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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

 

 

 

A 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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Lessons in Risk Management: A Broken Clock is Never Right -- It's Just Broken

The national recalibration caused by this weekend's fall-back to standard time is a reminder of the cliché recently repeated by a friend, that: 

“Even a broken clock is right twice a day ….”

Or so it is supposed, for the proposition that some information is better than none at all.

I will spare my friend's identity, since this is not personal. But as studied by my students in Risk Management, it is vitally important to scrutinize both what you know and what you don’t – and not be misled into missing the difference by the invocation of familiar but unexamined verities.

I surveyed my students – who with their PC’s and iPads and smartphones are carrying around an average of 2.5 devices providing them with the hour – of which only a fraction are readable by way of little hands pointing at a circular array of twelve numbers on a dial.

It’s the same in today’s public life: the handsome golden landmark clock in Grand Central Station is an anachronism, superseded by the blinking digital screens of the airport flight announcements, the pulsing scoreboard lights of the sports arenas and the obnoxious talking panels of the typical office elevator.

Even in the classroom for my MBA course, a sleek modern rectangular digital time screen hangs above the door.

Here’s the point: when broken, the ubiquitous digital clocks simply go blank. There is no sense in which, when non-functioning, a dark and empty display can ever be “right.”

So the claim is incomprehensible to anyone raised in a world of digital time-pieces. Baby-boomers are likely the last at risk of being led astray, having grown up with (and still using) analog time-keeping machinery.

At no time in the diurnal cycle is any meaningful time guidance offered by a crashed computer or an uncharged cell phone – or, for that matter, a dead microwave or DVD player or any of the myriad of appliances now equipped with digital clocks on which generations younger than the fogies rely.

The “right twice a day” assertion also suffers a more subtle flaw: How do you know? The question of “right-ness” is only testable by reference to an outside source. Looking at the hands of a broken clocked stopped at the classic “ten-to-two,” you may suspect being late for lunch.  But you can’t know without a working alternative. Whatever its format, no informational value is added by viewing the face of a dysfunctional clock.

The inquiry really needs to go down another layer, though, to the reason for calling on the cliché in the first place.

Examples abound where a little information is actually worse than none, especially where users are lulled into a false sense of security and over-confidence.

Unmarked and narrow country roads suffer a lower rate of fatal vehicle accidents, for example, than high-speed expressways, even if the latter are fitted with lane markers and rumble strips and crash barriers, precisely because the rural lanes demand high degrees of focus and attention, prudence and speed discretion.

Equally, day traders seduced by computer-generated graphs and charts of stock price activities are lured into the misapprehension that the flood of data is a reliable measure for predictability, only to crash and fail at the rate of amateur punters in a casino.

And on a global scale since 2007, the road to financial ruin has been littered with the reputational corpses of those who mistakenly believed that the quants’ “value-at-risk” models and their off-spring sufficed to support their portfolios of exotic financial products – among them, Jimmy Cayne of Bear Stearns, Chuck Prince of Citi, Dick Fuld of Lehman Brothers and most lately, Jon Corzine at MF Global.

Which is not to say that there is nothing at all to learn from a clear-eyed acknowledgement of the limits on the knowable. But more likely than an unexamined repetition of a maxim that is both conventional and therefore probably wrong, let the inquiry seek wisdom from the more humble perspective of the counsels of caution. 

PS: An invitation: send me your suggestions for other clichés worthy of attention and deflation. Thanks.

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A Lesson from the PCAOB's Inspection Reports -- Never Wrestle with a Pig

The October 17 release by the Public Company Accounting Oversight Board of previously-undisclosed portions of its 2008 inspection report on the Deloitte firm generated predictable bursts of umbrage from the usual suspects --  e.g.,  here, here and here.

The cottage industry of the professions’ critics may be satisfied with nothing less than the collapse of the large accounting firms’ business model and the entire franchise of privately-provided assurance. But because self-interest requires a steady supply of stones on which to grind their axes, the sniff of sanctimony resembles Captain Renault’s “shock” at the discovery of gambling at Rick’s Casablanca nightclub.

From its press release, the Board:

“takes very seriously the importance of firms making sufficient progress on quality control issues identified in an inspection report in the 12 months following the report. …The Board can and does make the relevant criticisms public when a firm has failed to do so." 

