Re:Balance -- Jim Peterson

GAAP/IFRS Convergence: The SEC's Roadmap is a Highway Leading Nowhere

For two reasons I’ve taken a while to step into the fray about the prospects for convergence between Generally Accepted Accounting Principles in the United States and the International Financial Reporting Standards.  

First, it was an honest and necessary but also dreary and time-consuming task to plow through the entirety of the SEC’s statement of February 24, “In Support of Convergence and Global Accounting Standards” – here.

Second, it was a toss-up which was more enervating: to slog through all 68 pages of the SEC’s turgid and repetitive bureaucratic prose, or to contemplate whether anyone thoughtful in that agency really believe in a highly-uncertain timetable that at its most optimistic extends more than halfway through this decade. 

Although the G-20 declared in Pittsburgh last September that global standard setters should complete their convergence project by June 2011 (here), the SEC gives itself all of next year even to be positioned to consider a determination whether to give more support to convergence, much less when or how. Depending on a new staff-level Work Plan that supplants the famous “Roadmap” of 2008 (here), the SEC projects that presently-undefined steps in implementation may be taken no earlier than 2015 or 2016.

The merits of convergence are debated across the spectrum, from industry sycophancy (here and here) to David Albrecht’s professorial patriotism (here) to Tom Selling’s sour challenges to its lack of intellectual substance (here) to the playful irreverence of Going Concern (here).

For me – I am agnostic on this point. First, the whole issue of whether convergence ought to happen is largely academic – because the complexities and judgments within either GAAP or IFRS themselves render the outcomes too challenging and non-comparable for any users except the dedicated experts.    

But second, there are understandable reasons, based entirely on process, why the SEC’s program for convergence has more qualifiers than this month’s NCAA basketball tournament. 

On the European side of the Atlantic, conspicuous on the personal roadmap of IASB Chairman David Tweedie is the stop sign of his June 2011 retirement. Now a lame duck, Tweedie has combined intellectual rigor and prickly Scottish wit, but his ability to achieve harmony among his constituents has been frustrated by the evident limitations on his diplomatic skills.

Disparate nationalistic players in Europe have shown the ability to evade, frustrate and maneuver around attempts at cross-border unification and cooperation at many levels:

• ·      The French bankers, abetted by no less an accounting expert than President Jacques Chirac, led years of lobbying to prevent the applicability of a single international auditing standard on derivatives accounting (here).
• ·      The Swiss judiciary continues to provide home-court advantage in frustrating the on-going efforts of the American IRS to obtain personal data on alleged tax evaders (here).
  
• ·      And eight years on from the passage of Sarbanes/Oxley, the SEC has officially permitted the PCAOB to bail for another three years (here) on its supposed mandate to inject itself into the inspection and oversight of ex-US accounting firms, unable to penetrate the European rules on privilege, privacy and confidentiality.

While on the American side, the SEC’s guidance-writers did not have a great winter:

• ·      Their late-January pronouncement on disclosure of the implications of climate change (here) was a cheerleading exercise in vacuity – see here.
• ·      On the subject of short-selling, the SEC voted 3-2 on February 24 to re-instate an uptick rule (here), but only for shares dropping more than ten percent – a debatable exercise in cosmetics at best, that will impose obnoxious compliance costs while substituting the vacillations of motion for the reality of progress. 
  
• ·      And on the subject of convergence, the flabbiness of a schedule measured in geological time makes clear that compared to a real roadmap, the agency’s navigators couldn’t find first base with a compass and a guide dog.

So on one side, the Europeans can waffle and jawbone the convergence process for as long as it suits – while the SEC's political dithering only kicks the can down the road, far past the tenure of any present office-holders. Which means that the absence of accomplishment half-a-decade from now will become the responsibility of a whole new set of map-readers.   

It’s all enough to speculate how Robert Frost’s 1916 poem, “The Road Not Taken,” would sound, if written by an observer of the GAAP/IFRS process:

Two roads converged in a wood.

And sorry I could not see the forest for the trees,

Long I stood in the undergrowth.

……

I shall be telling this with a sigh

Somewhere ages and ages hence:

Two roads never converged

And that has made absolutely no difference.

 

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Previewing 2010 -- And a Note of Thanks

As the old year winds down to the winter solstice and all those rituals by which we mark the holiday season, a brief look ahead.

Depending on reckoning, the New Year will either end an old decade or begin the next one. Whichever, here are a few events that will feature in 2010 among the on-going challenges to the global structure of large-company assurance:

• The Supreme Court in the US may well declare the PCAOB to have been illegally constituted (here or here). If so, predictable spasms of re-enactment and ratification by the SEC cannot successfully encompass such issues as the viability of pending investigations, the legitimacy of past inspection reports, or the need to re-register all the foreign accounting firms.

In the context of those issues of contention, the legislative mischief to be wrought by a Congress offered a blank page on which to re-debate the Sarbanes/Oxley law can scarcely be imagined.

• The fits and starts of accounting standards convergence will have no more traction than a pig on roller skates. The announced retirement of Sir David Tweedie as head of the IASB (here) will take one prickly personality off-stage, but will not solve the antagonisms among competing country and industry level interests. And as the scope of complexity and judgments within both GAAP and IFRS figure to be as significant as those between reporting systems, the achievability of comparability and comprehension will remain as elusive as ever. 

• Attempts to impose liability on the large accounting firms’ international structures will continue apace. The success of BDO International in confining the Bankest verdict in Miami to the Seidman firm alone (here) means that if that $521 million exposure becomes enforceable, BDO may need to find a new US member firm – a tactic painful enough for that organization but which none of the Big Four could achieve under like conditions.

Flashpoints for structural threats will include the Madoff-related feeder funds litigations, concentrated in the US but also spread around the world, and PwC’s exposure on Satyam.  And with PwC’s Indian partners on Satyam about to observe their first full year of local imprisonment, that network's attempts to extract itself from class action exposure in the American court system (here) raise the interesting question whether submission to Indian justice is really a preferred strategy.

• Tempting as it might be to be lured into the speculation about identifying which of the Big Four firm is most likely to disintegrate under the combined pressures of litigation and government threat, in 2010 or otherwise (here), I will decline – since the determining factor is the unpredictable timing of the cases themselves. Specify the judges’ scheduled trial dates for the 25 biggest cases hanging in Damoclean fashion over the large firms – and only then would I be able to offer a view.

• More broadly, strategic decision makers in the world of financial information will continue to confront the volatility of government conduct – an under-recognized factor in their overall risk assessment methodologies.
  

The reactive nature of public officials has been marked in recent years by an ad hoc cascade of unpredictable and unintended consequences – ranging in scope and scale from the back-of-envelope bank bail-out schemes to the bonus supertax in the United Kingdom to the first-ever invention in Dubai of a default-driven debt reorganization scheme of uncertain application or reliability.

So life in the forthcoming year will not be boring. 

Meanwhile, in this space, Re:Balance observes its second birthday. Launched in January 2008, this venture was the evolution from “Balance Sheet,” the column I had the six-year privilege and good fortune to write for the International Herald Tribune.

