Re:Balance -- Jim Peterson

Expanded Audit Reports: Good, Bad or Ugly?

Spoiler alert from down in the weeds of accountancy regulation: readers reluctant to go there should either stop now or don’t complain that you weren’t warned.

It’s up to new SEC chairman Jay Clayton, whether audit reporting in the US will move into line with most of the world. He is to approve, or not, the PCAOB’s proposed auditing standard, The Auditor’s Report etc. etc., filed on July 19, 2017.

If he does, the PCAOB will conclude its long-running flirtation with this issue by aligning with the earlier movers – the Financial Reporting Council in the UK, with its standard released in June 2013, and the IAASB’s International Standard on Auditing # 701, issued January 14, 2015.

At its core, the PCAOB would require that American public company audit reports include and discuss so-called Critical Audit Matters – briefly defined as those involving “especially challenging, subjective or complex auditor judgments.” The antagonistic advocates face each other with sharpened pens locked and loaded.

In opposition, the US Chamber of Commerce rounded up 27 businesses and groups to join its letter of August 18, 2017, bolstering its own letter of August 11, which complains that “this standard will lead to the disclosure of immaterial information, increase liability costs for businesses and audit firms, and create a chilling effect on audit committee-auditor communications.” As the Chamber concludes, the standard “will obfuscate disclosures for investors and make capital formation less efficient.”

The “pro” argument is cast in terms verging on the patriotic. Caleb Newquist at Going Concern for August 24 disparages the Chamber’s opposition as “poorly written (and) wholly unconvincing,” while the editors of Bloomberg put it the same day that “so far as investors are concerned, more information is better” and that “at stake is the reputation for good governance that has made America a magnet for investors and an attractive place to list a public company.”

To express doubt on the theme of “investor protection” is as if to criticize motherhood or apple pie – perhaps only possible in a convent serving the celiac-afflicted. Of the several areas of concern, however, here are three:

First, with three years of UK experience and a great deal of self-congratulatory back-patting by the insiders, there is no actual evidence-based support for the proposition that investors’ actions are guided by expanded auditor reports – one way or the other. Writ broadly, a guaranteed PhD thesis, tenure assurance and a career annuity of publication await the ambitious doctoral student ready to crunch those numbers. Narrowly, KPMG’s landmark report on the 2013 financial statements of Rolls-Royce, in the midst of a roller-coaster of company travails and swings in its stock prices, has never – down to date since I first addressed it (here) -- been either blessed or cursed for the value of its 5400-word length.

Second, convergence of CAM language to box-ticking uniformity and a bull market in boilerplate are a certainty, to the degradation of value to information users. That is quite simply because company similarities across sectors and industries are far greater than individual differences between them, so the parade of CAMs will evolve to standardized terms: every bank has issues with its portfolio of non-performing loans; every holder of exotic financial derivatives has issues with valuation; revenue recognition has been a challenge in the technology sector since IBM invented the gaming techniques in the 1950s.

Defensive file stuffing will prevail, as the Big Four prepare for second-guessing in their future PCAOB inspections. It may be safely predicted that — as a means of fending off the PCAOB’s ticket-counting inspection process — every Big Four audit in the United States will very quickly be found to have some minimum number of CAMs.

That sets up the third issue – liability. The Chamber elides the real exposure, which is that shareholder plaintiffs’ lawyers will be salivating over the documentary record to be created under the PCAOB’s inspection process, and the four-layered mischief to be inflicted by its deficiency-seeking process.

That is, as the engagement partners are grilled in the lawsuits after the stock-price busts, hostile lawyers will have an interrogation menu to choose from:

• “Your report discusses twelve CAMs, but not the specific “complex judgment” on the matter causing the stock price collapse. How did you miss it?”

• “Why was this “complex judgment” not identified for discussion with the audit committee (assuming it was considered and passed)?”

• “You discussed this “complex judgment” with the audit committee. How could you not have identified it as a CAM?”

• “Your report discloses a CAM for the very “complex judgment” involved in the collapse, which happened anyway. How could you and the company not have solved the issue?”

Squirming in the witness chair will be equaled only by unease in the jury box and an urgent call for settlement funding.

