Re:Balance -- Jim Peterson

Re:Balance Takes a Spring Time-Out -- Will the Silliness Please Take a Break Too!

For the first time since launching as a blog in 2008 after its run without a break from 2002 as “Balance Sheet” in the business section of the International Herald Tribune – “Re:Balance” is going to be dark for several weeks. 

Intense and nearly unbroken travel on three continents will impede staying current on all the mischief within the capabilities of the inter-locking participants in the structure by which assurance is provided on the financial statements of the world’s large companies: issuers, the large accounting networks themselves, users in the capital and investment markets, agencies of law enforcement and politicians and regulators.

Developments in this troubled world are likely to be consequential but cannot be predicted with any level of confidence – so there will be catching up late in the spring.

Three items in the last week head the list of topics to be monitored, however:

• The PCAOB announced consideration of a proposal for the reorganization of its auditing standards – something on absolutely nobody’s list of priorities -- while the agency has failed to get off the snide on either auditor rotation or the content of the auditor’s report – reinforcing the unavoidable conclusion that this body has lapsed into terminal inconsequence. 

• The vote of the European Parliament’s Economic and Monetary Affairs Committee to scrap a proposed requirement for mandatory auditor rotation, in favor of a less binding “directive” on periodic re-tendering, has potential to inflict a dose of reason and reality on a topic long threatening to float away on clouds of fantasy. 

• And the news from the UK -- that the move by Schroders to replace long-time auditor PwC with KPMG has foundered on the inability of the putative successor to satisfy the independence requirements -- provides early validation that even aspirations limited to periodic re-tendering are subject to the realities of a market for audit services too constrained to function under legislated mandates.

All of these challenges reinforce the over-arching need for fundamental re-engineering of the reporting and audit functions in their entirety. But this process is unlikely to advance in any significant way during my brief absence. 

Instead, there is every reason to be confident that these problems will all be here and awaiting attention when I return.

 

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The PCAOB’s Inspection Reports Nibble at PwC -- A Reader Asks, “Where’s the Beef?”

Food beyond compare

Food beyond belief

Mix it in a mincer

And pretend it's beef

Kidney of a horse

Liver of a cat

Filling up the sausages

With this and that

-- Thénardier, “Master of the House,” Les Misérables

The Public Company Accounting Oversight Board – overseer of the accounting profession in the United States – got in a snit recently, perceiving that PwC was lax in its efforts to remediate the “significant audit performance deficiencies” that the agency asserted in its 2008 and 2009 inspection reports.

Expressing pique as it only could, on March 7, the PCAOB released to an indifferent public the previously undisclosed “Part II” portions of those reports.

Did it arouse the aforesaid public to care? Or even to notice?

A predictable handful of the large accounting firms’ most reliably ardent critics did weigh in (here and here).

Meanwhile a measured comparison comes to mind – the teapot-scale tempest aroused in Britain and Ireland this winter, over the discovery of equine DNA in samples of meatballs and ravioli – not, enforcers emphasized, because of any actual consumer health hazard, but over alleged deficiencies in labeling and transparency.

On which my perspective takes from the attitude of my daughter, a situational vegetarian who, on assignment this last year in Southeast Asia, has extended her palate and appetite to include crickets, dog conch and scorpion.

In the European kerfuffle, a libertarian-oriented omnivore – believing in both cultural differences and regulatory intervention only to the minimum necessary – would favor a simple modified label: “May contain horsemeat”. 

As for the PCAOB, the question has to be asked -- How can an oversight function claim either legitimacy or effectiveness, that:

• Decides for itself how to define and identify not a legal or professional standards failure, but an elusive “significant audit performance deficiency.”

• Keeps score under its own methods and incentives, like a traffic meter maid sent on patrol with a book of tickets and a daily quota.

• Must under cover of confidentiality conceal both the names and the detailed particulars of its self-defined offenses.

• And then in a burst of ill-temper, decides for itself whether the undisclosed substance of a remedial effort is satisfactory within unmeasured and unarticulated standards.

It’s no wonder, for two reasons, that PwC saw no reason to pursue its right of appeal to the Securities and Exchange Commission.

First, because PwC negotiated the ability to append to the PCAOB’s release a pronouncement of its commitment to virtuous conduct, positively radiant with unctuous platitudes.

But second and more especially, because under the current model for compliance with the securities laws, under which there is no available alternative, the Big Four-dominated market for large-company audit services is armor-plated against the PCAOB’s pop-gun arsenal. 

Law enforcement, rules compliance and social norm-setting in general -- in contexts that are controversial, subjective and incomprehensible to the laity -- are subject to credibility challenges and diminution of the authority of their arbiters:

• The Supreme Court’s obscure definition of obscenity, “I know it when I see it” (Stewart, J., Jacobellis v. Ohio, 1964).

• The theological search for distinctions between mortal and venial sins.

• The nuances and complexity of sport, from soccer’s off-side and cricket’s leg-before-wicket to hockey’s high-sticking and baseball’s rules on balks and infield flies.