The challenges have been fascinating, starting with the anxiety-inducing migration from old-style print. No less than the accounting firms, the IHT itself -- like the other newspapers -- pursues its fading struggle in search of a sustainable niche business model. While in the world of rapidly mutating media platforms, the near-term impact of the likes of Twitter, Facebook and Kindle will continue at a dizzying pace to re-define the information landscape.  

It has been most gratifying over these two years, both to participate in community with an expanding group of smart and incisive commentators, and to experience steady growth in readership and especially in subscribers.

For these opportunities, I thank you all for your interest, your insights and your inputs.

Merry Christmas -- best holiday wishes -- and a healthy, peaceful and prosperous New Year to all. 

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Internal Control Reports Under Sarbanes-Oxley: Hazards Out of Washington

What’s in store for reporting on internal controls under the Sarbanes-Oxley law? The most important Washington development was not last week’s legislative merry-go-round over possible small-company exemption.

As discussed here, the SEC had earlier pushed back its deadline under Section 404(b) for auditor reports. Impelled by White House Chief of Staff Raum Emanuel, the House Financial Services Committee responded with approval of a permanent exemption, as proposed by Representatives Scott Garrett (R-NJ) and John Adler (D-NJ) (teed up in Edith Orenstein’s post of November 4 on her FEI Blog).

What may yet emerge from Congress is anybody’s guess – considering the opposition of Committee Chairman Barney Frank (D-Mass) and SEC Chairman Mary Schapiro and Commission Luis Aguilar. Their view is championed by Floyd Norris of the New York Times, quoting ex-SEC chief Arthur Levitt – here – in whose hyperbolic antagonism the climb-down on Section 404 would rank with repeal of the Bill of Rights or perhaps the Ten Commandments.  

Much more ominous, across the country in Seattle, was the October 27 opinion and order of federal district judge Marsha Pechman. As discussed by Kevin LaCroix (D&O Diary), Judge Pechman has sustained most of the shareholders’ class lawsuit against fallen home lending giant Washington Mutual, along with its senior executives and Deloitte, its auditors.

The case is based not only on the usual array of claimed false financial and other statements, but on WaMu’s allegedly defective internal controls and the opinions of management and the auditors – claims that WaMu “misrepresented the state of its internal controls, which were weakened in order to facilitate WaMu’s reckless lending practice,” and that Deloitte “made the false and misleading statement that its internal control reports were audited ‘in accordance with the PCAOB’s standards’.”

From the very passage of Sarbanes-Oxley in 2002, its requirement for opinions on internal controls has been an under-appreciated time bomb. Under Judge Pechman’s Order, the fuse is now lit, live and sparkling.

WaMu presents a major survivability hazard for Deloitte -- and by extension, for the viability of the entire big-firm assurance franchise. The investor claims involve securities totaling more than $ 4 billion -- well above the destruction threshold of Deloitte or any of the large accounting firms (see here).

And the plaintiffs are represented by the veteran law firm of Bernstein Litowitz Berger & Grossman – reported to have achieved five of the ten largest securities fraud recoveries in history, and to have collected over $ 20 billion on behalf of investors – here – thus no strangers to the extraction of serious amounts from their adversaries.

In the early years of Sarbanes-Oxley, while the accounting firms were reaping major revenues from their work on big-client compliance, two topics largely dominated the discourse: whether the cost was actually achieving any real value to the capital markets, and whether there could be a screwing down of the escalated fee increases felt to be windfalls to the large firms.

Two other themes were either lost or absent in the discussion. The first was that Section 404 reports and opinions comprised a new class of publicly-accessible statements on which investors might claim reliance to their detriment – no less than traditional financial statements and audit reports – a chicken now come home to roost in Seattle.

The second was the ultimate but eventual day of reckoning, with the certain arrival of large internal control failures. There a crucial mis-alignment lay concealed: the accounting profession’s cash-based business model involves immediate profit distribution to reward current partners, while the related litigation burden lies inchoate and deferred until inflicted years later on succeeding generations.

This kind of disconnect is broadly familiar:

• ·      The immediate benefits of large public works are consistently over-stated, for failure to recognize, for example, the future radioactive waste disposal costs of a de-commissioned nuclear plant, or the environmental disaster of a strip mine or a silted-up hydroelectric project.
• ·      Only now are the re-cycling impacts of consumer goods becoming visible – whether in the recoverability of scrap auto components or the packaging of home appliances or the extraction of metals and chemicals from old computers and refrigerators.
  
• ·      Closer to home, it’s a fair bet that the strategists in the law and accounting firms responsible for the tax shelter strategies so aggressively sold to their clients a decade ago did not include in their business plans the costs of their legal defenses, criminal trials, fines and civil settlements.
• ·      And nowhere is the timing mis-match more acute than in the legislative arena, where the sleight-of-hand calculations for health reform proposals or military hardware procurement or tax code revisions are fanciful exercises in advocacy.

In the same way, it is no small understatement that the profitability of the Big Four’s Sarbanes-Oxley compliance work would have been unpleasantly re-calculated, when the law was enacted in 2002, if future litigation exposures running into WaMu’s billions had been taken into account.

So concerning the yes-or-no desirability of Sarbanes-Oxley 404 for smaller companies, there is this interesting question:

With the potentially catastrophic impact of a WaMu trial now pending, and claims among the roster of failed financial institutions lurking in the background – why would a young partner in a Big Four firm think that more such expanded Sarbanes-Oxley work is a good idea?

Those who may think so are invited to explain why – especially to their dependents and their creditors.  

 

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Sarbanes-Oxley 404(b): Auditors' Reports on Internal Controls -- A Shot in the Arm, or a Poke in the Behind?

What’s to be made of the US Securities and Exchange Commission’s grant, on October 2, of yet another extension of its deadline for small companies to have reports on their internal controls by their independent auditors? (See Edith Orenstein’s FEI Blog – here and here.)

As the autumnal season for influenza raises alarmist cries of epidemic, the comparison with an improved but experimental vaccine seems apt.

The mandate of section 404(b) of the Sarbanes-Oxley law is criticized as a boondoggle for the accounting firms, or worse, by Tom Selling (The Accounting Onion), and the whole issue of auditors' work on controls is thoroughly raked over by Francine McKenna (Re:The Auditors). And there were short-lived legislative moves in Washington to extend or make permanent the small-company compliance exemption -- see the October 30 Compliance Week.

In this context, there is much to contemplate.

To start – just as with the question whether to submit to a shot against uncertain exposure to a new type of swine flu – is there any real upside?

Veteran readers here know my deeply skeptical view that Sarbox was never more than a knee-jerk political feel-good exercise – going back to my July 20, 2002 column in the International Herald Tribune: “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

In the general population, most will never even catch the flu at all, or at worst will spend a few days of bed-ridden discomfort. Most public companies, likewise, operate honestly and with generally satisfactory controls, or require only modest treatment of their symptoms in order to return to good corporate health.

There are sectors at special risk, to be sure. With new vaccines, officials struggle to identify and set priorities and to deliver to the right targets – the elderly, the infirm, the weakened. That’s tough enough, for expert epidemiologists and public health professionals. Errors and oversights are unavoidable, as with any system under human design, and there will be casualties.

