Re:Balance -- Jim Peterson

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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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.

 

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Mandatory Auditor Rotation -- The PCAOB Sails Off the Charts

“Otter: We could do it with conventional weapons, but that could take years and cost millions of lives. No, I think …that this situation absolutely requires a really futile and stupid gesture be done on somebody's part!

“Bluto: We're just the guys to do it.”

            “Animal House,” 1978

The Public Company Accounting Oversight Board's August 16 release and statements pose this central question on auditor independence and the prospect of attempted mandatory rotation:

“Will term limits, set at some appropriate length, with due regard for implementation complexities, reduce the pressures auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets?”

With all the ambiguity, nonsense and denial right there, focus on mandatory rotation. Time enough to come back to independence, when readers of stout constitution have stocked up enough antacid to alleviate their heartburn in digesting the Concept Release itself.

Consensus unhappiness with the current audit model and the historical “pass/fail” auditor’s report (alluded to by PCAOB member Jay Hanson and as I have discussed here) has, unsurprisingly, not strengthened the tissue-thin case for mandatory auditor rotation. Proof of weakness is, in this case, reciprocal with weakness of proof.

Each of the PCAOB members’ statements nods to the decades-old and too-familiar positions on rotation – Chairman Doty himself managing to mix up a metaphor that only a land-locked Texan could love:

“The learning curve, and cost-based issues involved in changing audit firms, cannot be fairly described as uncharted waters.” 

I have charted these waters, near and far (e.g., here and here) – so, not to repeat, this report from the distant end of Chairman Doty’s learning curve:

The world outside the United States is still terra incognita to the PCAOB, whose parochial approach has ignored the barriers to implementation of rotation on the large-company scale – the only sector where the issue should matter at all.

Between now and the public roundtable scheduled for March 2012, two matters of compelling impracticality should be on the table.

First is the PCAOB’s limited ex-US authority. Although the agency proclaims robust worldwide impact (e.g., the Chairman’s speech, here), its record is otherwise, and suspect.

Instead, the PCAOB has shown itself all too lacking in ability to operate effectively outside the US at all – witness the empty-handed return of its mission last month to China – a market from which the agency has been completely excluded although China has emerged in the last year as a major exporter to America of corporate malfeasance and shenanigans (tracked by Kevin LaCroix’s D&O Diary and even on the screen of researchers at the PCAOB itself).

Were the PCAOB to attempt mandated auditor rotation outside the United States, the consequences – fully foreseeable, and obnoxious -- would range from securities trading prohibitions on the American exchanges, to considerably irritated securities and accountancy regulators in countries understandably miffed at the infringements on their sovereignty.

Picture, for example, the situations of Deutsche Bank, audited in Germany by KPMG, or Sociéte Générale, audited jointly in France by Ernst & Young and Deloitte.

Even if replacement auditors were available, whether in the US or elsewhere – which is far from a certainty (see below) – it defies both logic and imagination to think that audit quality could be improved by obliging a German or French--based parent to engage an additional new audit firm to achieve a single opinion on its consolidated worldwide financial statements.  

As for auditor displacement at the parent level, there should be no reason to think that regulators of the securities markets and the accounting profession in those countries would tolerate, much less welcome, such an uninvited intrusion.

So the PCAOB’s ability to impose its will on major foreign regulators is comparable to the idea that audit quality requires each audit opinion to be personally signed by a Tyrannosaurus Rex – simplistic to mandate, although ill-advised, and impossible to achieve.

As for the second issue -- resource availability -- there is more than the PCAOB recognizes to the Big Four’s nearly total dominance at the global level of large-company audit – besides the awareness that mandatory rotation would only increase the tetrapoly’s hold. 

Namely – in many major economies one firm has clear leadership in large-company audits – e.g., PwC in the UK, KPMG in Germany, E&Y in France, and Deloitte in Spain.

A result is significantly lop-sided distribution of technical and industry expertise and personnel even among the Big Four, constraining rotation choices because such talent shortfalls are not readily or quickly solvable.

That is, what incentive would there be for a firm with a resource deficit to invest the time and cost to build or import the competence needed to rotate onto a complex, world-scale audit engagement – with the known prospect that its prospective new client and its stream of fees would be rotating away at the end of the cycle?

And if not, symmetrically, how does a large company rotate its auditors, if there is no place to turn?

Seekers for answers might recall the legend written on the old flat-earth maps – that beyond the horizons of ignorance, “there be dragons.”

