Re:Balance -- Jim Peterson

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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Auditor Liability for the Dixon Fraud - Scape-Goat Hunting in the Courthouse

A nightmare of auditor litigation was predictable, when the news broke last May that the comptroller of bucolic Dixon, Illinois, had helped herself to $ 53 million dollars of city funds (here). 

Having financed her luxury-level hobby horses on an apparently modest five-figure city salary, revealed as supplanted by twenty years of hand-over-fist embezzlement, Rita Crundwell now faces twenty years of federal prison time (here).

As of December, the town added Midwestern regional accounting firm CliftonLarsonAllen as a litigation target (here) – liability being asserted for its multiple roles including Crundwell’s own tax return preparer and keeper of the city ledger, as well as auditor of the town’s financial statements until 2006 when it dialed back to “compilation services.”

A full-out courtroom scuffle would be interesting. On the one hand, the accountability of Dixon’s own city fathers over the extended looting of an annual budget of only $ 8 to $ 9 million implicates their guardianship of the municipal barn door through which Crundwell cantered away with her bags of stolen loot.

But as I wrote at the time: 

“The accounting profession, mistakenly relying on disclosure of the limits on what a compilation report does or does not say, has traditionally looked on (compilation) work as low risk – which it mostly is. But consider the environment, and the typical level and quality of competence, governance and integrity in municipal government. What level of confidence should with safety be routinely reposed in those entrusted with management of a small city’s financial resources?” 

  On the recent reporting, the Clifton firm’s reliance on the limited duties associated with a compilation is exposed to collateral arguments about its deeper involvement: emails continuing to refer to “audits,” alleged working-paper support to the local sole practitioner putting his name to the opinions, and maintenance of a steady-to-increasing stream of fees even with the reduction in its stated scope of responsibilities. 

Limited as compilation work requirements may be, they continue to require fulfillment of professional standards of quality control, ethical principles of integrity, objectivity competence and due care.

And by way of reinforcement, commentators and standard-setters continue to press the importance of skepticism in oversight (here and here) – difficult enough to achieve, and hostage to fortune whenever tested under the harsh glare of hindsight.

However -- those expecting a shoot-out at the Dixon corral should prepare for a damp squib instead -- mainly because the prospect of an actual trial rather than an out-of-court settlement is so slight.

That’s because the Clifton firm’s exposure is life-threatening, and so unlikely to be tested in a trial.

Which is despite the fact that Dixon’s outside lawyers hold themselves out as personal injury lawyers, who do not publicize accountancy litigation as a practice area. So they are unconstrained outsiders to the culture of the traditional accountancy plaintiffs’ bar, which has long calibrated its high-end demands so as to wring only enough from the flock of Big Firm geese to enrich themselves while sustaining the steady supply of golden eggs.

Instead, using the model on which I have previously explored the shockingly small size of a litigation threat that would disintegrate a global-scale accounting firm (here), the Clifton firm’s reported $ 570 million of annual revenue is a fragile base from which to defend against a worst-case impact on the order of $ 53 million. [1]  

No management has the fortitude, much less the confidence – except under the most extreme duress -- willingly to submit the quality of its work to a civil jury for such a price.

Existential threats from litigation are an unconfronted daily reality for the Big Four firms (here). But no less for their smaller brethren, where the threat is on a “one-and-done” basis. BDO’s ability to withstand the adverse jury verdict in the Bankest case in Florida was a fortuitous combination of persistence, favorable court rulings and an eventual settlement – still not publicly disclosed (here and here). And the Baker Tilly firm’s $ 50 adverse verdict in Wisconsin in the Aqua Finance matter – unhappily including a coverage dispute with its insurance carrier (here) – surpasses its resources on a worst-case basis as well.

None of which bodes well for the strength, sustainability or long-term future of the assurance function – professed to be important to society’s ability to rely on audited financial statements.

Instead, the clock of doom ticks toward midnight.

 

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[1] Write me for the details if interested. My pencil pushing suggests a break point of around $ 50 million, but precision is impossible. Insurance coverage and deductibles have relevance, but only as a measure of the pain that might be inflicted on future generations of Clifton partners.

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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HP - Autonomy: How Might the Auditors Survive the Fall-Out?

The toxic cloud spreads, from the implosion of HP’s $ 11.1 billion Autonomy acquisition, and the $ 8.8 billion write-off announced on November 20 by CEO Meg Whitman: 

• Whitman’s claims of pervasive accounting fraud have been vigorously denied by Autonomy’s ex-CEO Mike Lynch, and derided by critics as a mask for HP’s own faulty due diligence, gross over-payment and post-transaction mis-management.

• Prompt lawsuits followed, derivatively on behalf of HP and by shareholders as a class, against the usual targets including Deloitte as Autonomy’s statutory auditor in the UK and KPMG in its role for HP. 

• Referrals have been made to authorities in both the US and the UK, the scope of whose interest and enthusiasm has yet to be made public.

As to the various Big Four firms, pointed questions arise -- beyond those expected about Autonomy’s revenue accounting and HP’s due diligence – going to the structural heart of the traditional auditor-client relationship:

• Floyd Norris in the New York Times: “’Where were the auditors?’…They were everywhere.”

• Francine McKenna, “Re: The Auditors: “’To the victor’s auditor go the audit spoils’…is not how the Big Four audit industry is played now that consulting is again King.”

• Tom Selling, “The Accounting Onion”: “If Autonomy’s accounting practices were too aggressive, would Deloitte’s staff have had the gumption to push back given the stakes?”

Meaningful discussion of these issues, which unfortunately have proved intractable for decades, requires confronting two essential issues: 

First, because Autonomy’s accounting and reporting and Deloitte’s issuance of the standard commoditized auditor’s report are targeted as unsatisfactory, just when critically important, the question is raised yet again: what good are models having the appearance of utility, only up to the point of their unexpected exposure as insufficient, when suddenly they don’t? 

