Re:Balance -- Jim Peterson

KPMG's Independence, Herbalife's Stock Price, and the Game of Name Blame

What does this say about the value placed by investors on the independence of outside auditors: 

Two trading days after KPMG withdrew its audit reports on the financial statements of its Los Angeles clients Herbalife and Skechers, because of inside information shared by its promptly sacked and criminally charged engagement partner Scott London, the stock price of both of those stocks has actually risen!

The consequences of London’s passing on, to the million-dollar benefit of his golfing pal Bryan Shaw, will be swift and nasty:

• Ratted out by Shaw, London will cut the fastest plea deal the prosecutors will offer.

• KPMG will hurl its checkbook at every dollar of costs incurred by its ex-clients to obtain replacement auditors.

• Aggressive plaintiffs’ lawyers will fashion some theory of shareholder harm – despite the stock price upticks – doubtless spinning a conspiratorial connection with the long-running spat over Herbalife between raider Carl Icahn and shortseller Bill Ackman, and eventually coercing a nuisance-level settlement.

• And the American securities and accountancy regulators – the SEC and the PCAOB – will vie with each other in a pell-mell rush, recalling the unseemly post-Enron haste with which the Sarbanes-Oxley law was passed in 2002, to push a requirement that auditors of US public companies identify by name their partners signing client audit reports.

This last has been opposed with intensity by the American accounting profession, although long in place in much of the world without measurable adverse effects.   

Nor, it should be noted, with measurable benefits either – as client managements and audit committees in the US have never lacked access to the decision-qualifying information necessary about the engagement personnel at their audit firms.

In the wishful search for magic bullets aimed at the structural weaknesses in the auditor-client business model, “partner naming” is a distinctly small-bore and ineffective weapon. 

But London’s downfall does require re-framing my opening question, this way, heretical as it may seem:

What value to the operation of the capital markets – if any -- is actually delivered by the entire structure of auditor independence? 

London’s professional position was destroyed, and his liberty put in jeopardy, not because he violated the elaborate dictates of the auditor independence rules, but because of his multi-year violations of the insider-trading prohibitions of the American securities laws.

And on the other hand, despite KPMG’s immediate and apologetic resignation and report withdrawals, the stock market has given credence to the assertions that the substantive content of the Herbalife and Skechers financial statements are unaffected (even given the charges hurled in the Icahn/Ackman dust-up).

In short, the indifference of equity investors to the state of KPMG’s independence speaks volumes.

I’ve long been saying (here and here) that – under the “client pays” business model for financial statement assurance, invented back in the Victorian era – the accounting profession has gained nothing positive for years, by way of reputation, stature or risk and exposure mitigation, from the intellectually unsatisfactory edifice of “appearance of independence.”

Now, the stock price non-event of Scott London’s misadventures equally shows the converse – that investors impose no downside price penalty on even a slam-dunk independence violation.

Conclusion: the time, energy and cost of maintaining the outmoded and anachronistic structure of “independence” should be re-directed to the long roster of topics legitimately worthy of the effort.

 

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

Food beyond compare

Food beyond belief

Mix it in a mincer

And pretend it's beef

Kidney of a horse

Liver of a cat

Filling up the sausages

With this and that

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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Happy New Year -- What's On the Accounting and Assurance "Worry List" for 2013?

For the financial information community – issuers, users and gate-keepers -- what looms ahead for 2013? Now that we have survived the end of the Mayan calendar, crawled back from the edge of the year-end fiscal cliff, dodged briefly the threat Greece poses against the Euro, and crowned Alabama as the champions of college football? 

For starters, in a very target-rich environment, three potentially malign influences may be in retreat:

First, on the everlasting postponement of converged international accounting standards, the combination of political antagonism and absence of a sensible rationale desirably signals the end of the endless charade.

IASB chairman Hans Hoogervorst did temper his usual bellicosity at the AICPA’s annual December knees-up with the SEC and the PCAOB – not that his sabre-rattling had ever done the cause any good. The SEC lacks a head cheerleader, being populated these days by lame ducks, ghosts and placeholders – so with newly-designated chief accountant Paul Beswick’s deputy Julie Erhardt the nearest to a champion, the diffidence in her understatement amounted to a punt from the regulatory end zone.