No less, the episodic outbreak of corporate malfeasance is unpreventable, and will strike a percentage of the most exposed. But no regulatory system yet conceived has been able to identify the “at risk” targets or find a way to avoid a non-zero victim count.

Secondly, there are the false negatives. Just as no vaccine provides protection against all strains, especially the newly emergent and opportunistic, the large-company experience with Section 404 has shown that Sarbanes-Oxley has failed to inoculate the corporate world against continued out-breaks of business dishonesty.

Attempts to legislate virtue have been no more effective than a mandatory vaccination program – whether among foreign companies with US-traded securities (Parmalat and Satyam), or individual perpetrators (the convicted Bernie Madoff, the accused Alan Stanford, and the recently-charged Raj Rajaratnam), or the long list of fallen financial institutions (Bear, Citi, Lehman, AIG, Merrill, etc.) whose cleanly-reported controls did not protect them from the fatal infection of the credit market collapse.

Third and most pernicious, there are the inevitable side effects.

It is mis-directed and erroneous to ask whether corporate behavior has improved since the post-Enron legislative spasm of 2002. Rather, Sarbox has never been fairly measured for its negatives – extravagant costs, severe disruption of the auditor-client dialog and relationship, and diminution of real value contributed by the assurance process. Just as most flu victims recover full good health, whether treated or not, the proper question is how the side effects of Sarbox weigh against the evolved corporate governance and controls that would have emerged in the normal cycle, had the law never been enacted at all.

Discussion of the Sarbox cost-benefit analysis typically omits recognition that the equivalent of “good health” practices was always in place. Just as preventive hand-washing and use of Kleenex will fend off most routine contagions, the prohibitions on false statements to investors under the American securities laws have a long tradition of deterrence – imperfect, to be sure, but nothing is. So the proper question is whether imposition of a universal requirement for additional measures under Sarbox could justifiably alter the prevention calculus for the better.

To conclude -- leave for another day, and soon, scrutiny of the potentially devastating litigation exposures run by small companies and their auditors when the next round of control failures show up in a renewed wave of investor litigation.

For now, compare with a health-delivery marketplace where individual choice still counts. Conscientious consumers can weigh the potential benefits of an experimental new vaccine. They can consider the risks of side effects and possible false comforts, absorb the publicity from a profit-driven drug industry, and decide accordingly.

With Sarbox 404(b), by contrast, unless a re-evaluation occurs while this latest deadline extension is pending, small listed companies will have no choice but to bend over and offer a fat and juicy target – to be stuck by a needle-wielding bureaucrat with the fear-inducing cry, “I’m from the SEC, and this shot is for your own good.”

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On the Calendar: What Every Auditor Should Know About Litigation

The fall speeds on, and the calendar is packed. I am looking forward with enthusiasm to being at Baruch College in New York on Wednesday, December 2, for the Robert Zicklin Center for Corporate Integrity's 4th Annual Audit Conference, "Ensuring Integrity."

Information on the agenda and registration is here. It will be an interesting day, led by Professor Doug Carmichael and including senior staff members of the SEC and the PCAOB as well as representatives of the large firms.

I will be on the last panel of the day -- deliberately scheduled, I suspect, so as not to put anyone off their lunch -- "What Every Auditor Should Know About Litigation." Professor Carmichael will moderate, and I will be joined by Jim Sabella of the hot plaintiffs-oriented law firm of Grant & Eisenhofer, and Willkie Farr & Gallagher partner Mike Young, probably the accounting profession's best-known adviser/spokesman.

The content for our panel will be under development in the next few weeks. I have some ideas of my own -- but I invite you to write with your thoughts. What would you like to have addressed? On what litigation topics should auditors know more -- or other than -- they do now? For that matter, to bend the topic a bit, what should other constituencies know about auditor litigation.

I'll welcome and take up your suggestions -- and will report back later with more to say.

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Happy Times for the Big Four Accounting Firms? It's All in Whom You Read

The familiar formula for measuring forward-looking attitudes has an update:

The optimist sees a glass half full.

The pessimist sees a glass half empty.

Whereas -- the consultant sees a glass that’s twice as big as it needs to be.

Varying spins are given to the report just issued by the flagship firm of PricewaterhouseCoopers in the United Kingdom, for its year ended in June – 72 pages of sunshine about its £2.25 billion in revenue, profitability that works out to a 34 percent profit margin, and £770 thousand average profits per partner.

The Lex column of the Financial Times cheerily bought in – here. The pink color of the FT’s pages infuses the lenses through which it sees two themes:

“First, firms and their auditors have become more conservative since the Enron and WorldCom debacles. Second, Sarbanes-Oxley in the US and harmonized reporting standards elsewhere have forced greater disclosure requirements.”

The always-acerbic blogger Dennis Howlett begs to differ – here - with a link to the PwC report itself. His focus is on the structural impact of the decline in PwC’s audit and tax revenues, as offset by its rise in advisory practices, with notable emphasis on the £100 million derived from PwC’s work on the Lehman administration: 

“PwC UK may be doing very well at the moment but you can see where it is going. I anticipate that over time, it will continue to reduce its dependency on assurance services as the engine for growth but with it will come renewed criticism of its conflicted advisory position.”

The FT manages with a straight face to say that “the most important asset the accountants have maintained in this recession is their reputation” – a rosy view, not even shared by Floyd Norris of the New York Times (here), and suffering two-fold difficulties:

First, it is hard to see the recent years as a Goldilocks era for the accountants, post Enron and Sarbox, with the lengthy list of financial institutions that have fallen to collapse, shotgun mergers or government control – all of them flagging clean reports on their financial statements and their controls even as they plunged over the cliff to ruin.

It is more likely proved once again that the capacity for scandal-driven public outrage is both limited and finite, the only variable being the number of targets at which insults are sprayed.

That is, the energy and attention demands of the various stimulus and rescue efforts, and the related demonizing of the institutions and their high-bonus leaders – screeched by politicians, regulators and media alike – have in effect given the auditors at least a temporary pass from hostile scrutiny.

Second, there is the FT’s remarkable proposition that “the downturn has not notched up a big accounting scandal.” That’s as may be, but only if from its London base the vision stops at the shores of the sceptered isle.

Because the rest of the world will not disregard the inclusion of auditors in claims directly associated with the collapsed financial institutions (tracked and summarized by Kevin LaCroix at the D&O Diary), the massive claims involving the audits of the Madoff feeder funds (here) or the existential threat posed by the Satyam fraud in India to PwC’s practice in that country or the on-going criminal prosecution of its personnel there – the last flagged by Howlett although ignored by the FT and indeed by the PwC UK report itself.

Solutions to the multi-faceted antagonisms that ensnare the Big Four and put their survivability at risk will not be brought forward under the dewy pandering of the Financial Times. But it’s not that Howlett gets a complete pass either.

Howlett may be signaling that PwC is his entry in the commentators’ pool on the next of the Big Four to catch a fatal bullet – here. The near future will test the marker he puts down, to “watch for a potential breakup a la Arthur Andersen in years to come. Especially if they get nailed on Satyam.”

