Re:Balance -- Jim Peterson

The PCAOB's Concept Release: What Might a Truly Useful Auditors' Report Actually Say?

First reaction to the Public Company Accounting Oversight Board’s Concept Release of June 21 (here), which puts on the table a buffet of possible revisions to the long-standing commodity language of the standard auditors’ report: 

It’s like Bob Dylan’s observation on the twelve-string guitar – you spend half your time tuning the damned thing, and the other half playing out of tune.

Thanks to readers for asking – more will be coming, through the comment period ending September 30.

A second reaction should be positive, since the project puts the US regulator’s stamp on a vital question, posed by Chairman James Doty during the public meeting (here), “how audit reports can be more useful to society?” 

But optimism should be carefully tempered. This is only the latest in the cyclical spasms of user dissatisfaction, going back to such barely-remembered efforts as the Cohen Commission of 1974 and the Treadway Commission of 1985. Vision and will have consistently turned to failure, over-taken by the return of bubbly investor enthusiasm, and this spring’s exuberant reception of the new media IPO’s (here), during which rational attention to the boundaries of quality accounting and reporting has been blinkered by investor frenzy, does not bode well.  

Researchers in group psychology have long known that human attitudes are asymmetrical towards rewards and detriments: people are risk-seeking on the upside, but risk averse on the downside.

Which means that the pain of a losing investment will more than outweigh the pleasure of a similar gain.

And therein lies the fallacy behind the traditional “pass-fail” audit report. As shown by recent behavior, investors will ignore all cautionary limitations within a clean report on such recent bubble companies as LinkedIn or Pandora – or the sketchy accounting proffered ahead of the upcoming launches of Facebook or Groupon. But on the other hand, they will never be satisfied – whatever the PCAOB staff may think they have accomplished with their “outreach” – absent an advance “fail” signal on a company poised to fall – Lehman, Bear, Countrywide, AIG, Fannie, and so on – not because the real desire is for a coherent and comprehensible articulation of a business model destined to failure, but to avoid the failure itself, at all.

What this “second-order” disconnect means, then, is that the auditor is truly at one remove from the core issue in today’s world of short-term score-keeping -- financial reporting is, essentially if emotionally, only a proxy for investors on the ultimate future success of the reporting enterprise. So it misses the point to keep belaboring the messenger.

Resolution is ready to hand, right within the framework of the Concept Release itself. But radical adjustment will be required, both to the reporting by issuers themselves and in the auditors’ report language.

That is, it must be for the company, not the auditors, to fully satisfy the regulators’ disclosure goals regarding, for example, the achievability of results dependent on management’s judgments, critical estimates, and difficult choices among permissible or alternative accounting policies – all of which contain and reflect the company’s business, operational and strategic risks, on which actual results depend.

The accountants then have two socially useful but limited roles:

First, to provide the necessary technical and professional competence to assist issuers in navigating through their many politicized and judgmental reporting choices – a process, by the way, which brings to the fore the many irrationalities involved in the unending fables of “convergence” among standards and the essentially irreconcilable inconsistencies between and among IFRS and the various versions of GAAP (for which, as always, see The Accounting Onion).

Second, the assurance role: to support – to the extent possible -- the clarity and transparency of the representations made in the financial statements to the community of users.

And that’s it – so much, and no more.

What may this mean for legitimately useful audit report language? Messages are required like, “We don’t know …. we cannot tell from the evidence …. we cannot test or provide a meaningful comment ….”  These, with some work on the drafting, can be properly articulated under several of the Concept Release’s rubrics -- whether Auditor Discussion & Analysis or Emphasis Paragraphs or Clarification of Language.

The profession’s leaders have been leery of any such rationalization of their role – a fear driven by economic self-interest and their unwillingness to confront the fragility of their business model.

Staying the present course to nowhere, however, risks their being revealed, like the Wizard of Oz, as little figures behind the curtain, puffing smoke and noise of no value or significance.

It needn’t come to that. Stay tuned – the upcoming months may tell.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy – both at the Main page.        

 

Mandatory Auditor Rotation -- Further Thoughts on PCAOB Chairman Doty's Bad Idea

 Why Chairman James Doty of the Public Company Accounting Oversight Board keeps pressing mandatory auditor rotation, neither useful to the capital markets nor achievable for large global companies (see his latest, June 2), remains beyond sense.

