Myths and fables are replete with urgent early warnings – only occasionally effective. The young shepherd who cried “wolf” -- the little Dutch boy plugging the dike -- the sharp-eyed lad to whom the Emperor was unclothed -- Chicken Little fearing skyfall – all the way back to poor Cassandra, doubly doomed to be disbelieved but proven right.
An emerging large-scale corporate scandal provides a vivid example – sprawling consumer conglomerate Steinhoff International NV, with its global operations based in South Africa, its principal share listing in Frankfurt, and its headquarters in the Netherlands.
As CEO Marcus Jooste put it in resigning on December 5, “I made some big mistakes and have now caused financial loss to many innocent people” – quite an understatement, with the company’s concession of “issues concerning the validity and recoverability of certain Steinhoff Europe balance sheet assets,” reported to reach an eye-popping € 6 billion.
The latest: alleged multi-billion euro accounting irregularities, the company’s share price dropped by 90%, its credit rating cut to junk, predators circling its local operations, politicians and commentators crying for accountability, and rumblings from regulators in the three countries plus the inevitable shareholders’ lawyers.
In this troubled context, there is this to ponder: Steinhoff’s 2015 financial statements bore the traditional and familiar “pass/fail” auditor’s report, issued by Deloitte’s Pretoria office. The next year, with the change in headquarters, the report by Deloitte’s Amsterdam office ran a full eight pages, over 3800 words with three paragraphs on “materiality” and five “key audit matters.”
Steinhoff thus offers a real-world test of the recent requirements imposed by the major regulators, that investors should receive -- and in theory might actually value -- auditor reports expanded to identify and discuss “critical” or “key” audit matters – see the IAASB’s 2015 International Standards on Auditing, and from the US audit regulator, the Public Company Accounting Review Board, its Auditing Standard on the Auditor’s Report, Docket 034, approved by the SEC on October 23, 2017.
The outgoing chairman of the PCAOB called its new standard “the first significant change to the standard form auditor's report in more than 70 years,” which will “breathe new life into a formulaic reporting model.”
Perhaps – although unlikely. My own skepticism – here – is mainly that the combination of liability anxiety and common if complex issues across companies will mean reversion to boilerplate language of anodyne simplicity.
The Steinhoff situation raises a different issue – namely, does anyone really care?
The United Kingdom is now in its third year of expanded auditor reports. While there has been a good deal of self-congratulation, the world of information users awaits an empirical study of whether extended report language in that country has had any effect on investor behavior – one way or another.
The Steinhoff saga should reinforce the doubts. From September 2015 when Deloitte South Africa issued its short report, the company stock had traded in a fairly narrow and stable range, through a series of large-scale acquisitions. The following year’s expanded report by Deloitte Amsterdam identified as two “key audit matters” the valuation of goodwill and intangible assets of over € 16 billion and the accounting for two major combinations for almost € 3 billion, and its balance sheet showed that long-term interest-bearing loans and liabilities had swelled from € 4.1 to € 7.1 billion – among the "critical" areas where the curious might have inquired for what are now the reported gaping holes.
So Deloitte’s expanded language might have been taken as cautionary. To the contrary, instead, media search fails to locate a single word on its extended opus – whether criticism, credit, or indeed comment of any kind.
Rather, impact if any among the investing public looks over-ridden by the animal spirits of the herd -- perhaps not incidentally including South Africa’s public employee pension scheme, the Public Investment Corporation – who all plunged together right up to this last December, when the bottom fell out and the company’s acknowledged if still unspecified accounting irregularities obliged Deloitte to withdraw its report altogether.
In addition to the apparent indifference of investors, history suggests that the affected legal systems will not be much impressed by protests of “we told you so.”[1]
As the blame-allocation exercise unfolds, it remains to be seen whether expanded auditor reporting will rank in importance at all – or whether defensive assertions will be credible that anyone relied on, or is bound by, the thousands of words by which Deloitte elaborated on the complexity of Steinhoff’s financial reporting.
Will it be shown that any of the expansive auditor verbiage mattered to anyone, more than the typical single paragraphs of audit scope and opinion?
The Dutch themselves would politely say, “vergeet do rest, volledig onnodig” (forget the rest, completely unnecessary). German and South African idioms would be similarly dismissive. The most printable American response would be, “couldn’t care less.”
There will be future developments -- watch this space.
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[1] As a model for the less-experienced jurisdictions, the American liability regime has for decades rejected the defense of compliance with professional standards. United States v. Simon (Continental Vending), 425 F.2d 796 (2d Cir., 1969).
You write, "...the world of information users awaits an empirical study of whether extended report language in that country has had any effect on investor behavior – one way or another."
I care less about the impact on investor behaviour than I do about the deterrent effect of expanded auditor reports on issuer behaviour. Of course, that is even harder to measure, but it is difficult to deny it exists.
Ergo, losses caused by Steinhoff's fraud may have been reduced by the new auditor report standard. More importantly, and more likely, other issuers concerned about the additional scrutiny that enhanced audit reports will attract, may scale back any bad behaviour (both fraudulent business practices and fraudulent financial reporting), at least to some extent, in response to this concern.
Reducing losses from fraud is just as valid a goal - and certainly more easily achieved - than eliminating fraud. It is not hard to imagine that where there is fraud, it may be dialed back to reduce the risk of being called out, or at least to moderate the severity of language that auditors may invoke based on their findings.
Posted by: Keith Mautner | January 05, 2018 at 02:56 PM
Keith - Thanks - interesting. Two reactions: First, if as alleged, the accounting issues at Steinhoff run to the scale of six billion euros, it gives pause to consider the extent to which losses as, as you suggest, have been reduced by the new report standard. In other words, if this is success, what would failure look like? Second, the proposition that other issuers would "scale back bad behaviour" would depend on a broadly accepted perception that extended auditor reporting attracted some form of benefit or reward for the issuer -- just the opposite of what would appear to be the case at Steinhoff. In any event, some scrutiny of facts on the ground would, as I suggest, be an appropriate starting point -- even if only to avoid the prospect of confirmation bias.
Posted by: Jim Peterson | January 05, 2018 at 03:23 PM
Does anyone really care? Yes they do, but their “care” is not prompted or alleviated by the report words of an auditor. Auditors have lost the confidence and respect of the interested investor.
Over the last couple of decades the focus of audit firms have shifted from a concern for quality in their work versus their personal financial gain. The auditors followed the mood of the 90’ that “if you weren’t getting rich, you were stupid”. They forgot that their raison d’être was to develop “trust”. When they satisfied that belief, the details of their report was interesting, but somewhat irrelevant. It’s doubtful that trust can be recovered.
Posted by: Duane Kullberg | January 10, 2018 at 12:55 PM