 

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

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

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

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

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

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

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

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

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

First, a few background assumptions:

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

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

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

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

So, now what? 

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

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

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

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

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

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

Be the judges – and please let me know.   

 

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The "Independent" Auditor's Real Client? Time to Re-Assess, I Kid You Not

 "Ahh, but the strawberries -- that's where I had them. They laughed at me and made jokes, but I proved beyond the shadow of a doubt and with geometric logic that a duplicate key to the wardroom icebox did exist, and I'd have produced that key if they hadn't pulled the Caine out of action"

    --Capt. Philip Francis Queeg, 1954

Comprehensive review of the scope and language of the standard auditors’ report has been long overdue. So with measured enthusiasm (here and here), the initiatives of both the Public Company Accounting Oversight Board and the International Auditing and Assurance Standards Board are welcome.

High on the list of barriers to clear thinking and potentially constructive evolution, however, is the persistent canard, renewed by PCAOB member Steven Harris at its June 21 public meeting (here), that auditors “must fully embrace the concept that the company paying their fee is not their client.”

This proposition is confusing in logic, wrong in history, and malign in its influence. Until snuffed out once for all, it will continue to deflect and distract from the achievable task of re-engineering a role for outside auditors that brings real value to the community of financial statement users.

Since the middle of the 19^th century, when Mr. Deloitte and his pioneering colleagues were first engaged to assist the “auditors” of Victorian-era public companies – themselves selected from among the body of corporate shareholders, to advise their fellows in their shared financial interests – the auditor/client relationship has been contractual, consensual and private.

The appliqué of “public interest” has been allowed not only to stick, but to become an incrustation on the auditors’ appropriate functions. Fostered since its infancy by the newly-invented profession itself, to its discredit and lately to its mortal threat, the label did fend off – if only temporarily – the prospect of government-provided assurance – but at high cost and under the now-realized hazard of exaggeration and misapprehension of its capacities.

The shaky structure on which Harris bases his claim, that “the ultimate client of an auditor of any publicly traded company must be investors” is the 1984 case of United States v. Arthur Young. There, perpetuating the unfortunately long tradition of judicial malappreciation of the auditors’ role, Chief Justice Burger invoked the inapposite image of the “public watchdog” -- that “the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.”

As a matter of jurisprudence, Burger’s gratuitous dictum was unnecessary to the Court’s holding that tax accrual working papers could be reached by IRS subpoena.

And as a matter of unexamined rhetoric, Burger defied the logic of canine behavior, by expecting even the most vigilant watchdog to bite the very hand that feeds it.  

Events have now shown that on such a tenuous rationale, the bulky but fragile edifice of constrained client service and “appearance of independence” cannot stand. 

Critics such as Harris of the “pass/fail” audit report model have much to complain of – but there will be no solutions in shooting at the messengers, for continuing to deliver this outdated and devalued commodity product. 

Instead, history provides many examples of the dangers that lurk in broadening the distance that separates the payor of fees or benefits from the subsidized interests ostensibly served:

• Raising the limits on depositors’ insurance incentivized the reckless behavior of the American savings and loan institutions in the 1980’s, underlying their ruinous boom-and-bust.

• Lodging the management of health care cost reimbursement decisions with self-interested insurers has opened the doors to the waste, abuse and mis-allocations in the pricing and delivery of medical services.

• And most recently, requiring an issuer-paid rating agency’s report as a “green light” to sell complex derivatives was a central element in the inflation of the subprime-mortgage driven crisis that has plagued the financial markets for four years and counting.

None of which is to say that the “agency problem” of close auditor relationships with corporate boards and managements can be addressed successfully by the further intrusion of government. The prospect that an audit regulator could take on and satisfy the task of providing even today’s out-dated “pass/fail” assurance is beyond Panglossian fantasy or imagination. 

Rather, hope for progress lies in a realistic re-framing of the results that can reasonably be expected from the auditors, in an environment where legitimate and valuable new forms of assurance can be designed and delivered.

Which requires putting aside inflated language, moderating unrealistic expectations, and nurturing the profession’s acknowledged and considerable expertise.

 

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The PCAOB's Concept Release: What Might a Truly Useful Auditors' Report Actually Say?

First reaction to the Public Company Accounting Oversight Board’s Concept Release of June 21 (here), which puts on the table a buffet of possible revisions to the long-standing commodity language of the standard auditors’ report: 

It’s like Bob Dylan’s observation on the twelve-string guitar – you spend half your time tuning the damned thing, and the other half playing out of tune.