Flawed, opaque and ineffectual the PCAOB’s inspection and reporting process surely is – measured by its failure to achieve public credibility as a constructive force for improved financial reporting quality, even as it adds to the lives of auditors only added stress and box-ticking.  

That said, here is a message for the large firms: there are at least two grounds on which to question the reflexive approach taken by Deloitte, to fight off the inspection process by repeating the theme that:

“Professional judgments of reasonable and highly competent people may differ as to the nature and extent of necessary auditing procedures, conclusions reached and required documentation. We believe that reasonable judgments should not be second guessed and, therefore, disagree with a number of comments as indicated below."

The first is simply that it is bad form to convey to a regulator a tone of unvaryingly stubborn antagonism – a lesson that Arthur Andersen’s death spiral should have etched in memory. Having neither competence nor authority to act on a preventive basis, the PCAOB’s only tool is deployment of its functionaries to use their hindsight after the fact. So its minions must feel the hostility of disrespect, when challenged in their very raison d’être. 

Or as my grandfather would say, back on the farm, “Don’t wrestle with a pig. You get covered with pig-sh*t, and the pig actually likes it.”

Second and more nuanced – the accounting profession’s on-going and unsuccessful struggle with the public expectation of “zero defects” performance is not aided by the futile repetition of arguments that all judgment calls should go its way.

Instead, successful improvement strategies involve the candid recognition that performance shortcomings present learning opportunities, however unpleasant. The fields of engineering, air traffic safety and hospital ER techniques are exemplary – whereas the auditing profession has never acknowledged or embraced the utility of an effective forum for “failure study.”

“Close calls,” when rationalized away, are not problems fully diagnosed or properly solved, but rather are only buried hostages to fortune, lurking and growing and waiting to erupt.

So a mindset at senior levels, that outsiders’ criticism is to be deflected as nuisance and distraction, is at least an impediment to improvement, and perhaps an invitation to disaster. Examples range from the NASA management’s over-ride and launch of the doomed shuttle Challenger in 1986, to the chain of multi-level risk assessment faults leading to the BP oil well blow-out, to the SEC’s blinkered refusal to credit the warnings around Bernie Madoff.

None of this is to single out Deloittes – not least because, frisky as he is acting these days, it’s a sure bet that PCAOB chairman Doty has a stack of other Big Four reports ready for near-term release on a slow news day, when the others will suffer in their turn.[1]   

It is rather to suggest – in terms my Risk Management classes address every week – that it is impossible to achieve improvement if you can’t really measure how good you are. 

That realization comes hard – especially when served up by a crude and intrusive regulator – but it still offers a pathway to wisdom.     

 

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[1] And worth noting -- my own dedication to the importance of professionally-provided accounting and assurance – services as old as human commerce – extends back to my first two experiences, decades ago – involving massive problems for Deloitte’s US firm, Haskins & Sells as it then was, each of which led to changes in accepted auditing standards. And sharp-eyed readers have observed the homage on this blog’s banner -- the report issued by Mr. Deloitte himself in 1850 – the first, by my research, and unarguably truly significant, by an independent auditor on a large public company.  

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

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

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

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

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

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

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

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

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

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

Meanwhile, back to the naming of names:

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

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

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

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

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

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

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

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

 

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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 Financial Times Stumbles Onto the Carousel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

Three examples:

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

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

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

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

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

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

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

“An object all sublime

“They shall achieve in time --

“To let the punishment fit the crime.”

  

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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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Mandatory Auditor Rotation -- Further Thoughts on PCAOB Chairman Doty's Bad Idea

 Why Chairman James Doty of the Public Company Accounting Oversight Board keeps pressing mandatory auditor rotation, neither useful to the capital markets nor achievable for large global companies (see his latest, June 2), remains beyond sense.

Doty, hands full with the challenge of an official re-think of the standard auditors’ report (here), is supported by blogger Tom Selling, whose Accounting Onion provides lucid and incisive commentary on the politicized and intellectually incomprehensible inconsistencies of global accounting standards.

Much as I value Selling’s work, I would be reluctant to call a “disagreement” my inability to share his enthusiasm (here). Instead, some “additional thoughts”:

The context for rotation – especially the long tenure and duration of auditor relationships among large companies – reminds me of the loyalties in the farming community of my youth.

