Re:Balance -- Jim Peterson

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

Food beyond compare

Food beyond belief

Mix it in a mincer

And pretend it's beef

Kidney of a horse

Liver of a cat

Filling up the sausages

With this and that

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free – both at the Main page.

 

 

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.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free – both at the Main page.    

 

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.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both on the Main page.

 

The Great Maple Syrup Caper -- A Sticky Mess in Quebec

While bidding farewell to the old year and welcoming the new, this Christmas Eve story out of Canada should not be lost in the holiday news cycle: 

“Over a one-year period during 2011 and ’12, some 6 million gallons of maple syrup – about $ 18 million worth – were stolen from the ‘strategic maple syrup reserve’ controlled by the Federation of Quebec Maple Syrup Producers (FPAQ)…. Last week, three men were arrested in connection with the heist.”

The Mounties have ridden to the rescue, the arrest total reportedly has reached 18, and weightier issues can now be on the table than a supply threat to the breakfast calorie count. Namely:

Producers around the world closely protect their strategic assets – whether Middle Eastern petroleum (OPEC), Japanese agricultural products (Nokyo), Colombian narcotics (Cali and Medellin) or American professional football and basketball players (NCAA). So it should not be surprising that the question is debated about Quebec, why our typically mild-mannered northern cousins maintain a government-run cartel to promote market stability in the supply and pricing of gourmet pancake toppings.

A better question, though, is just how fully one-quarter of the national stock – the equivalent of 16,000 barrels of syrup – could have been siphoned out of a warehouse described in the FPAQ’s own press release as “secured by a fence and locks, and visited regularly.”

The question must inevitably be asked, in short, “Where were the gate-keepers?”

Fortunately for the appetites of the world’s luxury crepe-and-candy consumers, the thieves were undone because they chose the hard way, working their felonious little scheme on the liquid commodity itself. Their sticky footprints left a trail, because to monetize their scheme required a disposition infrastructure – trucks and warehousing, a processing facility in neighboring New Brunswick and a sales pipeline through which to channel their slippery merchandise into the sweets-addicted US market. 

In this, they suffered the detection risks of scams like that of India’s Satyam in 2009 – where maintaining a roster of 13,000 phony employees would arouse the curious to wonder about the absence of ancillary evidence – the ghost workers’ non-existent desks, telephones and withholdings and remittances for health care and benefits.

Simpler, harder to detect and far less messy, would have been the time-honored creation of inventory that was fraudulent and fictitious from the outset. Consider these classics:

• The great Salad Oil Scandal of 1968, by which Tino DeAngelis floated only enough vegetable oil on bulk tanks of water to fool auditors who looked and tasted from the top rather than tapping the tanks at the bottom.

• Equity Funding in 1970’s Los Angeles, with over-stated death benefit liabilities under fictitious life insurance policies turned into cash through a Ponzi scheme of cessions to reinsurers.

• The South American coffee shipper, showing tons of stock on its balance sheet and available for collateralized borrowings, in reality comprising only camouflaged piles of sand under thin layers of beans.

• Over-stated Texas cattle herds, sold to unwary urban tax-shelter buyers – it being no great trick to run the same calves repeatedly through a maze of corrals, past the clip-boards of credulous city slickers unwilling to dirty their suits to exercise the control of chalk-marking the forehead of each passing animal.

• Or the related German scheme by which a fleet of trucks was over-counted in their repair sheds by auditors distracted from the back parking lots, where the vehicles were re-cycled by simply switching their license plates and dashboard bar codes.

The examples are as endless as the ingenuity of the criminal mind. Had the light-fingered Canadians only thought through the vulnerabilities of their targeted provincial cartel’s control system, they’d have kept their hands far cleaner while moving phony paper rather than hot syrup.

And they’d have made their illegal fortune while avoiding not just the brown sticky stuff, but what will now be extended stays in government custody, where the pancakes in the prison cafeteria will not be flavored with so much as a drop of down-market Aunt Jemima’s.

