Re:Balance -- Jim Peterson

The Pre-Election Mood: Enervation Over Innovation

 I awoke last night in the cold sweat of nightmare terror – my own version of Bill Murray in the 1993 film, “Groundhog Day”-- that CNN moderator Candy Crowley saw her shadow, and we were cursed with six more weeks of Presidential debates.

And PCAOB chairman Jim Doty kept scheduling “public meetings” on the exhausted topic of mandatory auditor rotation – the last in Houston having dragged through October 18 with no observable contribution to our wisdom – until he held one in the junior high school gym in Punxsutawney itself.

A tour of media, commentators, and those knowledgeable, confirms the prevailing sense of lassitude and ennui – owing much to the nationwide American paralysis ahead of its November 6 elections, but also to the absence of any credible display of energy, much less urgency, around the issues overhanging the accounting profession.

The usual crabbing continues, of course – ranging from the ineffective if age-old grousing about auditor skepticism -- vented by the PCAOB chair himself, webinars from the private sector, and such bloggers as the Grumpy Old Accountants – to the commenter on my last posting, about the British regulator’s new policy on re-tendering, stating mistakenly that I “ask for ‘proof’ that lack of auditor rotation is a cause of fraud,” when I want no such impossible thing, but only recognition, as I have often said (see here) of the absence of “any evidence of a link between auditor tenure and audit quality.”

In the gathering gloom and darkness of late autumn, then:

Nothing good can be expected from the Securities and Exchange Commission in Washington, where Chairman Mary Schapiro is said to be packing for her post-election departure, having in her light-touch tenure realized nothing of effect on the structure or stability of the assurance function. 

On the globalization of accounting standards, the dialog is if anything more sterile than ever: The SEC has only an interim chief accountant in place; the griping about non-convergence includes the hand-wringing of IASB trustee chairman Michel Prada and the sideline irrelevancies of AICPA president Barry Melancon; while FASB chair Leslie Seidman should be plainly tired of the censorious Dutch-uncle utterances of her counterpart at the IASB, chairman and non-accountant Hans Hoogervorst.  

While on the auditing standards side, the intellectual heft brought by the International Auditing and Assurance Standards Board to its project on Improving the Auditor’s Report is unmatched by the political skills or horse-power necessary for action in the face of entrenched resistance. At the same time, the PCAOB’s parallel Concept Release, going back to June 2011 – which by rights should be cooperative and complementary – wallows becalmed for lack of any readiness to re-engineer a reporting system in which all interested parties are invested in preserving the status quo.

Even what should be a bright spot – the launch earlier this month by seven joint sponsors of an assessment tool for audit committees, “Annual Evaluation of the External Auditor” – designed to support “an informed recommendation to the respective board of directors whether to retain the auditor,” has the taste of very thin gruel.

That is, it says precious little about the skill level of an audit committee, to think it requires such an anodyne checklist as these “get-to-‘yes’” examples: 

• “Was the cost of the audit reasonable and sufficient for the size, complexity and risks of the company?”

• “Was the audit engagement partner able to explain accounting and auditing issues in an understandable manner?”

Enough with the softball treatment. For a committee obliged to justify itself, why are there not such substantial questions as:

• “What qualifications and training does the audit committee itself have in the exercise of skepticism and the avoidance of bias?"

• “If forced to rotate or re-tender the audit, does the company have a realistic alternative choice?” 

• “What other or different forms of assurance, beyond the current standard audit report, would company management and its community of information users find useful and valuable?”

Historians of the evolution of knowledge teach that systems on the cusp of obsolescence – inherently resistant to the disruptions of fundamental change – evolve only when those contributing to the prevailing inertia are forced into confrontation. 

But that when they are, the realignments are highly disruptive, in ways unpredictable in advance.

Meaning that the groundhog’s looming shadow is long, dark and ominous.

 

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Mandatory Auditor Rotation -- The British Regulator's Latest Spin

The endlessly tiresome proposal that mandatory auditor rotation would improve audit quality – a mis-perceived solution long and desperately in search of a problem – approaches its defining moment – taking one of the forms I predicted last spring. 

The Financial Reporting Council – regulator of accounting and auditing standards and practices in the United Kingdom – on September 28 slipped this subtle sentence into section C.3.7 of its Governance Code: 

“FTSE 350 companies should put the external audit contract out to tender at least every ten years.”

Called “limited changes” by the FRC, this stealth provision has been little remarked at home and virtually ignored in the United States. But the impact and effects – once the dust settles – will be profound, if difficult to predict.

Consider first the global market for audit services. The largest 100 and second 250 British companies span the globe in their size and reach – from the agency giant WPP to BP in the energy sector to consumer leaders Diageo, SABMiller and Unilever to global bankers HSBC and Lloyds – with dominant business operations, dual stock listings and deep capital market participation across the world’s developed economies.

Audits of their financial statements are, with a handful of exceptions, the exclusive province of the Big 4 firms – 99 of the largest 100 and 234 of the next 250, when last surveyed (here and here). For reasons of cost and efficiency in any process of re-tender, the CFO’s and audit committees of those companies will invariably seek either the retention of the incumbent auditor, or the ability to transfer to another single provider. So choices made in London will be reflected in the structure of the audit market across the globe.

But, given the spotty and unequal world-wide distribution of audit competence and technical expertise, it is predictable that any auditor shifts resulting from the FRC’s dictate will, if anything, further tighten concentration at the top of the market.

Will any real changes actually emerge? The debate on mandatory rotation has been conducted in a vacuum of either evidence or intelligence on these two fundamental questions:

1. Why is there a total absence of facts even suggesting a causal connection between audit quality and the length of auditor tenure?

2. And, are choices for auditor replacement truly constrained by either disabling scope-of-practice conflicts or the firms’ unwillingness to surrender the value of such other services as tax, banking and consulting?

Two competing assessments are offered. One would be reluctance to tender – with the audit firms unwilling to invest the considerable time and expense to build sufficient size, expertise and geographic presence to pursue the uncertain process, especially when obliged to forego the certain revenue streams now generated by their non-audit work for these global giants.

In that case, the non-incumbents will take a pass; the result of re-tendering will only be the rationalized re-engagement of incumbents – a public relations exercise in “comply or explain” that may buy a decade or two of rhetorical peace but little else.

A second scenario rests on the hypothesis that large global companies now concentrate their non-audit services mainly in a single alternate Big Four provider. That firm might be a rotation candidate, assuming a “shadow cabinet” of existing skills enabling it to switch over to the audit with minimal disruption – and likely resumption of the non-audit status quo ante when it yields back the audit brief a decade hence.

A skeptic would be entitled to question whether professional skills are so fungible and transferable, much less available; or that the large firms’ current client relationships organize into such neat duopolies; or that, indeed, such a “pass-the-parcel” exercise is quite what the proponents of mandated rotation have in mind.

It is sure that London is already a-flutter. Fund manager Schroders has announced a re-tender after forty years of audits by PwC, for one example – despite no indication of either dissatisfaction or impaired quality.

About the only certainty is that the UK initiative will finesse both the already speed-bumped path to rotation urged by EU markets commissioner Michel Barnier and, in the US, PCAOB chairman Jim Doty’s extended series of hearings -- the latest, set for Houston on October 18^th which shows Doty’s willingness to pursue out-of-town try-outs in the futile search for an adult witness with a fact-based case in his favor.

Put another way, the FRC has now kicked down the road of mandatory rotation a can that bears the label, “Made in the UK -- for world-wide consumption.”

 

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