Thanks to readers for asking – more will be coming, through the comment period ending September 30.

A second reaction should be positive, since the project puts the US regulator’s stamp on a vital question, posed by Chairman James Doty during the public meeting (here), “how audit reports can be more useful to society?” 

But optimism should be carefully tempered. This is only the latest in the cyclical spasms of user dissatisfaction, going back to such barely-remembered efforts as the Cohen Commission of 1974 and the Treadway Commission of 1985. Vision and will have consistently turned to failure, over-taken by the return of bubbly investor enthusiasm, and this spring’s exuberant reception of the new media IPO’s (here), during which rational attention to the boundaries of quality accounting and reporting has been blinkered by investor frenzy, does not bode well.  

Researchers in group psychology have long known that human attitudes are asymmetrical towards rewards and detriments: people are risk-seeking on the upside, but risk averse on the downside.

Which means that the pain of a losing investment will more than outweigh the pleasure of a similar gain.

And therein lies the fallacy behind the traditional “pass-fail” audit report. As shown by recent behavior, investors will ignore all cautionary limitations within a clean report on such recent bubble companies as LinkedIn or Pandora – or the sketchy accounting proffered ahead of the upcoming launches of Facebook or Groupon. But on the other hand, they will never be satisfied – whatever the PCAOB staff may think they have accomplished with their “outreach” – absent an advance “fail” signal on a company poised to fall – Lehman, Bear, Countrywide, AIG, Fannie, and so on – not because the real desire is for a coherent and comprehensible articulation of a business model destined to failure, but to avoid the failure itself, at all.

What this “second-order” disconnect means, then, is that the auditor is truly at one remove from the core issue in today’s world of short-term score-keeping -- financial reporting is, essentially if emotionally, only a proxy for investors on the ultimate future success of the reporting enterprise. So it misses the point to keep belaboring the messenger.

Resolution is ready to hand, right within the framework of the Concept Release itself. But radical adjustment will be required, both to the reporting by issuers themselves and in the auditors’ report language.

That is, it must be for the company, not the auditors, to fully satisfy the regulators’ disclosure goals regarding, for example, the achievability of results dependent on management’s judgments, critical estimates, and difficult choices among permissible or alternative accounting policies – all of which contain and reflect the company’s business, operational and strategic risks, on which actual results depend.

The accountants then have two socially useful but limited roles:

First, to provide the necessary technical and professional competence to assist issuers in navigating through their many politicized and judgmental reporting choices – a process, by the way, which brings to the fore the many irrationalities involved in the unending fables of “convergence” among standards and the essentially irreconcilable inconsistencies between and among IFRS and the various versions of GAAP (for which, as always, see The Accounting Onion).

Second, the assurance role: to support – to the extent possible -- the clarity and transparency of the representations made in the financial statements to the community of users.

And that’s it – so much, and no more.

What may this mean for legitimately useful audit report language? Messages are required like, “We don’t know …. we cannot tell from the evidence …. we cannot test or provide a meaningful comment ….”  These, with some work on the drafting, can be properly articulated under several of the Concept Release’s rubrics -- whether Auditor Discussion & Analysis or Emphasis Paragraphs or Clarification of Language.

The profession’s leaders have been leery of any such rationalization of their role – a fear driven by economic self-interest and their unwillingness to confront the fragility of their business model.

Staying the present course to nowhere, however, risks their being revealed, like the Wizard of Oz, as little figures behind the curtain, puffing smoke and noise of no value or significance.

It needn’t come to that. Stay tuned – the upcoming months may tell.

 

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What Should Be In the Auditors' Report? Would Users Know When They Saw It?

 I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it ….”

       -- United States Supreme Court Justice Potter Stewart, on pornography, Jacobellis v. Ohio (1964).

A host of different interests are calling for a re-think of the standard auditors’ report.

Believing that its familiar commodity language has long given no value, except to satisfy the self-interest of the securities regulators, I fantasize a shared project between the International Auditing and Assurance Standards Board – which has the expertise to make it happen – and the Public Company Accounting Standards Board – which does not, but which must lead the American effort if there is ever to be success (here).

Essential would be this determination: what form of assurance is really desired -– what do users value, and what will they pay for?

Available pronouncements are unhelpful – neither such slogans as in PCAOB Chairman James Doty’s May 5 speech, that “the audit embodies core societal value and relevance”(here), or this month’s hyperbole from the European Parliament’s Committee on Legal Affairs, that the statutory audit is “an absolutely fundamental component of the democratic economic and political system” (here).