 

Happy New Year to all. Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free, both at the Main page.     

 

 

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.  

 

Thanks for joining this dialog. Please share with friend and colleagues. Comments are welcome, and subscription is easy and free, both at the Main page.

 

 

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.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both at the Main page.  

 

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.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both on the Main page.

 

 

 

Sarbanes-Oxley, Ten Years After -- Are We Having Fun Yet?

It has not been difficult, through this summer of discontent and turmoil in the world’s financial markets, to ignore with enthusiasm the comprehensively vacuous observations of the tenth anniversary of the Sarbanes-Oxley law. 

Readers will recall my long-held skepticism about that knee-jerk post-Enron exercise, going back to my July 20, 2002 observation in the International Herald Tribune about the preliminary Senate vote, that “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

Nor has the decade horribilis given any reason to change.

Of the smug and fatuous self-congratulations of the bill’s eponymous sponsors (webcast on July 30, 2012), the less said the better. As the English essayist Charles Lamb wrote about a blame-worthy poetic effort:

“It would be an insult to my readers’ understandings to attempt anything like a criticism on this farrago of false thoughts and nonsense.”[1]

Rather, some unasked questions should be advanced.

Regarding the self-interested back-patting of those with careers to be served by the inflictions of Sarbox –- the PCAOB’s members and staff and the spokesmen for the accounting oligopoly dependent on its compliance revenue:

“Would the elves in Santa Claus’s toy shop be expected to vote against Christmas?”

As for those purporting to see some claim of benefit, yet propounding no solutions to the continued eruptions of financial chicanery (here, here and here), the challenge remains that the cyclical nature of market bubbles makes inevitable a post-scandal period of cleansing and temporary return to virtue – political dynamics notwithstanding.  

Put another way, the storm of both scandal and outrage after Enron and WorldCom was bound to clear, no matter what. So instead of the wrong question, whether post-Enron corporate behavior is now improved, under both the Sarbanes-Oxley law and the law of unintended consequences, the proper operative question should be:

“Would financial reporting and assurance not be better if Sarbanes-Oxley had not been passed at all?”

First, American law since 1934 has pronounced it illegal to make false statements in connection with the purchase or sale of securities. So – as confirmed by the absence of prosecutions under the redundant Sarbox requirements for executive certifications of financial results (summarized by Michael Rapaport and Francine McKenna) -- that exercise has from the outset never been more than optics and cosmetics.

Second, a decade of PCAOB intrusion into the relationships between auditors and clients has engulfed the corporate reporting process in cost, paperwork and degradation of the assurance function (here and here) – while, into the bargain, failing either to advance coordinated global-scale assurance regulation and oversight in most of the world’s major capital markets (here) or to prevent (among others) the wave of securities malfeasance of off-shore origin, notably from China.

Third, as to the law’s centerpiece obligations on internal controls reporting and assurance, it was always true, even pre-Sarbox, that most decently-controlled companies would do reasonably well on compliance, most of the time – while a parade of horribles since then has made it clear that, for reasons of scope limitation or plain enforcement dysfunction, the law has been ineffectual against the rare but all-too-frequent and truly consequential cases.

A brief post-Sarbox sampler illustrates that – as generally true of large-scale challenges to risk identification and management -- it is the “outlier” cases that really matter:

• The control failures that brought down Bear Stearns and Lehman Brothers

• The “buco nero” at Parmalat and the ghost employees at Satyam

• The in-house looting by the chief financial officers of Koss in Milwaukee and the city of Dixon Illinois

• The undetected Ponzi schemes of Bernie Madoff and Alan Stanford, unremarked by gate-keepers, regulators and out-of-control client advisors and abettors alike 

• The valuation fantasies behind the window-dressing at Fannie Mae and Freddie Mac

• The incentives-driven perversions in the mortgage businesses models of Washington Mutual, Countrywide and New Century

• The derivatives and trading fiascos at UBS, JP Morgan Chase, MF Global and now Knight Capital

What then is the purpose of law-making? Sarbanes-Oxley has manifestly not ameliorated the flaws persistent in the nation’s corporate reporting and assurance structures -- then of what use or benefit has it been? 