Second, the finger-pointing at Deloitte’s alliance relationship with HP and the scope of its non-audit services for Autonomy raise again the unresolved obsolescence of the notion of “appearance of independence.”

Regulators have the large accounting firms’ expansion of non-audit services in their sights – most recently at the recent AICPA’s SEC-PCAOB conference:

Acting Chief Accountant Paul Beswick: “I question whether accountants' expanding practices into areas unrelated to their primary competencies weakens public trust.”

PCAOB Chairman James Doty: “Audit practices have shrunk in comparison to audit firms' other client service lines — not all of which are schooled in, or depend upon, the fundamental exercise of skepticism. This threatens to weaken the strength of the audit practice in the firm overall.”

If the accounting profession is to survive what will otherwise be another generation under this radioactive rhetorical cloud, fundamental adjustments are in order. 

The first would be a robust defense of the “client-pays” model: however much criticized, it dates to the invention of independent assurance in the 1850’s, and is the only approach ever to stand the test of actual adoption and use.

“Client pays” being irreconcilable with “independence in fact,” however, the HP-Autonomy fiasco is a reminder of the profession’s long-standing inability to articulate intellectually stable support for “independence in appearance.” 

So it is time to renew the proposition I have advanced for years (see my March 24, 2006 column in the International Herald Tribune) -- that, “the sacred cow of auditor independence should be led off and humanely put out of its misery.” What I said there remains vital:

“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.”

At the same time, clearance of the radioactive debris of independence inhibitions would free the marketplace once for all from the entire sterile debate over permissible services by auditors.

The community of financial information users is capable of defining, engaging and valuing the scope of services available from its gate-keepers -- whether bankers, lawyers, rating agencies or auditors.

If the trade-off for the large accounting firms, for release from a system of constraints that has long lost its value, is a downward re-assessment in the value of their traditional core product – which would only acknowledge a reality long suppressed or denied in any event – that is an exchange worth making. 

For their future as legitimate participants in the world’s capital markets may well hang in the balance.  

 

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Ratings Agency Liability -- The Aussies Turn the World Upside Down

The litigation exposure of the Big Four accounting firms has not been made easier. 

The global networks should take no satisfaction from the field-leveling decision of Judge Jayne Jagot of the Federal Court of Australia, who on November 5 found ratings agency Standard & Poor’s (S&P) negligently liable to the purchasers of “grotesquely complicated” derivatives, designed and sold by ABN Amro. 

Schadenfreude would be wrong – and not just because it’s too hard to spell.

Consider the cries for accountability, during the recent years of financial calamity, by the auditors and the ratings agencies (e.g., here and here) – both of them, depending on one’s perspective, either vital gate-keepers to the markets, or aiders and abettors of the malefactors.

When their roles are compared, the guilty shiver of pleasure at another’s troubles would under-estimate the potential spreading of exposure. Consider the similarities: 

• Both have come to be viewed as essential functions in the world’s capital raising – chiefly by their regulatory authorities, to whom self-preservation and continuing existence are their own primary raison d’être.   

• Both are engaged and paid by their clients, upon which direct financial relationship they construct an elaborate edifice in illusory support of the intellectually unsatisfactory concept of an “appearance of independence.”

• Both seek to advance credible arguments that there is legitimate competition in their sector, despite effective barriers to entry that maintain their pass-the-parcel hegemony and an ever-tightening dominance by their respective global cartels.

• Their core products – the standard audit report and the three-letter rating – are delivered to users in prescribed and commoditized language – of which the source is a matter of consumer indifference and authorship would not be obvious absent a letterhead. 

• And finally, both couch their language in the qualified language of “opinions” and “judgment. ”

As to the last, however, the critical survivability difference emerges.

Namely, while S&P and its brethren have succeeded in wrapping themselves in the fuzzy if heretofore liability-proof blanket of the First Amendment’s free-speech protection, the auditors have long skirted disaster at the hands of a hindsight jurisprudence that threatens damages far beyond the limits of their financial tolerance or capacity. 

For the detail geeks, ABN Amro’s eye-crossingly complex derivatives, code-named “Rembrandt,” and the model-gaming involved in the rating process are laid out in overwhelming detail in the summary of Judge Jagot’s massive decision, and are thoroughly and colorfully discussed elsewhere – here and here.

The result threatens to turn topsy-turvy the ratings agencies’ comfortably protected world. Her Antipodean perspective is that S&P’s triple-A ratings were “misleading and deceptive,” involved “publication of information or statements false in material particulars,” and could not have been given by “a reasonably competent ratings agency.

For the ratings agencies themselves, the threat of worldwide contagion after the Rembrandt decision may be mitigated by both the availability of continuing scorched-earth defense strategies and the likely expiration of statutes of limitations to shield them from crisis-era claims.

For the auditors, who as noted are already far more exposed, it may be otherwise. Because -- taking cautionary note that the Rembrandt investor plaintiffs were supported by a publicly-listed company whose business is the funding and financing of large-scale class action securities litigation (here) – the investor-protection bar is a ruthlessly effective learning organism – to which the Judge’s liability language will operate like a blood-soaked invitation into a shark tank.

Even if not in the already-fraught American litigation market, should her process of hindsight negligence analysis gain traction in the courtrooms of Europe and elsewhere, the large accounting firms will find no ready firewall against the spreading conflagration.

 

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Watch This Space -- The Academics are Coming

 August in Washington? You’ve got to be kidding. Not even the national politicians are dumb enough to hang around that malarial swamp. 

So what could be better?

Answer: three days in a monster convention center in suburban Maryland, at the annual meeting of the American Accounting Association. At least my own registration is now in and official.

