Re:Balance -- Jim Peterson

Re-Posting: Foreign Auditor Inspections? "China Syndrome" Strikes the SEC

Confidence in the American securities and accountancy regulators was not raised, when a press release on December 3 announced -- under the headline “SEC Charges China Affiliates of Big Four Accounting Firms …In Refusing to Produce Documents” – a proceeding against the five largest global networks.

For the first time in its eleven-year history, this column calls upon a graphic to illustrate the folly of a gang that couldn’t count straight -- here.

The PCAOB has been stymied for a decade in its futile attempts to enforce in China its asserted mandate under Sarbanes/Oxley to inspect and obtain working papers from auditors, including those in foreign countries, which audit more than twenty percent of a registrant’s assets or revenue (here and here). And the SEC itself has been piddling along with company-specific subpoena enforcement and administrative proceedings against Deloitte and its Shanghai affiliate.

So now they have called in the heavy artillery, in the person of Robert Khuzami, director of the SEC’s Division of Enforcement, who says that non-complying firms “face serious sanctions.”

Khuzami cannot be faulted for zealotry. He arrived on the scene of an agency whose Cox-era somnolence had missed not only Bernie Madoff’s predations on the domestic front but the internationally destructive tsunami of “reverse mergers” by which Chinese companies gained access to the world’s capital markets. That scorecard, a decade late and billions short, now includes more than 50 de-listings by the SEC and 40 fraud actions – and, elsewhere, a flurry of civil litigations, and most recently an agreement by Ernst & Young to settle civil litigation (but not a disciplinary proceeding) relating to Sino-Forest, by agreeing to pay C$ 117 million, the largest auditor settlement in Canadian history.

(As an aside, those disposed to see darkly conspiratorial revolving doors in the place of Chinese fire drills will note that this is the same Khuzami whose predecessor at SEC Enforcement from 1998 to 2001, Richard Walker, thereafter went in-house at Deutsche Bank, where he hired Khuzami in 2002. So the latter, before becoming the top American securities cop in 2009, was on-scene at DB when the bank – as now reported – according to three whistle-blowers concealed losses of up to $ 12 billion for failure to “mark-to-market” the exposure gap on a notional $ 130 billion of exotic derivatives known as “leveraged super-seniors.”)

Calling in Khuzami’s troops may look like the last act of desperate regulators – but it will actually play as the next act in “The Comedy of Errors.”

That’s not because it’s so little so late. Or because frustration of the PCAOB’s aspirations to access Chinese auditors and work papers would attract retaliation against their own ambitious plans to re-structure the global audit market by building and unleashing global-scale Chinese audit firms – an ambition otherwise unachievable both for want of competence in personnel and standards but also because, in reciprocal hostility, other countries will be no less protective of their local prerogatives.

It’s mainly that the US regulators’ only weapon of significance – banning Chinese affiliates of the large global accounting networks from qualifying to work on audits of American-listed companies – would ripple far beyond the toxic roster of China-based companies. There are potential consequences for global-scale companies with significant operations in China that go far beyond the inability of the PCAOB to inspect their local audit firms, whether or not maneuvered to keep below the 20% threshold.

Consider just two examples: Caterpillar, whose annual filing with the SEC does not set forth results by geography but discloses total 2011 sales of over $ 60 billion and elsewhere reports its China sales to be 3% of its total. Or HSBC, which does report by region including $ 3.6 billion in profits from China in 2011 and whose mainland Chinese operations include 133 outlets including 27 branches, even after the announced sale of its interest in giant insurer Ping An.

A barrier to the use of Chinese audit firms would make it impossible for those companies to include audited results from their Chinese operations in their global accounts. The result would be top-level consolidated financial statements with a huge unaudited portion, and auditors forced in their opinions to confront the professional standards for limitations on their audit scope.

Across the globe from KPMG in London and its top-level opinion on HSBC, to PwC in Peoria, Illinois for Caterpillar – unable to rely on their excommunicated Asian brethren – auditors would have no choice but to use the dread “qualify or disclaim” language -- never seen for a public company because anathema under the rules of the SEC itself. Or, in extremis, PCAOB de-registration of the whole of an audit network deemed non-compliant would render a company’s entire financial filing unacceptable.

Restoration of adult-level expectations and the pursuit of a non-litigated resolution process is essential, although a fading hope – since calling in the police as a last resort means an escalation of hostilities due to the one-dimensional DNA of their approach to problem-solving.

For good reason, then – under the latest blows from SEC Enforcement – the large accounting firms must feel like a bunch of nails in a hammer-testing factory.

 

My apologies for the re-posting, especially to subscription readers to whom the intended video clip did not feed -- a lesson learned in attempting to reach beyond competence with technology.

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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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HP-Autonomy: A Red-Ink Bath for Everyone

       “Either nobody in this deal understood the Company’s business, or someone was committing a fraud.”