SEC chairman Clayton may force this scenario on American public companies and their auditors. If he does, no part of the Big Audit model nor any of its players will be the better.  

 

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And for an extended examination of this and other issues threatening the viability of the Big Four and their large-company audit franchise, please see the just-released new edition of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”– its Amazon page is here.

Open Letter to EY’s Mark Weinberger: Do the Right Thing – Resign

I’ve just sent this letter to Mark Weinberger, the global Chairman and CEO of EY – third largest of the Big Four international accounting networks – and a member of President Trump’s Strategic and Advisory Council.

Dear Mark –

Somewhat uncertainly attributed to Winston Churchill, on the belated shift in US policy to support Britain in advance of the outbreak of World War II, is the sentiment that, “the Americans will always do the right thing, after exhausting all the alternatives.”

President Trump, in his unhinged press conference earlier today, put on enough spin to nauseate a dervish in re-doubling his repugnant position of Saturday that “many sides” were to blame for the murderous racially-motivated violence in Charlottesville the day before. In doing so, he just handed you the perfect second chance to do what you should already have done – resign from his Strategic and Advisory Council.[1]

Your anodyne tweet of yesterday (@Mark_Weinberger), that it is “time for business leaders and government to unite to help ensure we become stronger through our differences” no longer will wash. Having inherited both his money and his bigotry from his father Fred, and going to school on the ethics and tactics of that epitome of corruption, Roy Cohn, Donald Trump is not about to tolerate your unifying aspirations, however nobly intended.

You’ve known his character for years. Ernst & Young in 2004 qualified its opinion on the financial statements of Trump Hotels & Casino Resorts Inc., for its “substantial doubt about the company’s ability to continue as a going concern.” As your lawyers will tell you, the likelihood of recidivism for a huckster and a charlatan is essentially 100%.

That is today no more plainly displayed than in the reported absence of “self-discipline, control and personal honesty” in Trump’s golf game. Give credence to the observation of P.G. Wodehouse, that “to find a man’s true character, play golf with him” – as applied to the description of Trump’s game by former ESPN columnist Rick Reilly: “This guy cheats from start to finish…It was just one free mulligan after another.”

It should be a no-brainer. Not only do you have ample cover – at this writing there are already five other departures, led by Merck CEO Ken Frazier's departure from the President's American Manufacturing Council.

Moreover, you’re practically immune from any threat of blowback from the bloviator-in-chief, because you and your Big Four colleagues have a lock on the world’s large-company market. That presents you all with other very grave concerns (for which, see my recently-published book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms.”) But the legal requirement for public-company audits means your collective client base has nowhere else to go.

The call for you to act first went up yesterday – Caleb Newquist at his Going Concern clipped your own words, “We have to back up our rhetoric with action.”

Not all will agree, of course – but Newquist with his massive readership among the youngsters of the profession has his finger on its pulse – and you would be wise to give heed.

If you expect credibility with your young workforce, who drive your firm’s prosperity today and will one day inherit your mantle of leadership, then “back up your rhetoric.” The legacy for which you will be remembered will be marked by your behavior in response to the unacceptable dog-whistling now shrilling out of the White House.

Respectfully yours –

Jim Peterson

[1] Corrects earlier version which mistakenly referred to the American Manufacturing Council.

 

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Crowe Horwath – On The Rocks in China

In the original version of “between a rock and a hard place” -- as Homer tells the story in Book 12 of the Odyssey -- when Odysseus sailed for home through the narrow straits between Scylla the six-headed monster and the deadly whirlpool Charybdis, he escaped the twin hazards at the cost of only six of his sailors’ lives.

 No such luck for Crowe Horwath (HK) CPA Limited, the Hong Kong member firm of the eighth largest of the global accounting networks, and auditor of 22 modest-sized companies based in China and filing financial statements in the US with the Securities and Exchange Commission.

By its order dated July 27, 2017, the Public Company Accounting Oversight Board censured the firm and revoked its registration, for its refusal to produce documents to the PCAOB to enable its “access to the information that is necessary to be able to inspect (Crowe’s) audit work as required by the (Sarbanes-Oxley) Act and PCAOB rules” (¶ 2).

