Re:Balance -- Jim Peterson

Mandatory Auditor Rotation: If PCAOB Sanctions Were "Case-By-Case"

The Concept Release on auditor independence and mandatory rotation, issued by the Public Company Accounting Oversight Board on August 16, sought comments. Believing that those who presume to offer commentary should include potential solutions along with their griping, I put forward these thoughts: 

There is a way that rotation could be tried and tested without the cost, disruption and doubtful achievability of a wide-scale requirement – problems that leave me and most others so skeptical.

Which is that in a specific case, if the PCAOB can sustain its proof that long audit tenure was causally related to its definition of “audit failure,” it could include rotation in its toolkit of post-inspection sanctions.

Since the PCAOB looks annually at a sampling of engagements for each of the large audit firms, and claims to target its inspections on the basis of perceived engagement risk and exposure, the agency’s experience base should bring to light cases – if any – where audit quality might be affected by length of tenure.  

In which case, rotation could be proposed, and if necessary, imposed.

The sanction would not be an enforcement reach, if a credible case were made – the agency could act on its own statutory authority or in coordination with the powers of the SEC. (See the SEC’s imposition of a government-appointed monitor on KPMG as part of the 2005 resolution of the criminal investigation of its tax-shelter practice, or the six-month bar on new SEC clients imposed on Ernst & Young in 2004 for its impaired independence arising out of business relationships with its audit client PeopleSoft.)

Due process and negotiations would sort out the appropriate cases to require rotation. Many cases of financial statement failure – contrasted with the Concept Release’s definition of “audit failure” as involving alleged deficiencies in audit work alone – result in termination of the auditor/client engagement in any event, and would fall out. Other inspection cases would involve causal facts unrelated to tenure – such as personnel competence or supervision – making rotation a doubtful remedy. And since real sanctions would presumably only be applied in a publicly transparent environment, the PCAOB would achieve the disclosure it professes to desire (here) -- along with the obligation to establish the credibility of its findings.

Rotation if proposed as a sanction would allow the incumbent auditor to be heard and argue its case – or perhaps even to settle with an agreement to stand down. It would also open the record to possible resistance by a non-US regulator, in the especially challenging cross-border cases involving global companies (here) – as well as to the fact-based airing of issues of impracticality or constrained choices of successors. 

(By the way, a free-market evaluation of possible limits on alternative auditor choice could be made through the sanction of mandatory re-tender -- as opposed to the perhaps harsher remedy of outright rotation.)

The principle of “first, do no harm” was cited by PCAOB member Lewis Ferguson in his statement on the Concept Release. Case-by-case use of rotation as a sanction would satisfy the corollary: anticipate unintended consequences whenever possible, and do minimal harm in any event.

Selective required rotation would also address an emerging issue in the effectiveness of policy choices – a topic treated in my MBA-level course in Risk Management.

Namely, examples are increasingly discovered that where instances of non-compliance are serious – but rare and tightly clustered -- the deployment of a broad, sweeping enforcement program is likely to be both wasteful of scarce resources and ineffectual in achieving the desired goal.

Three examples:

• With the progress in control of automobile exhaust emissions, it is massively wasteful in administrative costs and car-owner time to require on-site tests for late model cars. The miniscule percentage of vehicles that generate most of the pollution can instead be detected by inexpensive, portable drive-by testing, with immediate ticketing and impoundment.

• The billions in costs and inconvenience inflicted on airline passengers by security programs, accomplishing only inconvenience and embarrassing privacy intrusions, have negligible anti-terrorist effect, compared with the highly sophisticated results of effective data-tracking and suspect profiling.

• And among the population of urban homeless, the great bulk of the cost of scarce resources for shelter, law enforcement and emergency medical care is consumed by a tiny fraction – who are more effectively addressed through individual identification and tailored attention.  

Mandated rotation in those rare cases where tenure length might demonstrably be an issue presents a similar environment. Audit failures being real, but also rare, across the entire time-line of auditor tenure, there has not even been a proper study, much less a showing, that length of tenure is a causal factor. 

So enforcement sanctions, including rotation, should be conserved and only deployed accordingly.

To summarize: individualized mandatory auditor/client rotation could be used as an appropriate case-by-case sanction – if but only if the PCAOB can persuasively show a basis. 