And, if only the mis-leading politically-motivated placebo that it appears, what more should be expected both of our elected representatives and of those aspiring to hold them to account?

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are always welcome, and subscription sign-up is easy and free, both at the Main page.  

 

 

---

[1] “On the Tragedies of Shakespeare,” 1811.

GAAP / IFRS Convergence -- Has the SEC Finally Shut It Down At Last?

With the news on July 10 that the SEC staff’s now-published report on International Financial Reporting Standards would not include a recommendation on whether, when or how the US should get on board, I observed that the whole benighted exercise of “convergence” between IFRS and US GAAP was now, finally and deservedly, dead and buried. 

A knowledgeable reporter pushed back, writing that, “it ain’t over till it’s over.”

Let’s take a look, because it’s hard to be any more “over” than this.

My own view on the desirability of accounting standards convergence fits nowhere on the spectrum of advocacy, from David Albrecht’s “buy American” to Tom Selling’s pleas for intellectual integrity to Yale professor Shyam Sunder’s support for competing systems – much less the profession’s own hand-clapping for the endless process of inching IFRS and US GAAP together.

Rather, without a dog in the fight, I’ve long been convinced that the complexities and judgments within any of the competing sets of standards present ample opportunity for issuers’ self-service and manipulation, beyond the capability and competence of regulators and gate-keepers to achieve transparency or comparability, thus rendering the convergence debate mainly a serious distraction and waste of time and energy.

As I’ve been saying for years (e.g., May 2008), the politicized nature of the process -- including the endless maneuvering and circular finger-pointing among the Financial Accounting Standards Board, the International Accounting Standards Board, and regulators in Washington, London and Brussels -- far outstrips either the case for convergence or the vision and competence of the players to achieve it, even if they wanted to, which they don’t. There is simply neither leadership nor authority to overcome the mutually antagonistic forces – as summarized here in March 2010.

Which only becomes more pronounced with the departure of the SEC’s chief accountant, James Kroeker. As I wrote in May 2010, Chairman Mary Schapiro has shown little energy for the issue – whether from disinterest or under an agenda of more pressing concerns.

As I put it in April 2011:

“Why no-one has called the question on this endless charade reflects the two-level fantasy in the dialog: the IASB and the FASB both pretend to believe in the desirability of fully-converged accounting standards, and the community of financial statement issuers and users pretend to believe them.”  

So why the persistence of this endless exercise – so stalemated that if Saul’s trip to Damascus had depended on an SEC-like “roadmap,” his conversion would never have happened and Christianity would have remained a minor Galilean sect? 

It’s because at bottom, the situation is not so distressed as to call forth real change.

Across great arcs of history, systems degrade toward collapse – Ptolemaic astronomy, the Weimar Republic, American health care. But they only reach the point of fundamental change on two conditions:

• First, the case for change is not only recognized by its advocates, but endorsed by (or more likely, forced upon) the entrenched interests of the status quo.

• And second, that an alternative paradigm is available – as evolution does not occur in a vacuum.[1]    

No less than the examples cited, there is deep and wide dissatisfaction with the current state of financial accounting, reporting and assurance. But it is also true that broad sectors remain committed, like the ancient stargazers, to structures as creaky and obsolete as geocentric models for planetary motion. Namely: 

• Financial statement issuers prefer accounting principles flexible enough to yield their preferred results.

• The first instinct of regulators is to protect and expand their limited turf.

• And the gate-keepers survive on a model unevolved since Victorian times.  

Commentators may continue to assert that there are real mileposts down a possible road to GAAP/IFRS convergence.

But from here, there is no other end: the road for this dead horse is a short haul to the knacker’s yard.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free, both at the Main page.

 

---

[1] See, e.g., Thomas Kuhn’s far-reaching 1962 essay, “The Structure of Scientific Revolutions”.

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.

 

Comments and suggestions are always welcome, and subscription sign-up is easy and free -- both at the Main page.

