“Audited and Approved”
Opinion of William Welch Deloitte dated 8th February 1850, on the half-year accounts of the Great Western Railway as of December 31, 1849, in its entirety
It's been downhill for auditors' reporting ever since.(1)Public Company Accounting Oversight Board (PCAOB) chairman James Doty described the changes proposed on August 13 to the long-standard auditors’ report to “mark a watershed moment.”
The releases from the large firms ranged from the straight-forward (PwC) to the enthusiastic (KPMG), with the expected cheer-leading coming from their flacks; muted criticism from Tony Catanach’s Grumpy Old Accountants and the corporate bar; along with a predictable flag of litigation risk from the Journal of Accountancy.
With formal comments due to the PCAOB by December 11, and as the polite applause dies down, a cooler perspective should see this tinkering as no more a “game change” than raising the stakes from a penny to a nickel.
That’s because the PCAOB is playing it small all the way. Board member Steven Harris emphasized “the need not to change what auditors do, but to change how they report what they do” (The emphasis is his, not mine). Board member Lewis Ferguson concurred, noting that “the standard does not require the auditor to do any additional work.”
To focus on what auditors currently do, however, misses entirely the point of investor concern. The famous and misunderstood “expectations gap” has never been about what auditors do. The gap does not even exist, in the minds or the behavior of investors until it bursts forth after a major corporate fraud or failure.
Unfulfilled auditor “expectations” have emerged with every outburst of serious issuer performance, from McKesson&Robbins in 1940 to JP Morgan Chase’s “London Whale” today.
“Where were the auditors?” does not concern transparency or the disclosed detail of audit work, but the perceived dereliction of not detecting or preventing a manifest problem – whether the collapse of Enron Corp. or the thievery of Bernie Madoff.
Investors are not demanding more nuanced wordsmithing about, for example, the auditors’ attention to issuer information outside the financial statements – the impossibly elusive articulation of a distinction between “read and consider” and “read and evaluate.”
What they do want are answers to share price-moving questions that neither the auditors’ work nor the PCAOB’s changes can ever hope to reach. They include questions like these:
- Will a particular pyramid-structured company – Herbalife comes to mind -- turn out to be a Ponzi scheme?
- Can a particular company whose customer base is concentrated on a high-tech device – Blackberry, perhaps -- actually survive in a world of fast-paced and constantly evolving competition?
- Which financial institution will suffer the next rogue trader at its derivatives desk?
Since securing the franchise to provide financial statement assurance for public companies, under the American securities laws of the 1930’s, the accounting profession has borne self-inflicted responsibility for the creation and expansion of the “expectations gap” – by such actions as:
- Over-selling the level of comfort its reports convey – going back to the inference of guaranty conveyed by the unfortunate and now-replaced terminology, “auditors’ certificate,” and the profession’s futile inability to escape its lingering shadow.
- Tolerating the misplaced label of “watchdog,” as applied by jurists and academics whose presumption of guidance exceeds their competence to pronounce.
- Fostering the obsolete and intellectually fragile “appearance of independence” – a trope at odds with the “client pays” model in place since Mr. Deloitte’s era, which delivers neither protection for the auditors themselves nor enhanced comfort to users.
One thing is for sure – the PCAOB anxiety about creating a bull market in boilerplate language is well founded. Defensive file-stuffing will prevail, as the Big Four prepare for the double-layered second-guessing in their future PCAOB inspections. Not only “Why was this issue not deemed a ‘critical audit matter’?” – but also “How did you decide that this ‘critical’ matter did not require disclosure?”
So it may be safely predicted that every Big Four client will have some minimum number of “critical audit matters.”
Moreover, similarities across sectors and industries are far greater than individual differences between companies. Every bank has issues with provisions for non-performing loans. And the entire technology sector has been challenged by revenue recognition in all the years since IBM pioneered its manipulation. So the pick-list of those items will quickly become standardized.
What is dispiriting is that, on such significant issues as those in the recent great collapses – think Bear Stearns and Lehman Brothers and Merrill, MF Global and Knight Capital and SAC -- it is right to question whether auditors might have contributed positively -- by way of targeted scrutiny and assurance – to management, boards and investors alike.
But it couldn’t have happened, and won’t -- not under the small-bore thinking of “no more work – only more words.”
And not so long as the assurance model is hostage to today’s binary “pass-fail” report – accurately described by PCAOB member Ferguson as something at which “they merely glance … to make sure that the opinion is unqualified….”
If anything good emerges, it is the end of the endless discussion of mandatory auditor rotation – a majority of the Board now accepting the absence of data even suggesting a relationship between auditor tenure and audit quality.
In a one-sentence summary – which propriety inhibited me from sharing with Ms Orenstein’s readers -- the PCAOB has acted on this one like the little boy in church, losing bladder control in his dark blue suit: the results don’t show very much, and he gets to feel relieved and warm all over.
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1. Until supplanted by an earlier-dated example, this pioneering statement – which I found hiding in plain sight in the National Archives of Britain in Kew, on the outskirts of London – is the first expression of independent assurance by one of the profession’s founders, on the financial statements of a large publicly-held corporation.