-- Big Firm audit manager’s file note

Such language doubtless lurks in the working papers of the Big Four accounting firms, concerning this Thanksgiving’s biggest corporate turkey – HP’s announcement on November 20 of the whopping write-off of  $ 8.8 billion of the $ 11.1 billion paid a year earlier to acquire the UK’s FTSE 100 Autonomy.

How the blame-mongering cost of this fiasco will be allocated will depend, since each member of the large-firm tetrapoly touched the deal – Deloitte as Autonomy’s independent auditor, E&Y in the same role for HP, KPMG as part of HP’s huge buyer-side due diligence team, and finally PwC, brought in to pick over the forensic wreckage.

The quoted memo itself goes back a generation, to an investigation into sketchy high-tech revenue accounting – where it figured prominently in the investor litigation and the company’s SEC consent decree, an exhibit to the hazards of recording ideas that were both prescient and dangerous.     

That’s context for these thoughts responding to my investment banker friend and regular reader, “waiting for commentary on the Hewlett-Packard news and how it will affect Deloitte.”

Happily for the global supply of bandwidth, this story broke in a holiday week, absorbing in turkey, shopping and football the perfervid reactions of the most strident critics and their demonizing of the audit franchise as systemically venal and corrupt (e.g., here and here).

It is pointless now – time enough as the process evolves – to judge the predictable protestations of virtue of ex-CEO Mike Lynch, or Deloitte’s statement that it “categorically denies that it had any knowledge of any accounting misrepresentations….”

The Autonomy claims involve aggressions as old as IBM’s practices under the Watsons in the 1950’s – long stale and banal, and at best only interesting as an undergraduate classroom exercise in the endlessly elastic opportunities for revenue manipulation.

HP’s allegations do not, so far at least, involve such classics as the empty boxes at Miniscribe (1989) or Crazy Eddie (1987), nor yet the bogus contracts of Lernhout & Hauspie (2000) or Satyam (2009), but only the dreary familiarity of channel-stuffing and phantom contract dates – activities perpetually inviting to companies creatively striving for sweetened earnings, and elusively beyond the persistent efforts of standard-setters, regulators or law enforcement. 

More to the point, given the long-running criticism of Autonomy’s reporting by hedge funds and short sellers, is that it defies acceptable practice for HP CEO Meg Whitman to attempt the lay-off, that “the board relied on audited financials – audited by Deloitte – not Brand X accounting firm but Deloitte.”

Sorry, Meg. Not for a generation has an effective due diligence team done any more with a standard audit report than throw it onto the compost heap at the back of the document repository.

The HP team, said to comprise three hundred people from KPMG, bankers Perella Weinberg and Barclays and a quintet of law firms, surely had ample experience to sniff out any issues deemed significant. Why it did not will abide further finger-pointing.

But collective memories should not have been so short as to miss the red alert flag that the Autonomy deal was being flogged by Qatalyst Partners in the person of Frank Quattrone.

Whose earlier heady days in Silicon Valley had ended with one hung jury, a conviction reversed on appeal and a deferred prosecution agreement. So to say as did Reuters that Quattrone “specializes in tech deals” is like saying that Typhoid Mary was just going about innocently looking for work.  

Surer proof that HP will fail to spin its Autonomy debacle as an Enron-scale accounting fraud, is its assessment by Lynn Turner, who in 1998 was levitated to the post of Chief Accountant at the SEC from his position in a since-disappeared high tech company, after two decades at Coopers & Lybrand where he had emerged as national leader of its High Technology Practice.

Turner – whose background would presumably recognize dubious practices in the sector –- resisted the chance to pile on his erstwhile large-firm brethren --  for whom he forsook any affection upon his extraction from their ranks, his animosity more typically achieving the zeal of the mad monk in The DaVinci Code. Asking how the Autonomy policies “translate into a $ 5 billion write-off?” he demurred, that “the big issue isn’t the fraud they’re talking about. The big issue is that HP has made acquisitions that have turned out to be a disaster.”    

And so to my friend’s question, who might ultimately be liable to whom? The news is unhappy for HP’s long-suffering shareholders, whose claims -- either as a class (immediately launched) or on behalf of the company – under either British or American jurisprudence will offer little recourse, against HP or its management, Autonomy’s sellers or Deloitte.

Direct HP litigation against Deloitte would seem unlikely, given their existing ten-year consulting relationship as global alliance partners. Nor could Meg Whitman relish hostile courtroom scrutiny of the acquisition decision of her predecessor, Leo Apotheker, given – on her watch -- the year of pre-disclosure operating experience HP had with Autonomy, its string of prior write-offs including the $ 9.2 billion charge related to EDS, and the skeptics’ suspicion that HP’s write-off is a “big bath” overstatement of Autonomy’s illness to the forward benefit of HP’s balance sheet.   

If the impact on Deloitte and the other gate-keepers is likely “not much at all,” it is also likely not zero -- depending on where the “smoking gun” memos of the quoted variety might reside and be discovered – since a multi-billion dollar claim is beyond the Big Four firms’ financial capacity or risk tolerance to take to trial (here) – however enthusiastic their press-office protestations of innocence and scorched-earth defenses. 

