Re:Balance -- Jim Peterson

Independent Auditors' Reports -- If They're Obsolete, What's the Alternative?

On March 27 I posted an earlier column from the IHT -- here -- which suggested that the concept of auditor independence is providing no value to either auditors or users of financial information, but is worthy only to be scrapped. The follow-up column summarized broad reader concurrence, and opened the question what should replace the now-obsolete one page report.

Auditing on the Brink

Originally published in the International Herald Tribune on April 8, 2006

I recently put forth the argument that, because of the doubtful prospects for survival of the global accounting firms, the rules of auditor independence should be scrapped and the auditors freed to solicit whatever business they liked.

I expected to be treated as if I had impugned the combined athletic divinity of Pelé, Joe DiMaggio and Tiger Woods. But no, the responses were both positive and supportive. From a reader in Belgium, "Auditor independence is not only killing knowledge, it is killing business." From France, "Leaving ethics to the auditors' conscience should suffice."

To go the next step, a comment from Britain - "the key issues are the integrity of the auditor and the transparency and completeness of the audit conclusions" - pairs up with the poignant view of a retired partner in a Big Four global accounting firm that the code, rules and constraints of independence are worth preserving as "the very essence of what the auditors are selling."

But these views lie at the heart of the problem, which is the dirty little secret of the auditing game: The auditors' core product - the one- page report with its opinion that financial statements are fairly stated and free of material error - is providing no value to investors or other users. No one reads it or pays attention to it. If not for the deeply embedded compliance requirements of the securities regulators, no rational chief financial officer would engage outside auditors to produce it.

The presumptive value of the independent audit report, which has come down to us from the Victorian era, has been one of those Jeffersonian verities - manifest, unexamined and immune from critical challenge. But the evidence of its irrelevance is compelling.

The most sophisticated investors have long since stopped relying on audit reports. This is shown by the fact that, in the past 20 years, no lawsuits against auditors have been brought by the really smart guys - the venture capitalists, the managers of private equity or the financiers of leveraged recapitalizations. These users look at the cover of an annual report, yawn, and go about their real diligence.

Less sophisticated investors also ignore auditor reports, as shown by the complete disconnection, during the bubble years of the 1990s, between share values and audited financial results. Soaring share prices were supported by neither assets nor earnings under generally accepted accounting principles - nor, in time, even by revenue. The analysts herded their clients, and each other, down roads paved with airy business plans, empty promises and inflated expectations. At the point of collapse, the audit report provided only a ticket to the courthouse.

That audit work of real value could be delivered to users who would be prepared to pay handsomely is a proposition that deserves to be tested.

Here, off the top of my head, are examples of special audit reports that a savvy post-Enron chief financial officer would commission:

Focused attention, after Shell, on the procedures for evaluating petroleum reserves and the results of that evaluation.

Line-by-line scrutiny, after Parmalat and Bawag PSK, on the operations of Cayman Islands subsidiaries and Caribbean trading partners.

Detailed portfolio scrutiny, after Fannie Mae and American International Group, on complex financial instruments like derivatives and finite insurance.

Investment banks and investors in search of best-in-class assurance would line up for such information, and on contract terms that would eliminate ruinous auditor liability. And they would not give a tinker's damn for auditor independence. Their focus, and expectation, would be top qualifications and good-faith performance.

But not today. The combination of ossified compliance requirements, obsolete practice restrictions and runaway liability mean that auditors today could not sell such products even if they wanted to.

Those who pine for the days when an auditor earned broad professional respect by detailed examinations of the distinct items in corporate accounts are entitled to mourn. What they cannot avoid, however, even through the best-intentioned sentimental wishes, is the inevitable evolution that has taken the profession to the brink.

Valuable forms of financial statement assurance remain to be created and brought to market. What form the profession will take that will do so remains a vital question. The only certainty is that the structure will be different from the one that exists today.

BDO International and the Bankest Case – Another Nail in the Structure of the International Accounting Firms

When I first wrote last summer about the adverse jury verdict inflicted on the Seidman accounting firm in the Bankest matter in Miami, to the tune of $521 million – here – I suggested that it was the valedictory not only for that firm, but for the model of all the large international accounting networks.

Since then, Seidman’s pending appeal proceeds apace, and the firm survives –although with the ominous axe still overhanging, who knows what holds it together, other than inertia.

To complicate matters, the Florida appellate court’s decision of March 12 has now held that BDO International, the coordinating entity for the network of which Seidman is the US member, must go back for a trial that could hold it liable for the US firm’s astronomical damages.

The time required for this latest procedural wrangling will extend past the Seidman firm’s own appeal, so this new adverse development will not trigger the bullet aimed at BDO’s heart. That impact will be delivered by the resolution against Seidman itself – a critical link in the BDO network, but now hostage to a verdict far exceeding its capability to pay.

The forbearance of the plaintiff, Banco Espírito Santo, cannot be assumed; its lawyers will have a duty of professional advocacy to benefit their client, irrespective of the impact on Seidman’s viability. And like law enforcement agencies, plaintiffs’ lawyers are programmed by their DNA to carry out their mandates – for the former, prosecution where justified; in the civil system, maximum feasible recoveries.

What the appellate court has done is further expose both the fragility of the large firms’ international structures and the absence of achievable solutions.

So far as reported, Seidman’s engagements to audit Bankest had no cross-border aspects. But ominously for the large firms in their international practices, the Florida court essentially provided a blueprint from which other courts will look at the business reality and find a unity or integrity of interests.

Audits of complex enterprises simply cannot be done without some form of top-level management, whether across international borders or among several local offices. Mechanisms are required for standard-setting, communication and problem-solving – whether called control, oversight, or outright ownership.