While across the Atlantic (see the always-informative Edith Orenstein for the FEI), the ICAEW in the UK bailed out. Its report, The Future of IFRS, calls for non-adopters with “strong national GAAP” to take their own convergence “option” – an unmistakable message to the US to go its own way.

Second -- if finally game-over for convergence, it’s no less so for mandatory auditor rotation – never more than an unachievable notion in futile search for evidentiary support (here). Reality has taken hold in Europe in a climb-down from proposed six-year rotations and “audit-only” firms, despite a fervid pro-rotation residue unrelieved by the complete lack of factual basis. And an important voice of reason is heard in the US -- PCAOB member Jay Hanson – conceding at the AICPA conference that he “doesn’t know” what a “reliable study … would conclude with respect to audit tenure’s effects on audit failures and deficiencies…” and expressing skepticism “as to whether we would ever be able to make that connection.”

Third – the always-fraught issue of auditor liability remains challenging, if unlikely to be existential.

The manipulators of short-term statistics did nobody a favor by asserting in December that “things have changed” for the better from the post-Enron wave of auditor liability claims – a hostage to fortune disprovable at the time and subject to immediate invalidation (see below).

On the contrary, the Big Four in the UK fell all over themselves to emphasize their litigation exposure, in resisting the Competition Authority’s suggestion of a benign environment. True enough, that official proposition dangles from two illusory hooks – that short-term calm portends a longer-lasting trend, and that the large firms have available insurance remotely adequate against potential claims measured in the billions – neither of which is sustainable.

The real problem is that the large firms have never succeeded in carrying the burden of their message – dating back to 2008 and the embarrassing inability of the US Treasury’s fractious Advisory Committee on the Audit Profession even to agree that life-threatening litigation was an issue.       

In this tangle among the confused, the perplexed and the unpersuasive, three recent items are informative:

First, Ernst & Young’s agreement to pay C$ 117 million to settle civil litigation in Canada relating to its work for the failed Chinese company, Sino-Forest, does not approach the calculable limit of E&Y’s financial tolerance. But it is amply big enough to exceed either E&Y’s local Canadian resources or its global-scale nuisance value. And an upward re-set of the liability record in any developed economy cannot bode well in the hands of aspirational plaintiffs’ lawyers.

Second, the slow-moving litigation machinery in Iceland has ground out not only prosecutions and now jail sentences for senior members of its renegade banking sector, but also new claims against PwC in both Iceland and the UK, on the non-trivial order of $ 490 million, relating to its audits of Landsbanki, added to a prior claim for $ 2 billion over its work for Glitnir Bank, commenced against the firm in the US in 2010 and re-started in Iceland in 2012 (here).

Third, the HP-Autonomy fiasco in the UK saddles the Deloitte firm with years of runaway defense costs and disruptive diversion of senior management. Even if Autonomy CEO Mike Lynch’s robust defense of his company’s accounting proves entirely vaporous, however, or substance emerges in the announced investigation by the US Justice Department, Deloitte’s exposure is wrapped in several layers of insulation:

• The reluctance of the UK system to impose death-threat damages.
• HP’s reluctance to proceed adversely against its own alliance partner.
• The high threshold facing HP shareholders attempting to sue Deloittte derivatively in the company’s name.
• And the hostility of American courts to claims having a foreign nexus and one step removed from HP’s own financial reporting.

Auditor regulators in the United Kingdom not having a record of aggression, timeliness or ferocity, the Autonomy debacle is unlikely to tar Deloitte, either at all or at least within a time span occupied by anyone currently in positions of authority or responsibility.

So much for what may pass as good news. There’s a good deal more of concern, in this new year – but not today – so please watch this space.

 

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Foreign Auditor Inspections? "China Syndrome" Strikes the SEC

 

Confidence in the American securities and accountancy regulators was not raised, w

hen a press release on December 3 announced -- under the headline “SEC Charges China Affiliates of Big Four Accounting Firms …In Refusing to Produce Documents” – a proceeding against the five largest global networks.