Or as Messrs. Gilbert & Sullivan’s Mikado nearly put it in 1885:

“An object all sublime

“They shall achieve in time --

“To let the punishment fit the crime.”

  

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Mandatory Auditor Rotation -- The PCAOB Sails Off the Charts

“Otter: We could do it with conventional weapons, but that could take years and cost millions of lives. No, I think …that this situation absolutely requires a really futile and stupid gesture be done on somebody's part!

“Bluto: We're just the guys to do it.”

            “Animal House,” 1978

The Public Company Accounting Oversight Board's August 16 release and statements pose this central question on auditor independence and the prospect of attempted mandatory rotation:

“Will term limits, set at some appropriate length, with due regard for implementation complexities, reduce the pressures auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets?”

With all the ambiguity, nonsense and denial right there, focus on mandatory rotation. Time enough to come back to independence, when readers of stout constitution have stocked up enough antacid to alleviate their heartburn in digesting the Concept Release itself.

Consensus unhappiness with the current audit model and the historical “pass/fail” auditor’s report (alluded to by PCAOB member Jay Hanson and as I have discussed here) has, unsurprisingly, not strengthened the tissue-thin case for mandatory auditor rotation. Proof of weakness is, in this case, reciprocal with weakness of proof.

Each of the PCAOB members’ statements nods to the decades-old and too-familiar positions on rotation – Chairman Doty himself managing to mix up a metaphor that only a land-locked Texan could love:

“The learning curve, and cost-based issues involved in changing audit firms, cannot be fairly described as uncharted waters.” 

I have charted these waters, near and far (e.g., here and here) – so, not to repeat, this report from the distant end of Chairman Doty’s learning curve:

The world outside the United States is still terra incognita to the PCAOB, whose parochial approach has ignored the barriers to implementation of rotation on the large-company scale – the only sector where the issue should matter at all.

Between now and the public roundtable scheduled for March 2012, two matters of compelling impracticality should be on the table.

First is the PCAOB’s limited ex-US authority. Although the agency proclaims robust worldwide impact (e.g., the Chairman’s speech, here), its record is otherwise, and suspect.

Instead, the PCAOB has shown itself all too lacking in ability to operate effectively outside the US at all – witness the empty-handed return of its mission last month to China – a market from which the agency has been completely excluded although China has emerged in the last year as a major exporter to America of corporate malfeasance and shenanigans (tracked by Kevin LaCroix’s D&O Diary and even on the screen of researchers at the PCAOB itself).

Were the PCAOB to attempt mandated auditor rotation outside the United States, the consequences – fully foreseeable, and obnoxious -- would range from securities trading prohibitions on the American exchanges, to considerably irritated securities and accountancy regulators in countries understandably miffed at the infringements on their sovereignty.

Picture, for example, the situations of Deutsche Bank, audited in Germany by KPMG, or Sociéte Générale, audited jointly in France by Ernst & Young and Deloitte.

Even if replacement auditors were available, whether in the US or elsewhere – which is far from a certainty (see below) – it defies both logic and imagination to think that audit quality could be improved by obliging a German or French--based parent to engage an additional new audit firm to achieve a single opinion on its consolidated worldwide financial statements.  

As for auditor displacement at the parent level, there should be no reason to think that regulators of the securities markets and the accounting profession in those countries would tolerate, much less welcome, such an uninvited intrusion.

So the PCAOB’s ability to impose its will on major foreign regulators is comparable to the idea that audit quality requires each audit opinion to be personally signed by a Tyrannosaurus Rex – simplistic to mandate, although ill-advised, and impossible to achieve.

As for the second issue -- resource availability -- there is more than the PCAOB recognizes to the Big Four’s nearly total dominance at the global level of large-company audit – besides the awareness that mandatory rotation would only increase the tetrapoly’s hold. 

Namely – in many major economies one firm has clear leadership in large-company audits – e.g., PwC in the UK, KPMG in Germany, E&Y in France, and Deloitte in Spain.

A result is significantly lop-sided distribution of technical and industry expertise and personnel even among the Big Four, constraining rotation choices because such talent shortfalls are not readily or quickly solvable.

That is, what incentive would there be for a firm with a resource deficit to invest the time and cost to build or import the competence needed to rotate onto a complex, world-scale audit engagement – with the known prospect that its prospective new client and its stream of fees would be rotating away at the end of the cycle?