Of my two gigs there, the heavy lifting will be a panel on August 6 on “Rationalism in Accounting.”

Okay, stop the snickering! Just because such cringe-inducing pronouncements as the joint mash-up of the IASB and the FASB on lease expensing make the title of the panel sound as oxymoronic as "Jamie Dimon on risk management” or "François Hollande on French political leadership.” Teaser: leading the roster of smart people among whom I will struggle to keep up is always thoughtful Shyam Sunder of Yale – recently readable on this topic here. So at least have the good manners to hold your derision until you’ve sat in on the session.

The second should be more relaxed, and worth sticking around until the last afternoon – Dave Albrecht of The Summa hosting on the fun and games of blogging about the interesting issues that convene this group of party animals. 

Hope to see many of you there. Until then, enjoy the summer.

 

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The Big Four Accounting Firms' Financial Tipping Point -- Time for a Fresh Look

How quickly time does fly. It’s been three long years since my last review of the litigation “tipping point” that would disintegrate the fragile business models of the Big Four accounting networks. 

It’s time again. And not just because of the regulators’ threatened imposition of mandatory auditor rotation and other limitations sure to impair the quality of audits -- both PCAOB Chairman James Doty and EU markets commissioner Michel Barnier (see his November 30 press release, FAQ’s and provisional directive).

Those worrying about the incomprehensibility of Barnier’s financial and market thresholds for splitting off the non-audit practices of the European networks or injecting second-firm auditors (here) are looking in the wrong place.

That’s because the inventory of multi-billion dollar financial scandals in the firms’ client lists is constantly refreshed: revelations this fall alone include Kweku Adoboli’s roguish trading at UBS, the $1.2 billion shortfall in customer accounts at MF Global, and the decades of under-performance at Olympus concealed by dubious advisors’ fees.

Back in September 2006 – to re-set, and for new readers -- a report by the consulting firm London Economics to then-EU markets commissioner Charlie McCreevy (here) modeled the threshold limits of financial pain that would be tolerable to a Big Four UK partnership, before its owners would withdraw their loyalty and their capital and vote with their feet[1] – a process that would, unfortunately, lead to the rapid disintegration of the entire franchise of privately-provided assurance to the world’s large public companies.

I applied the London methodology to the global financial results published by the Big Four, in December 2006 and again in October 2008 – yielding calculations that, however ominous, were never disputed, nor have they been displaced by alternate models or methods.

It is poorly appreciated, if at all, that the private partnerships comprising the large international accounting networks operate with razor-thin levels of capital, for three reasons:

• Their major working capital needs – employee salaries, space costs and technology and methodology investments – are financed out of the fire-hose cash stream of client-derived revenues.

• The tax codes of the largest economies are cash-based for partnerships, creating a powerful incentive for the firms to distribute current income out to the partners to match with their tax liabilities.

• And, there being no alternatively valuable need or opportunity for the deployment of excess capital under the firms’ current business models, idle cash would serve only to whet the appetites of the litigation sharks circling in the feeding pens.

Latest available figures for the Big Four indicate total annual global revenues of some $ 102 billion.[2]

Applied to those figures, the model indicates that the break-up threshold for any one of the Big Four firm’s litigation “worst-cases” would be in the range from a maximum of $ 6 billion down to $ 2.2 billion, if viewed at the global level.

That is a considerable increase from the earlier numbers, owing to the great leap in total big-firm revenues in the intervening years.

But cautions remain. Most importantly, cohesion of the international networks under the strain of death-threat litigation, or the extended availability of collegial cross-border financial support, cannot be assumed. Arthur Andersen’s rapid disintegration in 2002 with the flight of its non-US member firms is illustrative.

So it is necessary to look at the bust-up range based on figures alone from the Americas, the most hazardous region. If left to their local resources, as was Andersen’s US firm, the disintegration range shrinks, from a maximum of less than $ 3 billion down to a truly frightening $ 675 million.

Amounts at that level compare ominously with the litigation settlements recently extracted from the larger debacles of the last decade – examples led by Bank of America’s post-Countrywide mortgage-securities settlement of $8.5 billion (here) and including such investor settlements as Enron ($7.2 billion), WorldCom ($6.2 billion) and Tyco ($3.2 billion) (here).

But those amounts were only available because inflicted on the investor-funded balance sheets of the corporations contributing to the settlements – resources not available to the private accounting partnerships. And they are even more darkly comparable with the exposures looming in the pending claims inventory.

True, in recent months the large accounting firms have enjoyed remarkable success in disposing of large litigations for modest sums – examples include KPMG resolving Countrywide for $ 24 million (here) and New Century for $ 45 million (here), and Deloitte settling Washington Mutual for $ 18.5 million (here).

However, hope for the indefinite continuation of such forbearance on the part of the plaintiffs is not a strategy, but only a wish.

As the catastrophic impact of “black swan” events makes clear, it only takes one. And at that tipping point, all the marginal fiddling by Barnier, Doty and their ilk becomes academic.

 

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[1] To summarize the model, as I wrote previously, “The original London study assumed that, in a highly-charged crisis environment dominated by the pressure and publicity of a massive adverse litigation result, critical numbers of partners would defect, so as to put a firm into a death spiral, if faced with a profit reduction of from 15 to 20 percent and extending over three or four years.”

[2] Deloitte, as of May 31, 2011: Global revenue $ 28.8, Americas $ 14.3 (here).

   Ernst & Young, as of June 30, 2011: Global revenue $ 22.9, Americas $ 8.9 (here).

   KPMG, as of September 30, 2010: Global revenue $ 20.6, Americas $ 6.4 (here).

   PwC, as of June 30, 2011: Global revenue $ 29.2, Americas $14.1 (here).           

