Re:Balance -- Jim Peterson

EY's Collapsed Split Attempt -- Questions for the Audit Model

The collapse of Project Everest, the doomed attempt by accounting giant EY to split its consulting and audit practices, leaves a landscape like a medieval battle-field -– strewn with casualties and be-set by looters.

The mood is dour –- a retired partner sees “a lot of animosity within the firm,” and an academic says that “short-term turmoil and leadership changes are probably going to happen.” Job cuts were announced for the local firms in the US and the UK.

Uneasy lie the heads that wear the crowns: Carmine Di Sibio, EY's global chief executive; UK managing partner Hywel Ball; their principal antagonist Julie Boland in the US. The tenures of EY’s leadership are in the balance, along with the cohesion of the network and its $ 45 billion of 2022 revenue.

Renewed questions are now aimed at the fitness of the Big Audit model -- see Bloomberg, the Financial Times, and The Economist. As reporters Amanda Iacone and Michael Rapaport put it (all emphasis added):

“Experts say some problems are baked into the very way audits are structured, and that the system actually provides incentives for auditors not to do a tough audit. It’s hard to change that without scrapping the whole system and starting from scratch.”

That view is not shared by the participants. The compensation packages of the partners are linked by golden chains to the unexamined verity of an outmoded product from the Victorian era. That they might willingly imagine a different world would be unthinkable.

Except that it’s not. The depth of EY’s wounding is yet to be felt, with the potential loss of clients, practice stagnation, and the poaching and flight of disaffected personnel. “Expedited hiring discussions” are initiated by opportunistic competitors, and at least two life-threatening litigations are looming –- NMC in the UK and Wirecard in Germany.

It is well to remember that kernels of supposedly eternal truth are ground to dust in the mills of the gods:

• Galileo’s 17^th century inquisitors were piously confident that heliocentrism was divinely condemned.

• “If God had meant man to fly, He’d have given him wings.”

• “I think there’s a world market for maybe five computers,” said IBM Chairman Thomas Watson in 1943.

Irony not being a Bloomberg characteristic, its writers’ question deserves serious and expanded treatment:

“Does the current way of doing things need to be scrapped and rebuilt from scratch, then?”

“What if” the disintegration or collapse of EY? And the unavoidable consequence: an unsustainable Big Three model that would make unavailable, at any price, audit reports for the world’s large companies.

Vexing issues gathered by Bloomberg confront the accountants, with hands wrung in angst and frustration –- here summarily re-cast as “the latest flare-ups of a rolling, seemingly intractable series of crises over audit quality, the role of consulting, and auditors’ integrity”:

• The firms pronounce that audit "is at the heart of the DNA of these firms…They all take very seriously their public interest role…”, and regulators assert that “We’re confident that audit quality has improved, at least at the biggest firms” –- despite persistent outbreaks that at minimum suggest the contrary.

• “The firms, their critics, and their regulators have tried for 25 years to solve the industry’s recurring problems -– but while some observers say audit quality has improved by some measures, failed audits and corporate collapses haven’t stopped.”

• “All of the Big Four firms have had significant audit blowups in recent years” -– see the current attention to KPMG as auditor for the “three-fer” of recently failed American banks SVB, Signature and First Republic.

• “(A)uditors maintain that they actually aren’t responsible for doing as much as investors think they are –- something the auditors call the ‘expectations gap’.”

• “Even as rulemakers contemplate setting high bars for auditors, regulatory enforcement of those rules historically has resulted in penalties that amount to a slap on the wrist…”.

• “In theory, an EY split could help alleviate conflict-of-interest concerns, but … a break-up could hamper EY auditors’ access to expertise, specialists, and technology from the firm’s consulting side.”

• Quoting a plaintiffs’ lawyer, “I don’t think anyone believes what the auditors say anymore…They don’t see any risk to being wrong or to not uncovering something, where there is a risk to uncovering something.”

Hypothesizing a failed EY and a future in which the traditional opinion is no longer obtainable -- resolution of all the above issues is available in that future:

Assurance providers would be freed from their shackled role as “statutory auditors” and enabled to provide targeted, bespoke assurance, extending to all or portions of company information, both financial and as to Sustainability.

The over-hang of death-threat litigation would lose its significance. The “expectations gap” would be closed, as opinions would be delivered under contracts defining third-party reliance and caps and limits on liability.

Firms freed to offer a full range of assurance would hire the equally broad range of required talent and expertise. Career paths would open up. Limitations of auditor independence and constraints on scope of service would have fallen obsolete.

