subject, when they must suppose that local country rules on professional qualifications and rights to practice would be no less applicable for auditors than, e.g., for lawyers or doctors.

But given the back-footed positions of the SEC and the PCAOB on such matters as the recent scandals among the Chinese reverse-merger companies coming to the US capital markets, and the still-lengthy roster of ex-US firms and issuers not subject to the PCAOB’s halting efforts beyond its native soil (re-capped by Francine McKenna here), it might seem a dubious judgment for the PCAOB to encourage public airing of the gaping holes in its inspection and enforcement regime.

In other words, “be careful what you ask for” – advice perhaps not high on the list of commentary welcome in the halls of the PCAOB. But then, an agency capable of addressing mandatory auditor rotation with a straight face is equally liable elsewhere to trip onto its chin and mistake the pratfall for forward progress.

 

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Mandatory Auditor Rotation -- The Financial Times Stumbles Onto the Carousel

On the complex issue of mandatory auditor rotation, a journal of the gravitas normally expected of London’s Financial Times owes better treatment than its September 6 Lex column, which casually endorses maximum engagement terms of no more than five years. 

The debate on whether rotation should be mandated has been over-discussed for thirty years – all as thoroughly reviewed in the August 16 release of the Public Company Accounting Oversight Board.

On the merits, as I have long said (here and here), the case is not made. There is not so much as a study, nor yet an evidence-based showing, that length of auditor tenure is at all coincidentally related to issues of audit quality – even less that there is any causal relationship between the two.

The assertion by Lex that a new pricing equilibrium based on the consequences of mandatory rotation would be “to the benefit of the entire financial system” fails to consider that any such new balance would include further diminishment in the opinion’s value and the profession’s esteem, going even beyond that already well-recognized by the regulators themselves (my take on the PCAOB’s concept release of June 21 on possible revision of the standard – and obsolete -- auditor’s report is here). 

More importantly, the prior threshold question -- blithely ignored and never examined by Lex -- is whether auditor rotation can be mandated.

That’s because at least two separate and distinct reasons compel the conclusion that mandatory limits on auditor tenure cannot be achieved for large global companies.

The first is the absence of regulatory authority to address the multi-nationality of the audits of virtually all large global enterprises. No country-level audit regulator – whether the UK’s Financial Reporting Council, the PCAOB in the US or otherwise – is in a position to compel rotation for the assurance required outside its own borders – assurance that is legitimate and desired in those foreign jurisdictions, and in many cases required by statute, in geographies far beyond the reach of their remits. 

Instead, there is ample evidence of the impotence of cross-border regulators:

• Since Sir David Tweedie left office as chair of the International Accounting Standards Board, the always-doubtful prospect of a single set of globally-accepted accounting standards has become only steadily dimmer – as nowhere better dissected than in Tom Selling’s Accounting Onion – e.g., here.

• Despite the recent surge in financial alarms among US-listed companies located in China, the PCAOB has been completely snookered in its attempted access and inspection efforts there – its personnel’s spring-break trip to that country having returned with no more progress than a reciprocal invitation for a Chinese junket to Washington.

• And although the PCAOB has known since non-US audit firms first began registering as required by Sarbanes/Oxley that foreign secrecy laws would be barriers to their production of documents beyond those borders, the SEC has just commenced subpoena-enforcement proceedings in the American courts against Deloitte’s Shanghai firm for its unwillingness to produce papers relating to its now-resigned engagement for Longtop Financial Technologies Limited (See Francine McKenna on September 9 at Forbes.com).  

So – while there is no hope for agreement among the various regulators -- the second bar to the achievability of mandatory rotation is the assurance model’s self-inflicted inability to make successor choices available.

As the record in the UK itself would show to Lex, it has been known for years, as put by the Oxera report to the Financial Reporting Council in April 2006, that a number of large UK companies “have no effective choice of auditor in the short run.” Concentration having only increased in the last five years, this single-country example is even more acute globally, as I have expanded here.

The breezy insouciance with which Lex ignores the unsolvable issues of over-riding importance does a disrespectful disservice to the gravity of the topic. It is one thing to have minimal expectations of regulators or politicians – the likes of Mr. Doty or EU Commissioner Barnier – who are unrestrained in their follies by the limits of the realistic. It inheres in their DNA, rather, to play to the illusion that progress takes the form of lofty if fantastic pronouncements.

But those in positions of editorial authority, with the opportunity to shape the direction of serious debate, are chargeable with the obligation at least to acknowledge the scope of the full picture. 