Doty, hands full with the challenge of an official re-think of the standard auditors’ report (here), is supported by blogger Tom Selling, whose Accounting Onion provides lucid and incisive commentary on the politicized and intellectually incomprehensible inconsistencies of global accounting standards.

Much as I value Selling’s work, I would be reluctant to call a “disagreement” my inability to share his enthusiasm (here). Instead, some “additional thoughts”:

The context for rotation – especially the long tenure and duration of auditor relationships among large companies – reminds me of the loyalties in the farming community of my youth.

There, partisans of the trucks made by Ford or Chevy passed their abiding devotion along from fathers to sons, while on each farmstead along the rural roads, the tractors and combines glowed exclusively in bright Farmall red or the deep green of John Deere.

These intense affinities were debated non-stop in the village café and the adjoining pool hall, by sunburnt advocates wearing baseball caps branded to proclaim their choice of machinery. The system was stable -- client service was dependable if unimaginative, the cartel of dealers prospered, and it would have been thought foolish to sacrifice decades of accumulated knowledge, relationships and bins of technology and spare parts for no identifiable advantage.

Out in the fields of corn and soybeans, meanwhile, there was no rational performance difference between the competing commodity brands. Cosmetics were immediately obscured under the prairie dust, and a dirty red tractor worked not any better or worse than a green one.

In today’s audit market, to which the metaphoric characteristics of farmyard equipment extend, Selling’s endorsement of mandatory rotation omits a number of considerations.

To start, while correct that “audit failures … are small potatoes” below the mega-level of Lehman or AIG, Selling misses the stumbling block of international impossibility.

Which is, for example, that American rotation would impose on such global-scale but US-listed companies as Deutsch Bank or Total or Banco Santander or Nokia. Would the regulators in Germany or Switzerland or Spain or Finland adopt and enforce the obligatory sacking in their countries of, in these cases, KPMG or E&Y or Deloitte or PwC? And if not, how do those parent-level firms possibly coordinate and perform their locally-contracted statutory engagements?

No way -- given the halting steps of the PCAOB in the nine endless years of its aspirations – reflected in its still-complete exclusion from China (here) and the twenty-page list of large companies outside the US where, as of last year, its auditor inspection access was denied (here and here).

Second, where does the wheel of rotation turn for these companies? Where are alternatives to be found? It is not appreciated that the malign effects of independence and scope-of-service restrictions, and the uneven distribution of Big Four resources in the large economies, have squeezed or eliminated any viable rotation opportunities. Back to the study for the Financial Reporting Council in 2006 (here), and instances in the UK where “companies may have no effective choice of auditor in the short term” (emphasis added).

Third, Selling too gently observes that, “we don’t have a lot of evidence that audit firm rotation is going to work.” Truth is, we have none – the only experience being Italy, where rotation has contributed to greater Big Four concentration, and figured not least in the divided-audit environment at Parmalat. 

Fourth, Selling’s attribution of significance to the AICPA’s lobbying against rotation, back when the Sarbanes-Oxley law was passed in 2002, misses the irrelevance of that body to today’s market. That’s because, at the big-company level (the segment that matters, as he and I agree), rotation would be a pass-the-parcel exercise among the Big Four. Their dominance in the scope and coverage gap with the smaller firms has only grown over the last decade; rotation would if anything likely further squeeze the smaller firms out of the top-tier market.

Finally and most important, Selling asserts that the overhanging prospect of rotation would improve performance – in his hypothetical, “the fifth year of a 7-year relationship” – “some yet-to-be-disclosed successor auditor will have every incentive to examine each page of the old working papers with a fine tooth comb.”

This is backwards, and the incentives go the other way. A successor’s incentive and mandate are to examine old work only to lay a foundation for the current year’s engagement. To do otherwise, recalling that the successor is not an agent of law enforcement or regulatory oversight, is to pry for skeletons in old closets on a gratuitous basis.

Consider the hindsight judgment that a prior error might require correction. The company is in no position to force the now-dismissed prior auditor back onto the job of re-issuance. Yet the successor is in no position to re-perform old and stale work – at least not without inflicting massive time and cost on the current job.

