Re:Balance -- Jim Peterson

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.

Replace the Big Four with Audits by Government? More Heat in the Kitchen -- and Less Light

What will it take, once for all, to lay forever the ghastly fantasy that audits done by government employees could provide any value to the world’s capital markets?

Like Banquo’s ghost, the gruesome spectre keeps stalking the discourse on the troubled state of privately-provided assurance – for now, dominated for global-scale companies by the fragile and threatened Big Four.

In search for a metaphor with an edge sharp enough to the task, consider:

Does anyone choosing a restaurant ever give one second’s thought to the local health inspector’s report on the state of the kitchen?

I thought not.

Never did a restaurant owner welcome diners or execute a menu with the least consideration of the requirement to pay a nuisance fee, just in order to post on his back wall the same ticket of compliance issued to everyone else – whether the tea shop or the burger joint or the elite purveyor of haute cuisine. 

Nor does that annual documentation provide any significant comfort.

On one hand, whatever that irrelevant certificate may say, competition applies relentless quality pressure in the narrow-margin food service business. A chef has ample incentive for the sake of survival to conform to the standards generally accepted among his peer group – whether running a gyros wagon or a three-starred temple of gastronomy. With ready access to reviewers’ critiques and customers’ word-of-mouth, a clientele will quickly vote the extent of its satisfaction and loyalty with its feet.

So irrespective of the commodity language of the inspector’s report, quality and value will quickly reach equilibrium.

On the other hand, the narrow limits of an inspector’s box-tick are illuminated by the commentators with inside knowledge. The celebrity ex-chef and international foodie, Anthony Bourdain, exposes to the point of hilarity the dirty little secrets of fully-compliant professional kitchens: never order fish on Monday that was carried over the weekend – the best chance for freshness is the chef’s daily special, because of the high volume and extra attention – and for salmonella’s sake, keep distance from the salad bar, never knowing who or what has rooted around there.

Bourdain makes it clear that a restaurant inspector’s annual pass-through leaves customers un-informed about what lurks beneath the grease trap or inside the meat cooler – consigning their reliance instead to the combination of peer influence and managerial attention to reputation and survival.

Which should validate the efficacy of market dynamics over further regulatory intrusion over the audit sector: restaurants, like corporate issuers, fail for multiple reasons, but above a minimal level of legitimacy, not for lack of code compliance.

Just as a health inspector is in no position to assure the quality of a dining experience, audit by government agencies would be helpless in the search for financial statement assurance of any real value -- too little, too slow, and far too late behind the speed of creative private enterprise.

Government audits could be imposed, of course – especially in the event of Big Four disintegration. But the impulse would be expedient and superficial – primarily under politicized motivations as cover for legislators and secondarily to serve the self-interested bureaucracy that would quickly become entrenched.

And the results would be much like the other models for agency-enforced compliance. Effectiveness would be measured by easily–measured inputs rather than defects exposed – think of the numbers of grandmother pat-downs reported by airport security, or inspections conducted by the PCAOB – neither of which has a record of detection or deterrence for all the wasted effort, disruption and expense.

Other examples abound. Consider drivers’ licenses. Above a minimal threshold level, anyone can get one – only to support a large and costly administrative structure interested primarily in its own perpetual existence – while delivering a compliance certificate offering no assurance on the quality of the holder’s ability behind the wheel. 

The entirely justifiable public dissatisfaction with the institutions at the heart of the financial crisis of the last four years, reflected in the legal claims working through the court systems – Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, New Century, Countrywide, Washington Mutual, as the start of the US list; plus endless examples elsewhere that would include banks in the UK and across Europe from Germany through Ireland to Iceland – rightly challenges the utility of the current financial reporting model and the performance value of privately-delivered assurance.

But great care and caution is required before speculating that the manifest deficiency of an existing model would be relieved by trashing it for another of uncertain and highly doubtful capabilities.

Or as a percipient restaurant critic might suggest – the leap from a well-seasoned but encrusted frying pan may be into an unknown and far more dangerous fire.

 

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Evolution of the Accounting Model: What Would Darwin Say?

So where will the initiative for innovation really come from, in the inevitable but elusive evolution of financial reporting and assurance?