But he is experienced, skeptical and critical enough of the large firms’ exposed position to contribute above the unhelpful one-dimensional finger-pointing ordinarily delivered by the profession’s usual cast of critics. The sharp point of his pen could constructively jab at an issue much more challenging than the Big Four’s public relations exercises – such as this:

“If the large-company audit structure collapses, what takes its place?”

That’s a discussion yet to start.   

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How Valuable is Today's Audit Report? Military History's Metaphor for "Expensive, Obsolete and Irrelevant"

The dog days of summer. I’d rather be under a beach umbrella, doing teaching outlines for the fall semester with the facilitating aid of something cold and rum-based. Instead I am in deep dialog on tough issues with one of the world’s thoughtful accountancy regulators.

A very small group, that. “Thoughtful accountancy regulator” being as oxymoronic as “Italian justice system” or “effective Belgian government,” their entire convocation could be booked in a telephone booth with room to spare.

On our table was one of my persistent themes, under the rubric of the threatened survivability of the Big Four and their nearly exclusive franchise to audit large global companies – only one major shock away from disintegration, which once started will be unstoppable not least because of the limited vision and authority of the political and regulatory classes.

Namely, there is no real chance to get ahead of this destructive tidal wave without explicit confrontation of the obsolete and anachronistic nature of the audit report in its current form.

To this proposition, my correspondent suggests there is at least some chance of traction under cover of the legislative debates on the question why auditors did not do more in relation to the credit and banking crisis of the last two years.

Possibly. But because the lawmakers’ limited attention span is focused elsewhere – on executive pay schemes and bank survival subsidies and constraints on short sales and flash trading -- I doubt it.

Our exchange calls to mind a recent holiday, and the moving experience of touring one of the surviving fortresses of the Maginot Line – the defensive installations named for France’s Minister of Defense, built in the 1930’s and left largely unscathed when the invading Germans simply and speedily flew their planes and drove their tanks over and around.

Dug deep into the Alsatian hills, these brutal piles of 1920’s military technology – built for 3 billion francs and among the largest public projects in France since the construction of the Gothic cathedrals – are derided by history as a strategic failure, because they were rendered irrelevant by the German circumvention.

Yet consider the success -- in terms, the Line did its job. It was evaded, rather than destroyed by direct attack; surrendered largely whole, rather than bombarded; and only thereafter abandoned by government to the effects of rust, decay and amateur tourism.

It’s much the same for the modern-era audit report: Conceived in an earlier and simpler time, oriented to the avoidance of problems no longer meaningful, and now ignored by aggressors with superior tools in their armory. Consuming vast sums of defensive budgets, engaging battalions of trained and expensive manpower in an endeavor of questionable value, and achieving no obvious deterrence against threats on a scale of systemic corporate collapse.

Life for the French garrisons would have been misery: cramped underground in caves of steel and concrete; enclosed by machinery, ducts and wiring; ventilators struggling with the confluent mixture of petrol, dangerous explosives and close human quarters. Happily, except for times of drills and alerts, they were often able to emerge into the French forests, to hunt the birds and rabbits that relieved their military rations. 

Contrast the modern audit engagement team – inflicting vast costs on their clients for a marginal purpose, toiling away to tick the boxes required by Sarbanes/Oxley and its equivalents, facing a hostile world through the narrow visor of inflexible reporting requirements and a crude and outmoded arsenal of opinion language, and exposed to being out-flanked or over-run without warning by antagonists of superior mobility and strategic imagination.

Just as the Maginot Line proved its worth as a sublimely ironic success against invasion that never came, the current audit report stands as a bulwark effective only against the kind of assaults about which no one cares.

Instead, just as the hapless French troops were obliged to surrender without a struggle when overtaken from the rear, the modern system of assurance has been revealed as dug in and powerless against such invasive forces as the exotic financial derivatives of the credit crisis or the guerrilla tactics of a Bernie Madoff or an Alan Stanford.

And to what end? The metaphor can be pressed one step further. By surrendering the Maginot Line’s indefensible position, the French cut losses that would otherwise have been catastrophic, and survived to be joined by their allies in a strategic re-grouping.

As with supplanting the dimly mis-guided André Maginot, can the regulators find in their weary ranks the likes of a Churchill or Roosevelt or DeGaulle?

Cometh the hour, cometh the man? The future of the profession can only hope.  

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OK -- It's Agreed: There's a Crisis in Audit. So When Do We Get Down To It?

The city-bred sportsman hires a local fishing guide, who promises great results as they anchor in a remote spot. From the tackle locker, the guide pulls out a stick of dynamite, lights it, and throws it over the side. A huge explosion, and dozens of stunned fish float to the surface. As the guide nets the fish, the tourist begins to rant about poor sportsmanship and illegality.

The guide calmly lights another stick of dynamite and hands it over. “Are you going to keep running your mouth?” he asks as the fuse sputters. “Or do some fishing?”

Readers here are well advised to invest an hour catching up with last Thursday’s webcast, “2009 Mid-Year Review – Securities Litigation and Enforcement” (archived and available here).

This edition of Bruce Carton’s valuable extensions of his vital news source, Securities Docket, assembled four of the bloggers on my must-read list – Lyle Roberts (10b-5 Daily), Tom Gorman (SEC Actions), Francine McKenna (Re:The Auditors) and Kevin LaCroix (D&O Diary).

It was barren times for the subject indeed, back in 2002 when the Paris newspaper launched my financial and accountancy column. But since then the family of commentators continues to grow, who contribute substantially to the consensus of crisis in the entangled relationships among issuers of financial statements, their auditors, and the hyena herd of regulators, politicians and hostile lawyers.

Along with those noted above: Edith Orenstein (FEI Blog), Dennis Howlett (AccManPro), Tom Selling (The Accounting Onion), and Broc Romanek (CorporateCounsel.net) – and, with apologies, some I’ve surely missed.

The webcast is useful, on a variety of relevant fact-gathering and predictions; so too all the other increased attention. But concerning the on-going threats to the survivability of the large-company audit function, the discussion has yet to go past voyeurism, scape-goating and finger-pointing.

Here it is, seven years since the collapse of Arthur Andersen and the infliction of the ill-considered Sarbanes/Oxley law and its malign effects -- and two years and counting into a financial markets crisis of epic proportions. And not a constructive word is heard on the shape of the future.

Calling the dis-honor roll of those accountable:

The large firms’ leaders are handcuffed to a business model that they are powerless to change, under the combined constraints of the securities compliance regimes and their own partners’ appetites for the status quo of short-term profits. 

Their most vocal critics, among the commentariat, bay the cry of the profession’s self-serving venality, without taking even a first step down the path to re-design an assurance system now presumed (but not proved) to be important or worth working to save. 

The noisiest and most enthusiastic reader comments, meanwhile, range unconstructively from the punitive (“let them fail” and “jail them all”) to the self-destructive (“break up the Big Four” and “up with the little firms”) to the wildly impractical (“mandatory rotation” and “let the government do audits”).