In this case, the court looked at the international network’s articles of association, which had an objective to “manage and control” the BDO member entities; agreements providing international-level ownership and management of technical manuals and software; and public reports noting the implementation of international quality control and training programmes.

On this basis, the court has set up the prospect of a trial on the existence of an agency relationship between BDO International and Seidman, having found enough evidence indicating acknowledgment and acceptance of a right of control.

It has been advocated elsewhere – for example, here – that this recent decision calls for revision of the rules that limit ownership of accounting firms, and for opening them up to outside capital.

But that misses the point. As just noted, the issue for the court in Bankest did not involve the level or source of Seidman’s capital, or who could invest in a BDO firm, but the basics of operational necessity.   

And in any event, while the large firms run today on the financial support of their partners' capital, there is no feasible way to attract a level of outside investment sufficient to withstand the liability impact of worst-case claims -- as shown by the absence of available insurance manifesting that industry’s lack of enthusiasm for the accountants’ business model.

So revision of the ownership limitations to address cross-border litigation exposure is a futile undertaking, even if politically feasible, which it is not in the face of multiple and over-lapping regulatory authorities.

Defect-free audit performance is neither an option nor an achievable goal. A non-trivial number of audit failures are inevitable, as under any system designed and run by fallible humans. So nothing – short of fundamental re-structuring of all elements of the model for the delivery of financial statement assurance for large global companies -- can prevent the impact of another Bankest against the still-surviving Big Four.   

To Save a Collapsing Audit Firm? Leadership Replacement is a Non-Starter

On the troubled state of the large audit firms, it has perhaps been wrong of me to be so critical of the attention given by the various committees and think tanks, for their general failure to grasp the truly serious issues and the vacuity of their discussion – examples here.

Because – from a recommendation given by the US Treasury Department’s Advisory Committee on the Auditing Profession – when they do advance a substantive idea, it is so breath-taking in its misguided impracticality.

On April Fools Day that group put forward, in all apparent seriousness, the notion that the partners in the large audit firms, anticipating the possibility of a catastrophic threat – that is, a fatal litigation or prosecution – should voluntarily modify their agreements to trigger the replacement of their leadership. Or failing such a step, the Securities and Exchange Commission should be authorized to apply in court for a trustee.

The text of the recommendation – and, for the masochistic, the webcast of the Treasury committee’s March 13 discussion meeting – are available here. 

As Oscar Wilde described his reaction to a plot by Charles Dickens, only the truly hard-hearted can read this pathetic work without breaking into hysterical laughter.

First, who’s to decide? In the history of leadership, the concept of anticipatory abdication is a complete non-starter. Especially under challenge, leaders believe they can work through their crises, and will fight to stay in office. In the political sphere, leaders from Louis XVI to Richard Nixon to Robert Mugabe have shown the inability to anticipate their own downfall.

Business professionals are no different. Is it any more likely that the large-firm partners would willingly turn over their careers and their fortunes to an outside stranger, than that the shareholders or directors of Bear Stearns or Northern Rock – or, for that matter, of Enron or WorldCom – would have enacted advance terms for the displacement of their executives?

But if not done by leaders themselves, who would pull the trigger? An external decision-maker would have to be credible to all constituents, at least as informed as management itself, and presciently ready to act decisively at a moment’s notice. 

But the corporate world does not keep world-class crisis managers stocked in reserve. Anyone meeting those job requirements already has his energy and talents fully committed elsewhere.

Nor, paying respects to the grey eminences who populate the advisory committees themselves, is this a function to bolster the resumes of the retired. The learning curve of a real-time audit firm survival crisis would be too steep to be climbed by those for whom robust knees and lungs are the memories of youth.

As for the notion of timely SEC intervention, the Treasury Committee’s members themselves grasped at least two among the fatal flaws:

•    First is the issue of timing. The Andersen firm disintegrated in a matter of weeks in 2002, following the tardy but eventual capitulation of its CEO and an aborted effort to bring in outside leadership. Even the provisions of the US Constitution for the temporary transfer of presidential powers contemplate a timetable of four weeks or more.

•    Second, who is to recognize the need? The Public Company Accounting Oversight Board, regulator of the profession in the US, disavows responsibility for audit firm viability as outside its remit, and rightly so. The timing and scope of that body’s practice quality sampling program is already all it can handle.

Which leads to the unrecognized crux. The supposed rationale for a rehabilitation process is that new leadership might preserve a firm by dealing more successfully with its litigation adversaries or prosecuting authorities than those on the scene of the wreck.

But such a view, while real, entirely misses the broader point.

Namely, as should have been learned from the Andersen experience – or those recently of Bear Stearns or Northern Rock – the franchise value for those selling commodity products rests entirely on the preservation of trust, and not just on fresh negotiating positions or the appearance of new faces. Once the fuse is lit and a credible challenge to that trust has started to run – whether doubts about the “safety and soundness” of a regulated bank or eroded “client confidence” for an audit firm – it’s too late, and an explosion is inevitable.

Finally, it is argued that the SEC’s power to apply for a trustee – even if “in the pocket” and never expected to be used – would be an incentive to the firms to improve.

But again, that naïve view defies reality. The audit firms’ managements already know that they face death-threat exposures today. So if at the brink they would not be saved by SEC intervention – and when existing leadership will have been cashiered in any event – a regulatory tool that is both inutile and ineffective would, if anything, create a disincentive to constructive change. 

There’s value to wild and unworkable schemes – they can focus attention on what really can and needs to be done. This one has served its purpose – and can now be scrapped as it deserves.