The cavalier Lex endorsement of auditor engagements no longer than five years adds no substance to the discussion, but only prolongs a noise level that should have been damped long ago.

 

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Mandatory Auditor Rotation: If PCAOB Sanctions Were "Case-By-Case"

The Concept Release on auditor independence and mandatory rotation, issued by the Public Company Accounting Oversight Board on August 16, sought comments. Believing that those who presume to offer commentary should include potential solutions along with their griping, I put forward these thoughts: 

There is a way that rotation could be tried and tested without the cost, disruption and doubtful achievability of a wide-scale requirement – problems that leave me and most others so skeptical.

Which is that in a specific case, if the PCAOB can sustain its proof that long audit tenure was causally related to its definition of “audit failure,” it could include rotation in its toolkit of post-inspection sanctions.

Since the PCAOB looks annually at a sampling of engagements for each of the large audit firms, and claims to target its inspections on the basis of perceived engagement risk and exposure, the agency’s experience base should bring to light cases – if any – where audit quality might be affected by length of tenure.  

In which case, rotation could be proposed, and if necessary, imposed.

The sanction would not be an enforcement reach, if a credible case were made – the agency could act on its own statutory authority or in coordination with the powers of the SEC. (See the SEC’s imposition of a government-appointed monitor on KPMG as part of the 2005 resolution of the criminal investigation of its tax-shelter practice, or the six-month bar on new SEC clients imposed on Ernst & Young in 2004 for its impaired independence arising out of business relationships with its audit client PeopleSoft.)

Due process and negotiations would sort out the appropriate cases to require rotation. Many cases of financial statement failure – contrasted with the Concept Release’s definition of “audit failure” as involving alleged deficiencies in audit work alone – result in termination of the auditor/client engagement in any event, and would fall out. Other inspection cases would involve causal facts unrelated to tenure – such as personnel competence or supervision – making rotation a doubtful remedy. And since real sanctions would presumably only be applied in a publicly transparent environment, the PCAOB would achieve the disclosure it professes to desire (here) -- along with the obligation to establish the credibility of its findings.

Rotation if proposed as a sanction would allow the incumbent auditor to be heard and argue its case – or perhaps even to settle with an agreement to stand down. It would also open the record to possible resistance by a non-US regulator, in the especially challenging cross-border cases involving global companies (here) – as well as to the fact-based airing of issues of impracticality or constrained choices of successors. 

(By the way, a free-market evaluation of possible limits on alternative auditor choice could be made through the sanction of mandatory re-tender -- as opposed to the perhaps harsher remedy of outright rotation.)

The principle of “first, do no harm” was cited by PCAOB member Lewis Ferguson in his statement on the Concept Release. Case-by-case use of rotation as a sanction would satisfy the corollary: anticipate unintended consequences whenever possible, and do minimal harm in any event.

Selective required rotation would also address an emerging issue in the effectiveness of policy choices – a topic treated in my MBA-level course in Risk Management.

Namely, examples are increasingly discovered that where instances of non-compliance are serious – but rare and tightly clustered -- the deployment of a broad, sweeping enforcement program is likely to be both wasteful of scarce resources and ineffectual in achieving the desired goal.

Three examples:

• With the progress in control of automobile exhaust emissions, it is massively wasteful in administrative costs and car-owner time to require on-site tests for late model cars. The miniscule percentage of vehicles that generate most of the pollution can instead be detected by inexpensive, portable drive-by testing, with immediate ticketing and impoundment.

• The billions in costs and inconvenience inflicted on airline passengers by security programs, accomplishing only inconvenience and embarrassing privacy intrusions, have negligible anti-terrorist effect, compared with the highly sophisticated results of effective data-tracking and suspect profiling.

• And among the population of urban homeless, the great bulk of the cost of scarce resources for shelter, law enforcement and emergency medical care is consumed by a tiny fraction – who are more effectively addressed through individual identification and tailored attention.  

Mandated rotation in those rare cases where tenure length might demonstrably be an issue presents a similar environment. Audit failures being real, but also rare, across the entire time-line of auditor tenure, there has not even been a proper study, much less a showing, that length of tenure is a causal factor. 

So enforcement sanctions, including rotation, should be conserved and only deployed accordingly.

To summarize: individualized mandatory auditor/client rotation could be used as an appropriate case-by-case sanction – if but only if the PCAOB can persuasively show a basis. 

Or as Messrs. Gilbert & Sullivan’s Mikado nearly put it in 1885:

“An object all sublime

“They shall achieve in time --

“To let the punishment fit the crime.”

  

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