Re:Balance -- Jim Peterson

NOCLAR: The Auditors' Impossible Task Under a PCAOB Proposal

 

"Why, sometimes I've believed as many as six impossible things before breakfast."

-- The Red Queen, Lewis Carroll's "Through the Looking Glass," 1872

As I was pleased to address today for Bloomberg, the American audit regulator is at it again:

The Public Company Accounting Oversight Board is promoting a flawed plan to escalate the responsibility of auditors for their clients’ noncompliance with laws and regulations, called NOCLAR. As proposed, the auditors’ duties would be new, expanded, and impossible to fulfill.

For context, current standards recognize that “whether an act is, in fact, illegal is a determination that is normally beyond the auditor’s professional competence.” Reflecting reality, the standards have provided since 1988 that an audit normally “does not include audit procedures specifically designed to detect illegal acts.”

The PCAOB’s draft rules would both raise the bar and obscure its height. On top of the standard for fraud detection (AS 23401), auditors would:

• “Identify the laws and regulations with which noncompliance could reasonably have a material effect”
• “Assess and respond to risks of material misstatement” caused by “noncompliance with those laws and regulations”
• “Identify whether there is information indicating noncompliance with those laws and regulations has or may have occurred”

Supporters of the proposal include PCAOB chair Erica Williams, who said, “We’ve seen far too many examples of investors getting hurt due to noncompliance with laws and regulations. And we’ve heard calls from investors for auditors to live up to their responsibilities. It’s time we answer those calls.”

The new standard “is a great step forward for auditor responsibility and empowerment, and for the protection of investors and the markets,” board member Kara Stein said.

However, opposition from corporate America and the large and small accounting firms on whom the burden will fall comprised the bulk of the now 137 comment letters posted to date. The comment period ended in August.

PCAOB member Duane DesParte, one of the two dissenters on the five-member board, said the “expanded scope raises concerns when coupled with the additional proposed requirement for auditors to ‘plan and perform procedures to identify whether there is information indicating noncompliance.’”

The lines of disagreement are drawn with a sharp and simple reason to be wary: The Big Audit model isn’t designed to meet the proposal’s expectations or to bear its consequences.

The only meaningful assessment of auditor performance is in the small number of cases that “go wrong,” with the inevitable question—"Where were the auditors?”—tested in the litigation or regulatory actions that arise with serious corporate malfeasance.

NOCLAR reporting has challenged audit practices for decades. In the courtroom, the plaintiffs’ script follows a crisp and successful template: The “audit plan” was incomplete or inadequate - the auditor’s “search” was insufficient to catch the illegality at issue - even assuming thorough planning and search, the auditors failed to identify and mitigate this particular wrongdoing.

The auditors’ defense is that as non-lawyers who aren’t trained in substance or procedure of criminal law, they were fooled by the concealed criminality of their malfeasant clients—no less than general participants in the capital markets.

DesParte flagged what would be a changed and more threatening environment: “While the proposal focuses the auditor on those ‘laws and regulations with which noncompliance could reasonably have a material effect on the financial statements,’ the filtering threshold of ‘reasonably could’ is not adequately explained in the proposal and is not addressed elsewhere in PCAOB standards.”

Under the proposed standard, the plaintiffs’ updated playbook would argue that a particular illegality or noncompliance should have been identified as material and that indicators of noncompliance that may have occurred were overlooked.

Translating DesParte’s diplomacy into the ruder language of litigation exposure - if anything, the proposed standard’s ambiguities and imprecision would mean that defense of the auditor’s work would become even more difficult, not less.

Compounding their difficulty, the auditors could expect little help from their clients’ in-house or outside counsel. The lawyers’ long-running protection of their privileged client communications (see the US Chamber of Commerce’s comment letter) enables a black hole in corporate reporting, by which the lawyers pretend to be unable to quantify their litigation and contingency assessments, while the auditors and information users pretend to believe them.

Going forward, the deserved scrutiny of the PCAOB’s proposal would compare the proposed standards with expectations under the old. A useful exercise would back-test recent examples. If the proposed standards had been in place, would there have been any difference in PwC’s audits of Colonial Bank? Or in Deloitte’s audits of Taylor Bean & Whitaker?