For the first time in its eleven-year history, this column calls upon a graphic to illustrate the folly of a gang that couldn’t count straight:

 

   The PCAOB has been stymied for a decade in its futile attempts to enforce in China its asserted mandate under Sarbanes/Oxley to inspect and obtain working papers from auditors, including those in foreign countries, which audit more than twenty percent of a registrant’s assets or revenue (here). And the SEC itself has been piddling along with company-specific subpoena enforcement and administrative proceedings against Deloitte and its Shanghai affiliate.

So now they have called in the heavy artillery, in the person of Robert Khuzami, director of the SEC’s Division of Enforcement, who says that non-complying firms “face serious sanctions.”

Khuzami cannot be faulted for zealotry. He arrived on the scene of an agency whose Cox-era somnolence had missed not only Bernie Madoff’s predations on the domestic front but the internationally destructive tsunami of “reverse mergers” by which Chinese companies gained access to the world’s capital markets. That scorecard, a decade late and billions short, now includes more than 50 de-listings by the SEC and 40 fraud actions – and, elsewhere, a flurry of civil litigations, and most recently an agreement by Ernst & Young to settle civil litigation (but not a disciplinary proceeding) relating to Sino-Forest, by agreeing to pay C$ 117 million, the largest auditor settlement in Canadian history.  

(As an aside, those disposed to see darkly conspiratorial revolving doors in the place of Chinese fire drills will note that this is the same Khuzami whose predecessor at SEC Enforcement from 1998 to 2001, Richard Walker, thereafter went in-house at Deutsche Bank, where he hired Khuzami in 2002. So the latter, before becoming the top American securities cop in 2009, was on-scene at DB when the bank – as now reported – according to three whistle-blowers concealed losses of up to $ 12 billion for failure to “mark-to-market” the exposure gap on a notional $ 130 billion of exotic derivatives known as “leveraged super-seniors.”)  

Calling in Khuzami’s troops may look like the last act of desperate regulators – but it will actually play as the next act in “The Comedy of Errors.”

That’s not because it’s so little so late. Or because frustration of the PCAOB’s aspirations to access Chinese auditors and work papers would attract retaliation against their own ambitious plans to re-structure the global audit market by building and unleashing global-scale Chinese audit firms – an ambition otherwise unachievable both for want of competence in personnel and standards but also because, in reciprocal hostility, other countries will be no less protective of their local prerogatives.

It’s mainly that the US regulators’ only weapon of significance – banning Chinese affiliates of the large global accounting networks from qualifying to work on audits of American-listed companies – would ripple far beyond the toxic roster of China-based companies.

There are potential consequences for global-scale companies with significant operations in China that go far beyond the inability of the PCAOB to inspect their local audit firms, whether or not maneuvered to keep below the 20% threshold.

Consider just two examples: Caterpillar, whose annual filing with the SEC does not set forth results by geography but discloses total 2011 sales of over $ 60 billion and elsewhere reports its China sales to be 3% of its total. Or HSBC, which does report by region including $ 3.6 billion in profits from China in 2011 and whose mainland Chinese operations include 133 outlets including 27 branches, even after the announced sale of its interest in giant insurer Ping An.

A barrier to the use of Chinese audit firms would make it impossible for those companies to include audited results from their Chinese operations in their global accounts. The result would be top-level consolidated financial statements with a huge unaudited portion, and auditors forced in their opinions to confront the professional standards for limitations on their audit scope.

Across the globe from KPMG in London and its top-level opinion on HSBC, to PwC in Peoria, Illinois for Caterpillar – unable to rely on their excommunicated Asian brethren – auditors would have no choice but to use the dread “qualify or disclaim” language -- never seen for a public company because anathema under the rules of the SEC itself.

Or, in extremis, PCAOB de-registration of the whole of an audit network deemed non-compliant would render a company’s entire financial filing unacceptable.

Restoration of adult-level expectations and the pursuit of a non-litigated resolution process is essential, although a fading hope – since calling in the police as a last resort means an escalation of hostilities due to the one-dimensional DNA of their approach to problem-solving.