Traditional debate platforms are empty. Former Treasury Secretary Henry Paulson’s Advisory Committee dissolved into insignificance without a trace, a year ago, behind a thin veil of posturing and animosity. The PCAOB, successful at least in perpetuating its own existence, is dribbling on the conflagration with an eye-dropper. Business lobbyists and academics alike are pre-occupied elsewhere.

And with no sign of a politician or a regulator in Washington or London or Brussels having either the vision, the interest or the initiative to take a lead, neither are there any other jurisdictions having the maturity or the salience to provide any influence.

The requirements for a useful forum ought to be within the grasp of the expanding collective of New Media mavens.

Ground rules and administrative questions should be modest enough: on-site or virtually distributed – freely accessed or modestly moderated to minimize the bickering and partisanship – live and real-time or via postings and dialog threads – open only to the credentialized or anonymous – sponsored or subscription or wide open.

Here’s the challenge: If this dynamite stick explodes, it will sink the boat and all in it. So it’s time to fish.

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Future Directions for Accounting and Audit: Can Anyone Get There From Here?

   

Recall the frustrated Irish villager, trying to direct a befuddled tourist toward Dublin:

        “If I was to be going there, I wouldn’t be starting from here at all.”

Last week came the news that Mark Olson is resigning as chairman of the American audit regulator, the Public Company Accounting Review Board.

Timely of Olson. He paddles away from a leaking ship, likely to be scuttled next year by a predictable Supreme Court ruling that the agency’s basic authorization under Sarbanes/Oxley back in 2002 was constitutionally flawed.

Also: Paul Boyle is departing as chief executive of the Financial Reporting Council, the United Kingdom’s audit regulator. Charlie McCreevy’s time is shortening as EU Markets Commissioner, whence comes what passes in Brussels for guidance on the topic. And Mary Schapiro and her crew of SEC newbies are fully pre-occupied with agency rehabilitation.

Along with the turn-over in all these seats, Treasury Secretary Tim Geithner this week may propose a “council of regulators” whose inevitable internecine squabbling will dilute even further the alphabet soup of American financial oversight.

So this long-pending question takes on renewed freshness:

Where is the leadership with the focus, vision and stature to bring about the fundamental and necessary re-structuring of both financial reporting and the related assurance – existing models having proved so ineffectual in the global financial crisis?

For dismal context, all this shuffling comes while a death-watch gathers around the continuing Bankest trial in Miami. There, a looming $ 522 million liability threatens to drop the final curtain on both the Seidman firm and BDO, its global network – here – proof to come that the mantra of “too big to fail” has no application to the large private accounting networks.

The likely legislative reconstruction in 2010 of a freshly-authorized PCAOB will present a one-time opportunity to write on a blank page, especially if Seidman has by then been hauled off to the knackers' yard. But the prospects are grim for grown-up guidance or perspective.

Certainly not from government. William McDonough, Olson’s predecessor at the PCAOB, left office in 2005 with the candid if pessimistic concession that “None of us (regulators) has a clue what to do if one of the Big Four failed”-- here. Four years on, and no clues have been revealed -- nothing has changed.

And as discussed almost a year ago – see here and here -- the gathering of talent known as the Treasury Department’s Advisory Committee on the Auditing Profession, convened by then-secretary Henry Paulson, limped into oblivion -- without managing even to agree that privately-provided large-company audits faced a serious threat to survivability, much less offering any hint of a blueprint for an achievable future.

Nor are there signs of life in the Big Four executive suites, where a managing partner would be deposed by immediate revolt for daring to propose serious change to the current model, creaky and obsolete as it is.

And the lobbying muscles flexed by issuing companies, over such contentions as mark-to-market and GAAP/IFRS convergence, have shown their allegiance to the status quo – preferring diminished transparency and reduced user value as the trade-off for their own control and dominance over the reporting and standard-setting process. 

The essential elements of a functional financial information regulatory structure are in principle not so complex:

•    Sufficiency of input to the setting of accounting and reporting standards.

•    Licensing and oversight of the audit function by which assurance is delivered.

•    Investigative and enforcement resources for the level of detection, prevention and deterrence of irregularity that society is prepared to pay for.

•    Finally, a last-resort structure for investor protection to supplant a liability regime that has run beyond the limits of sustainability.

Unhappily, the incremental nature of government evolution – including the certainty that the first priority for any agency is its own self-renewal and perpetuation – means there is only one true blank page: if the slate were wiped clean by the collapse of the Big Four networks and their consequential elimination as the only available source for large-company audit delivery.

That highly disruptive scenario is not one that any reasonable participant in the dialog could want or wish for.

But how else, the ominous question remains hanging, is a guiding force to come forth – one to map a future reachable by intelligent public exploration, discourse, negotiation and agreement?

As in the Irish village, there is no choice but to start from here. 

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Re-Post: The Supreme Court Targets the PCAOB: If Things Could Hardly Be Worse, Might They Perhaps Get Better?

For reasons known only to Mercury, the god of communications, this post from Thursday was not fed to most subscribers. So this re-posting, with apologies to anyone finding or receiving it a second time.

When I went to make breakfast on Tuesday, I found a tempest swirling in my teapot: the report that the United States Supreme Court is to resolve a constitutional challenge to the law establishing the Public Company Accounting Oversight Board – created by the post-Enron legislative spasm of the Sarbanes/Oxley law of 2002.

This is an abstruse squabble over the scope of the presidential authority to appoint government employees classified, without any apparent irony, as “inferior officials.”

Paying almost no attention, the mainstream American media have their priorities right, putting their focus instead on the Court’s agreement the same day to review the criminal conviction of corporate kleptocrat Conrad Black.

The news-consuming public, in other words, understandably has less interest in whether a bunch of rascals are to be thrown out, than if one should be thrown in.

I’m not generally one for wagering, for reasons I’ve spelled out – here – life already being sufficiently full of risks and hazards. But the easiest signal of the high court’s acceptance of the PCAOB’s legitimacy would have been to leave standing the lower courts’ orders. So it is a decent prediction that some time in next year’s term, the axe will fall.

And then?

And then will come the kind of grandstanding that Washington does so well. Led in the Senate by Chris Dodd (D-Conn.), chairman of the Banking Committee, and in the House by Barney Frank (D-Mass.), chairman of the Committee on Financial Services, the elected mob – of whom humorist Will Rogers sagely observed that “no man’s purse is safe while the legislature is in session” – will serve up a new kind of bail-out.

Which is, they will resuscitate the old agency in a new guise, only this time arrayed in bells and whistles reflecting their politicized reaction to the economic turmoil lately inflicted on us all.

And where will the vitally-interested accounting profession figure?

Historically, the high point of their influence lay in securing the franchise of privately supplied assurance, under the audit requirements of the securities laws of 1933 and 1934. In the following three-quarter century, sadly, the degree of attention and respect given to the auditors in the shaping of their regulatory fate has been like that in the research into shark feeding, as given to the food.

Because the Democrats control both houses of Congress and have their rock-star in the White House, the “appointment authority” issue will be repaired with the legislative equivalent of a piece of duct tape or a whack with a wrench. Making it a total non-event, the fix-up will include a wholesale re-adoption and ratification of everything wrought by the then-defunct PCAOB, so the transition will be seamless and invisible – turning the entire affair into little more than an ego exercise for those angling to get their names into the law case reports.