Those exposed illegalities may be the easy cases. What if the inquiry were more nuanced? Would KPMG’s procedures have differed in its audits of Silicon Valley Bank, where the question of legality still needs unpacking?

Or this: Verizon and AT&T recently have been sued in investor class actions over their failure to recognize the remediation costs of lead-clad cables, long since abandoned underground.

While no auditor’s risk assessment would wish exposure under both the environmental and securities laws, the auditors are flirting with the former—see the International Auditing and Assurance Standards Board’s advocacy of its proposed Global Sustainability Assurance Standard—while the scope of auditor diligence under the NOCLAR proposal is hardly likely to extend to ancient cables long buried and forgotten.

Comment letters on the proposal urged further public input, whether by task force, roundtables, or field testing. These might gracefully allow for reconsideration and retreat from the backward formulation of the PCAOB’s motivation, even as Williams contends the board’s majority is “simply making sure that the protection investors think they are getting today matches what the standard requires.”

That articulation should be concerning. A standard based on what one of the affected constituencies “thinks they’re getting” has it the wrong way around, even if the auditors are too delicate to say forthrightly, “we can’t” or too timorous to step up with “we won’t.”

For the sake of its credibility as it strives to show its value, the PCAOB should demonstrate better diligence over a proposal with potential for such dramatic unintended consequences.

 

Originally published at Bloomberg Tax Insights & Commentary, September 8, 2023, and reproduced with permission. Copyright 2023 Bloomberg Industry Group, Inc. (800-372-1033) www.bloombergindustry.com.

Alert for readers here, although too late to footnote in the Bloomberg version: on September 1, Francine McKenna provided a fulsome tour of the history of company reporting for litigation and other contingencies on her substack, The Dig -- both a helpful primer for new arrivals to the NOCLAR topic and a useful reminder for veterans of the long and tortured relationship between auditors and lawyers.    

 

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Silicon Valley Bank -- When a "Standard" is not a Standard

Guest-posted on April 19, with pleasure, on Francine McKenna's sub-stack, The Dig:

KPMG, auditor for failed Silicon Valley Bank, has been included as a defendant in a securities fraud case filed April 7 in the federal court in San Francisco — along with directors and officers of the bank and its underwriters Goldman Sachs, Bank of America and Morgan Stanley.

It won’t be the last. SVB failed back on March 10, and the only surprise is that it took so long.  

KPMG’s clean audit opinion on SVB’s 2022 financial statements was delivered February 24, three weeks before the bank’s closure by the California Department of Financial Protection and its takeover by the FDIC as receiver. The firm and the other defendants are charged with misrepresenting SVB’s balance sheet, liquidity and position in the market and by understating and concealing the magnitude of the risks it faced.

The plaintiffs, led by the City of Hialeah Employees Retirement System, claim that auditor KPMG did not qualify its opinion for doubts as to the bank’s ability to continue as a going concern, and did not identify as a “critical audit matter” the impact that rising interest rates could have on the unrealized losses on the bank’s bond holdings and its ability to hold those bonds through what was the potential, and eventually destructive, flight of customer deposits.  

If it feels like a somewhat geeky sequel to a movie we’ve all seen before, it should.

The comparison has long been available that — just as professors of literature teach that there are a small number of great plots that have been revised and recycled through the history of Western culture — so too the inevitable periodic outbursts of financial malfeasance come in cycles with a handful of recurring themes.