To sum up: the case cannot be made at the large-company level that mandatory auditor rotation confers any benefits or justifies its costs. It is particularly impractical at the global level in any event. And requiring rotation only for smaller companies would be expensive, ineffective and politically impossible.

The proposition that rotation deserves a try, only because “every other device for loosening the bond between auditor and client has been tried and fallen far short of the mark,” is not a strategy, but a wish – and a wistful one at that. Better to focus on ideas that are both justifiable and within the range of practicality, than to continue lobbying for one that is neither.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both at the Home page.   

 

 

What Should Be In the Auditors' Report? Would Users Know When They Saw It?

 I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it ….”

       -- United States Supreme Court Justice Potter Stewart, on pornography, Jacobellis v. Ohio (1964).

A host of different interests are calling for a re-think of the standard auditors’ report.

Believing that its familiar commodity language has long given no value, except to satisfy the self-interest of the securities regulators, I fantasize a shared project between the International Auditing and Assurance Standards Board – which has the expertise to make it happen – and the Public Company Accounting Standards Board – which does not, but which must lead the American effort if there is ever to be success (here).

Essential would be this determination: what form of assurance is really desired -– what do users value, and what will they pay for?

Available pronouncements are unhelpful – neither such slogans as in PCAOB Chairman James Doty’s May 5 speech, that “the audit embodies core societal value and relevance”(here), or this month’s hyperbole from the European Parliament’s Committee on Legal Affairs, that the statutory audit is “an absolutely fundamental component of the democratic economic and political system” (here).

Two more helpful but ultimately depressing generalizations may be made:

The first, addressing the tumult of the last four years, is that users emphatically do not want the “clean” assurance that was delivered within weeks or months of an issuer’s demise – the unqualified opinions on such casualties-in-waiting as Bear Stearns, Lehman Brothers, Merrill Lynch, Citigroup, General Motors or AIG.

The palpable annoyance in London of the House of Lords Economic Affairs Committee, at the UK banks escaping “going concern” qualifications only through closed-door sessions between their auditors and banking supervisors – the Bank of England or the Financial Services Authority (here) -- makes the point.

The other unreality -- the re-emerging credibility gap between the traditional one-page report and the market behavior of investors – reprises the roller coaster of the late 1990’s in the current IPO wave of “new media” and other darlings – where stock prices, enterprise valuations and near-hysterical crowd behavior give every indication of a new bubble well inflated.

The poster child must be LinkedIn, with its IPO on May 19 at an upwardly-adjusted $45 and its first-day explosion to $122 – and its gradual post-offering descent back in the general direction of reality, now around $ 74, leaving all after-market purchasers under varying depths of water. 

LinkedIn’s indicated post-offering enterprise value -- $ 4 billion-plus -- pales next to the mooted $ 15 billion for Groupon and the staggering $ 50 billion for Facebook – figures bearing no terrestrial relationship to the companies’ available financial data.

Illustrative is the straight-faced ability of Groupon to base its offering on results that should exclude its sky-rocketing marketing expenses and acquisition costs (here). Flouting five centuries of accounting theory under which double-entry bookkeepers have recorded and reported everything on both sides of a ledger, the company would spin Luca Paccioli and his successors in their graves, while spinning the enthusiasms of investor credulity.

Elsewhere the valuation landscape is no less fanciful. Glencore’s launch at 530 pence on May 19 was well over-subscribed, but slipped to this week’s 480-ish – reasonably attributable to the over-heated state of the commodities markets at the core of its business, even ahead of its rumored (and now disavowed) targeting of ENRC to extend its mining activities into those havens of business and political stability, Kazakhstan and Congo (here).

More illustrative of the wild variability are Yandex – Russia’s clone of Facebook, offered on May 24 at $ 25 and lofting to almost $ 39, now at $ 31, or its Chinese opposite, RenRen -- launched at $ 14 on May 4 with a first-day pop to $ 19, but presently slumped to under $ 8. No surprise, the latter, while a cavalcade of failed Chinese companies after American “reverse-merger” listings has amply illustrated the opacity and distress at the heart of Chinese accounting, reporting, governance and over-all business legitimacy.

Or, right down to date, the June 14 offering of music-streaming Pandora at $ 16 per share, twice raised since its initial filing – an indicated company valuation of $ 2.6 billion, despite a consistent and unbroken loss-making history -- came out of the gate of open public-trading today to climb above $ 23 before starting to slip.