 

 

 

A Prescription for What Ails Large-Company Audit: Real Medicine, for a Change

“Reality must take precedence over public relations, for nature cannot be fooled.”

            -- Physicist Richard Feynman's appendix to the Rogers Commission Report on the space shuttle Challenger disaster, January 28, 1986   

 A reader of my July 17 post acknowledged the continuing sterility of the dialog among the community of financial statement users, about the degraded status of the standard auditors’ report and the deep illness threatening the survival of the large accounting firms. But he chided me for offering only “bromides” rather than my own substantive prescription.

I felt the point of that needle – even though potential solutions have figured for the nearly ten years since this blog’s predecessor, my column "Balance Sheet," launched in the International Herald Tribune.

After the Enron debacle, the politicians’ infliction of Sarbanes/Oxley, and the many-faceted and still-unfolding events of the financial crisis, book-length treatment is surely called for -- despite the discouraging message from authors’ agents and publishers, that while the topic is worthy, the size of the interested audience would not support their investment.

Faute de mieux, I have stayed this course, appreciating the interest and support of a readership well prepared to share suggestions and criticisms.

It is a challenge to address the complex issues, within both column-length constraints and a comprehensive “holistic approach,” such as called for in June by PCAOB chairman James Doty (here), who himself lacks the vision, authority or resources to achieve it.

But by way of synthesis, a snapshot is possible of a sustainable future, using links back to the archives for detail.

First, a few background assumptions:

• A forthright reading of the projects to re-consider the scope and language of the standard auditors’ report, by the PCAOB and the IAASB among others, confirms an emerging consensus that the current “pass/fail” report is obsolete, serves no purpose other than securities laws compliance, and should be supplanted by assurance of real value.

• The existential threat hanging over the Big Four firms’ complete dominance of the large-company audit market -- the “supply side” – is simply not addressed by any of the so-called “solutions” addressed to market concentration – whether mandatory rotation, break-up or new entries, liability reforms, audit catastrophe insurance or bonds, living wills, leadership replacement, etc., etc., blah, blah, blah. As the first head of the PCAOB confirmed, regulators “don’t have a clue” – a widely shared and unchanged attitude of denial.

• There is no credible case for government-controlled delivery of audits worth the effort and expense – whether by direct execution, engagement assignments or otherwise. The output of the artificial and pathetic “profession” that would exist under such regimes would be inferior even to today’s devalued state, much less to the evolved conditions now called for.  

• And, it is time to acknowledge, the entire intellectually fragile structure of auditor independence is anachronistic, ill-suited to today’s conditions, and deleterious to both performance quality and the potential for useful change – a sacred cow that should be taken out and put to a quick and humane end (here and here).

So, now what? 

A framework does exist for regulators to license or charter sustainable audit-only firms (here). But – if and only if – a reconfigured legal and regulatory environment both permits, invites and encourages: 

• Full-service relationships between auditors and providers of other services.
• The attraction and deployment of outside capital, as would be required to support such new multi-service providers, with corresponding changes in permissible ownership structures.
• The appropriate involvement of meaningful regulatory oversight, quality enforcement and investor rights recognition.
• The emergence of geographic and industry-based new competitors.
• And, perhaps, even the return of today’s understandably reluctant insurance industry. 

Under such a fundamentally re-engineered regime, truly new and valuable forms of reporting could be designed and delivered (here and here).

These could be responsive to the needs of financial management and audit committees, welcomed by both executive teams and directors alike, and subscribed to by users under sustainable liability terms). They could be, at the same time, respectful of the value perceived by shareholders and others of the influential presence of “outside experts.” 

Simultaneous attention to all aspects of this framework is essential, however, because until then – as today’s impasse shows -- neither issuers nor auditors have any incentive to take on the increases in both cost and liability imposed under today’s exposed conditions.

I have been calling for years for an adult dialog among the inter-locking and antagonistic interests, who today are only wasting their energy in paralysis and finger-pointing. Without seeking endorsement or even agreement, I suggest that there is much more available here than “bromides.” 

Be the judges – and please let me know.   

 

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Can Value Be Brought Back to the Auditor's Report? A Tale of Two Systems

 Is it the best of times, in the struggle to re-introduce value into the traditional auditor’s report – or the worst of times? The age of wisdom or the age of foolishness?

Latest to join the Dickensian-length of characters is the International Auditing and Assurance Standards Board, which on May 16 released its consultation paper, “Enhancing the Value of Auditor Reporting: Exploring Options for Change” (here).

Compared to the others, whom to list takes up three full pages of its appendix, the IAASB brings the essential combination of intelligence and technical skills. Well it should, charged with the promulgation of international standards on auditing (ISA’s), thus conversant with such abstruse but centrally relevant topics as the auditor’s responsibility for published information other than financial statements (ISA 720), and use of “emphasis of matter” and other paragraphs in an auditor’s report (ISA 706). 

Among the most prominent of those heard from, and least likely to offer substantive contributions, is the United Kingdom’s upper legislative chamber, whose Economic Affairs Committee has this spring gotten its lordly knickers in a twist over the bogus suggestion of a malign influence of international accounting standards on the crisis-era reporting of the British banks (here), and also prodded the UK’s Office of Fair Trading into an inquiry as to the market dominance of the Big Four (here) – yet another tedious exercise destined to yield neither surprises nor constructive suggestions. 

Joining the Lords in fullness of volume and emptiness of ideas has been EU markets commissioner Michel Barnier, whose “green paper” consultation served mainly to remind anyone interested of the capacity of European bureaucrats to sacrifice forests of trees to document the lowest-hanging fruit on a fragile bush (here). 

