A New Entry in Charlie Munger’s Daily Journal

The usually sharp-tongued Francine McKenna was the very vision of under-statement in her Market Watch for March 3, describing the auditor merry-go-round at the Daily Journal Corporation (DJCO), the odd public company controlled by Charlie Munger – himself better known as the long-time advisor, consigliere and general-purpose wheelman to investor legend Warren Buffett.

In September 2014, Munger had loudly replaced EY with BDO, intolerant of successive annual auditor letters criticizing the internal controls and identifying potential weaknesses at the Daily Journal and snarling, about what he called an “audit from hell,” that EY had been “like the doctor who wanted to cure the nosebleed by fishing around in the groin.”

BDO promptly proved itself no more tractable, in Munger’s view – sacked on this February 17 after two years of “material weakness” letters, to be replaced considerably down the audit firm food chain by the Squar Milner firm.

Slightly re-wording Oscar Wilde’s Lady Bracknell:

“To lose one auditor may be regarded as a misfortune; to lose two looks like carelessness.”

Or something else. Twice within two years, it’s a double-barreled validation of the diminished role of independent auditors, at least as seen by Munger as board chairman and major shareholder.

That is, the language of the Daily Journal’s next auditor’s report will look precisely the same, whether signed by EY, BDO or Squar, wherever they may fall on the profession’s size tables.

Of the Squar Milner firm it expresses no disrespect to note that its handful of offices in southern California (plus an outpost in the Cayman Islands showing one resident), 19 audit partners and $ 55 million in annual revenue make it approximately 1/500^th the size of EY, third largest of the global Big Four and reporting 212,000 world-wide employees and $ 29 billion in 2015 revenue.

The lack of auditor value as perceived by a company chairman as confident and self-regarding as Munger should come as no surprise. The greater point is that the public holders of the 38% of the Daily Journal’s stock not in the hands of insiders also showed their complete indifference.

That is, the company’s stock price in the week of BDO’s firing and Squar’s arrival held rock steady at the news ($ 189 - $ 190, and since risen to $ 194) – just as it had done 18 months earlier (between $ 181 and $ 182) with the firing of EY.

Put somewhat differently, the entire episode makes plain again that the identity of the audit firm placing its name to the commodity language of the traditional “pass/fail” report as required by the SEC is a matter to which investors attribute no value at all.

Those continuing to extol the value of privately-provided assurance, at least in the form currently prescribed by the world’s securities regulators, are just as entitled to their views as is Munger.

As the evidence continues to mount, however, that their position is belied by the real behavior of the participants in the capital markets – Munger providing the latest example – a more valuable exercise would involve a fundamental re-examination of the premises underlying that self-serving proposition.  

 

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And please see here for access to and a synopsis of “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”—my recently published book where these and other concerns for the large-company audit model are fully explored.  

Comments

[Herb Chain]

Jim,

I respectfully disagree with you. You may be blaming the victim here. Munger apparently did not believe that appropriate controls were important, so he fired those doing the right, ethical thing at the risk of losing what might have been a profitable client. And he not only did it once, but did it twice...moving to a small firm that he probably will have more leverage with and where he would be one of its bigger clients.

As for the investor reaction, that is not a function of a "pass/fail" report on the financial statements (the subject as you know of a PCAOB proposal for enhanced language). The investors clearly did not believe that a material weakness is important for their investment decision. (A decision to hold is a decision.)

There are many reasons to question the language of an auditor's report (language that is in part driven by legal considerations), but I don't think that this is an example of one.

[Jim Peterson]

Hi Herb and thanks -- and I suspect we're more aligned than you might think; covering a multi-faceted topic thoroughly in 700 words can present a challenge. I certainly intend no blame on the auditors here, nor would anyone consider Munger a "victim."As for his leverage going forward, time will tell. As for the standard report's "pass/fail" language, I've written elsewhere on the "small change" nature of the PCAOB (and IAASB) proposals - meanwhile this observation of stock price indifference to an auditor change is only one among many indications of the diminished value to investors of the product at the heart of the current Big Audit model.

[Herb Chain]

Jim, thanks for the response. We do tend to be in sync....one point to consider, though, I don't think the PCAOB's proposal on the audit report is "small change." Adding context and discussion of "critical audit matters" is a very big change. It would require the auditor to discuss the judgments and other considerations that framed the audit (e.g., risks, estimates, etc) - matters that many in the profession believe should be discussed by management. And as in many of these situations, there is a perceived risk on the legal front.

I don't disagree that communications by definition should add value and do understand the objective of the proposal. But it is a big step that needs to be thoroughly vetted. The report will change I believe-the tide seems to be flowing in that direction.