• The subtleties of line-drawing between shrewd and informed investing and insider trading, or the bribery of officials and accepted business facilitation.

Here -- the mutual hypocrisy in the whole sorry audit regulatory environment is pervasive:

The PCAOB gets to pretend it is engaged in a meaningful exercise, worthy of being taken seriously in the capital marketplace.

The audit firms are obliged to pretend that they take the cost and impositions of the inspection process as something more than the de facto license fee paid as a nuisance to maintain their franchise.

And to the limited extent they really care, financial statement users can only search elsewhere for meaningful assurance, beyond the model unchanged since the Victorian era and long since degraded into obsolescence. 

Critics of this dysfunctional structure are entitled to their finger-pointing cynicism. But their bile is misplaced – until and unless they unite in advocating an achievable effort to re-engineer the entire system of reporting and assurance that today only fosters ambiguity, inconsequence and disrespect.

Until which, at the foot of each PCAOB inspection report should be appended an adapted version of the suggested European meat label – “May contain horse-sh*t.”

 

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Re-Structuring the Audit Profession: The UK's Competition Commission Hunts the Woozle

 After the United Kingdom’s Competition Commission issued its report on February 22, asserting that the Big-Four-dominated audit services market is non-competitive, I sought to raise a flag of warning that, unless de-railed, its rush to fait accompli would soon inflict mandatory auditor rotation or at least re-tender on global-scale companies.

Diligent digging through the Commission’s augean piles of paperwork makes clear that its ostensibly supportive “research” ranges from the shallow and irrelevant to a results-driven reflection of its confirmation bias.

Comes to mind A.A. Milne’s 1926 fable of Winnie-the-Pooh and his pal Piglet, earnest and naïve, circling their own tracks around a spinney of larch-trees, and befuddled in their speculation that they might be tracking a Woozle.

 

Despite a forthright bias in favor of “auditor switching” – reflected in the finding that “incumbent auditors … face less competition for their ongoing engagements than they would were the company more willing to switch thereby reducing rivalry” -- the Commission fails to elicit any evidence-based impact of auditor tenure on audit quality.

To be sure, the Commission’s inquiry into the rate of “switching” is voluminous – building elaborate calculations in search of relationships among such elements as client size, audit complexity, geographic spread, client evolution from private to listed status, length of tenure at the start of the measured period, etc.

Yet, it does not attempt to examine, much less resolve, these two related but distinct questions:

• With the considerable number of long-tenured auditor-client relationships where the record of non-controversial financial reporting is unbroken, is there any identifiable relationship between the length of auditor tenure and the incidence of diminished quality or “audit failure”?

• As to the extremely small population of actual “audit failures” – compared to the huge number of non-problematic audits – is there any identifiable relationship between the length of auditor tenure and such failures themselves?

Nor is the integrity of the Commission’s history of the profession any better than that of their economic research. Their lengthy discussion of the early audit requirements, evolving from the Joint Stock Companies Act 1844 through to the superseding Act of 1856, omits essential facts:

• First, the terms of the 1844 Act were met by “auditors” chosen from among the company shareholders – non-professional co-investors engaged to examine and report on their company’s results, with interests not independent but precisely aligned economically with their fellows. 

• Second, it was not until the dawn of the next decade that these amateur “auditors” reached out to the nascent profession for assistance – e.g., William Welch Deloitte, then aged 32, joined Messrs. John Dickinson and Richard Atkinson, the shareholder auditors of the Great Western Railway’s accounts for the six months ended December 31, 1849, in the terse opinion dated February 8, 1850 – “Audited and Approved.”

• Third, therefore, by the Act of 1856, developments in the market for independent audit had surged forward, making that legislation essentially reactive, in the same manner as today for government regulators typically late to the party. 

Shortcomings in the Commission’s approach include a rose-tinted survey of the mid-tier firms’ “self appraisals of their capability and willingness to audit FTSE 350 companies” – noting, however, that as of 2010, the Big Four audited 99 companies of the FTSE 100, and 96% by number and 99% by fees of the entire FTSE 350.

In that context, asking a mid-tier business developer about his firm’s capability to audit a global-scale FTSE 100 enterprise would be like asking a sophomore in a fraternity house how he’d like a date with the Sports Illustrated swimsuit cover model. What possible response could be expected?

My graduate-level course in Risk Management uses a reading exercise in what legitimate, non-ideological research ought to look like – drawn from the very Victorian era when independent audit was invented, on whose history the Commission is so dim.

It’s the 1855 diary of physician John Snow, whose meticulous tracking of epidemic cholera cases around the publicly-accessible water pump at Broad Street in central London ranks among the origins of forensic medicine.

Dr. Snow’s techniques made inquiry in both directions: Not only who got sick, after drinking water from the pump – including both residents and casual visitors to the neighborhood. But also, who lived and worked in the vicinity and yet stayed well – such as brewery workers who preferred their own product to pump water, and factory hands in a facility with a separate and independent well.

By so doing, Snow avoided precisely the trap of disregarding the “absent evidence,” into which the Commission’s ends-serving inquiry falls headlong.