The Americans arrived on May 5, when the chairman of the Public Company Accounting Oversight Board, James Doty, promised a “concept release” this summer “to consider how the auditor’s report can be changed to provide more useful, relevant and timely information” (here).

Where the IAASB suffers a gap between competence and authority, of course, is in its lack of muscle to carry out its aspirations. Sponsorship and support of senior regulators are required, led by the Americans, for a legislative re-engineering of the liability landscape, because assurance in any innovative area can only be designed and delivered if relieved from the devastating exposure to hindsight second-guessing that today shackles the auditors to their obsolete model.

Fantasize, for a moment, an “age of wisdom” in which the IAASB and the PCAOB actually made common cause. What might be accomplished?

The IAASB release makes the obligatory musings on possible adjustments to the current report itself – whether to move the opinion paragraph to the top, or to push the explanatory language to a footnote. But cosmetic niceties are inconsequential, as the grown-up technicians surely realize; knowledgeable readers would be neither confused nor influenced by this syntactical re-arrangement of the deckchairs, and others simply would not care.     

Once past political correctness, however, the IAASB does press into important new territory, recognizing “the demand for additional, and more pertinent, information about entities and the processes that support the quality of their financial information.”

Its delicate suggestion of “perceptions that auditor reporting is not meeting the needs of financial statement users” is a rhetorical bow to the tensions among competing constituencies and the understandable retreat into euphemism – where what is called for is removal of this barrier to clear thinking and precise articulation.

Teasing the blunt inference out of the IAASB’s sensitivity, today’s audit report is obsolete and, beyond compliance for which Doty and the other regulators are acutely self-interested, delivers no real user value.

If it were an old horse, it would be given due respect for its decades of good service -- then the worn-out old nag would be led off to the knacker’s yard and given the humane dispatch its dumb loyalty deserves.  

Within the scope of the IAASB’s standard-setting, it lists readily identifiable subjects for auditor contribution:

• “Corporate governance arrangements.
• “Business model, including the sustainability thereof.
• “Enterprise-wide risk management.
• “Internal controls and financial reporting processes.
• “Key performance indicators.”     

The release further tables the desirability and value of auditor insights in such financial reporting issues as:

• “The quality of the entity’s internal controls and financial reporting processes.
• “Qualitative aspects of the entity’s accounting policies, including the relative conservatism or aggressiveness reflected in management’s selected policies.
• “The auditor’s assessment of management’s critical accounting judgments and estimates, including where each critical judgment or estimate falls within a range of possible results.
• “The quality and effectiveness of the entity’s governance structure and risk management, and the quality and effectiveness of its management.”

 Here lies real opportunity. The IAASB solicits comments until September 16. Disinterest, silence and the retention of the status quo should not be tolerable options.

 

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The Role and Relevance of Audits: PCAOB Chairman Doty Creates His Own Expectations Gap

 There are at least two positive reasons for attention to the New York speech delivered on May 5 by the PCAOB’s newbie chairman James Doty – here.

Although no rhetorical threat to the real wordsmiths of the Beltway, Doty has the ability to turn an adult phrase -- finally re-writing the agency’s longstanding pattern of turgid language and opaque vision.

As can be seen, first, in his readiness to reject the “structural alternatives such as a third-party payor or insurance-based system,” or to see the trial balloons floated in the UK or in Brussels to break up the Big Four – properly “the bailiwick of competition authorities” – as having a “negative effect on audit quality.”

Modest applause – these diversionary detours being long since exposed as dead ends (see here and here). 

Second, Doty offers relief at last – although perhaps inadvertently -- from the otherwise reluctant but compelling conclusion that since passage of the Sarbanes-Oxley law in 2002, the PCAOB has managed to pass from immature ineffectiveness directly to self-perpetuating inertia without ever achieving a record of real accomplishment.

Namely, a healthy admission of the agency's inward focus is at least implicit in Doty’s acknowledgement that auditor oversight and quality enforcement are shrouded in PCAOB confidentiality and concealed from public transparency and deterrent impact. The same inference is recognizable in Doty’s reference to recently commenced “joint inspections with U.K. and Swiss authorities” – surely two of the lowest-hanging fruits dangling from the limbs of cross-border enforcement – only showing the glacial pace of progress over nine years.

Meanwhile for candor and completeness, his concession of an inability “to inspect a registered firm’s work” in context of the “growth in the number and size of Chinese companies seeking access to capital in U.S. securities markets” requires acknowledgement of this year’s outbreak of litigation claims against Chinese issuers – catalogued by the ever-informative Kevin LaCroix’s D&O Diary, and the risk-based subtext of the PCAOB’s own March-dated research note.  

Credit as due for these positions, but the Chairman ventures onto even riskier ground.

To start, his cheerleading that the auditors’ “lofty status” as “guardian of a cultural value” is akin in importance to electricity or water, presumes to invoke the name and record of the late chief accountant of the SEC. But the legacy of Sandy Burton’s 1980’s advocacy for greater auditor responsibility only highlights the absence of substantive change over the span of an entire generation. 

Likewise, Doty’s critique of the payment model by which “the auditor is hired and paid by the company itself” is devoid of vision for change in a structure embraced since the emergence of independent assurance to assist shareholders in the Victorian era of the 1850’s.

The market's vote for persistence of “client pays” does not fault the limited influence of audit committees on economic relationships having 150 years of history, pace Doty’s slap at their lack of impact. The durability of that model and the absence of viable alternatives only expose, instead, the intellectual fragility of the entire cosmetic attempt to regulate “appearances of independence” and the richly-deserving consignment of that sacred cow to a decent burial (as I have written for years – see here and here). 

Rather, it is the narrow and anachronistic language of the current compliance-oriented audit report itself – a document having value in today’s environment not by the free choice of issuers or users but only because required by the fraternity of regulators to which Doty himself belongs – that operates as a shackle on innovation.