For good reason, then – under the latest blows from SEC Enforcement – the large accounting firms must feel like a bunch of nails in a hammer-testing factory.  

 

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Re-Posting: Foreign Auditor Inspections? "China Syndrome" Strikes the SEC

Confidence in the American securities and accountancy regulators was not raised, when a press release on December 3 announced -- under the headline “SEC Charges China Affiliates of Big Four Accounting Firms …In Refusing to Produce Documents” – a proceeding against the five largest global networks.

For the first time in its eleven-year history, this column calls upon a graphic to illustrate the folly of a gang that couldn’t count straight -- here.

The PCAOB has been stymied for a decade in its futile attempts to enforce in China its asserted mandate under Sarbanes/Oxley to inspect and obtain working papers from auditors, including those in foreign countries, which audit more than twenty percent of a registrant’s assets or revenue (here and here). And the SEC itself has been piddling along with company-specific subpoena enforcement and administrative proceedings against Deloitte and its Shanghai affiliate.

So now they have called in the heavy artillery, in the person of Robert Khuzami, director of the SEC’s Division of Enforcement, who says that non-complying firms “face serious sanctions.”

Khuzami cannot be faulted for zealotry. He arrived on the scene of an agency whose Cox-era somnolence had missed not only Bernie Madoff’s predations on the domestic front but the internationally destructive tsunami of “reverse mergers” by which Chinese companies gained access to the world’s capital markets. That scorecard, a decade late and billions short, now includes more than 50 de-listings by the SEC and 40 fraud actions – and, elsewhere, a flurry of civil litigations, and most recently an agreement by Ernst & Young to settle civil litigation (but not a disciplinary proceeding) relating to Sino-Forest, by agreeing to pay C$ 117 million, the largest auditor settlement in Canadian history.

(As an aside, those disposed to see darkly conspiratorial revolving doors in the place of Chinese fire drills will note that this is the same Khuzami whose predecessor at SEC Enforcement from 1998 to 2001, Richard Walker, thereafter went in-house at Deutsche Bank, where he hired Khuzami in 2002. So the latter, before becoming the top American securities cop in 2009, was on-scene at DB when the bank – as now reported – according to three whistle-blowers concealed losses of up to $ 12 billion for failure to “mark-to-market” the exposure gap on a notional $ 130 billion of exotic derivatives known as “leveraged super-seniors.”)

Calling in Khuzami’s troops may look like the last act of desperate regulators – but it will actually play as the next act in “The Comedy of Errors.”

That’s not because it’s so little so late. Or because frustration of the PCAOB’s aspirations to access Chinese auditors and work papers would attract retaliation against their own ambitious plans to re-structure the global audit market by building and unleashing global-scale Chinese audit firms – an ambition otherwise unachievable both for want of competence in personnel and standards but also because, in reciprocal hostility, other countries will be no less protective of their local prerogatives.

It’s mainly that the US regulators’ only weapon of significance – banning Chinese affiliates of the large global accounting networks from qualifying to work on audits of American-listed companies – would ripple far beyond the toxic roster of China-based companies. There are potential consequences for global-scale companies with significant operations in China that go far beyond the inability of the PCAOB to inspect their local audit firms, whether or not maneuvered to keep below the 20% threshold.

Consider just two examples: Caterpillar, whose annual filing with the SEC does not set forth results by geography but discloses total 2011 sales of over $ 60 billion and elsewhere reports its China sales to be 3% of its total. Or HSBC, which does report by region including $ 3.6 billion in profits from China in 2011 and whose mainland Chinese operations include 133 outlets including 27 branches, even after the announced sale of its interest in giant insurer Ping An.

A barrier to the use of Chinese audit firms would make it impossible for those companies to include audited results from their Chinese operations in their global accounts. The result would be top-level consolidated financial statements with a huge unaudited portion, and auditors forced in their opinions to confront the professional standards for limitations on their audit scope.