Two more helpful but ultimately depressing generalizations may be made:

The first, addressing the tumult of the last four years, is that users emphatically do not want the “clean” assurance that was delivered within weeks or months of an issuer’s demise – the unqualified opinions on such casualties-in-waiting as Bear Stearns, Lehman Brothers, Merrill Lynch, Citigroup, General Motors or AIG.

The palpable annoyance in London of the House of Lords Economic Affairs Committee, at the UK banks escaping “going concern” qualifications only through closed-door sessions between their auditors and banking supervisors – the Bank of England or the Financial Services Authority (here) -- makes the point.

The other unreality -- the re-emerging credibility gap between the traditional one-page report and the market behavior of investors – reprises the roller coaster of the late 1990’s in the current IPO wave of “new media” and other darlings – where stock prices, enterprise valuations and near-hysterical crowd behavior give every indication of a new bubble well inflated.

The poster child must be LinkedIn, with its IPO on May 19 at an upwardly-adjusted $45 and its first-day explosion to $122 – and its gradual post-offering descent back in the general direction of reality, now around $ 74, leaving all after-market purchasers under varying depths of water. 

LinkedIn’s indicated post-offering enterprise value -- $ 4 billion-plus -- pales next to the mooted $ 15 billion for Groupon and the staggering $ 50 billion for Facebook – figures bearing no terrestrial relationship to the companies’ available financial data.

Illustrative is the straight-faced ability of Groupon to base its offering on results that should exclude its sky-rocketing marketing expenses and acquisition costs (here). Flouting five centuries of accounting theory under which double-entry bookkeepers have recorded and reported everything on both sides of a ledger, the company would spin Luca Paccioli and his successors in their graves, while spinning the enthusiasms of investor credulity.

Elsewhere the valuation landscape is no less fanciful. Glencore’s launch at 530 pence on May 19 was well over-subscribed, but slipped to this week’s 480-ish – reasonably attributable to the over-heated state of the commodities markets at the core of its business, even ahead of its rumored (and now disavowed) targeting of ENRC to extend its mining activities into those havens of business and political stability, Kazakhstan and Congo (here).

More illustrative of the wild variability are Yandex – Russia’s clone of Facebook, offered on May 24 at $ 25 and lofting to almost $ 39, now at $ 31, or its Chinese opposite, RenRen -- launched at $ 14 on May 4 with a first-day pop to $ 19, but presently slumped to under $ 8. No surprise, the latter, while a cavalcade of failed Chinese companies after American “reverse-merger” listings has amply illustrated the opacity and distress at the heart of Chinese accounting, reporting, governance and over-all business legitimacy.

Or, right down to date, the June 14 offering of music-streaming Pandora at $ 16 per share, twice raised since its initial filing – an indicated company valuation of $ 2.6 billion, despite a consistent and unbroken loss-making history -- came out of the gate of open public-trading today to climb above $ 23 before starting to slip.

By way of these two central themes, it is knowable both what financial statement users do not want at all, and what they will completely ignore.

For what that teaches about new forms of assurance, unfortunately, the news is not good. As baseball sage and philosopher Yogi Berra would have put it, “If investors don’t want to act sensibly, you can’t stop them.”

 

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Mandatory Auditor Rotation -- PCAOB Chairman Doty Takes an Old Idea Out for Another Spin

Say this for Jim Doty, the new chairman of the American audit regulator – he is willing to pack his bags and go on the speaking circuit. Following his May 5 gig in New York (here), where he flagged the prospect of a re-visited approach to the standard auditor’s report (my thoughts here), the PCAOB head was off to California on June 2 (here).

There he promised “a holistic approach to addressing the cultural challenges inherent in auditing” – a notion whose meaning will emerge in time, out from behind the sloganeering of “addressing relevance, credibility, and transparency of the audit by all available and effective means”(emphasis his).  

His one specific is to drag back out, yet again, the question, “whether mandatory audit firm rotation would help address the inherent conflict created because the auditor is paid by the client.”

As Doty at least has the candor to concede, “the idea of a regulatory limit on auditor tenure is not new.” It was not new when examined in 1977, as Doty cites – back when audit choices included eight large firms and a real middle tier – nor yet again in the post-Andersen era of the Sarbanes-Oxley law of 2002.

But – unlike fine wines or monumental architecture, which will mellow and improve with age – a bad idea does not acquire respectability with the passage of time.

