Re:Balance -- Jim Peterson

Can Value Be Brought Back to the Auditor's Report? A Tale of Two Systems

 Is it the best of times, in the struggle to re-introduce value into the traditional auditor’s report – or the worst of times? The age of wisdom or the age of foolishness?

Latest to join the Dickensian-length of characters is the International Auditing and Assurance Standards Board, which on May 16 released its consultation paper, “Enhancing the Value of Auditor Reporting: Exploring Options for Change” (here).

Compared to the others, whom to list takes up three full pages of its appendix, the IAASB brings the essential combination of intelligence and technical skills. Well it should, charged with the promulgation of international standards on auditing (ISA’s), thus conversant with such abstruse but centrally relevant topics as the auditor’s responsibility for published information other than financial statements (ISA 720), and use of “emphasis of matter” and other paragraphs in an auditor’s report (ISA 706). 

Among the most prominent of those heard from, and least likely to offer substantive contributions, is the United Kingdom’s upper legislative chamber, whose Economic Affairs Committee has this spring gotten its lordly knickers in a twist over the bogus suggestion of a malign influence of international accounting standards on the crisis-era reporting of the British banks (here), and also prodded the UK’s Office of Fair Trading into an inquiry as to the market dominance of the Big Four (here) – yet another tedious exercise destined to yield neither surprises nor constructive suggestions. 

Joining the Lords in fullness of volume and emptiness of ideas has been EU markets commissioner Michel Barnier, whose “green paper” consultation served mainly to remind anyone interested of the capacity of European bureaucrats to sacrifice forests of trees to document the lowest-hanging fruit on a fragile bush (here). 

The Americans arrived on May 5, when the chairman of the Public Company Accounting Oversight Board, James Doty, promised a “concept release” this summer “to consider how the auditor’s report can be changed to provide more useful, relevant and timely information” (here).

Where the IAASB suffers a gap between competence and authority, of course, is in its lack of muscle to carry out its aspirations. Sponsorship and support of senior regulators are required, led by the Americans, for a legislative re-engineering of the liability landscape, because assurance in any innovative area can only be designed and delivered if relieved from the devastating exposure to hindsight second-guessing that today shackles the auditors to their obsolete model.

Fantasize, for a moment, an “age of wisdom” in which the IAASB and the PCAOB actually made common cause. What might be accomplished?

The IAASB release makes the obligatory musings on possible adjustments to the current report itself – whether to move the opinion paragraph to the top, or to push the explanatory language to a footnote. But cosmetic niceties are inconsequential, as the grown-up technicians surely realize; knowledgeable readers would be neither confused nor influenced by this syntactical re-arrangement of the deckchairs, and others simply would not care.     

Once past political correctness, however, the IAASB does press into important new territory, recognizing “the demand for additional, and more pertinent, information about entities and the processes that support the quality of their financial information.”

Its delicate suggestion of “perceptions that auditor reporting is not meeting the needs of financial statement users” is a rhetorical bow to the tensions among competing constituencies and the understandable retreat into euphemism – where what is called for is removal of this barrier to clear thinking and precise articulation.

Teasing the blunt inference out of the IAASB’s sensitivity, today’s audit report is obsolete and, beyond compliance for which Doty and the other regulators are acutely self-interested, delivers no real user value.

If it were an old horse, it would be given due respect for its decades of good service -- then the worn-out old nag would be led off to the knacker’s yard and given the humane dispatch its dumb loyalty deserves.  

Within the scope of the IAASB’s standard-setting, it lists readily identifiable subjects for auditor contribution:

• “Corporate governance arrangements.
• “Business model, including the sustainability thereof.
• “Enterprise-wide risk management.
• “Internal controls and financial reporting processes.
• “Key performance indicators.”     

The release further tables the desirability and value of auditor insights in such financial reporting issues as:

• “The quality of the entity’s internal controls and financial reporting processes.
• “Qualitative aspects of the entity’s accounting policies, including the relative conservatism or aggressiveness reflected in management’s selected policies.
• “The auditor’s assessment of management’s critical accounting judgments and estimates, including where each critical judgment or estimate falls within a range of possible results.
• “The quality and effectiveness of the entity’s governance structure and risk management, and the quality and effectiveness of its management.”

 Here lies real opportunity. The IAASB solicits comments until September 16. Disinterest, silence and the retention of the status quo should not be tolerable options.

 

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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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Risk Management: Where Shall Learning Be Found?

Here comes summer.

School is out - oh happy day.

     --    Jerry Keller, 1959

Classes finished last weekend for the students in my MBA-level course in Risk Management. They are even now beavering away on their final papers: assessments of the flaws and defects in risk handling among the many catastrophic business failures of the last four years.

While awaiting their efforts and the task of year-end grading, I have two summer projects – both involving the re-calibration of our syllabus, which explores the lengthy catalog of executive and governmental bias, errors, misapprehension and general group-based follies that have defined the recent era of unprecedented excess and turmoil. The differences will be interesting.  

For one, I am asked by a professor at a near-by college whether this curriculum on the diagnostics of fallibility would deploy for a classroom of capable undergraduates. My cautious “yes” rests on the continuity and commonality of the themes:

To take only one of our subjects of study --  the group-think, dissent suppression and publicity-oriented overrides of technical competence that led to the break-up and loss of the Challenger space shuttle in 1986 were replicated in the blow-out of the Deepwater Horizon oil-well in April 2010. Are we learning anything yet?

Or – it does not require a degree in finance to appreciate that the unlearned lessons of the failed financial models that took down Long Term Capital Management in 1998 recurred in the model-driven rush to disaster that spun out of the subprime mortgage derivatives sector starting with the implosion of the Bear Stearns real estate funds in 2007.

The lessons may have evaded the decision-makers at the time, but they are well within the aptitude of a collection of above-average undergraduates.

I am less confident of my second mission – a call from the leadership of a world-class professional services organization. There, job-by-job client delivery is impeccable, but the prevailing attitude toward risk is that “we’ve always done it this way, and it works” – a view that leaves the firm hostage to an inability to distinguish skill from dumb luck.

The challenge to offering advice in the commercial world – an environment be-set by the logically flawed belief that if a problem has not arisen in the past, it will not in the future – is the lack of appetite for the same kind of time and effort that my students put into the scrutiny of multi-disciplinary learning opportunities. “Manage what you measure” is an unfortunately blinkered approach, when it is precisely what you don’t know that blows up and kills you – whether it is among the dinosaurs unable to conceive or adapt to the emergence of the faster, smarter mammals, or Bernie Madoff’s investors with their addictive blindness to the reality behind monthly account statements simply too good to be true. 

It is sensitive, to find diplomatic language in which to convey risk process deficiencies to a senior executive team, where as one commentator bluntly puts it, “They’re not good, and they don’t know it.”

One alternative, in an only slightly more nuanced articulation, is put as a question: “How can you design a strategy to get better, if you lack the skills to evaluate how good you really are?”

Studying past failures is a good place to start. That’s where my students focus their attention – working toward their own personal pay-off in superior skills in analysis and application once they are launched into the workplace.

But that’s not an approach that goes down well in the business and professional world. The humility of accepted limits comes hard to a latter-day Ozymandias such as Dick Fuld or Chuck Prince or Angelo Mozilo – their reputations along with their visages now lying shattered and half-sunk. 

So even as I search for the ways to press for improved perceptions and performance among my clients, it’s a certainty that a renewed cycle of mis-behavior, failures and collapses is brewing and will continue to feed the academic appetite for new material.

Readers having good examples under any of these headings are cordially invited to contribute to the searching.

 

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