Re:Balance -- Jim Peterson

A Taxman Cometh – The United Kingdom Gets a New Audit Regulator

London continues the center of political and regulatory threats to the Big Audit model – there being no way to tell the difference between Washington’s summer torpor and the chronic somnolence at the SEC and the PCAOB:

 “Cometh the hour, cometh the man”? Perhaps – although not clear.

Whitehall’s July 18 announcement is that career civil servant Sir Jonathan Michael Thompson – “Jon” yclept – will leave his post as chief executive of HM Revenue and Customs, succeeding Steven Haddrill, the lame-duck chief executive of the Financial Reporting Council.

He will arrive in interesting times. The FRC – “toothless and passive” as described by Labour MP Rachel Reeves, and in City grandee Sir John Kingman’s December 18, 2018, report (¶ 4) “a rather ramshackle house … built on weak foundations” – is to mutate into a newly configured Audit Reporting and Governance Authority.

Or not. Housekeeping adjustments at the FRC began with uptake of the Kingman report by Greg Clarke, cabinet secretary for Business, Energy and Industrial Strategy. More serious changes require legislation, although whether any law-making energy survives the Keystone Kops environment of Brexit will abide – as will, indeed, any policy initiatives that may outlive the dubious tenure of a Tory government predicted to be led by Boris Johnson.

To fulfill ARGA’s charge, described in the July 18 Financial Times as “restoring confidence in the quality of the audit work in the UK after scandals at companies such as Carillion, the outsourcing group,” Thompson steps into fraught conditions.

First, as addressed in detail in my new book – “DOA: Can Big Audit Survive the UK Regulators?” – he will find his regulatory cookbook lacking achievable recipes:

• The headline recommendation in the April report of the Competition and Markets Authority was that all but the largest of the FTSE 350 companies should engage two audit firms. The problem is that if enacted, a requirement that second auditors be selected from the ranks of the “challengers” would suffer irredeemable impracticality based on those firms’ limited scale, capacity, financial resources and risk tolerance.
• The CMA’s other proposals -- that there be “organizational separation” of the Big Four’s audit practices, and that they should foreswear all ancillary services to audit clients -- were already either fait accompli or well capable of adoption, yet are of dubious and unproven impact on the quality of auditor performance.

Second, the more aggressive actions urged by press and academic critics as well as the April 2019 report of the Reeves committee -- such as enforced reduction of the Big Four’s market dominance, actual break-up, or shrinkage of the large firms to “audit only” -- have failed to acquire traction.

Third, presuming the best of regulatory intentions at the new ARGA, reality will intrude to impose practical limits on the scope of any enforcement penalties -- the head-on hazard that the failure of another Big Four firm, in a reprise of the 2002 litigation-driven collapse of Arthur Andersen, would disintegrate the entire model.

Last and most important, ARGA will inherit two of the FRC’s structural handicaps – that by the nature of its auditor oversight remit it is distant by two removes from the machinations of corporate malefactors; and that, like any enforcer, it will be under-resourced, politically stressed, and consistently late to arrive on the scene of the next and inevitable outbreak of scandal.    

In this less-than-optimistic setting, Sir Jon brings to his new task a CV in government accounting and finance and a career-long string of civil service postings – none relating to the profession of public accounting or, in particular, the national and global complexities of the Big Four networks’ provision of audits for the world’s large public companies.

Rather, as the FT observed, his tenure at HMRC included “controversy over staff bullying” and “an independent review (that) found that abrasive behavior was prevalent.”

Context affects the prospects for success. “Horses for courses,” as the English put it. Or in the tactics manual of the American mob, “don’t bring a knife to a gun fight.”

Is a bare-knuckled bureaucrat well suited to the UK’s multi-party bun-fight over its audit model? Critical public reaction to the evidence given in last January’s committee hearings by non-auditor representatives of the large accounting firms suggests the importance for credibility’s sake of detailed experience and communication capability.

Credit Sir Jon with the energy and skill set of an experienced civil servant –- whether or not transferable to a radically different context, where both enthusiasm and ideology may well be sucked into the vortex of Big Audit’s technical, professional and business structure and culture – enough to smother the best of intentions.

One risk is clear: his initiatives will be hostage to the Dunning-Kruger effect – the prospect that inexperienced decision-makers will suffer all-too-human over-confidence and fail to recognize the limits of their capabilities in a complex field.

As the current occupant of the White House in Washington has been fond of saying since 2016, about his own ad lib initiatives that so often dissolve into thin air or inaction, “We’ll see.”