Since the proponents of rotation are undeterred by the only available evidence -- namely the experience of Italy, where both mandatory rotation and divided responsibility between two audit firms were part of the context of the debacle of Parmalat – two other arguments should bear:

First, the feasibility of rotation clashes with the reality of global concentration. The Big Four now have a virtual lock on large-company assurance; as the risk management leaders of the surviving mid-tier firms would admit (if only off the record, and despite the public posturing of their leaders), the smaller firms could not take over the audit of a global-scale bank or airline or manufacturer or service enterprise, if handed the job on a no-bid silver platter.

The consequence – again with focus on the world’s largest companies where both the risks and the concentration are greatest – is the absence of auditor choice imposed by the constraints of service delivery under the shibboleth of independence.

That is, a large company, engaging one Big Four firm for its audit, will disqualify another that is used for consulting services, and a third that provides financial and transactional advice.

Then comes into play the factor usually omitted from discussion, namely the uneven distribution of expertise around the large world economies. Consider the varied market-leading significance of KPMG in Germany, Ernst & Young in France, Deloitte in Spain or PwC in the UK or Switzerland. A global-scale company requires audit services in all of those countries, and US rotation requirements would be viral in application -- but shortcomings in available industry competence and geographic coverage would constrain alternative choices. Enforced rotation would confront severe dislocations, amounting in effect to unachievable demands.

The second branch of the two-fold parochialism seemingly behind the recurring advocacy for rotation is that it somehow favors an improved mind-set of auditor skepticism.

As if the assurance function had ever reflected the kind of innocent, pre-lapsarian virtue ascribed by the proponents of “independence.”

History is to the contrary. Since its invention in the Victorian 1850’s by Mr. Deloitte and his counter-parts, professional assurance has been under the direct engagement – and payment – by the owner-managers, who until then had selected “auditors” from among their own, surely-interested ranks.

The nascent profession, together with its clients, saw off the proposal of nationalized government audit in the 1860’s in England, and did so again in the US in the 1930’s. Over an unmodified 160-year history of “client pays,” the full-service firms’ economic incentives to satisfy those paying clients’ audit needs have been at least arguably no more than for a firm deriving no revenue at all from ancillary services.

So the intellectual stability of the entire structure of appearance-based independence restrictions and limitations on the scope of permissible services resembles nothing else than an elaborate edifice built on the shifting fragility of a sandbar.

I’m therefore obliged to take issue with the enthusiasm of the commentators on Doty’s speech – not least, my blogging colleague the usually insightful Tom Selling, who in the Accounting Onion proffers applause and pride at Doty’s tone and plan of action.

In the park around the corner from my house is a decades-old carousel – beloved by hordes of small children who for one euro can circle in safety astride old-fashioned wooden horses, stabbing and grasping at the rings held out by the grizzled operator of the ancient apparatus.

The metaphor extends. There is no more adult substance to Doty’s spin on mandatory auditor rotation than there is to the revolving fantasy of an antique and anachronistic merry-go-round.

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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The House of Lords -- Experienced with "Disconcerting Complacency" -- Looks at the Market Concentration and Role of the Auditors

Adulatory commentators are treating the March 30 report of the House of Lords Economic Affairs Committee on the market concentration of the Big Four audit firms and their role in the financial crisis (here) as a call to arms not heard since King Henry’s exhortation to his troops on St. Crispian’s Eve.

While the print media played it pretty much with a straight bat (here the Financial Times, the Guardian, the WSJ and the NYT), the blogging community went into adjectives-on-steroids: “hard-hitting” (both Ian Fraser and AccountingWeb), a “watershed” (Accountancy Age), “tough, no-nonsense” (BigFourBlog) and “skewers the auditors” (Francine McKenna).  

Yet soft a while. This on-high manifestation of the Lords’ work is hardly “band of brothers” material.

Truth told, other than its sound-bite charge that the auditors of the UK banks were “disconcertingly complacent” in carrying out their mission, the report is pitiably thin in substance:

Its most solid recommendation, first, is for mandatory five-year auditor rotation – an approach backed by nothing but hope for beneficial effects, and conspicuous by its adverse unintended consequences in Italy, the only major country with experience.

Second, the suggestion of “living wills,” for the relief of an audit firm in crisis, would follow the distinctly inappropriate model for rehabilitating a failing bank – which is an entirely different proposition. Bank separation of the good from the toxic involves a balance sheet of identifiable if hard-to-value assets and liabilities, to be worked through by a fungible and entirely replaceable leadership team – whereas the only value in a service-based accountancy partnership resides in its reputation and the highly-mobile skills of its people – both of which (as was shown in the Andersen disintegration) can dissipate faster than any putative rescuer can possibly control.