Confronted by Christopher Robin’s challenge that they had been chasing their own footsteps, rather than the imaginary Woozle, Pooh had the grace to concede:

"‘I see now,’ said Winnie-the-Pooh.

‘I have been Foolish and Deluded,’ said he, ‘and I am a Bear of No Brain at All.’

…. And then he brightened up suddenly.

‘Anyhow,’ he said, ‘it is nearly Luncheon Time.’

So he went home for it." 

 

Commission group chairman Laura Carstensen and her fellows should do no less.

 

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Mandatory Auditor Rotation: The UK's Competition Commission Stirs the Pot

For a charm of powerful trouble,

Like a hell-broth boil and bubble.

Double, double toil and trouble;

Fire burn, and caldron bubble.

            W. Shakespeare, “MacBeth,” 4.1

The simmering caldron of accountancy regulation was brought to a rolling boil in the United Kingdom on February 22, when the five-strong Audit Investigation Group of the Competition Commission issued its provisional findings.

No less sweeping than its assertion that the supply of statutory audit services to large public companies is rife with adverse effects on competition, the Group's suggested “remedies” would be draconian – among them, mandatory re-tendering for audit engagements every five to seven years, and mandatory rotation of audit firms after seven to fourteen years.

Remarkably, while the UK press treated these landscape-altering proposals as a one-day story (e.g., the Financial Times, BBC and Independent), attention in America beyond minor pick-up from the news services has included not the first word of either reporting or commentary.

Which had better change, and quickly too – not just because the basic impracticality of mandatory rotation is a long-standing barrier to its implementation (here, here and here). It’s because Group Chairman Laura Carstensen and her coven of non-accountants are working to the accelerated timetable of March 21 for comments, and publication of a final report by October 20 of this year.

By then, under the typical regulators’ effects of both momentum and inertia, their “provisional” hell-broth is likely to be fully cooked.

And a toxic brew it is indeed.

The Group did give the market-dominating Big Four tetrapoly a back-handed compliment, by exonerating them from the most malign charges of the profession’s fiercest critics:

“The CC also considered whether the market conditions are conducive to coordination or that Big 4 firms engage in tacit collusion; that they bundle audit and non-audit services together in order to raise barriers to expansion to other firms; that they target the customers of Mid Tier firms with particularly low prices; or that they are able to exercise undue influence over the formation of regulation or on regulatory bodies through their extensive alumni networks. To date, the CC has not identified sufficient evidence to support these other theories of harm.”

Scant comfort, indeed, as they went on to “find” an entire menu of ostensible reasons for a dramatic re-structuring of the audit services market:

            “Companies face significant hurdles in comparing the offerings of an incumbent auditor with those of alternative suppliers other than through a tender process.

            “It is difficult for companies to judge audit quality in advance due to the nature of audit.

            “Companies and firms invest in a relationship of mutual trust and confidence from which neither will lightly walk away as this means the loss of the benefits of continuity stemming from the relationship.

            “Company management face significant opportunity costs in the management time involved in the selection and education of a new auditor.

            “Mid Tier firms face experience and reputational barriers to expansion and selection in the FTSE 350 audit market.

            “Auditors have misaligned incentives, as between shareholders and company management, and so compete to satisfy management rather than shareholder demand, where the demands of executive management and shareholders differ.

              “Auditors face barriers to the provision of information that shareholders demand (in particular, from the reluctance of company management to permit further disclosure)."

Beyond these mostly unexceptional characteristics of a properly-functioning market for specialized professional services, of course, the unresolved and gaping logical gap in the Group’s entire approach is two-fold:

• First, Big Four dominance of large-company audit is a natural-market result of client demands for scale in geographic coverage, expertise and exposure tolerance – all of which are beyond the capabilities of the smaller firms.
• Second, at the same time, the widely-shared dissatisfaction of the user community -- that the standard and commoditized auditor’s report is grievously obsolete and provides no value -- is destined to be unrealized by the attempted re-engineering initiatives of such standard-setters as the PCAOB or the IAASB.

Nor is either of these root difficulties touched at all by the asserted but unsubstantiated claims of benefit to audit quality to be wrought by mandatory tendering or rotation.

Instead, within what the FT described last fall as the Commission’s “sheaves of working papers,” there is not a single research under-taking, much less a scintilla of evidence, showing an actual link between the length of an auditor’s tenure and the quality of either its audit work or its client’s financial reporting.   

Put in summary, the fundamental dysfunctionalities in the reporting and assurance models are untouchable by the “solutions” urged by those having the authority (if not the evidentiary basis) for their mischief-making, while mandatory re-tendering and rotation remain as “remedies” in search of problems yet to be grounded in reality.

But if not stopped, the Competition Commission is likely to work its will.

A regulator on a results-oriented mission is dangerous enough. But undiluted by the flavoring effects of the facts, the Commission’s recipe for a reconstituted audit structure will leave a foul taste all around.

Those obliged to sup at this devil’s banquet are advised to bring very long-handled spoons.

 

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