By way of these two central themes, it is knowable both what financial statement users do not want at all, and what they will completely ignore.

For what that teaches about new forms of assurance, unfortunately, the news is not good. As baseball sage and philosopher Yogi Berra would have put it, “If investors don’t want to act sensibly, you can’t stop them.”

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy, both at the Main page.  

Mandatory Auditor Rotation -- PCAOB Chairman Doty Takes an Old Idea Out for Another Spin

Say this for Jim Doty, the new chairman of the American audit regulator – he is willing to pack his bags and go on the speaking circuit. Following his May 5 gig in New York (here), where he flagged the prospect of a re-visited approach to the standard auditor’s report (my thoughts here), the PCAOB head was off to California on June 2 (here).

There he promised “a holistic approach to addressing the cultural challenges inherent in auditing” – a notion whose meaning will emerge in time, out from behind the sloganeering of “addressing relevance, credibility, and transparency of the audit by all available and effective means”(emphasis his).  

His one specific is to drag back out, yet again, the question, “whether mandatory audit firm rotation would help address the inherent conflict created because the auditor is paid by the client.”

As Doty at least has the candor to concede, “the idea of a regulatory limit on auditor tenure is not new.” It was not new when examined in 1977, as Doty cites – back when audit choices included eight large firms and a real middle tier – nor yet again in the post-Andersen era of the Sarbanes-Oxley law of 2002.

But – unlike fine wines or monumental architecture, which will mellow and improve with age – a bad idea does not acquire respectability with the passage of time.

Since the proponents of rotation are undeterred by the only available evidence -- namely the experience of Italy, where both mandatory rotation and divided responsibility between two audit firms were part of the context of the debacle of Parmalat – two other arguments should bear:

First, the feasibility of rotation clashes with the reality of global concentration. The Big Four now have a virtual lock on large-company assurance; as the risk management leaders of the surviving mid-tier firms would admit (if only off the record, and despite the public posturing of their leaders), the smaller firms could not take over the audit of a global-scale bank or airline or manufacturer or service enterprise, if handed the job on a no-bid silver platter.

The consequence – again with focus on the world’s largest companies where both the risks and the concentration are greatest – is the absence of auditor choice imposed by the constraints of service delivery under the shibboleth of independence.

That is, a large company, engaging one Big Four firm for its audit, will disqualify another that is used for consulting services, and a third that provides financial and transactional advice.

Then comes into play the factor usually omitted from discussion, namely the uneven distribution of expertise around the large world economies. Consider the varied market-leading significance of KPMG in Germany, Ernst & Young in France, Deloitte in Spain or PwC in the UK or Switzerland. A global-scale company requires audit services in all of those countries, and US rotation requirements would be viral in application -- but shortcomings in available industry competence and geographic coverage would constrain alternative choices. Enforced rotation would confront severe dislocations, amounting in effect to unachievable demands.

The second branch of the two-fold parochialism seemingly behind the recurring advocacy for rotation is that it somehow favors an improved mind-set of auditor skepticism.

As if the assurance function had ever reflected the kind of innocent, pre-lapsarian virtue ascribed by the proponents of “independence.”

History is to the contrary. Since its invention in the Victorian 1850’s by Mr. Deloitte and his counter-parts, professional assurance has been under the direct engagement – and payment – by the owner-managers, who until then had selected “auditors” from among their own, surely-interested ranks.

The nascent profession, together with its clients, saw off the proposal of nationalized government audit in the 1860’s in England, and did so again in the US in the 1930’s. Over an unmodified 160-year history of “client pays,” the full-service firms’ economic incentives to satisfy those paying clients’ audit needs have been at least arguably no more than for a firm deriving no revenue at all from ancillary services.

So the intellectual stability of the entire structure of appearance-based independence restrictions and limitations on the scope of permissible services resembles nothing else than an elaborate edifice built on the shifting fragility of a sandbar.

I’m therefore obliged to take issue with the enthusiasm of the commentators on Doty’s speech – not least, my blogging colleague the usually insightful Tom Selling, who in the Accounting Onion proffers applause and pride at Doty’s tone and plan of action.

In the park around the corner from my house is a decades-old carousel – beloved by hordes of small children who for one euro can circle in safety astride old-fashioned wooden horses, stabbing and grasping at the rings held out by the grizzled operator of the ancient apparatus.