 Not from what passes for leadership, where the paralysis is complete:

• Not in the United Kingdom, where the House of Lords inquiry is wagging fingers at the politicized nature of the banks’ accounting (as Ian Fraser writes from London) and the cozy discussions on “going concern” between the Bank of England and the large accounting firms (see Francine McKenna). 

• Not in Brussels, where the EC green paper was an embarrassment (here) and the Big Four are winkling out crisis-survival plans (summarized here and detailed on their websites) -- unfortunately no more achievable to preserve a disintegrating network of private partnerships than the ill-fated attempt to foist outside management upon the partners of Arthur Andersen (here).

• Not in the US Congress, which flailed away at the financial crisis without a nanosecond’s attention or a single word in the Dodd-Frank legislation on the fragile state of the large-company audit market.

• And not even among the authorized critics – the squabbling parties comprising the Financial Crisis Inquiry Commission having issued their variously antagonistic reports without even glancing at the role of the auditors (nowhere better summarized than by Tom Selling).

Evolutionary biology teaches that successful adaptations do not occur at the crowded center of a population, where conformity pressures suppress deviance and outliers. Instead, successful mutations emerge under stress at the margins.

Recall -- the dinosaurs thrived unchallenged for millennia, until sudden climate change exposed the vulnerability of their inflexible lack of ability to adjust.

It’s the same with industrial development -- mainstream complacency under the illusion of stability puts a damper on innovation. Consider the lag in cell-phone technology and acceptance in the large English-speaking countries, under the inertia of their large fixed-line capacity, subject to leadership take-over and exploitation by the Finns and the Japanese.

For decades the Big Three automakers in the US – the dinosaurs’ counterparts – delivered dull commodity products and burdened themselves with unbearable costs, ignoring the Japanese whose under-the-radar combination of small-engine expertise and meticulous quality processes evolved world-class cars.

The unrecognized fragility of a seemingly stable structure is exposed by surprise disruptions at its outer edges. An assassination in far-off Sarajevo lit the fuse on pre-war Europe’s vulnerability to collapse in 1914. Last month in Tunisia, the self-sacrifice of a fruit vendor in an obscure market street triggered demonstrations fatal to a despotic regime -- today spreading to engulf Egypt’s government and reverberating in every corner of the Arab world.

Large-country regulators and law enforcement agencies in the post-Andersen world have shown their disinclination either to evolve the financial reporting model or to force the re-engineering of the Big Four dominance of global audit – the only significant claim being the state-level action in New York against Ernst & Young over the repo accounting at Lehman Brothers.

Instead, evolution could well occur out at the fringe. A country or an industry sector may be so small as to be immature, unpredictable and ignored, but large enough to disrupt the global regimes for reporting and assurance. Under conflagration conditions, the fatal match could touch anywhere in the fuel pile.

That is, many economies are too small for significant global effect. The challenges of Satyam in India could ultimately cost PwC its practice organization there, but without a hiccup at the global scale; likewise the problems of the banks in Iceland are too localized to metastasize.   

But no large accounting network could survive the loss of practice in a country of G8 scale – say France, Germany, Spain or Italy in Europe, or Japan or Korea in Asia – because of the number of large companies relying on Big Four services there.

Just as most of the once-great sauri ended up sunk in the tar pits, to have their fossils excavated by the descendants of the tiny fury creatures once disregarded at their feet – so too the future of financial statement assurance will involve competition from new firms grown from small size and great agility.

Once the clean-slate opportunity is provided by the eventual recognition that the traditional one-page audit report is obsolete (and here is welcome the voice of Professor David Albrecht’s commentary and advocacy), the scale and structure of the Big Four will be otiose and unnecessary.

Some fragments might evolve to survive. A few dinosaurs did pass on their genetic code to become the modern world’s birds, whose rainbow varieties have thrived in successful competition with each other and with predators up and down the food chain.

Evolution can be stalled, but it will not be stopped. The successor to the auditors’ report, stuck in its tracks since the 1930’s, may break out in some obscure and unexpected mutation. When it does, the landscape of assurance will be populated by a different menagerie of creatures. 

 

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