It’s necessary to remember that the Supreme Court’s power runs only to the narrow questions offered. It will not do a qualitative assessment of all the mischief since Sarbox was enacted – not answering, for example, the question that could be reasonably asked by, say, the battered investors in Bear or Lehman or Merrill or Citi or AIG: “Over the last seven years, has the PCAOB made the world of financial reporting and assurance a better place?”

Which means there is nothing to be served by trying to pick a winning side in this punch-up: there isn’t one, in any way that matters.

If adult perspective prevails, the accounting profession will resist the lure of friend-of-court advocacy, saving itself both large legal fees and whatever amity it might salvage for the lawmakers’ debate to come.

For there is now a window, of perhaps six to nine months, in which a blueprint might be developed for the successor agency to be enabled when the Supremes pull the PCAOB’s plug.

Avoiding the post-Enron stampede that flattened all before it in the rush to Sarbox – footnote below -- the accountants along with whatever friends they can muster have the chance to organize in support of a coherent and achievable structure – here.

Namely: federal-level chartering of auditors of US public companies could be combined holistically with standard-setting, oversight, inspection and discipline -- along with investor protection including insurance that would be industry-funded but government-backed, to relieve the firms’ current “survivability” issue – namely, the deadly overhang of life-threatening litigation exposure.

Ambitious – yes, surely. But Dodd and Frank will have their law-drafting pencils sharpened anyway. The opportunity to write on a blank page is too good for the profession to waste.

Note: As I wrote back in July 2002 about the Senate’s passage of Sarbox, “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.” You’ll have to trust me, though; as the International Herald Tribune for whom I was then writing in Paris moves closer to full absorption by its parent, the New York Times, its archive has somehow disappeared from internet accessibility – here.

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The Supreme Court Targets the PCAOB: If Things Could Hardly Be Worse, Might They Perhaps Get Better?

When I went to make breakfast on Tuesday, I found a tempest swirling in my teapot: the report that the United States Supreme Court is to resolve a constitutional challenge to the law establishing the Public Company Accounting Oversight Board – created by the post-Enron legislative spasm of the Sarbanes/Oxley law of 2002.

This is an abstruse squabble over the scope of the presidential authority to appoint government employees classified, without any apparent irony, as “inferior officials.”

Paying almost no attention, the mainstream American media have their priorities right, putting their focus instead on the Court’s agreement the same day to review the criminal conviction of corporate kleptocrat Conrad Black.

The news-consuming public, in other words, understandably has less interest in whether a bunch of rascals are to be thrown out, than if one should be thrown in.

I’m not generally one for wagering, for reasons I’ve spelled out – here – life already being sufficiently full of risks and hazards. But the easiest signal of the high court’s acceptance of the PCAOB’s legitimacy would have been to leave standing the lower courts’ orders. So it is a decent prediction that some time in next year’s term, the axe will fall.

And then?

And then will come the kind of grandstanding that Washington does so well. Led in the Senate by Chris Dodd (D-Conn.), chairman of the Banking Committee, and in the House by Barney Frank (D-Mass.), chairman of the Committee on Financial Services, the elected mob – of whom humorist Will Rogers sagely observed that “no man’s purse is safe while the legislature is in session” – will serve up a new kind of bail-out.

Which is, they will resuscitate the old agency in a new guise, only this time arrayed in bells and whistles reflecting their politicized reaction to the economic turmoil lately inflicted on us all.

And where will the vitally-interested accounting profession figure?

Historically, the high point of their influence lay in securing the franchise of privately supplied assurance, under the audit requirements of the securities laws of 1933 and 1934. In the following three-quarter century, sadly, the degree of attention and respect given to the auditors in the shaping of their regulatory fate has been like that in the research into shark feeding, as given to the food.

Because the Democrats control both houses of Congress and have their rock-star in the White House, the “appointment authority” issue will be repaired with the legislative equivalent of a piece of duct tape or a whack with a wrench. Making it a total non-event, the fix-up will include a wholesale re-adoption and ratification of everything wrought by the then-defunct PCAOB, so the transition will be seamless and invisible – turning the entire affair into little more than an ego exercise for those angling to get their names into the law case reports.

It’s necessary to remember that the Supreme Court’s power runs only to the narrow questions offered. It will not do a qualitative assessment of all the mischief since Sarbox was enacted – not answering, for example, the question that could be reasonably asked by, say, the battered investors in Bear or Lehman or Merrill or Citi or AIG: “Over the last seven years, has the PCAOB made the world of financial reporting and assurance a better place?”

Which means there is nothing to be served by trying to pick a winning side in this punch-up: there isn’t one, in any way that matters.

If adult perspective prevails, the accounting profession will resist the lure of friend-of-court advocacy, saving itself both large legal fees and whatever amity it might salvage for the lawmakers’ debate to come.

For there is now a window, of perhaps six to nine months, in which a blueprint might be developed for the successor agency to be enabled when the Supremes pull the PCAOB’s plug.

Avoiding the post-Enron stampede that flattened all before it in the rush to Sarbox – footnote below -- the accountants along with whatever friends they can muster have the chance to organize in support of a coherent and achievable structure – here.

Namely: federal-level chartering of auditors of US public companies could be combined holistically with standard-setting, oversight, inspection and discipline -- along with investor protection including insurance that would be industry-funded but government-backed, to relieve the firms’ current “survivability” issue – namely, the deadly overhang of life-threatening litigation exposure.

Ambitious – yes, surely. But Dodd and Frank will have their law-drafting pencils sharpened anyway. The opportunity to write on a blank page is too good for the profession to waste.

Note: As I wrote back in July 2002 about the Senate’s passage of Sarbox, “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.” You’ll have to trust me, though; as the International Herald Tribune for whom I was then writing in Paris moves closer to full absorption by its parent, the New York Times, its archive has somehow disappeared from internet accessibility – here.

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Antagonisms Among the Audit Regulators -- A Warning Bell, or a Final Toll for the Profession?

There’s a gaping disconnect between the pieties on coordinated regulation of the global financial markets, espoused at last week’s G20 conference in London, and the contrary behavior of the national-level minions on the ground.

Recall Aesop’s simple little tales, where the Greek storyteller often leaves a hanging question. For today, it’s the conundrum that ends the debate among the mice -- just who is to bell the cat?

It is unremarked in fabulist scholarship that from the perspective of the large and dangerous cat, the rodents’ vacillations are inconsequential. Whereas, a seriously threatened interest goes unrecognized – namely, who is looking out for the cheese?

The same dissonance continues in the trans-Atlantic mouse-tussling among the various national agencies that claim to oversee the global accounting firms.

I wrote recently about the Securities and Exchange Commission as international spoilsport, for its hostile declaration that financial statements of a United Kingdom company would be unacceptable for American compliance, if using the legitimate UK rules permitting negotiated limits of auditor liability (here).

In so doing, I had missed an earlier shot aimed the other way. On February 19, EC Internal Markets and Services Commissioner Charlie McCreevy shut down further discussion about mutual recognition and reliance by the various national accountancy oversight bodies – here -- until the Commission receives the Obama administration’s views as to the attitude of the US regulators.

