Re:Balance -- Jim Peterson

The Next Home for International Financial Scandal? If You Can Find It -- It's Malta

I recently made my first visit to the tiny island nation of Malta – once the Mediterranean crossroads of crusaders, smugglers, pirates and profiteers, now better known as a way-stop on the marine route of refugees fleeing coastal North Africa for near-by Sicily and mainland Italy.

My impressions -- of a country and people with much to be modest about -- leave me uneasy, with Malta now touted as headquarters to a rapidly-expanding roster of European-based hedge funds – e.g., here and here.

This is not good news. Because if true, the fuse is lit and sparking on the next explosive weapons of financial destruction.

For all its storied history, today’s Malta is a backwater. The country’s low-wage economy survives on limited tourism for history buffs, and second-language schools serving a heavy demand for English because the native tongue with its Arabic origin and Latin orthography is unlearnably complex, marginalized, and disappearing.

In by far the smallest country in the Euro zone, with a population of 400,000 mainly unprepossessing Catholics, the focus of governance is limited to the legality of divorce. While, as I was told by the under-employed college graduate who drove our taxi from the airport, ”You’ll probably never see a policeman during your visit. There’s so little crime, they go into the parks and sleep in their cars behind the trees.”

Transport on Malta until last summer’s upgrading was dominated by fleets of clapped-out orange and yellow buses, of a vintage more worthy of pre-Castro Cuba than a full-fledged member of the European Union.

The inevitable question asked by a tourist looking over the pervasively sand-colored Italianate architecture is, “Doesn’t a country with aspirations to be taken seriously care enough to wash its cars and clean the dirt off its windows?” To which the prompt and unashamedly self-deprecating answer, “who cares?” is that the prevailing winds off the African desert make a daily layer of dust as inevitable as the sunrise itself.

After centuries of outside dominance, latterly in the form of British colonial oppression until independence in 1964 and eventual troop withdrawal in 1979, a legacy of brain drain and talent flight assures a vacuum of local vision and mediocrity of leadership.

“Maltese” evokes several things – post-Crusade centuries of knightly influence, toy-sized white dogs in the laps of ladies who lunch, and the elusive avian statue that so bedeviled Humphrey Bogart’s Sam Spade in the eponymous 1941 re-make of Dashiell Hammett’s noir novel. 

What it does not call up is a legitimate industry of well-regulated financial institutions.

So what is nascent, with the explosive growth of a Maltese hedge fund sector, is dangerous regulatory arbitrage – the potential for a rush to the bottom not seen since “regulatory capture” in Antigua and Barbuda laid the foundations for Allen Stanford’s Ponzi scheming, through his purchase of a tin-plated knighthood along with the compliant gate-keepers’ keys to that country’s thatched-cottage banking industry.

The cases are legion that even big-country regulators have been asleep on the watch – from the SEC’s failure to finger Bernie Madoff, to OFHEO’s late-arriving blinking at the sub-prime mortgage trainwrecks of Fannie Mae and Freddie Mac, to the PCAOB’s belated discovery of something rotten in reverse-merger Chinese public companies coming to America to list on its exchanges.

So the chances that the Maltese have the competence to escape a worse fate, in response to the invading hordes of hedgies in their private jets and sharply tailored suits, are precisely nil.

I have been bold in this space to make an occasional prediction about the expected times and places for outbreaks of unpleasantness – in Islamic finance, a Madoff-related suicide, or the rates of white-collar recidivism exemplified by Barry Minkow’s return to prison – with a record that is almost distressingly robust. 

Readers prepared to files these views on the likelihood of serious mischief erupting on Malta into a time capsule with a three-to-five year seal are invited to check back with me then.

In the meantime, pending the passage of time sufficient to prove me right, prudence suggests that investors seek a home for their hot and mobile Euros other than Malta.   

 

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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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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.  

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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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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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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IASB / FASB "Convergence" Postponed Again: Tweedie and Seidman March Back to the Future

In a late pre-retirement hurrah, outgoing International Accounting Standards Board chairman David Tweedie has made a bequest to his successor: last week’s agreement with Leslie Seidman, his opposite number at the Financial Accounting Standards Board, to extend by “an additional few months” the already elastic June 1 date for completion of the decade-long aspiration to converge international and American accounting standards (transcript here or here).

Is there a sentient being on the planet who is so benighted as to claim surprise?

Long predicted (here), the continued slippage in this always-distinct possibility – hardly deserving to be credibly described as a “target,” much less a “deadline” – continues to recede into the distant future.

Which was inevitable, for two reasons, purely aside from the dubious substantive merits (no better addressed than by Tom Selling’s acerbic Accounting Onion).

First is that the still-unfinished workload of four pending priority projects – the individually challenging topics of leasing, revenue recognition, financial instruments and insurance – had long been recognized as impossible of accomplishment within the resources of the two bodies and the politicized obligations to their antagonistic constituents (here). And that’s even if there had been agreement between the bodies themselves, which on these highly-complex subjects, there is not.

Second and more fundamentally, the tediously-reported proclamation of real convergence commitment has never been more than a smokescreen behind which the divergent interests of the Americans and the Europeans have knocked heads to the point of insensibility. (For which, recall the continued fudging of the SEC as to whether, if ever, that agency is even going to confirm a date certain on which to decide if to weigh in or not (e.g., here and here).)

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

At the same time, the complexity of standards within either IFRS or US GAAP expands apace. The example is the latest annual report from HSBC, which achieves a stunning 392 pages (here), thereby vying in both bulk and opacity with such legislative monstrosities as the Dodd-Frank law or the EU rules defining chocolate.