Here Doty stands exposed. Correctly recognizing that “auditors don’t have a natural incentive to evolve their reports to what investors want” – a position long argued (e.g., here, here and here) – Doty has put down a major marker: He promises a “concept release” for early summer, to consider “how the auditor’s report can be changed to provide more useful, relevant and timely information.”

Can the Chairman really mean it? And how, without conceding that his own agency (along with the SEC) holds the keys to the lock?

He avows that “there is no silver bullet to address these challenges.”

But in this he is wrong. That bullet today is loaded in the deadly weapon of litigation roulette, which aims existential exposure at the large firms for their issuance of the very reports Doty purports to recognize as failing to deliver value to users.

To disarm that weapon – to create and nourish an environment in which real innovation in assurance and investor value can be brought forth – will require a leader's brave step, up to now unimaginable: scrap as worn-out and useless the obsolete one-page compliance report, along with the devastating machinery of liability that has grown to encage it, and start with fresh and creative authorship, written on an entirely blank page.

The first PCAOB chairman left office with the admission that regulators “don’t have a clue”(here). Today's occupant not only has the opportunity to show otherwise. Doty's speech makes hostage to fortune and accountability in office his own readiness to act.

 

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Disintegration of the Big Four Audit Firms? As They Tell the House of Lords, "We Don't See That on the Horizon"

The epitaph for the private delivery of audit services to the world’s large global companies was written in London on November 23.

During its generally amiable ninety-minute stumbling around the topic of auditor concentration – available here and observed on here and here -- the House of Lords Economic Affairs Committee queried the invited heads of the Big Four, “You do share the general unease about the fact that it could be Four coming down to Three?”

For the quartet’s response, the senior partner of Deloitte’s UK firm, John Connolly, contributed this entry to the lexicon of the self-deluded: “I don’t see that on the horizon at all.”

Which will go down next to the grim valedictory of Citigroup’s Chuck Prince in July 2007, that “as long as the music is playing . . .we’re still dancing,” only months before his forced departure, or – closer to home – PCAOB chairman William McDonough’s concession in September 2005 that among the regulators, “None of us has a clue what to do if one of the Big Four failed.”

Although memorable language would not be expected from a “numbers guy,” Mr. Connolly’s invocation of an empty horizon has real resonance.

Military comparisons are inevitable – and instructive. General Custer did not foresee danger from the invisible Indians. The American forces at Pearl Harbor were heedless of the approaching Japanese. And to Hitler, the beaches of Normandy were both well-defended and bare of Allied threat.

While in this decade’s uniquely impactful if unforeseen event, nineteen Saudi thugs with box cutters in their backpacks begat a world-wide season of terror, destruction and disruption, the effects of which have altered history.

As with these examples, and the grievous lessons that emerge only in the hindsight of the short-sighted, Mr. Connolly’s handicap is the limit on his vision – because a clear view of a blank horizon is of little value if the surveyed circumference extends no farther than arm’s-length.

I am indebted to my friend Shyam Sunder at the Yale School of Management for the Sanskrit folk tale of koopa mandooka – the “frog in the well”, which lives in blinkered comfort so long as confined within the boundaries of his closed little world.

But should he venture forth, the perils of the world outside are unknown. It may indeed be a paradise, full of succulent insects and comfortable lily pads and luscious companions with which the frog can disport and sire entire populations of little tadpoles.

Or, it may be a hell of deadly predators – voracious snakes and hawks and sharp-toothed fish. Or a searing desert beyond the fringes of the oasis, where a clueless frog will be pan-seared in minutes.

Unless informed and prepared, the frog in the well has no way to differentiate a prosperous future from one of mortal danger.

And the consequences of his ignorance are just as fatal as those of being wrong.

Here’s what the Big Four leaders might have said, in answer to the Lords’ call:

“We not only share your unease. We are terrified for the survival of our firms – not so much for our generation, who if fortunate may hope to ease soon into retirement, but for the future of a profession that depends for its sustainability on the talent and commitment of our younger personnel.

“Our ability to provide valuable assurance remains important to the capital markets. But it must evolve beyond the binary choice, whether or not to pronounce “true and fair” -- a choice exposed in the banking crisis by our delivery of unqualified audit reports on soon-to-fail institutions as not only unresponsive but affirmatively dangerous.

“Yet we are shackled to obsolete reporting by regulatory requirements confining us to an unhelpful commodity product. What is needed is no less than a fundamental re-structuring, under which:

• “Supplanting the current report form which no longer serves a useful purpose, we could tailor our reports to the real needs of particular users.

• “Our ability to deploy a full range of services would include access to the expertise of non-audit personnel to achieve more sophisticated performance and improved quality.

• “The interests of investors would be reasonably supported by government oversight, enforcement and protection such that our reporting would not create liability exposure of a magnitude that would destroy us.”

They might have said that. But they didn’t. For want of a vision extending to that far but visible horizon, a golden opportunity was allowed to pass. 

 

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The European Commission's Green Paper on Audit: After the Posturing, an EC Agenda for Real Progress

Say this for EC Internal Markets and Services Commissioner Michel Barnier’s call for public comments on his October 13 green paper, “Audit Policy: Lessons from the Crisis”:

No sooner had I sent in my own ill-tempered two euros worth – here – than my readership statistics showed a serious spike from addresses across the European Union. There’s real interest out there!

Having taken M Barnier to task, I was rightly challenged by readers to stop complaining and be constructive. So with a response deadline of December 8, this is to invite all those concurring that more is required from Brussels than a feckless and ill-informed exercise in redundancy, to register their views at the EU site – here.

The message is this:

All that needs be known is already at hand, to build the agenda for a really effective discussion on the re-engineering of a sustainable audit function to serve the world’s global-scale companies.