Across the globe from KPMG in London and its top-level opinion on HSBC, to PwC in Peoria, Illinois for Caterpillar – unable to rely on their excommunicated Asian brethren – auditors would have no choice but to use the dread “qualify or disclaim” language -- never seen for a public company because anathema under the rules of the SEC itself. Or, in extremis, PCAOB de-registration of the whole of an audit network deemed non-compliant would render a company’s entire financial filing unacceptable.

Restoration of adult-level expectations and the pursuit of a non-litigated resolution process is essential, although a fading hope – since calling in the police as a last resort means an escalation of hostilities due to the one-dimensional DNA of their approach to problem-solving.

For good reason, then – under the latest blows from SEC Enforcement – the large accounting firms must feel like a bunch of nails in a hammer-testing factory.

 

My apologies for the re-posting, especially to subscription readers to whom the intended video clip did not feed -- a lesson learned in attempting to reach beyond competence with technology.

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The Pre-Election Mood: Enervation Over Innovation

 I awoke last night in the cold sweat of nightmare terror – my own version of Bill Murray in the 1993 film, “Groundhog Day”-- that CNN moderator Candy Crowley saw her shadow, and we were cursed with six more weeks of Presidential debates.

And PCAOB chairman Jim Doty kept scheduling “public meetings” on the exhausted topic of mandatory auditor rotation – the last in Houston having dragged through October 18 with no observable contribution to our wisdom – until he held one in the junior high school gym in Punxsutawney itself.

A tour of media, commentators, and those knowledgeable, confirms the prevailing sense of lassitude and ennui – owing much to the nationwide American paralysis ahead of its November 6 elections, but also to the absence of any credible display of energy, much less urgency, around the issues overhanging the accounting profession.

The usual crabbing continues, of course – ranging from the ineffective if age-old grousing about auditor skepticism -- vented by the PCAOB chair himself, webinars from the private sector, and such bloggers as the Grumpy Old Accountants – to the commenter on my last posting, about the British regulator’s new policy on re-tendering, stating mistakenly that I “ask for ‘proof’ that lack of auditor rotation is a cause of fraud,” when I want no such impossible thing, but only recognition, as I have often said (see here) of the absence of “any evidence of a link between auditor tenure and audit quality.”

In the gathering gloom and darkness of late autumn, then:

Nothing good can be expected from the Securities and Exchange Commission in Washington, where Chairman Mary Schapiro is said to be packing for her post-election departure, having in her light-touch tenure realized nothing of effect on the structure or stability of the assurance function. 

On the globalization of accounting standards, the dialog is if anything more sterile than ever: The SEC has only an interim chief accountant in place; the griping about non-convergence includes the hand-wringing of IASB trustee chairman Michel Prada and the sideline irrelevancies of AICPA president Barry Melancon; while FASB chair Leslie Seidman should be plainly tired of the censorious Dutch-uncle utterances of her counterpart at the IASB, chairman and non-accountant Hans Hoogervorst.  

While on the auditing standards side, the intellectual heft brought by the International Auditing and Assurance Standards Board to its project on Improving the Auditor’s Report is unmatched by the political skills or horse-power necessary for action in the face of entrenched resistance. At the same time, the PCAOB’s parallel Concept Release, going back to June 2011 – which by rights should be cooperative and complementary – wallows becalmed for lack of any readiness to re-engineer a reporting system in which all interested parties are invested in preserving the status quo.

Even what should be a bright spot – the launch earlier this month by seven joint sponsors of an assessment tool for audit committees, “Annual Evaluation of the External Auditor” – designed to support “an informed recommendation to the respective board of directors whether to retain the auditor,” has the taste of very thin gruel.

That is, it says precious little about the skill level of an audit committee, to think it requires such an anodyne checklist as these “get-to-‘yes’” examples: 

• “Was the cost of the audit reasonable and sufficient for the size, complexity and risks of the company?”

• “Was the audit engagement partner able to explain accounting and auditing issues in an understandable manner?”

Enough with the softball treatment. For a committee obliged to justify itself, why are there not such substantial questions as:

• “What qualifications and training does the audit committee itself have in the exercise of skepticism and the avoidance of bias?"

• “If forced to rotate or re-tender the audit, does the company have a realistic alternative choice?” 