 

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What Price Wrong-Doing? Sanctions Against KPMG Are Complicated

It's always a pleasure to be a guest at Going Concern -- where the post below appears as of this morning, looking at two front-burner topics this summer in the US and the UK. For a detailed review of the threatening and volatile environment in the UK, where official actions threaten the stability of the Big Four business model and the viability of their franchise to audit large public companies, I invite you to my new book, available on Amazon in paperback and e-reader formats -- "DOA: Can Big Audit Survive the UK Regulators?

“Sell in May and go away” was an investors’ adage invoked as vacation strategy in a more genteel era. Returns in the summer were said to lag the rest of the year—and in any event, that’s how brokers justified their holiday cottages on the eastern seaboard.

This year the maxim has twice failed my attempt to stay off the grid. Most visibly, the SEC on June 17 ordered a $50 million fine against KPMG LLP; the penalty was a two-fer: both a complement to the criminal proceedings against senior personnel of the firm and the PCAOB for the theft and misuse of agency inspection information, and also for the firm’s gaming of internal training and tests, including those done under prior orders of the SEC itself.

Also there is the inquiry in the U.K. into the “purpose of audits,” led by former London Stock Exchange chair Sir Donald Brydon, under a charge from Greg Clark, Secretary of State for Business, Energy and Industrial Strategy—latest in a series of official proceedings involving the Big Audit model, inspired by a series of scandals originating with the January 2018 collapse of the giant public contracting enterprise Carillion.

Sir Donald’s convocation of two diverse advisory groups, and his upbeat Twitter note that his Call for Views in April elicited 110 responses, provide optimism that the project will not only look at the expectations of the capital markets for an audit model fit for modern purpose, but also assess the realities, weaknesses, and challenges in the existing market dominance of the Big 4.

Uncertainties around KPMG’s punishment connect the two. The link is the under-appreciated fragility of the Big 4—the shockingly low ceiling on the financial capacity of the firms to survive a fine or judgment on the scale that Enron inflicted on Arthur Andersen, because another collapse would put at risk the entire model.

A $50 million fine against KPMG is not itself of that magnitude. Spread among the roughly 2,200 partners of the U.S. firm, with its 2018 revenue on the order of $9 billion, the bearable impact is about $23,000 per partner. (The LLP does not disclose profits per partner, but a comparison with the disclosed 2018 partner profits of the KPMG network’s firm in the U.K.—£601,000, or about $765,000, is probably reasonable.)

Skepticism about the size of the hammer wielded by the SEC has come from well-recognized critics: in the U.S., Jason Bramwell at Going Concern, Matt Kelly at Radical Compliance, Francine McKenna at MarketWatch; in the U.K., twittering academics @premsikka and @atulshah among others.

Which is not unfair. A fine of even $100 million would not raise the individual impact above $50,000 each for the average KPMG LLP partner.

But the critics’ argument for a fine of $1 billion, nearing $500,000 per partner, would be another matter. That would be seriously painful and, if doubled, would raise the existential challenge that insecure partners would swallow their loyalty, withdraw their capital, and vote with their feet—throwing the firm and its entire global network into an Andersen-like death spiral.

Theoreticians and policy-makers concerned with crimes and punishments have agonized over the complexities: What level of sanctions properly balances society’s desire for deterrence with the appropriate pain on a wrong-doer? How well is justice served, where collateral concerns—here, the survival of the Big Audit model itself—put a practical ceiling on the ability to punish?

If the problems with money fines are intractable, what other tools are available? The SEC’s June 17 order (paragraphs 65 to 82) includes a basket of multiyear reviews, reports and undertakings by leadership of KPMG LLP, and requires the engagement of an independent consultant.

Enough to satisfy the critics? If those impositions are too light to be credible, suppose creation of an office of the CEO, with C-suite presence of outsiders on a day-to-day supervisory basis.

The idea that senior management be supplanted by outside leadership has been advanced at least twice—first in 2002, as Arthur Andersen lurched to its collapse, with the non-starting notion that the eminent Paul Volcker should step in, and again in 2008 as a proposal of the Advisory Committee on the Auditing Profession convened by Treasury Secretary Henry Paulson.

Both met understandable ridicule and rejection. The powers of a newly-arrived corporate CEO to hose the stables might be effective—wholesale firings and reorganizations would be well within scope. Not so, as Andersen’s experience demonstrated, where a partnership’s viability depends on retention of the skills, votes, and mutuality of trust and confidence among a committed collection of partners.

“Solutions” either facile or intemperate being unhelpful, here are offered two desires:

First, that for the sake of their credibility, the critics should be obliged to annotate their harsh rhetoric with constructive proposals by which to replace the current Big Audit model, which the draconian penalties they urge would threaten to destroy.

Second, that Sir Donald Brydon’s review will have sufficient breadth to embrace the entire array of inter-connected issues, including the survivability of the Big 4 model for privately provided large-company audits.

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