The audit firm defended its position based on a direction from the Chinese Ministry of Finance under that country’s laws. Sympathy is in order for Crowe Horwath’s global CEO, who Tweeted (@jkevingmcgrath), “Our Hong Kong member firm (is) caught between compliance with laws & regulations of the Chinese govt and their desire to comply with the PCAOB.”

Thus is brought forward a hostage to fortune that was embedded in the prospect of cross-border clashes of sovereign powers, immediately with the post-Enron enactment of Sarbanes-Oxley in July 2002 -- legislation that created the PCAOB and its inspection and oversight authority over the auditors of US-registered public companies.

That is, the PCAOB has been failing since 2002 to fulfill its members’ wishful promises of solutions to its inability to conduct inspections of Chinese firms – history dating to the PCAOB’s willingness to register non-US audit firms despite their explicit declarations of foreign legal impediments to compliance with its inspection regime.

The PCAOB’s revocation order made clear (¶ 10) that Crowe Horwath was to get no regulatory surcease under the May 2013 Memorandum of Understanding with the Chinese Securities Regulatory Commission and the country’s Ministry of Finance – deprecating that document (¶ 11) as a “non-binding agreement between the signing parties.” So stated, the PCAOB effectively conceded the internal inconsistency between the MOU’s “intent with regard to mutual assistance and the exchange of information for the purpose of enforcing and securing compliance with the respective Laws and Regulations of (the parties’) jurisdictions” and the bail-out that “it is ‘not intended to create legally binding obligations or…supersede domestic laws’ of the parties” (ellipsis in the order).  

The PCAOB’s slap at Crowe Horwath might demonstrate effective agency muscle – or, as likely, could be foundational for dramatically unintended consequences. While the firm’s China-based US registrants will be forced to look elsewhere for audit services, there are broader reasons to be skeptical.

To start, Paul Gillis in his China Accounting Blog for July 26 calls out the agency to “pick on someone their own size” – with implications much deeper than a dig at the Big Four’s dominance of the large-company market in China.

Here is the context: at last count there were reportedly 92 Chinese companies with securities listed on the American exchanges. The upper end is totally dominated by the Big Four – of the ten largest companies in Standard & Poor’s index of the top 50 US-listed Chinese firms, PwC’s member firms audit six – Deloitte three – EY one.

Meanwhile, questions about accounting and reporting in China are fraught and persistent – the year-ago news of an SEC investigation into the accounting of Chinese giant Alibaba makes the point. An eruption of financial malfeasance in China is a simple inevitability, on a scale to have disruptive effect on the share prices of companies listed in America, to which the American regulators will be obliged to fashion a responsive strategy.

Those reactions will be intractably complicated. The SEC will be unable to secure documents and testimony, on the assumption that the Chinese securities regulator would exercise the veto granted in the largely illusory “settlement” of February 2015 – and the PCAOB will be prolonged in the paralysis of its fifteen-year inability to inspect.

Yet with its enforcement action taken against Crowe Horwath’s Hong Kong firm, the PCAOB has firmly nailed its policy colors to the mast – and (to thoroughly mix the metaphors of maritime hazard) will now, with its blind eye turned to the future, cruise merrily along until it too strikes the rocks.

That is because, to maintain any semblance of credibility as enforcer, it would seem obliged to maintain consistency with its sanction of Crowe Horwath, up the ladder of size to events involving Big Four clients. Yet – yanking the ticket of a Big Four firm in Hong Kong or China would have repercussions going to the heart of the global Big Audit model. Simply put, a regulatory deathblow against a Big Four firm in an economy the size of China would threaten the integrity and presage the collapse of a global Big Four network. And in turn, the limited range of auditor replacement choice renders impossible the functioning of a “Big Three” model – whether for the US-listed sector of large Chinese companies on its own or on the larger global stage.

Or put in Homeric terms – by pursuing Crowe Horwath between a rock and a hard place, the PCAOB may very well have sailed itself into those same troubled waters.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free – both at the Main page.

 

And please also consider the comprehensive discussion of these issues in the new edition of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – just released by Emerald Books and available at Amazon.