What this latest dreary escapade does portend is several years of uncontrolled legal and litigation costs, and a flurry of inconclusive regulatory and oversight investigations – the end results of which will be inconsequential.

And finally, a wager is offered here, that Meg Whitman will not survive in place at HP to see it through.

 

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RIP Daniel Pirron -- Deloittes Mourns the Loss of a Partner -- And We Should Too

What internal demons impel a suicide?

No reaction but sorrow seems appropriate, for the self-inflicted gunshot death on August 13 of New York-based Deloitte partner Daniel Pirron.

Limited attention has been paid in the accountancy media (here and here). Of which, some comments are tracking his family’s suggested linkage to Deloitte’s UK client Standard Chartered Plc, and the Iran-related money-laundering scandal in which, the week before, the bank had agreed with the New York Department of Financial Services to a $ 340 million fine.

That speculation is unfortunate, for reasons only starting with Pirron’s scope of work itself, in the office of Deloitte’s general counsel, and the firm’s statement that “he was not involved in any way” with its work for Standard Chartered.

Focus here on suicides proximate to financial and corporate wrong-doing – an area of my concern long-predating my unhappily accurate prediction on December 16, 2008, that it was a "safe but unfortunate bet…that at least one remorse-driven suicide will further color the already tawdry (Madoff) tale” – coming only too true a week later with the suicide in his Madison Avenue office of Rene-Thierry Magon de la Villehuchet, the founder of a fund whose investors lost millions with Bernard Madoff. 

That context is difficult enough – initially because the sample size is miniscule, making attempts at meaningful generalizations intensely hazardous. The conditions are, however, readily distinguishable from the impulsive acts of the emotionally immature – fortunately most often not effective – or the reasoned acts of the gravely ill – movie director Tony Scott’s recent fatal leap being perhaps explicable by a report (since disputed) of his terminal brain cancer.

A non-comprehensive survey of scandal-related suicides starts with one point of interest – that with the exception of the recent failed attempt by Peregrine CEO Russell Wasendorf Sr, those driven to act are not the principal perpetrators.

Which should be no surprise. The necessary level of introspective regret and remorse would not be in the DNA of the typical white-collar criminal. Think of the egos both of those actually brought to book – a sample including Bernie Cornfeld, Bernie Ebbers and Bernie Madoff – and those of tattered moral fabric although escaping the formalities of prosecution – “Chainsaw Al” Dunlap and Donald Trump and Angelo Mozilo and Dick Fuld.

Instead it’s the secondary players – the lower-level executives and the gate-keepers – Frank Shuch, the least of the accused triumvirate at Connecticut’s Colonial Realty (1992); Cliff Baxter at Enron (2002); Bernie Madoff’s son Mark (2008); or the reported attempt by Satyam CFO Srinivas Vadlamani (2009).

Even so noted, extreme personal acts are not in character for those choosing careers in professional services, particularly accountancy – there being perhaps some dignifying comfort behind the tradition of ill-founded ridicule of the bean-counters’ brown shoes and green eye shades.

True enough that accountants are neither saints nor angels. As with any fallible system of human design, the firms’ best-tuned screens for personal quality will let slip the rare exceptions – those challenged by intelligence or discipline, the addict or the abuser, the venal or the pliable. And while public accounting is not a vehicle for great wealth accumulation, those shifting to entrepreneurship or the executive suite are on occasion seduced or suborned.

But in the four decades of my broad experience across the profession, only a handful have met the defined standards of the criminal mind. Practitioners of independent assurance -- first delivered to Victorian-era public companies starting in 1850 with the report by William Welch Deloitte himself on the accounts of the Great Western Railway -- have overwhelmingly been people of stability, intelligence, good faith and honorable intentions.

The best scholarship on human behavior and choice-making counsels us to resist the instinctive impulse to construct simplistic stories in a futile search to comprehend the irrational.

So – rather than press an inexplicable coincidence, genuine mourning by the profession is in order – joining with his family, friends and colleagues – for the sad death of troubled Dan Pirron.

 

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Guest Post at the FEI Blog: When Litigation Kills the Accounting Profession -- Don't Say You Weren't Warned!

Edith Orenstein's FEI Blog is a "must read" -- a thorough and lucid map of the goings-on in Washington among the  legislators, regulators and agencies of law enforcement. I have the pleasure this week of taking up Edith's kind invitation for a guest post, while she is on vacation:

With the devilish details of the Dodd-Frank Act now to be worked out and many special interests weighing in, legislative activity in the American financial sector returns to a standstill – probably until after the elections of November 2012.

So what would bring to the forefront a topic that to most is sleep-inducing, although it keeps some few from sleep: namely, the very viability of the large accounting firms and their fragile franchise to audit the world’s global companies?

Nothing less, presumably, than an existential shock to the stability of one of the Big Four tetrapoly – an unresolvable criminal investigation or a “bad case” outcome in one of their nightmare civil cases. . . . . For the entire post, and to see the scope and quality of Edith's own work -- please see here.

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