There is a striking and pertinent observation, in academic studies of breakdowns and failures in large-scale strategies: once a project starts to go over time and budget, each of the successive series of further delays and over-runs is typically longer and more costly than the last.

Public works projects are notorious: the Sydney opera house was completed in 1973 for A$ 102 million, nine years late and 15 times over its initial A$ 7 million budget. Finally completed four years late in 2003 for $ 14.6 billion, Boston’s “big dig” harbor highway tunnel tripled its initial estimate. The Eurotunnel was a happy contrast, only one year late in 1994 and a mere $ 3.6 billion over budget.

Military and political conflicts are equally instructive. President Bush’s May 1, 2003 speech under the “Mission Accomplished” banner, two months into the conflict in Iraq, is now at eight years and counting. The continuing escalations of American commitment in Vietnam for a victory supposedly just around the corner still have tragic resonance. The broken promises of peace in the land of Abraham’s children date not just to the founding of Israel in 1948 but at least back to the Balfour Declaration of 1917.

In Joseph Heller’s darkly comic 1961 war novel “Catch-22” – still the best manual in print on the absurdities of dysfunctional organizational management (see my January 2004 review in the International Herald Tribune) – the sycophantic lieutenant Scheisskopf secured his reputation and his promotion by the strategy of announcing that the much-despised weekend parades would not be held. 

(Anyone missing the scornful locker-room epithet is invited here for his name’s translation from the German.)

Tweedie and Seidman having picked their low-hanging fruit, they now confront the reality of a tree too tall to climb. So the virtue of their other modest accomplishments being acknowledged, their adoption of the Scheisskopf technique of perpetual postponements invites skepticism and ridicule in kind.

 

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The PCAOB Settlement in Satyam: PwC Agrees to Fall on its Pen-Knife

“Two aristocrats challenge each other to see which can come up with the larger number. The second agrees to the contest, concentrates for a few minutes, and proudly announces, “Three.” The proposer of the game is quiet for half an hour, then finally shrugs and concedes defeat.”

-- John Allen Paulos, “Innumeracy,” 1988

 

 The PCAOB’s April 5 settlement with the Indian firms of the PwC network, over the billion-dollar fraud at Satyam Computer Services Limited, adds a $1.5 million fine to the six million dollars the auditors also agreed to cough up to the SEC.

(Statements from the agencies are here and here; see Going Concern for the orders; and the NYT for statements from PwC.)

The amount compares to the aggregate salary of the five PCAOB members of $2,366,000. It would be a small fraction of either the annual compensation of PwC’s global chief Dennis Nally, or the firm’s legal fees on Satyam to date. And even measured by the $ 550 million ponied up by Goldman Sachs under its August 2010 SEC settlement of its one-issue dispute over the “Abacus” derivative peddled by its fabulous Fabrice Tourre (here), the amount is derisory. 

The Big Four giant is still facing on-going investor claims, to be sure. But the exposure is well-fenced; the Supreme Court’s June 2010 decision in Morrison closed the doors of the American courts to foreign securities claimants who bought their shares abroad, and the inexperienced Indian judicial system lacks the competence to be an attractive plaintiffs’ venue.

Consider the motives from the regulatory perspective. The settlement timing ahead of the April 6 hearing of the Senate Finance Committee on the role of the accounting profession in the financial crisis (here) gave senior officials a public forum. And the media coverage allowed the SEC’s enforcement head Bob Khuzami and FCPA unit chief Cheryl Scarboro, and the PCAOB’s chairman Jim Doty and his enforcement head Claudius Modesti, all to strut their achievement against foreign auditors – even while avoiding the obligation actually to try their case across international borders.

From the PwC perspective, meanwhile, the chance for a cheap exit from a major problem would have been a no-brainer. Consider:

First, an enforcement ding on the Satyam engagements had to be coming, sooner or later. From the PCAOB’s order – which PwC agreed not to contest – the Indian engagement teams on the audits from 2005 through 2008 basically did not:

• Adequately audit the company’s cash positions
• Control the confirmation process on bank balances or accounts receivable
• Pursue indications of inconsistent information or control weaknesses
• Follow PwC global directives on audit execution
• Inform or advise higher-level quality oversight personnel
• Document the work actually done (or not) in the work-papers, until subsequent back-dating while already under regulatory scrutiny

So a strategic decision not to defend the indefensible indicates early recognition of a step toward sustainable credibility. 

As for the sanctions – PwC’s undertakings on future practice quality, staffing, training and internal oversight are no more than necessary for an enterprise with aspirations to professionalism; the two-year presence of an outside monitor only adds one more stranger to the list of foreign intruders imposed on its Indian practice; and the six-month restraint on new SEC clients runs only to the settling Indian firms, so does not inhibit either the global network or its other Indian affiliates.

And, lastly, the financial impact of the fines on the massive PwC network is no more than a dime added to a roll of nickels.

For good measure, with the week’s news cycle dominated by military activities in Libya and a threatened government shut-down in Washington, and subsidiary attention to post-earthquake Japan’s nuclear hazards and Silvio Berlusconi’s “bunga bunga” trial, the entire story will drop off the media screen in less than no time.

Predictably, critics of the accounting profession who are unwilling to settle for less than the scalps of the Big Four leaders nailed to an enforcer’s door will make their outrage known.

But they will fail to acknowledge that both the regulators and PwC itself are only acting in full accordance with their respective DNA.

So once again, this settlement points up the challenge to the long-term achievability of a valuable, sustainable assurance function, to serve the issuers and users of the financial information of global-scale companies: the terms of the discourse are revealed as hopelessly inadequate.

 

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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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