There, partisans of the trucks made by Ford or Chevy passed their abiding devotion along from fathers to sons, while on each farmstead along the rural roads, the tractors and combines glowed exclusively in bright Farmall red or the deep green of John Deere.

These intense affinities were debated non-stop in the village café and the adjoining pool hall, by sunburnt advocates wearing baseball caps branded to proclaim their choice of machinery. The system was stable -- client service was dependable if unimaginative, the cartel of dealers prospered, and it would have been thought foolish to sacrifice decades of accumulated knowledge, relationships and bins of technology and spare parts for no identifiable advantage.

Out in the fields of corn and soybeans, meanwhile, there was no rational performance difference between the competing commodity brands. Cosmetics were immediately obscured under the prairie dust, and a dirty red tractor worked not any better or worse than a green one.

In today’s audit market, to which the metaphoric characteristics of farmyard equipment extend, Selling’s endorsement of mandatory rotation omits a number of considerations.

To start, while correct that “audit failures … are small potatoes” below the mega-level of Lehman or AIG, Selling misses the stumbling block of international impossibility.

Which is, for example, that American rotation would impose on such global-scale but US-listed companies as Deutsch Bank or Total or Banco Santander or Nokia. Would the regulators in Germany or Switzerland or Spain or Finland adopt and enforce the obligatory sacking in their countries of, in these cases, KPMG or E&Y or Deloitte or PwC? And if not, how do those parent-level firms possibly coordinate and perform their locally-contracted statutory engagements?

No way -- given the halting steps of the PCAOB in the nine endless years of its aspirations – reflected in its still-complete exclusion from China (here) and the twenty-page list of large companies outside the US where, as of last year, its auditor inspection access was denied (here and here).

Second, where does the wheel of rotation turn for these companies? Where are alternatives to be found? It is not appreciated that the malign effects of independence and scope-of-service restrictions, and the uneven distribution of Big Four resources in the large economies, have squeezed or eliminated any viable rotation opportunities. Back to the study for the Financial Reporting Council in 2006 (here), and instances in the UK where “companies may have no effective choice of auditor in the short term” (emphasis added).

Third, Selling too gently observes that, “we don’t have a lot of evidence that audit firm rotation is going to work.” Truth is, we have none – the only experience being Italy, where rotation has contributed to greater Big Four concentration, and figured not least in the divided-audit environment at Parmalat. 

Fourth, Selling’s attribution of significance to the AICPA’s lobbying against rotation, back when the Sarbanes-Oxley law was passed in 2002, misses the irrelevance of that body to today’s market. That’s because, at the big-company level (the segment that matters, as he and I agree), rotation would be a pass-the-parcel exercise among the Big Four. Their dominance in the scope and coverage gap with the smaller firms has only grown over the last decade; rotation would if anything likely further squeeze the smaller firms out of the top-tier market.

Finally and most important, Selling asserts that the overhanging prospect of rotation would improve performance – in his hypothetical, “the fifth year of a 7-year relationship” – “some yet-to-be-disclosed successor auditor will have every incentive to examine each page of the old working papers with a fine tooth comb.”

This is backwards, and the incentives go the other way. A successor’s incentive and mandate are to examine old work only to lay a foundation for the current year’s engagement. To do otherwise, recalling that the successor is not an agent of law enforcement or regulatory oversight, is to pry for skeletons in old closets on a gratuitous basis.

Consider the hindsight judgment that a prior error might require correction. The company is in no position to force the now-dismissed prior auditor back onto the job of re-issuance. Yet the successor is in no position to re-perform old and stale work – at least not without inflicting massive time and cost on the current job.

To sum up: the case cannot be made at the large-company level that mandatory auditor rotation confers any benefits or justifies its costs. It is particularly impractical at the global level in any event. And requiring rotation only for smaller companies would be expensive, ineffective and politically impossible.

The proposition that rotation deserves a try, only because “every other device for loosening the bond between auditor and client has been tried and fallen far short of the mark,” is not a strategy, but a wish – and a wistful one at that. Better to focus on ideas that are both justifiable and within the range of practicality, than to continue lobbying for one that is neither.

 

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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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