Third, the extent of Big Four concentration at the upper end of the audit market long pre-dates Andersen’s collapse in 2002. So the Lords’ buck-passing to the Office of Fair Trade, to re-visit yet again the age-old and insoluble matter of large-firm concentration, is hardly inspired or inspirational – especially in the complete absence of any indication of authority or vision as to how a split of resources and expertise could increase auditor choice or quality of performance.

Specifically: to split the large firms along industry lines would not increase choice. A Big Four firm depleted of its global-scale expertise in a complex sector – say, insurance or communications or defense contracting -- would have no more motivation or access to resources for a re-start than the current mid-sized firms – whose lack of appetite for the risks and challenges is already manifest.

Yet the alternative -- surgical bifurcation of existing teams of talent -- would devolve onto new firms, now smaller and weaker, all the existential challenges looming today over the Big Four themselves, along with the added burden of cost and management diversion to build duplicate centers of technical, industry, quality and risk management competence.

So on the actual content of the Lords report, it is either laughable or pathetic to invoke the image of Hercules confronting the stables of King Augeas. Instead of donning its boots and seizing a pitchfork, the Lords report holds a hanky to its delicate nose as it minces past the shit-pile, all the while whining that someone else, evidently the OFT, ought to get on with the stable boy’s dirty work.

Shame on the House of Lords committee, for a lazy approach to important issues of real substance. More shame on the observers failing to hold them to account.  


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Two Obsolete Models: Global Financial Reporting and Audit -- And Pimping Spam Viagra With AOL's Rogue E-Mail

 

Last week came a very peculiar e-mail, from an old and trusted friend whose judgments I have long valued and whose recommendations are informed by insight and experience.

There was no text – just a link. It led to the web site of an enterprise in Canada, offering remarkable discounts on an extensive array of exotic pharmaceuticals – mainly those promising cut-rate prices for exceptional enhancement in male potency and performance.

The note had multiple addressees, so it was evidently not a well-intentioned if gratuitous extension of concern for my personal functionality, satisfaction and well-being.

To pursue my second thought, I wrote my friend to ask if the site was being flogged as an outburst of his own endorsement and enthusiasm. His reply identified the third and real possibility – his long-standing AOL e-mail account had been high-jacked, and under hostile influence was engaged in stealth marketing beyond his control.

I have deliberately kept my distance from AOL for some years – first because a company capable of so thoroughly bungling its tie-up with Time Warner must suffer a fatal infection in its vision and its maladroit execution. But right at home, AOL’s long history of service lapses had finally ended with its sudden and irretrievable termination of my whole family’s portfolio of accounts, without so much as a word of explanation or a hint of assistance or apology.

So I have had a definite lack of interest in the recent kerfuffle over AOL’s bleeding of its declining but remarkably durable dial-up customer base to fund its $ 315 million acquisition of Huffington Post – a project of great enrichment to Arianna Huffington herself, if not to the cadre of free-lance bloggers who toiled without for years without compensation, to enable a generous pay-day redounding to her benefit alone.

On all this background I wrote my friend again, suggesting it was well past time he acted on his long-held awareness, that monthly AOL subscription fees were a wasteful expense drain for an inferior product that had long since been over-taken in the marketplace, and also that he had just experienced the last-straw disruption and inconvenience commonly inflicted by an outmoded service, pernicious in its obsolescence.

As for extending the metaphor -- where have we heard this before?

The answer of course is that for the last twenty-five years, nothing but in-bred regulatory inertia and supine user acquiescence have propped up the standard auditor’s report on a financial reporting model that is no less obsolete than that of AOL.

Nobody reads an audit report – nobody attends to its commodity language. No transactions of significance turn on its content, which can be purchased without qualification by any company short of bankruptcy, no matter its dubious reputation or parlous condition. No candid banker or institutional investor, claiming to act in other than a herd-oriented role, will admit to laying value on a document behind which individual due diligence is obligatory.    

While on the contrary, retail investors lack the time, tools and expertise to de-construct the arcana of financial reporting standards too complex and multifarious for the comprehension of mere mortals. 

Finally, the costs to consumers are indirect, buried far from view and only moderately painful. And with self-interested players having their own reasons to prefer a system subject to their gaming, the indifference of the sluggish acts like gum in the gears of evolution and innovation.