Dixon Illinois: Fifty Three Million Dollars Go Missing -- So Who Let the Horses Out?

 

    Trust – but verify.

            -- Ronald Reagan 

The revelation of a $ 53 million embezzlement by the treasurer and comptroller of the city of Dixon Illinois – home of the 40^th American president – once again brings this to the fore:

“Why are the accountants still so bewildered that there should be an ‘expectations gap’?”

According to her criminal indictment released on May 1, Rita Crundwell went undetected since 1990 in accumulating all the appurtenances of a life of rural luxury – not only the typical clothing and jewelry, but trucks and trailers, Liberty Coach motor home and Ford Thunderbird convertible -- all supporting her sideline prominence in the boots-and-bling world of quarterhorse breeders (here).

Extractions of that magnitude, from the coffers of a city with an annual budget of only $ 8 to $ 9 million, might have required her full-time devotion to shoveling the cash with both hands. But the self-efficient Ms. Crundwell did not scruple to observe four full weeks of paid vacation each year, and was evidently only caught out when she extended her absence to an additional twelve weeks.

Separation of employees’ duties? Back-up authority that someone else should glance at the city’s checkbook? Allowing her family members to pick up the city’s mail while she was on her holidays? Could the demands of minding the city’s affairs be so simple, naive and blasé, even in the exurban Midwest?

As for the expected queries (here and here) – what about the gatekeepers at the corral?

A large regional accounting firm is reported to have done compilation services for the city since 2006, having done audits in prior years.[1] But the distinction has so far not been explored.

Which, borrowing a metaphor from Ms. Crundwell’s expensive equestrian hobby, is to beat a sad and very dead horse. Because, as the professionals are in the process of learning to their sorrow, simple proximity and association are enough to attract whole worlds of grief.

The International Auditing and Assurance Standards Board – source of auditing standards on a global basis – on March 16 issued a new version of guidance on the performance of compilations:

"Since a compilation engagement is not an assurance engagement, a compilation engagement does not require the practitioner to verify the accuracy or completeness of the information provided by management for the compilation, or otherwise to gather evidence to express an audit opinion or a review conclusion on the preparation of the financial information."

The IAASB also speaks to the intended use of compiled financial statements, however, posing the question whether: 

"External parties other than the intended users of the compiled financial information are likely to associate the practitioner with the financial information, and there is a risk that the level of the practitioner’s involvement with the information may be misunderstood …"

What the IAASB does not offer – understandably, considering the many settings in which full-blown audits are not worth the cost or effort involved – is aide to either the profession or the user community on a necessary risk-based inquiry:

“Just because a service can be done, does it make any sense and should it be done?”

The accounting profession, mistakenly relying on disclosure of the limits on what a compilation report does or does not say, has traditionally looked on that 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?

A typical compilation report – while offering no opinion – does recite that the accountant has performed with appropriate skill, ethics and the exercise of appropriate professional judgment. But that is all it takes to get burned.

I have tried to get across, both to my students in Risk Management and to my friends and clients in the profession, that for one caught holding an empty gasoline can, while standing next to a suspicious conflagration, it is not easy to avoid suspicion of arson. The explanation goes down hard, that the container was an innocent impulse purchase at the local hardware store.

As both an exercise for law and business students, and a message in the real world: there is no harm in not wearing a seatbelt, most of the time – or in not locking the barn door. Except for the rare time when it isn’t okay – and then it really matters. A long record of “being lucky” or a history of “getting by” counts for nothing when a bad event exposes the devastation wrought by casual habits.

How accountable the good townsfolk of Dixon will hold their city fathers for the quality of their stewardship – and whatever the exit cost may ultimately be, for a blinkered exercise in the assessment of risk and exposure to Crundwell’s plundering – it is once more made crystal clear that the accounting profession continues to market services that are under-comprehended and over-sold.

 

Thanks for joining this dialogue. Comments are welcome, and subscription is easy and free, both at the Main page.