And if not, symmetrically, how does a large company rotate its auditors, if there is no place to turn?

Seekers for answers might recall the legend written on the old flat-earth maps – that beyond the horizons of ignorance, “there be dragons.”

 

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A Prescription for What Ails Large-Company Audit: Real Medicine, for a Change

“Reality must take precedence over public relations, for nature cannot be fooled.”

            -- Physicist Richard Feynman's appendix to the Rogers Commission Report on the space shuttle Challenger disaster, January 28, 1986   

 A reader of my July 17 post acknowledged the continuing sterility of the dialog among the community of financial statement users, about the degraded status of the standard auditors’ report and the deep illness threatening the survival of the large accounting firms. But he chided me for offering only “bromides” rather than my own substantive prescription.

I felt the point of that needle – even though potential solutions have figured for the nearly ten years since this blog’s predecessor, my column "Balance Sheet," launched in the International Herald Tribune.

After the Enron debacle, the politicians’ infliction of Sarbanes/Oxley, and the many-faceted and still-unfolding events of the financial crisis, book-length treatment is surely called for -- despite the discouraging message from authors’ agents and publishers, that while the topic is worthy, the size of the interested audience would not support their investment.

Faute de mieux, I have stayed this course, appreciating the interest and support of a readership well prepared to share suggestions and criticisms.

It is a challenge to address the complex issues, within both column-length constraints and a comprehensive “holistic approach,” such as called for in June by PCAOB chairman James Doty (here), who himself lacks the vision, authority or resources to achieve it.

But by way of synthesis, a snapshot is possible of a sustainable future, using links back to the archives for detail.

First, a few background assumptions:

• A forthright reading of the projects to re-consider the scope and language of the standard auditors’ report, by the PCAOB and the IAASB among others, confirms an emerging consensus that the current “pass/fail” report is obsolete, serves no purpose other than securities laws compliance, and should be supplanted by assurance of real value.

• The existential threat hanging over the Big Four firms’ complete dominance of the large-company audit market -- the “supply side” – is simply not addressed by any of the so-called “solutions” addressed to market concentration – whether mandatory rotation, break-up or new entries, liability reforms, audit catastrophe insurance or bonds, living wills, leadership replacement, etc., etc., blah, blah, blah. As the first head of the PCAOB confirmed, regulators “don’t have a clue” – a widely shared and unchanged attitude of denial.

• There is no credible case for government-controlled delivery of audits worth the effort and expense – whether by direct execution, engagement assignments or otherwise. The output of the artificial and pathetic “profession” that would exist under such regimes would be inferior even to today’s devalued state, much less to the evolved conditions now called for.  

• And, it is time to acknowledge, the entire intellectually fragile structure of auditor independence is anachronistic, ill-suited to today’s conditions, and deleterious to both performance quality and the potential for useful change – a sacred cow that should be taken out and put to a quick and humane end (here and here).

So, now what? 

A framework does exist for regulators to license or charter sustainable audit-only firms (here). But – if and only if – a reconfigured legal and regulatory environment both permits, invites and encourages: 

• Full-service relationships between auditors and providers of other services.
• The attraction and deployment of outside capital, as would be required to support such new multi-service providers, with corresponding changes in permissible ownership structures.
• The appropriate involvement of meaningful regulatory oversight, quality enforcement and investor rights recognition.
• The emergence of geographic and industry-based new competitors.
• And, perhaps, even the return of today’s understandably reluctant insurance industry. 

Under such a fundamentally re-engineered regime, truly new and valuable forms of reporting could be designed and delivered (here and here).

These could be responsive to the needs of financial management and audit committees, welcomed by both executive teams and directors alike, and subscribed to by users under sustainable liability terms). They could be, at the same time, respectful of the value perceived by shareholders and others of the influential presence of “outside experts.” 

Simultaneous attention to all aspects of this framework is essential, however, because until then – as today’s impasse shows -- neither issuers nor auditors have any incentive to take on the increases in both cost and liability imposed under today’s exposed conditions.

I have been calling for years for an adult dialog among the inter-locking and antagonistic interests, who today are only wasting their energy in paralysis and finger-pointing. Without seeking endorsement or even agreement, I suggest that there is much more available here than “bromides.” 

Be the judges – and please let me know.   

 

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