McCreevy may have a long wait.

Back in 2002 when the unfortunate coupling of Senator Paul Sarbanes and Representative Mike Oxley begat the Public Company Accounting Oversight Board, the world of regulatory oversight was not really crying out for the birth of a hegemonic American agency. But it got one anyway, under the “go it alone” attitude of the Bush era.

The resistance made it unsurprising that long-outstanding proposals on cross-border relations – here – have languished unapproved by the Americans:

•    From the passage of Sarbox down to date, as recently as PCAOB Chairman Mark Olson’s platitudinous speech to the Fédération des Experts Comptables Européens in December 2008 – here -- there has been no more than cosmetic attention to the unresolved issues of competing legal systems in such compelling areas as client confidentiality and personal data privacy.

•    Meanwhile the PCAOB has been obliged, faute de mieux, to adopt rules deferring its inspections of a roster of non-US audit firms, in the face of unfinished dialog to resolve the very outstanding issues that have been pending since 2002 -- here.

To an observer interested in the nourishment of international comity, the compound adjective “mickey mouse” is appropriate to characterize nearly seven years of murine antagonism.

While the regulatory mice play cross-border tit-for-tat, unfortunately, the world is not sitting still:

•    Last week’s billion-dollar lawsuit against KPMG by the liquidating trustee of New Century Financial (here) is not the first of the new wave of auditor mega-claims, but it does show that the predatory plaintiffs’ bar continues its aggressive prowling for appetizing targets.

•    And although troubling questions about the role of the accounting profession in the tumult of the global credit and financial markets have largely gone unasked, the question “where were the auditors?” is increasingly heard. There’s the business press – here. The always-trenchant Tom Selling (The Accounting Onion) is as skeptical on the dysfunctionality of accounting standards as I am about assurance. The idea of some form of nationalization is even floated, by both bloggers and academics -- here and here.

The American regulators cannot progress global auditor oversight on their own, beyond and despite all the threat and saber-rattling -- among other places, the PCAOB faces unsolved inspection impasses in China and Hong Kong. For his part, Commissioner McCreevy has put down the marker that continued American bluster means nothing more than further stalemate. But whether Mary Schapiro as President Obama’s new SEC head can cut a path out of the diplomatic swamp – or even wants to – remains to be shown.

This period of uneasy quiet is not a sign of stability – quite the opposite. Nothing has happened since the collapse of Arthur Andersen in 2002 to address, much less to reduce, the potential for a systemic shock to the franchise of privately-provided large company assurance. Yet the continued squabbling among the regulators makes plain their lack of vision or authority by which to collar the many challenges to auditor survivability.

All the while the deliverability of ostensibly valuable audit services to global-scale companies – the block of cheese in this little folktale – sits unprotected and exposed – nibbled away by hostile forces and showing signs of the furry mold of neglect.

Parenthetically, I plead no contest to the several weeks passed in sniffing out McCreevy’s statement, among the emanations from the bilge-pump of the European Commission’s publicity machinery. Oscar Wilde observed that when good American die, they go to Paris – while the city of Brussels, modest as its other virtues may be, must surely be the graveyard of effective regulators’ press.  

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Another Blow to Limited Auditor Liability -- A Non-Surprise from the SEC

As reported in the on-line Financial Times for March 10 – here – the Securities and Exchange Commission has declared that financial statements are unacceptable for US purposes, where UK companies have followed that country’s recent rules permitting negotiated agreements for the proportionate liability of their auditors.

The only surprise about the SEC’s position – which effectively slams the door on the world’s only remotely influential action affecting the large auditors’ deadly litigation exposure – is that it took so long to arrive.

The British initiative was uncertain enough from the outset, but was bound to be dead on arrival. It is not just that Washington’s attitude toward British rule has been revolting since 1776. London had every reason to see the SEC’s hostility right out in broad daylight.

For as I wrote last July – here – the new UK rules were “hostage to the unremitting hostility of the SEC to any attempts to reduce unlimited auditor liability exposure, as well as the uncertain application by US judges of limits contracted under foreign laws.”

Since the 1860’s, when Mr. Deloitte himself led the Victorian-era pioneers of independent audit in fighting off potential government take-over of their newly defined function, the principle has been established that auditor engagement and payment directly by clients were acceptable.

Despite endless futile debates since, no intellectually certain or solid basis has emerged upon which to measure the elusive and ever-shifting “appearance” of impaired independence (see here). So the SEC’s passionate history of opposition to auditor liability limits is matched only by its irrationality.

Which should be a signal to the stiff upper lips in London, whose fallback proposal is to seek the same package via British legislation: Forget it. Fold the hand.

Because the SEC is not about to accept limitation agreements, even in the doubtful case that the UK profession might succeed in shepherding an enabling law through Parliament, it is an immovable opponent. So move on to something productive.

Trans-Atlantic struggles over conflicting regulatory schemes are the common stuff of impasse. Look only at the state of extra-territorial examinations by the Public Company Accounting Oversight Board, still close to immobilized, nearly seven years after the passage of Sarbanes/Oxley, by cross-border conflicts over secrecy laws and client confidentiality. Or listen to the inflamed rhetoric with which UBS is opposing the identity disclosure of 25,000 of its clients – banking secrecy being one of the few topics to arouse observable dudgeon among the phlegmatic Swiss, even with the early signs of reluctant easing.

More importantly, even a UK “success” would be hollow. Proportionate auditor liability – along with its companion, monetary liability caps – are both politically unachievable in the US and, in any event, are ineffectual to solve the fundamental problem, namely the crying fragility of the auditors’ financial capacity to answer litigation claims of death-blow magnitude.

The capital structure of the Big Four partners can be calculated to have upper limits on a worst big case of under $2 billion – here. Yet the size of the recent failures that embroil the auditors extend from the Lehman Brothers bankruptcy, where with $635 billion of assets there is an estimated quarter-trillion dollar recovery shortfall, to the ever-shifting $50 or $67 billion involving the feeder funds to now-jailed Bernard Madoff – and lists of other claims, complex to maintain but readily accessible (here). 

With those numbers over-hanging, no reasonable Big Four chief executive could with confidence send a team of trial lawyers into court, with the life of his firm in their hands, but depending for survival on achieving a jury’s fault allocation at a percentage in the low single digits.

So – taking note of the dictionary definition of a chimera as “an impossible or foolish fancy” – the SEC’s entrenched if churlish animosity should inspire the large audit firms to re-deploy the well intentioned but misdirected resources they have devoted to this futile exercise.

For the large firms, “liability caps” is a losing position – whether as skirmish, battle or campaign. Better to select a ground for change on which there is some non-zero possibility for success.  

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Don't Like "Mark to Market"? How About "Mark to Congress"?

With the chaos in Washington over legislation to bail out Wall Street, looking like nothing so much as the stateroom scene in the Marx Brothers’ “Night at the Opera,” it’s remarkable that only now have the poor accountants shown up.