---

[1] My requests to the firm’s media contact for an opportunity to converse have not been answered.

Unification of Global Accounting Standards? It's Time to Call Time

On the substance beneath the unending, noisy and fruitless wrangling over the relationship between generally accepted accounting principles in the United States and the International Financial Reporting Standards, there is no more trenchant observer than Tom Selling. 

Tom’s recent three-piece series in The Accounting Onion – “Ten Claims in Support of IFRS Adoption by the SEC – and Why They are False” -- is required reading for all who are interested in why “debits equal credits.” But while Tom is among the advocates for the superiority of American standards, my own position – agreeing with his conclusion -- is agnostic on the relative quality of the two systems.

Here’s why: It just doesn’t matter.

Even if, by whatever name, “convergence” were desirable (and Tom is persuasive that the case is not made), it is not achievable. The entire effort is massively distracting and a colossal waste of time, energy and resources.

There are three reasons:

First, deferential as I am to others far more versed in the accounting literature, I rely on deep-background guidance from a friendly expert with world-class credentials. This impeccable source provides a crystal-clear message, that the manifold complexities and range of judgmental decision within either of these sets of standards are so extensive as to render illusory any sense of transparency or comparability.

We are past the point, in short, that anything in quality of standards can be gained through the wrenching process of forced amalgamation of the two.

Second, on the pure politics of convergence – whether by SEC adoption of IFRS or otherwise – the simple truth is that the American regulators lack the will, the skill and the patience to navigate the path.

Just as, ten years after the passage of Sarbanes/Oxley, the PCAOB is only now making faltering steps toward an international presence, and remains entirely shut out of China and a host of other markets, the SEC’s proposed “roadmap” to convergence is yellowed and brittle with age and disuse, while the speechmakers’ superficially supportive platitudes fail to offer any substantive indication of actual progress down the road.

Finally, it is time to acknowledge the application to the GAAP/IFRS dysfunction of a basic principle observed on large-scale projects of social and political importance.

Which is that once the timetable for a complex undertaking begins to slide, its ultimate and successful completion date only gets farther away, at ever-increasing cost and ever-higher risk of total failure.

Sketched out in Nassim Nicholas Taleb’s incisive but frustrating and much mis-understood book, “The Black Swan” (of which my May 2007 review in the International Herald Tribune is here), the proposition is readily illustrated by public works projects, diplomatic initiatives and military actions:

• The Sydney Opera House, scheduled for completion in 1963, was ten years late and fourteen times over its original $ 7 million budget.

• Peace in the Middle East, fraught enough as of the Balfour Declaration of 1917, drew further away with the creation of an independent Israel in 1948 and today is more distant than ever.

• President Bush’s 2003 announcement of the conclusion of primary hostilities in Iraq, standing on the aircraft carrier USS Abraham Lincoln under the banner “Mission Accomplished,” was cruelly premature to the extent of thousands of casualties, billions of dollars and the onward spread of violence and destruction.

To use “input measures” can be grievously misleading, in short, whether measured by budgets spent to date, diplomats’ lofty promises or the number of boots on the ground. 

The same for agency posturing on the differences between IFRS and US GAAP – on which the agenda of unfinished business grows no shorter, even as the world of financial reporting continuously presents new and challenging reasons to grind the process onward forever.

There are more than enough divergent and antagonistic interests competing in the accounting standards “debate” to drive the conclusion that reconciliation will not ever occur, even if deemed desirable by many of good will and genuine bona fides.

So – let in the fresh air of reality. Let the global markets decide – US GAAP or IFRS, or other frameworks able to compete for attention and adoption. Let the energy and intelligence currently being wasted be deployed to goals worthy of the attention of the participants and realistically susceptible to beneficial solutions.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both at the Main page.  

 

 

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. 

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both at the Main page.

 

 

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.”

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free, both at the Main page.

 

 

UBS: Roguery at the Bank Provides a Teaching Moment

Kweku Adoboli has done me a great favor.