The metaphor extends. There is no more adult substance to Doty’s spin on mandatory auditor rotation than there is to the revolving fantasy of an antique and anachronistic merry-go-round.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both at the Main page.

 

 

 

 

 

Racing to Avoid a Crash: On the Track -- On the Street

There’s a stack of final papers in my Risk Management course – and an apero on the sunny terrace of the neighborhood café, to ease the grading process.

And a fond wish for one more class session, to dissect last weekend’s lesson in the disastrous consequences of bad risk assessment and choice-making under high-stress competitive conditions.

It happened at Sunday’s Indianapolis 500. Rookie driver JR Hildebrand had a comfortable lead going into the final lap. But instead of riding easily to victory, he attempted a high pass of a slower car on the very last corner, crashed into the wall, and slid his wreck to a second-place finish – passed by the doubtless astounded Dan Wheldon, on whom Hildebrand’s error of judgment and the fickle gods of fate bestowed a gift beyond imagination.

Aggressive, brave or foolish – the high cost of immature enthusiasm under “win or crash” analysis is not rare. Recall the Olympic gold medal that snowboarder Lindsey Jacobellis threw away on her final run at Turin in 2006, with her ill-advised showboating stunt attempt on the last bump.

My class of MBA and Finance students focuses on lessons from highly-consequential decisions, especially in failure situations – drawn from many fields into the worlds of commerce and professional services, where most will eventually work, and where senior leaders charged with risk responsibility have performed so poorly over the last four years.

From Hildebrand’s split-second choice – now part of racing lore and a life-long mark on his career record, they would take at least these two:

First, the skills and energy of the young are to be recognized and respected; a new hot-shot does command attention and can achieve greatness, whether in sport or government or a trading room. But as events at Indy showed, the converse is no less valid. Beginner’s luck is no substitute for seasoned strategy, and those surviving to accumulate the scars of experience bring wisdom that tempers rash choices.

Provided Hildebrand does learn his risk/reward lesson, in other words, he is not likely to repeat it.

Therein lies learning for business and financial disciplines, still struggling past the recent crisis. The tragically short time horizon of the designers of exotic derivatives, and the exclusion from the quants’ risk models of events beyond their recollection, created the conditions for the crushing impact of events erroneously thought to be unforeseeable.

The second lesson from Hildebrand’s choice-making looks at the structure of his decision matrix: a binary choice -- “try to pass” or “lay off” -- but with alternative and different benefits and detriments for each.

The consequences of playing safe and cautious were in his favor: there was no downside, as he was at no risk of being overtaken, and to cruise safely meant a checkered flag.

In choosing to charge the corner, on the other hand, he had negligible upside – he was already holding a dominant lead – while, as events proved, the downside of being unsuccessful was catastrophic.

(Take note, of course, that the calculation could alter dramatically – if, for one case, he was trailing and needed a last-minute pass to advance, or if he was tightly shadowed and at risk of losing his lead.)

The metaphor extends, readily enough:

Should an investment manager double down on a losing strategy, which unless reversed will bankrupt his fund? Or should the size of his positions be controlled along the way, so that no single exposure could threaten his entire firm’s survival?

Should an entrepreneur put all his capital at risk to start a new venture? To a retiree in reasonable comfort, the upside is limited, but the hazard of a failed and penurious old age is real; while to a new graduate with a long view, fortune favors seizing the greatest number of jackpot opportunities.

The under-appreciated risk-assessment obligation, all of this should suggest, lies in deliberate attention, usually overlooked, to the alternative choice: the action foregone, the rejected Plan B, the road not taken, the decision not to charge ahead.

To a rookie Indy driver with his hair on fire and his foot to the floor, this would all seem abstract, bloodless and pedantic. But it should feel otherwise to a risk officer whose strategic control over a floor of stoked-up traders is his bank’s best hope for survival through the next bubble.

Because my students are more likely, post-graduation, to steer companies and to run portfolios, than to drive turbocharged racing cars, the sorry case of JR Hildebrand’s impetuous mis-chance will keep a place in my curriculum.

Thanks for joining this dialog. Please share with friends and colleagues. Comments and suggestions are welcome, and subscription is easy and free – both at the Main page.