It would have these three components:

• Certain basic truths would be taken as established.

• Any further reference to the over-debated but impractical or unachievable “non-starters” would be barred.

• Focus would be on the handful of truly difficult, challenging questions – on which views would differ profoundly, but which are inescapably important to any progress.

In the first category, there may not be consensus on all details, but these propositions are basically beyond debate:

• Other than for purposes of statutory compliance, the standard one-page audit report no longer serves a function that justifies its cost to issuers or the exposure it imposes on auditors. Evolution to new forms of assurance is essential.

• The concentration of large-company audits among the Big Four is down to a critical minimum. A three-firm model is unworkable; failure of any one will disintegrate the entire structure.

• The organizational and capital structure of the Big Four leaves each one exposed to an unsustainable shock, from regulatory or law enforcement proceedings, or a civil litigation outcome in the $ 1 to $2 billion range.

• Regulators and politicians lack the vision, authority or means – separately or collectively – to rescue and sustain a large accounting firm once a shock tips it into a downward spiral.

In the second category, the catalog of “non-starters” includes:

• Liability “caps”, whether monetary limits or allocated percentages of responsibility.

• “Break-up” of the Big Four firms – an act of aggression having neither a rationale nor a basis in law. 

• The emergence of new global-scale entrants to the Big Four’s audit market, whether by merger, subsidy or organic growth. 

• The injection of outside investment into the Big Four’s capital structure, or alteration of existing ownership restraints.

• Mandatory auditor rotation or replacement.

• Contingency plans to replace the management of a firm under existential threat.

• Re-introduction of genuine forms of private insurance, by way of “catastrophe bonds” or otherwise.

Finally, to table a selection of the hard but unavoidable questions:

• What are the forms of assurance that issuers and users would actually value and pay for, and what structural changes are required – competitive, organizational, legislative and regulatory – to enable the evolution of a profession capable of meeting those needs?

• What form of regulatory oversight, inspection, enforcement and discipline would achieve a sustainable balance between investor support and protection and an audit function that is both disciplined and robust? In particular, what is the necessary form and amount of financial involvement of government – whether an investor protection fund, insurance of last resort or otherwise?

• Under a newly-structured audit delivery model, and with a comprehensively refreshed legislative mandate, what are the proper limits and guidelines on the scope of services deliverable to audit clients, and what re-visiting of concepts of auditor independence and conduct are indicated?

The envisioning of a symposium devoted to such an agenda – much less its convening – has yet to occur. Until it does, and the process moves on to real substance, the stability of the current audit model and the four firms providing most of its delivery are both at risk.

 

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The EC's Green Paper, "Audit Policy: Lessons from the Crisis": The Bureaucrats Blow Another Chance

  

  "We've gotta do something, They"re serious this time.

    "You know what we gotta do. Toga party.

    "We're on double secret probation, whatever that is. We can't afford to have a toga party.

    "You guys up for a toga party?"

            -- "Animal House" -- 1978

  As the October 13 release of the European Commission’s Green Paper, “Audit Policy: Lessons from the Crisis” – here -- by rookie Internal Market and Services Commissioner Michel Barnier, illustrates:

Any newly-arrived bureaucrat, tempted to launch the machinery of inquiry, should first demonstrate the need for further admiration of an already tediously-explored agenda, and the vision and will to do more than re-plow the same sterile ground.

The naïve tone in which the Green Paper articulates the role of auditors, and the clueless innocence of its “questions,” make evident another major exercise in resource-wasting.

The vacuity of leadership vision and reasoning on the grave issue of the viability of global-scale audit has been on view for years -- here -- and continues in Brussels:

The Green Paper starts with the customarily limp and tedious observations – e.g., that audit “provides assurance on the veracity of the financial health of all companies,” and that “continuity in the provision of audit services to large companies is critical to financial stability.”

But this exercise in self-congratulatory amour-propre is empty. Its adherents have never known a world in which public company financial statements have not borne the commodity appliqué of the one-page standard auditor’s report. The alternative proposition, of life without the legal requirement of an audit – an obligation that survives only by force of law, not by market choice – has never been tested.

No less, the last of the weak and aging dinosaurs on their terminal descent into the tar pits no doubt had themselves persuaded of the vital centrality of their role and influence in their ecosystem -- just as the tidal wave of unstoppable evolution was gathering to wash them to oblivion.

Consider a few examples of the Green Paper’s tiresome re-cycling of old material (question numbers are kept; some wordings are streamlined):

Can smaller firms emerge to become viable participants in the large-company market segment (# 27):

Would someone please do the arithmetic? Assume the impossible – that all the small firms doing any public company audits were merged into a single practice. That unmanageable monstrosity would still be smaller than the smallest of the Big Four.

Just as the case has never been made that smaller firms can deliver competitively superior quality of service, their limitations of geographic scope, breadth of expertise and capacity for risk tolerance are disabling to the notion that a Big Fifth can be either grown or built. And their leaders willing to be candid will admit it.

Should alternative structures be explored to allow audit firms to raise capital from external sources (# 23):

A better question: did anyone with business literacy vet the Green Paper? The Big Four capital structures, with their modest partner investments and operations financed by their client receivables, do not need and could not deploy major outside capital if handed over on a platter (here). Rather, such funds would only be a honey pot to attract the further attention of potential litigants.

Would contingency plans, including “living wills,” address the systemic risk of a large-firm failure (# 31):

First advanced in 2008 as part of the cringe-worthy output of Treasury Secretary Paulson’s Advisory Committee on the Audit Profession, this trial balloon deflated without lift-off (here) – for the obvious reason as shown by Arthur Andersen’s rapid disintegration in 2002, that the death spiral of client and personnel flight, once started, is irreversible.