Comprehensive global presence and scale no longer being essential, new providers could offer niche services under new structures and capitalized by new sources –- superseding current concerns for limited competition and range of choice.

Rather than answer to the narrow prescriptions of the regulators, disclosures and assurance would be testable and evaluated in the capital markets.

• Anticipating the anxiety of the bureaucrats, however, nothing in this brave new world would eliminate either issuer responsibility for appropriately defined disclosures to investors or suitable oversight of assurance providers.

No prediction, when or whether a Big Four network might collapse like Arthur Andersen in 2002. But it would be reckless to believe that it cannot or will not happen. 

That possible future, however, should not be so scary as to self-censor an exercise in scrutiny that needs be both thorough and candid. 

 

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Silicon Valley Bank -- When a "Standard" is not a Standard

Guest-posted on April 19, with pleasure, on Francine McKenna's sub-stack, The Dig:

KPMG, auditor for failed Silicon Valley Bank, has been included as a defendant in a securities fraud case filed April 7 in the federal court in San Francisco — along with directors and officers of the bank and its underwriters Goldman Sachs, Bank of America and Morgan Stanley.

It won’t be the last. SVB failed back on March 10, and the only surprise is that it took so long.  

KPMG’s clean audit opinion on SVB’s 2022 financial statements was delivered February 24, three weeks before the bank’s closure by the California Department of Financial Protection and its takeover by the FDIC as receiver. The firm and the other defendants are charged with misrepresenting SVB’s balance sheet, liquidity and position in the market and by understating and concealing the magnitude of the risks it faced.

The plaintiffs, led by the City of Hialeah Employees Retirement System, claim that auditor KPMG did not qualify its opinion for doubts as to the bank’s ability to continue as a going concern, and did not identify as a “critical audit matter” the impact that rising interest rates could have on the unrealized losses on the bank’s bond holdings and its ability to hold those bonds through what was the potential, and eventually destructive, flight of customer deposits.  

If it feels like a somewhat geeky sequel to a movie we’ve all seen before, it should.

The comparison has long been available that — just as professors of literature teach that there are a small number of great plots that have been revised and recycled through the history of Western culture — so too the inevitable periodic outbursts of financial malfeasance come in cycles with a handful of recurring themes.

A partial list of examples — paired up so that by squinting and some flexibility, parallels may be drawn:

A hero comes to save the people from a monstrous threat: David v. Goliath, Rashomon and The Magnificent Seven, Jaws, Blazing Saddles 

Schemers loot the savings of the credulous: Charles Ponzi, Bernie Madoff, Elizabeth Holmes, Sam Bankman-Fried

The comic effects of mistaken identities: Plautus’s Menaechmi, Shakespeare’s Comedy of Errors, Oscar Wilde’s The Importance of Being Ernest 

Assurance providers fail to properly “count the stuff”: The mis-weighed beans in the 1920s, Tino DeAngelis’s fictive tanks of vegetable oil in the 1960s, the € 1.9 billion found in 2020 not to exist at Wirecard

Inter-generational conflict: The House of Atreus in both Greek myth and the plays of Aeschylus, Shakespeare’s Henriad and also King Lear and his fractious daughters, Coppola’s Godfather trilogy, today’s Succession

Accounting principles tortured into misapplication: the netting of accounts at Continental Vending, the Arctic oil leases held by Investors Overseas Services, the special-purpose entities at Enron, the long-term contracts at Carillion

Over the centuries, the rocky course of young love: Hero and Leander, Romeo and Juliet, the romantic mis-adventures of Emily in Paris

The devastating effect of mis-matched interest rates in the strategies of financial institutions, going back to the American savings & loans of the 1980s and the sub-prime mortgage portfolios of 2007-2008, and now erupted at, among others, KPMG clients SVB and Signature Bank

It is, of course, no less predictable that fresh outbursts of financial chicanery will re-trigger the usual reactions, just as authors, playwrights and scriptwriters will reprise the classic themes:

• Hand-wringing accompanies the cry, repetitive but hollow, “Where were the auditors?”
• Regulators and oversight agencies spring into action.
• Lawyers for investors sprint to the courthouse, lawsuits in hand.
• Academics and other commentators get attention from the business media, while jostling to be engaged by plaintiffs as well-paid “experts.” 
• Renewed rounds of recrimination, blame-mongering and futile attempts to alter human behavior capture public attention but only briefly and with minimal effect.