• “What other or different forms of assurance, beyond the current standard audit report, would company management and its community of information users find useful and valuable?”

Historians of the evolution of knowledge teach that systems on the cusp of obsolescence – inherently resistant to the disruptions of fundamental change – evolve only when those contributing to the prevailing inertia are forced into confrontation. 

But that when they are, the realignments are highly disruptive, in ways unpredictable in advance.

Meaning that the groundhog’s looming shadow is long, dark and ominous.

 

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

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

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

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

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

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

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

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

As I put it in April 2011:

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

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

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

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

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

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

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

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

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

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

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

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

 

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---

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

Mandatory Auditor Rotation: Will What Goes Around Come Around?

 Could there be a plausible explanation why James Doty, chairman of the Public Company Accounting Oversight Board, would promote such a protracted timetable for decision on the notion of mandatory auditor rotation?

It’s been a mystery, ever since the PCAOB’s August 16, 2011 concept release revived this much-discussed and long-discredited idea. Nor was any clarity brought to Doty’s thinking by the parade of 47 witnesses during the two days of hearings on March 21-22.

The comment deadline has been extended, following receipt of a record number of letters, 95% negative, and Doty has announced a travelling road show of further hearings.

One of my good sources, versed in the ways of Washington agency politics, offered as a rationale for Doty’s stalling efforts the growing list of smaller-county regulators who are stumbling toward mandatory rotation.

Why would Doty get behind this array? I’d be reluctant to buy the hypothesis that by postponing long enough, he could claim to fall into line behind an artificially-created “consensus” – which would look less like global leadership from a US regulator than weak-spined passivity.

But consider the hedge in Doty’s reticence – it being likely that the collective short-term experience will collapse in misguided impracticality.

Here is the country list, with their varying and mutually inconsistent deadlines:

• Italy – and its nine-year rotation schedule, despite scholarly criticism and even after the 2003 debacle at Parmalat.

• South Korea – rotation after seven years, under rules in place since 2006, although the academic research concludes that “mandatory auditor rotation increases the cost for audit firms and clients while having no discernible positive effect on audit quality.”

• Brazil – five years, extendible to ten for companies that establish credibly functioning audit committees (here).

• Netherlands – and a newly-imposed eight-year schedule (here).

• India – under the new Companies Bill of 2011, rotation will be imposed after five years for individual practitioners and ten years for audit firms (here and here).

Plus the increasing possibility that instead of requiring rotation, the UK will go instead to either audit engagement re-tendering or “comply and explain” for extended auditor tenure (here). 

Taken together, the aggregate GDP of the countries involved approaches that of the United States itself.[1] But such measures would understate the impact of a disparate set of rotation timetables.

That’s because large players in whole industries would have operations in all the affected countries – e.g., the petroleum majors, the large auto and truck manufacturers, the global airlines, and the big banks.

Picture the next decade of rotation-driven challenges to audit committees and chief financial officers – obliged to engage new firms of auditors, from outside the network of their main firm, for significant country-level audits on six or seven different and irreconcilable cycles and deadlines.

Administration of the very basics of engagement performance would be horrifically complex – deployment of replacement firms nearly every year, each with its own culture, personnel and methodology, and the upstreaming of country-level results for global consolidation. And that’s without a thought for the impossibility of achieving uniform standards of quality and execution.

A comparison worth noting is the annual task faced by American major-league baseball, to deploy four-man crews of umpires across a season of 162 games played by thirty teams. That data-management challenge for the “national pastime” has been addressed in recent years by ground-breaking innovations from a university professor specializing in complex scheduling software (here).

For baseball, there are said to be “a host of constraints such as union-mandated vacations and league rules that regulate, for example, coast-to-coast travel and potential overexposure to individual teams.”

Child’s play, by comparison. Putting teams in the field to call balls-and-strikes in the global audit market makes baseball’s difficulty look like Little League.

It could be inferred from the PCAOB’s March hearings that Doty lacks the votes for rotation. So enough frustration and implementation difficulties in foreign jurisdictions would provide him with political cover under which to retreat.