Many others could not say the same. They include Oswald Grüber, Carsten Kengeter and Maureen Miskovic – the chief executive, head of investment banking and senior risk officer of UBS – whose balance sheet the 31-year-old trader has blown up to the tune of $ 2.3 billion, through the unimaginative if devastating use of fictitious customer trades to mask his massive wrong-way bets on the S&P 500 and other major indices.

While Adolboli will stay another month in custody in London, and Grüber’s team of gnomes in Zurich begin the extended process of damage assessment and control of this latest outbreak at the troubled bank, I have the privilege of bringing to a seminar at the University of Chicago Law School the MBA-level course in Risk Management I have taught at business schools these last three years.

Arrested on the third anniversary of the collapse of Lehman Brothers, Adoboli not only lets me throw out the opening pages of my introductory lecture notes, on the inevitable eruption of large-scale unmanaged risks in complex systems. He also replaces Société Générale’s Jérôme Kerviel as a final exam topic on the test question, “Where’s the rogue?” 

In the law school environment, we will explore the proposition freshly demonstrated at UBS, that compliance-oriented risk systems – limited in concept, execution and assurance to the narrow and unsatisfactory conclusion that “most things are working, most of the time” – are both wasteful and ineffective to detect or deter an existential threat.

It’s as true for a rogue trader as for a suicide terrorist: doing pat-downs or box-ticks of an entire population, whether grandmothers on airplanes or bank clerks writing customer orders, will not stop the dangerous deviant capable of causing a blow-up – however much those intrusive and costly procedures may serve the political goal of lulling both leaders and constituents into a false if harassed sense of security.

In context of Adoboli’s shenanigans, said to date back to 2008 when UBS itself was bailed out of the consequences of its ill-fated venture into subprime mortgage-backed derivatives, on through its climb-down before the Justice Department over the business of sheltering US taxpayers, there is painful irony in reading the bank’s self-congratulation on the subject of its risk management. Take, for example, excerpts from its 2010 annual report:

“Operational risk is the risk resulting from inadequate or failed internal processes, human error and systems failure, or from external causes (deliberate, accidental or natural). Events may be manifested as direct financial losses or indirectly in the form of revenue forgone as a result of business suspension. They may also result in damage to our reputation and to our franchise causing longer term financial consequences.

“Managing risk is a core element of our business activities, and operational risk is an inevitable consequence of being in business. Our aim is not to eliminate every source of operational risk, but to provide a framework that supports the identification and assessment of all material operational risks and their potential concentrations in order to achieve an appropriate balance between risk and return.

“… Management, in all functions, is responsible for establishing an appropriate operational risk management environment, including the establishment and maintenance of robust internal controls and a strong risk culture.” (All emphasis added.)

With that, a question could be posed to Mr. Grüber concerning the bank’s reported 2010 payment of fees to Ernst & Young of 67.4 million Swiss francs ($ 59 million at today’s exchange), of which CHF 58.5 million were classified as audit, to obtain the latest annual version of a standard auditor’s report:

“With hindsight, how badly would you have wished to re-direct some portion of that audit fee to an engagement to conduct a precise and effectively directed, root-and-branch scrutiny of the condition of the controls at the sections of your bank having potential to inflict multi-billion dollar harm?”

Because herein lies the puzzle, about the unavailability of such valuable assurance to replace today’s outmoded commodity product:

In launching its concept release on the auditors’ report, Public Company Accounting Oversight Board chairman James Doty’s June 21, 2011 statement acknowledged “generalized investor dissatisfaction with the pass-fail model, and generalized frustration with auditors who had issued unqualified opinions on the financial statements of banks that later failed.”

And yet -- the entire community of financial statement issuers, users, regulators and auditors remain committed to what one comment letter notes as “the PCAOB’s intent to retain the current (‘pass/fail’) form of the auditor’s report.” As stated, there is “overwhelming support from all stakeholder groups for retaining this long-standing approach to auditor reporting.”

Why?

Kweku Adoboli now stands as poster boy for the unrecognized urgency of replacing that model.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free, both at the Main page.