If this sounds like a tragicomedy, it’s not as if we haven’t seen this show before. Rather, if the implications of “same old, same old” are so obvious, why haven't we learned from the past?

One place to look for an answer is the hindsight perspective of the critics. Pinning it on the expectation of a “going concern” warning is futile. Good guidance for practitioners has been an intractably elusive challenge for standard-setters for decades. Such an opinion qualification is a “nuclear option” that auditors are passionate to avoid because the company may immediately be in breach of loan covenants. Or worse, for lack of a plan to recover, the qualified opinion becomes a self-fulfilling prophecy.

As for CAMs —and their analogs elsewhere in the world where “key” is substituted, thus KAMs — their availability and use have been gradually creeping into practice since introduced via the International Auditing Standards in 2016 and imposed by PCAOB requirements with application starting in 2019.

Wider use, however, has not made C[K]AMs more illuminating, reliable or demonstrably useful to information users. The limited available scholarship on their ability to signal future issues is no better than mixed, since there's no good research proving up the questionable hypothesis that investors actually pay attention to CAMs or make real-world decisions based on their inclusion in corporate disclosures. And there is at least anecdotal evidence that, in fact, they do not. That includes instances where fresh inclusion of a CAM or KAM was met with the typical indifference of investors and negligible effect on the reporting company’s share price. 

Reporting in the Wall Street Journal is provocative with regard to the prospects for the SVB litigation, and whether it will be persuasively argued that KPMG’s professional judgments deviated so far from acceptable practices as to sustain a successful claim for the plaintiffs.

WSJ reporter Jean Eaglesham writes that, on the one hand (emphasis added):

“Auditors for nine other U.S. banks most exposed to bond losses also didn’t flag this as an issue…"

“The Journal reviewed the audit opinions for the 10 small to midsize U.S. banks that last year reported the highest losses on held-to-maturity securities as a proportion of their shareholder equity… Silicon Valley Bank ranked second on the list."

“None of the auditors included a critical audit matter related to the bank’s treatment of the bonds. Instead, nine of the 10 reported a critical audit matter for estimated losses from loans or other bad debts.”

And, on the other hand:

“Silicon Valley Bank’s unrealized losses in its bond portfolio appear to ‘meet every definition of a possible critical audit matter,’ said Martin Baumann, a former chief auditor at the PCAOB who had a leading role in designing the new measure.”

And further:

“That appears to tick all the boxes for the auditor to highlight this issue as a critical audit matter. ‘The judgment as to whether or not Silicon Valley Bank had the ability to hold these securities to maturity was certainly a complex question, it was material to investors, and it is hard to see how liquidity was not a matter for discussion with the audit committee,’ said Mr. Baumann, who is also a former senior partner at Big Four audit firm PricewaterhouseCoopers.”

In a world where standards are well-designed and dependably applied, and where liability is imposed in a way that can be perceived as both predictable and fair, the two positions — disclosure decisions of the various auditors for group of small banks, and the attribution of liability to KPMG — cannot be reconciled. They cannot credibly co-exist.

That is, after years of disrespect for the audit profession’s attempts to improve the discipline in their processes, the distasteful choice is between elevating “box ticking” by hindsight to the status of a threshold for liability (insert sarcasm emoji here), or finding that the bar for liability has sunk so low that it requires a serious evaluation and re-set.   

That's not to say, at this point at least, that KPMG’s audit performance will be assessed as above reproach. We shall see as the litigation runs its course.

But in that context, it bears noting that back in a happier era before the hijacking of audit standard-setting by regulators under the pernicious influence of the Sarbanes/Oxley law of 2002, the term “generally accepted” had its literal meaning. That is, actual application of standards was observed in practice, tested for usefulness and practicality, and adjusted incrementally; opportunities for evolution and improvements could be taken without the querulous intrusion of censorious bureaucrats.

All changed, and not for the better. If the harshest allegations now brought forward are based on KPMG’s good-faith judgments to omit either a CAM or a going concern opinion paragraph, then — to borrow a metaphor from the world of the theater in that nostalgic time — the plot is so thin that this production should close in out-of-town previews.

 

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Demise of EY's Project Everest Stems From Self-Inflicted Wound

No one should be surprised at the canceled split of EY’s audit and consulting practices following a confrontation between the firm’s global and US leaders. But a post-mortem period of recriminations, blame-mongering, and blood-letting is inevitable.

That's the lede of my guest post today on the home page of Bloomberg Tax, with thanks for the opportunity:

Carmine Di Sibio’s mountain has fallen to a pile of rubble.