And well he should – but right now, on a well-formed record, and without further delay. 

Mandatory auditor rotation is an unambiguously bad idea, unsupported by any evidence of a link between auditor tenure and audit quality. As the growing list of local rotation obligations will soon make clear, it will prove unmanageable for complex global companies.

More important issues confront the issuers and users of financial information – such as the basic content and value of corporate and auditor communications to users, under scrutiny by both the PCAOB and the IAASB. The energy devoted to the misbegotten effort on rotation would be better used elsewhere.

 

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[1] Data from the International Monetary Fund indicate a global total of $ 78.9 trillion, with the US accounting for $ 15.1 trillion. The five countries add to $ 10.88 trillion, to which the UK would add $ 2.23 trillion.

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

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

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

Here’s why: It just doesn’t matter.

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

There are three reasons:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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Mandatory Auditor Rotation -- The Financial Times Stumbles Onto the Carousel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

Three examples:

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

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

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

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

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

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

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

“An object all sublime

“They shall achieve in time --

“To let the punishment fit the crime.”

  

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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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Whence The Next Fresh Accounting Scandal? The Ominous Threat of A Shoe That's Yet to Drop

There’s a folk tale’s moral about the aggressive bird, who filches a whole length of sausage from the butcher’s market stall, eats his larcenous fill, and celebrates by singing from the treetops at full voice – only to be spotted and shot for a hunter’s dinner:

    When you’re full of bologna, keep your mouth shut!

Or as attributed to Voltaire, with rather more gentility – “better to keep silent and be thought a fool, than speak up and remove all doubt.”

As calendar-year American public companies face their deadlines for annual filings with the Securities and Exchange Commission, there are benefits to a blogger’s ability to keep quiet – a comfort compared with my prior writing life under the regularity of a newspaper deadline – especially in resisting the siren call to publish for the sole sake of reader traffic above all else.

But even for want of a compelling subject, fingers get itchy at the keyboard. Something feels ominous in the world of financial scandal and accountancy distress. It’s just been too quiet out there.

It could simply be impatience with officialdom’s combination of lassitude, inattention and inertia:

• Michel Barnier’s EU-level initiative of a green paper consultation on the fragile state of the global audit franchise has come out as the predictably damp non-event (here).

• America’s Dodd-Frank legislation addressed not a word to the obsolescence of the entire financial reporting and assurance model.

• Regulators have walked on tip-toes around the implications of issues from the degraded state of Citibank’s internal controls (here) to the Bank of England’s body language that enabled clean audit reports on the UK banks (here).[1]

• And the re-cycled trio of new members at the PCAOB, with old SEC hand Jim Doty in the chair, has offered only more of the same likely inaction that has characterized the torpor of its first nine years (here).

Not for nothing do major financial scandals emerge around the time of full-year information release. Investors’ expectations are whetted. Ponzi schemes escalate toward their inevitable explosion. And those pesky auditors are poking and prodding in dark and unwelcome corners.

Think back: Parmalat broke in December 2004; the rogue trading at Société Générale came out in January 2008; Bernie Madoff was exposed in December 2008; the CEO’s letter of confession in Satyam was delivered in January 2009; and January 2010 unveiled the looting via Amex card at Koss.

There are ample examples validating the risks concealed in the calm before the storm: the crime-solving deduction by Sherlock Holmes from the dog that didn’t bark, the siege guns’ silence just before the invasion, the receding waters before the tsunami, the movie cliché when the hero’s B-list sidekick whispers in terror that the native drums have suddenly stopped.  

The looming sound of silence is not always a signal. Sometimes the other shoe never does fall. An extended period of quiet does not mean that an outbreak must occur. But that is not ground for comfort or complacency either – it’s a flawed and mistaken inference that because the scandal level has been muted, it won’t erupt.

Somewhere out there, instinct cries, fresh new trouble is brewing.

 

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[1] Those with an appetite for satiric musical comedy are invited to imagine the UK’s House of Lords committee or the commissioners of the SEC as part of this chorus of hapless and ill-equipped pirates in Gilbert & Sullivan’s classic.