The death of AOL’s dial-up business has been an inevitability ever since it became common knowledge that the cost of internet connectivity would approach zero. So came the recognition by CEO Tim Armstrong, that evolution for the sake of survival was least expedient. Whether achievable, time will tell -- although the immediate post-merger firing of 900 AOL employees suggests an imminent re-play of the old maxim that a strategy of “shrinking to greatness” is next to impossible.

As for the equally obsolete model of financial reporting and assurance, the spam being broadcast to user communities in the form of traditional annual reports and auditors’ opinions remains unchecked, if only for the moment.

To paraphrase the health warning on my friend’s inadvertently intrusive Canadian web site – seek immediate medical relief for any audit report that generates excitement lasting more than four seconds.

 

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Replace the Big Four with Audits by Government? More Heat in the Kitchen -- and Less Light

What will it take, once for all, to lay forever the ghastly fantasy that audits done by government employees could provide any value to the world’s capital markets?

Like Banquo’s ghost, the gruesome spectre keeps stalking the discourse on the troubled state of privately-provided assurance – for now, dominated for global-scale companies by the fragile and threatened Big Four.

In search for a metaphor with an edge sharp enough to the task, consider:

Does anyone choosing a restaurant ever give one second’s thought to the local health inspector’s report on the state of the kitchen?

I thought not.

Never did a restaurant owner welcome diners or execute a menu with the least consideration of the requirement to pay a nuisance fee, just in order to post on his back wall the same ticket of compliance issued to everyone else – whether the tea shop or the burger joint or the elite purveyor of haute cuisine. 

Nor does that annual documentation provide any significant comfort.

On one hand, whatever that irrelevant certificate may say, competition applies relentless quality pressure in the narrow-margin food service business. A chef has ample incentive for the sake of survival to conform to the standards generally accepted among his peer group – whether running a gyros wagon or a three-starred temple of gastronomy. With ready access to reviewers’ critiques and customers’ word-of-mouth, a clientele will quickly vote the extent of its satisfaction and loyalty with its feet.

So irrespective of the commodity language of the inspector’s report, quality and value will quickly reach equilibrium.

On the other hand, the narrow limits of an inspector’s box-tick are illuminated by the commentators with inside knowledge. The celebrity ex-chef and international foodie, Anthony Bourdain, exposes to the point of hilarity the dirty little secrets of fully-compliant professional kitchens: never order fish on Monday that was carried over the weekend – the best chance for freshness is the chef’s daily special, because of the high volume and extra attention – and for salmonella’s sake, keep distance from the salad bar, never knowing who or what has rooted around there.

Bourdain makes it clear that a restaurant inspector’s annual pass-through leaves customers un-informed about what lurks beneath the grease trap or inside the meat cooler – consigning their reliance instead to the combination of peer influence and managerial attention to reputation and survival.

Which should validate the efficacy of market dynamics over further regulatory intrusion over the audit sector: restaurants, like corporate issuers, fail for multiple reasons, but above a minimal level of legitimacy, not for lack of code compliance.

Just as a health inspector is in no position to assure the quality of a dining experience, audit by government agencies would be helpless in the search for financial statement assurance of any real value -- too little, too slow, and far too late behind the speed of creative private enterprise.

Government audits could be imposed, of course – especially in the event of Big Four disintegration. But the impulse would be expedient and superficial – primarily under politicized motivations as cover for legislators and secondarily to serve the self-interested bureaucracy that would quickly become entrenched.

And the results would be much like the other models for agency-enforced compliance. Effectiveness would be measured by easily–measured inputs rather than defects exposed – think of the numbers of grandmother pat-downs reported by airport security, or inspections conducted by the PCAOB – neither of which has a record of detection or deterrence for all the wasted effort, disruption and expense.

Other examples abound. Consider drivers’ licenses. Above a minimal threshold level, anyone can get one – only to support a large and costly administrative structure interested primarily in its own perpetual existence – while delivering a compliance certificate offering no assurance on the quality of the holder’s ability behind the wheel. 

The entirely justifiable public dissatisfaction with the institutions at the heart of the financial crisis of the last four years, reflected in the legal claims working through the court systems – Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, New Century, Countrywide, Washington Mutual, as the start of the US list; plus endless examples elsewhere that would include banks in the UK and across Europe from Germany through Ireland to Iceland – rightly challenges the utility of the current financial reporting model and the performance value of privately-delivered assurance.

But great care and caution is required before speculating that the manifest deficiency of an existing model would be relieved by trashing it for another of uncertain and highly doubtful capabilities.