The aspiration of EY’s global leader to separate the Big Four firm’s audit and consulting practices under the grandiose title of Project Everest was announced on April 11 to have failed. A post-mortem period of recriminations, blame-mongering, and blood-letting is inevitable.

No one should be surprised. Two weeks of silence on the resistance of EY’s crucial US firm after the late-March confrontation between Di Sibio and US leader Julie Boland spoke to the deal’s imperiled state. Project Everest’s trajectory went from a strategic imperative to re-engineer Big Audit to an abrupt collapse labeled “chaos” by EY’s own partners that will feature as a case study in business school curricula.

Preliminary conclusions are already available. The memorandum of capitulation by EY’s global executive team, which dangled the notion of a future revival, listed the requirements: “to adapt our governance, operating model, cost structures, capital investments, and go-to-market approach.” It didn’t acknowledge that each of these was identifiably inadequate when Everest was announced.

Looking back on the face-off between Di Sibio and Boland, the Americans’ stated concern was the allocation of EY’s tax practitioners—between a new consulting practice with its planned public listing and cascades of financial benefits, and the legacy audit firm staying behind in a traditional partnership structure.

There’s much more. The echoes of surrender were still reverberating on April 12, when Boland announced a US strategy and cost-saving program. It’s a complex aspiration on its own and clearly a card she held closely in the weeks of wrangling with Di Sibio.

Going forward, Di Sibio’s credibility must be fatally wounded despite global messages; Boland will be non grata among large and disappointed portions of EY’s various partnerships. But she has the US firm tagging $500 million in savings—a handy bucket she can claim by dropping the foregone costs of canceled recruits and staff defections.

Inside EY, there’s some sympathy. It’s to be hoped that the consultants anticipating multimillion-dollar IPO windfalls were restrained in their eager down payments on vacation homes, bigger boats, and fancier cars. Meanwhile, poaching will advance. Individual partners will test the waters to affirm the handsome valuations they’d been led to believe they represented. Some, at least, will be met with open arms.

And where now, for the contours of global Big Audit? Although EY posited that its practice separation would be a “road map for reshaping the profession,” and urged that it would “inevitably be copied” by its brethren, Di Sibio might regret the move.

Early reactions from other large firms ranged from quiet skepticism to downright disdain in an in-house video from Deloitte’s global leader, Joe Ucuzoglu. To say they’re having a moment likely understates the muted snickering behind closed doors. In Australia, KPMG’s leader Andrew Yates was quoted that “the deal’s collapse showed that clients still wanted a one-stop shop.” To the same effect, Deloitte’s Adam Powick said “we have been unwavering in our commitment to our multi-disciplinary and private partnership model.”

Advocates for the large firms’ retention of the ancillary expertise necessary to carry out global-scale audits—tax and appraisal, and evaluation and crypto and cybersecurity--may not have won an outright battle. But those arguing that an “audit only” firm can hire or outsource those necessary resources are now disarmed.

Most important, the anticipated stream of defections hopefully will be moderate enough to leave behind a stable firm. The Big Four tetrapoly that survived Arthur Andersen’s 2002 collapse is down to a critical minimum. A three-firm model might be unsustainable under existing scope of practice limitations and uneven global distribution of resources and expertise.

The emergence from this dark period of a vital EY affects the survival of the Big Audit model itself, at least in its current form. However, EY’s survival as an essential player depends on its leaders’ ability to face and resolve a set of challenges:

• Satisfy its uneasy clients that engagement quality has not suffered;
• Recast internal messages to return to work after the massive distraction of nearly a year of speculation and uncertainty;
• Ramp down any misrule among the resident troops; and
• Reach out to recruits and applicants with whatever assurance can be mustered that adults are in charge and have their interests at heart.

As Di Sibio feels his once-shining star fade to a cinder, he may find a bit of solace in the emollient words of a niche London consultant: “The fact that this deal, as constructed, now seems unlikely to go ahead doesn’t mean that the thinking that underpinned it was wrong.” Translated from the jargon of someone angling to be hired in the future, this means, “Sorry, you blew it—perhaps another time, although not likely, and not on your watch.”

With EY facing a distinctly clouded future, the book-makers running the betting pool on the over/under date of Di Sibio’s retirement are no longer accepting wagers.

 

Reproduced with permission. Published April 13, 2023. Copyright 2023 Bloomberg Industry Group 800-372-1033. For further use please visit https://www.bloombergindustry.com/copyright-and-usage-guidelines-copyright/  

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