Should audit mandates be limited in time (# 18), or should rotation be mandatory (#29):

To this, the complete one-word answer has always been, “Italy.” The only country of any significance with mandatory auditor rotation – a land capable of producing neither enough children to sustain its population nor enough honest politicians to sustain functional government – did manage to produce the scandal of Parmalat – world-class malfeasance enabled by the rotation-inflicted division of audit responsibility between two firms. Enough said.

Are there benefits to joint audits or consortia including smaller firms (# 28):

The French structure of joint audits is argued for, but is profoundly unsatisfactory as a persuasive example – perpetrated as it is by the lobbying of the small firms’ nationalistic appeals to preserve a miniscule local slice of the world market.

The fanciful notion that minor rump-end participation in an otherwise global-scale audit engagement could give a small firm the muscle to supplant a failed Big Four firm is belied by the record: at present, every audit of the CAC 40 is led by a Big Four firm. If small-firm consortia were credible, there would already be at least one example in practice.  

Finally, should audit appointments and remuneration be managed by government (## 16-17):

Consider this long step down the short road to nationalized audit agencies. Nowhere else are markets for commodity products, other than audit reports, subject to such artificial constraints – whether auto manufacturers, retail bankers or espresso vendors.

Yet if viewed as a legitimate target for government take-over, audits performed by low-grade civil servants -- the only ones to find appeal in such a career post -- would descend in value and repute even further to the level of nationally-administered postal delivery, rail service and health care.

It’s all too depressing, to belabor these points yet again. But since Commissioner Barnier looks as green as his paper, the only hope is to administer sunlight and fertilizer and pray he ripens quickly.

 

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In the News: Crain's Chicago Business on the Funk Pervading the Accounting Industry -- And My Five-Word Quote

 

Steve Strahler reports in yesterday’s edition of Crain’s – here – that “revenues are down, margins are squeezed and many employees are unhappy” – especially at the Big Four, where the combination of recession and exposure makes for a zeitgeist of uncertainty and dissatisfaction.

For which, a tip of the hat.

And another for compressing one of my central themes into a quote of record-setting brevity, on one of the fundamental but underexplored issues threatening the viability of the large firms: “They’re not capitalized to survive.”

 

And those who persevere will see a modification of the cliché: Five words is worth a picture. 



Dodd-Frank Lets Small-Company Auditors Off the Internal Controls Hook: Putting a Partial Lid on the Sarbox

At least one piece of the Dodd-Frank legislation now has a ribbon neatly tied around it: the Securities and Exchange Commission has issued its rules to exempt small companies – generally those with less than $75 million of common equity – from having a separate independent auditor’s report on their internal control assurance under Section 404 of the Sarbanes-Oxley law.

(For her customarily concise and lucid summary, see Edith Orenstein’s FEI Blog.)

I’ve been quiet on Dodd-Frank. Why not? Unmanageable in its creation, incomprehensible in its enactment, unpredictable in its consequences, as it was. Who could work up an appetite to ingest such a pigs’-breakfast of law-making?

Small companies may say, with the night watch in Hamlet’s Elsinore, “For this relief much thanks.” But marginal tinkering with the mis-begotten obligations of Sarbox 404 will matter less, and for different reasons, than are usually put on view.

To start, the toxic post-Enron environment in which Sarbanes-Oxley was enacted in 2002 has effectively immunized its impositions from critical cost-benefit evaluation. Persistently asking the wrong question – “Has the quality of corporate reporting actually improved since the days of WorldCom and HealthSouth?” – not only ignores the built-in cyclicality by which outbursts of scandal are purged by self-cleansing returns to virtue. It also leaves unasked the proper question: “Is that reporting better than if Washington had done something else – including doing nothing at all?”

More importantly, can any scarred survivor of the last three years of Bear-Lehman-Fannie-Freddie-AIG-Merrill – the most disruptive economic period since the Great Depression – argue seriously that auditors’ reports on the “out-of-controls” of those fallen industry giants actually made any positive contribution to systemic safety, stability or credibility?

In that dreary context, of course, it makes perfect rational sense to give small companies a “Get Out Free” card.

That’s because, as I was advised about parenting strategy when our daughter was born: “Little kids, little problems; big kids, big problems.” A new father’s worries escalate, from the essentially trivial inconvenience of an infant’s colic or spilled oatmeal, on to little league injuries and a teenager’s driving safety, up to college admission and the launch to the challenges of adulthood.

In the same way, the fewer zeroes on a balance sheet, the lessened likelihood of systemic impact of mis-behavior that makes a difference. “Out-of-control” at a Koss or an American Apparel may be inconvenient for a limited constituency, and provide grist for the mill of the plaintiffs’ securities class action lawyers – but otherwise doesn’t matter in the great scheme of things. It’s altogether different when the entire global financial system can seize up under the effects of a threatened, undetected and undeterred collapse at an AIG or a Lehman.

History and experience teach that regulatory systems designed and applied under motives of political correctness over the fat part of the compliance curve are wasteful and ineffective – whether aimed at school truancy, auto emissions or corporate disclosures. Instead they will fail to identify and address the “outliers” that actually prove disruptive – the SEC’s sorry performance in regard to Bernie Madoff and Allen Stanford make the case. 

Section 404 reports on small companies were never any more likely to be effective by way of detection or deterrence for small companies than they have proved for the large. So it was an inevitability that inflicting Sarbox 404 auditor reports on small companies would have been largely an exercise in even further futility. If regulation has not worked for the big and dangerous, in other words, how can it be good or useful for the small and irrelevant?

Drab as it may seem, finding negative comfort that at least our legislators have stumbled into a way to avoid making a weak situation even worse, there is both logic and benefit in leaving bad enough alone.

 

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