Should politicians be entrusted to write accounting standards? With the Securities and Exchange Commission already leading the way – here -- relief is proposed of the obligation to “mark to market” the toxic waste on institutional balance sheets – the accumulated tranches of subprime mortgages, credit default swaps and other creative derivatives now freezing up the financial markets. 

The idea is that the otherwise imminently sensible Statement 157 of the Financial Accounting Standards Board – and its cognates in Europe, if French President Nicholas Sarkosy and UK Conservative leader David Cameron have their way – would be eased to allow companies to apply their own judgment – such as it may be – in valuing financial holdings that nobody understood or could properly value from the time they were invented and launched into the stream of commerce in the first place.

And why not? The injection of politics into accounting rules has a long and sorry history – from the technology industry’s perfervid opposition to expensing stock options, to Enron’s lobbying for permissive rules on special purpose entities, to the French-led revolt of European banks against the use of “mark to market” rules for derivatives.

So should Congress be trusted to meddle with the intricacies of financial instruments valuation -- in the same way that they railroaded the Sarbanes/Oxley law in the summer of 2002? What they accomplished then, in an exercise in unintended consequences, was to inflict immense cost and disruption on corporate governance, poison the relationships between issuers and auditors, and entrench a bureaucracy at the PCAOB whose principal achievement is its own perpetuation, while – as today's turmoil makes clear -- conspicuously failing to instill corporate virtue by either fiat or paperwork.

Can it be sensible to relieve the holders of locked-up financial instruments of the obligation to confront the reality of their distressed values – when the wreckage extending from Bear Stearns through Merrill and AIG to Washington Mutual and Wachovia is eloquent testimony that the bankers were and remain clueless as to legitimate and reliable valuations? To do so is to perpetuate an environment instinct with hazard, to reduce the already doubtful quality of financial information available to investors, and to foist off to the future the ultimate reckoning in further barrels of red ink.

The rationale that “mark to market” need not be applied so long as the mysterious paper will be held to either maturity or at least a restored and active market suffers two reality checks:

First, this year’s cascade of institutional failures makes questionable any assumption that a particular holder will survive long enough to see its portfolio restored. And second, with the depths of the American recession still unmeasured both in real estate and across the spectrum of household consumption, there is no currently realistic estimate of the ultimate write-offs still to be taken.

All else aside, it’s likely not to work. How can trust and confidence be restored, when financial statement readers will sniff out the bags of garbage still rotting on the balance sheets – whatever their new names or mythified valuations? Reducing rigor and transparency in the name of management judgment leaves the keys to the henhouse in the hands of the foxes.

There is one glaring irony in the “mark to market” discussion – namely the late-arriving opposition of the large accounting firms themselves to the easing of the rules – here. As usual their position is rationally argued and intellectually sound – and as appears usual, they appear to lack both friends and influence.

The accountants have been demonized in the post-Enron era, and have failed to secure relief against the looming risk of catastrophic collapse of their franchise to audit large global companies.

But what they have not grasped is that a shift of accounting standards under the sanction of the Congress amounts to a “Get Out of Jail Free” card – a transfer of responsibility they could never achieve on their own.

For decades the accountants have been pilloried for their accommodation to their clients, in the courts and in the halls of the legislators. A suspension by law-makers of the “mark to market” requirements can no more relieve the consequences of past financial excesses than an attempted repeal of the law of gravity would enable pigs to fly.

But it would allow the accounting firms at last to hand back to the politicians the consequences of their folly.   

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Accounting for Subprime -- Scoring the Scorekeepers

This audit season the skeletons just refuse to stay in the closets. Latest this month, but far from last, are AIG’s $4 billion loss estimate increase and Credit Suisse’s $2.85 billion write-down in its asset-backed securities.

Both examples read directly on a question put by a friend and regular reader -- a business school professor in Paris: “How much of the subprime thing is related to the accounting?”

Not that she needs my help with a lesson outline for her MBA students. But having been a guest in her classroom, I’m happy to offer. If I were teaching her class, I’d get there in three steps:

At the level of human behavior, subprime in its origins was first about the disconnect between incentives and risks: the mortgage originators took their fees immediately, but repackaged and laid off the future stream of payment obligations. Then the bankers, abetted by the ratings agencies, gamed the credit rating system by pushing untestable valuation models onto their credulous customers.

Second, as after-effect, subprime is now about legal responsibility. With the filing of new investor lawsuits back to Enron-era levels (for which, see the helpful running count being kept by the D&O Diary,here ),  the roster of defendants includes not only the banks and mortgage companies, but also the three dominant credit rating agencies and, at last count, three of the Big Four accounting firms.

But third, with the global harm extending from villages in the Norwegian Arctic to counties in rural Florida to bush hamlets in Australia, we should go back to basics: accounting principles and methods for the recording and reporting of transactions are as old and pervasive as trade itself.

As soon as commerce moved beyond one-to-one barter, conventions were required to quantify such inherently judgmental issues as the hazard of re-payment in future periods, the time value of money to change hands at a later time, or the transfer of performance to a third-party.

So viewed, subprime and the credit market turmoil are all about the accounting, and nothing else. Fundamentally flawed assessments were made – whether out of venality or ignorance – about the quantification, timing and transferability of the risks associated with uniquely complex financial derivatives, and the collapse in their values as knowledge and experience eventually caught up.

So the accounting for mortgage-based assets and their off-spring should be seen as a proxy for the reckoning of financial reality in all aspects:

For a family buying its first home with an adjustable-rate mortgage, the expense entry for housing cost changes from rent to mortgage payment. Its balance sheet now has an asset, the house, with the associated mortgage debt as a liability. When a depressed housing market erodes any equity, and the payment escalates beyond the family’s means, the accounting confirms the reality – red ink and foreclosure.

An investment bank that sponsored and sold exotic tranches of financial products now has the task of re-assuming them back onto its balance sheet and marking their value to a collapsing market rather than a discredited black-box model, which means filling the accounting holes. Costly new rescue capital, opportunistically supplied to the likes of Citi and Merrill, Northern Rock and the monoline insurers, may provide a lifeline but dilutes or even destroys the prior shareholders.

As for investors – whether an individual shareholder of the banks or a pension or retirement fund that bought the exotic products – their losses may not yet be realized for accounting purposes, unless they have sold out the positions, but they can plainly feel the real-world loss of wealth, and unsurprisingly are taking advice from the plaintiffs’ lawyers.

As shown already by AIG and Credit Suisse, the accounting challenges pinpointed by the professor are fraught both for the financial institutions and also for any investor who heard the siren song of higher rates and traded off for unknown future risks.

That’s because the more candor and rigor are brought to this year’s audit process, the more stark will be the ultimate concession that the valuation models on which subprime was built were creatures of myth and unreality. And therein lies a ghastly liability implication -- that the well-controlled and smoothly operating systems required under Section 404 of the looming Sarbanes-Oxley law simply weren’t there.

In the end, to wrap up for the good professor’s class, the quality of accounting is an effect, not a cause – the level of its virtue and integrity is observable in a mirror held up to commercial society.

Or as first put in the early 1970’s by cartoonist Walt Kelly’s swamp philosopher, Pogo the possum, “We have met the enemy, and he is us.”