Or as a percipient restaurant critic might suggest – the leap from a well-seasoned but encrusted frying pan may be into an unknown and far more dangerous fire.

 

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Evolution of the Accounting Model: What Would Darwin Say?

So where will the initiative for innovation really come from, in the inevitable but elusive evolution of financial reporting and assurance?

 Not from what passes for leadership, where the paralysis is complete:

• Not in the United Kingdom, where the House of Lords inquiry is wagging fingers at the politicized nature of the banks’ accounting (as Ian Fraser writes from London) and the cozy discussions on “going concern” between the Bank of England and the large accounting firms (see Francine McKenna). 

• Not in Brussels, where the EC green paper was an embarrassment (here) and the Big Four are winkling out crisis-survival plans (summarized here and detailed on their websites) -- unfortunately no more achievable to preserve a disintegrating network of private partnerships than the ill-fated attempt to foist outside management upon the partners of Arthur Andersen (here).

• Not in the US Congress, which flailed away at the financial crisis without a nanosecond’s attention or a single word in the Dodd-Frank legislation on the fragile state of the large-company audit market.

• And not even among the authorized critics – the squabbling parties comprising the Financial Crisis Inquiry Commission having issued their variously antagonistic reports without even glancing at the role of the auditors (nowhere better summarized than by Tom Selling).

Evolutionary biology teaches that successful adaptations do not occur at the crowded center of a population, where conformity pressures suppress deviance and outliers. Instead, successful mutations emerge under stress at the margins.

Recall -- the dinosaurs thrived unchallenged for millennia, until sudden climate change exposed the vulnerability of their inflexible lack of ability to adjust.

It’s the same with industrial development -- mainstream complacency under the illusion of stability puts a damper on innovation. Consider the lag in cell-phone technology and acceptance in the large English-speaking countries, under the inertia of their large fixed-line capacity, subject to leadership take-over and exploitation by the Finns and the Japanese.

For decades the Big Three automakers in the US – the dinosaurs’ counterparts – delivered dull commodity products and burdened themselves with unbearable costs, ignoring the Japanese whose under-the-radar combination of small-engine expertise and meticulous quality processes evolved world-class cars.

The unrecognized fragility of a seemingly stable structure is exposed by surprise disruptions at its outer edges. An assassination in far-off Sarajevo lit the fuse on pre-war Europe’s vulnerability to collapse in 1914. Last month in Tunisia, the self-sacrifice of a fruit vendor in an obscure market street triggered demonstrations fatal to a despotic regime -- today spreading to engulf Egypt’s government and reverberating in every corner of the Arab world.

Large-country regulators and law enforcement agencies in the post-Andersen world have shown their disinclination either to evolve the financial reporting model or to force the re-engineering of the Big Four dominance of global audit – the only significant claim being the state-level action in New York against Ernst & Young over the repo accounting at Lehman Brothers.

Instead, evolution could well occur out at the fringe. A country or an industry sector may be so small as to be immature, unpredictable and ignored, but large enough to disrupt the global regimes for reporting and assurance. Under conflagration conditions, the fatal match could touch anywhere in the fuel pile.

That is, many economies are too small for significant global effect. The challenges of Satyam in India could ultimately cost PwC its practice organization there, but without a hiccup at the global scale; likewise the problems of the banks in Iceland are too localized to metastasize.   

But no large accounting network could survive the loss of practice in a country of G8 scale – say France, Germany, Spain or Italy in Europe, or Japan or Korea in Asia – because of the number of large companies relying on Big Four services there.

Just as most of the once-great sauri ended up sunk in the tar pits, to have their fossils excavated by the descendants of the tiny fury creatures once disregarded at their feet – so too the future of financial statement assurance will involve competition from new firms grown from small size and great agility.

Once the clean-slate opportunity is provided by the eventual recognition that the traditional one-page audit report is obsolete (and here is welcome the voice of Professor David Albrecht’s commentary and advocacy), the scale and structure of the Big Four will be otiose and unnecessary.

Some fragments might evolve to survive. A few dinosaurs did pass on their genetic code to become the modern world’s birds, whose rainbow varieties have thrived in successful competition with each other and with predators up and down the food chain.

Evolution can be stalled, but it will not be stopped. The successor to the auditors’ report, stuck in its tracks since the 1930’s, may break out in some obscure and unexpected mutation. When it does, the landscape of assurance will be populated by a different menagerie of creatures. 

 

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