A partial list of examples — paired up so that by squinting and some flexibility, parallels may be drawn:

A hero comes to save the people from a monstrous threat: David v. Goliath, Rashomon and The Magnificent Seven, Jaws, Blazing Saddles 

Schemers loot the savings of the credulous: Charles Ponzi, Bernie Madoff, Elizabeth Holmes, Sam Bankman-Fried

The comic effects of mistaken identities: Plautus’s Menaechmi, Shakespeare’s Comedy of Errors, Oscar Wilde’s The Importance of Being Ernest 

Assurance providers fail to properly “count the stuff”: The mis-weighed beans in the 1920s, Tino DeAngelis’s fictive tanks of vegetable oil in the 1960s, the € 1.9 billion found in 2020 not to exist at Wirecard

Inter-generational conflict: The House of Atreus in both Greek myth and the plays of Aeschylus, Shakespeare’s Henriad and also King Lear and his fractious daughters, Coppola’s Godfather trilogy, today’s Succession

Accounting principles tortured into misapplication: the netting of accounts at Continental Vending, the Arctic oil leases held by Investors Overseas Services, the special-purpose entities at Enron, the long-term contracts at Carillion

Over the centuries, the rocky course of young love: Hero and Leander, Romeo and Juliet, the romantic mis-adventures of Emily in Paris

The devastating effect of mis-matched interest rates in the strategies of financial institutions, going back to the American savings & loans of the 1980s and the sub-prime mortgage portfolios of 2007-2008, and now erupted at, among others, KPMG clients SVB and Signature Bank

It is, of course, no less predictable that fresh outbursts of financial chicanery will re-trigger the usual reactions, just as authors, playwrights and scriptwriters will reprise the classic themes:

• Hand-wringing accompanies the cry, repetitive but hollow, “Where were the auditors?”
• Regulators and oversight agencies spring into action.
• Lawyers for investors sprint to the courthouse, lawsuits in hand.
• Academics and other commentators get attention from the business media, while jostling to be engaged by plaintiffs as well-paid “experts.” 
• Renewed rounds of recrimination, blame-mongering and futile attempts to alter human behavior capture public attention but only briefly and with minimal effect.

If this sounds like a tragicomedy, it’s not as if we haven’t seen this show before. Rather, if the implications of “same old, same old” are so obvious, why haven't we learned from the past?

One place to look for an answer is the hindsight perspective of the critics. Pinning it on the expectation of a “going concern” warning is futile. Good guidance for practitioners has been an intractably elusive challenge for standard-setters for decades. Such an opinion qualification is a “nuclear option” that auditors are passionate to avoid because the company may immediately be in breach of loan covenants. Or worse, for lack of a plan to recover, the qualified opinion becomes a self-fulfilling prophecy.

As for CAMs —and their analogs elsewhere in the world where “key” is substituted, thus KAMs — their availability and use have been gradually creeping into practice since introduced via the International Auditing Standards in 2016 and imposed by PCAOB requirements with application starting in 2019.

Wider use, however, has not made C[K]AMs more illuminating, reliable or demonstrably useful to information users. The limited available scholarship on their ability to signal future issues is no better than mixed, since there's no good research proving up the questionable hypothesis that investors actually pay attention to CAMs or make real-world decisions based on their inclusion in corporate disclosures. And there is at least anecdotal evidence that, in fact, they do not. That includes instances where fresh inclusion of a CAM or KAM was met with the typical indifference of investors and negligible effect on the reporting company’s share price. 

Reporting in the Wall Street Journal is provocative with regard to the prospects for the SVB litigation, and whether it will be persuasively argued that KPMG’s professional judgments deviated so far from acceptable practices as to sustain a successful claim for the plaintiffs.

WSJ reporter Jean Eaglesham writes that, on the one hand (emphasis added):

“Auditors for nine other U.S. banks most exposed to bond losses also didn’t flag this as an issue…"

“The Journal reviewed the audit opinions for the 10 small to midsize U.S. banks that last year reported the highest losses on held-to-maturity securities as a proportion of their shareholder equity… Silicon Valley Bank ranked second on the list."

“None of the auditors included a critical audit matter related to the bank’s treatment of the bonds. Instead, nine of the 10 reported a critical audit matter for estimated losses from loans or other bad debts.”

And, on the other hand:

“Silicon Valley Bank’s unrealized losses in its bond portfolio appear to ‘meet every definition of a possible critical audit matter,’ said Martin Baumann, a former chief auditor at the PCAOB who had a leading role in designing the new measure.”

And further:

“That appears to tick all the boxes for the auditor to highlight this issue as a critical audit matter. ‘The judgment as to whether or not Silicon Valley Bank had the ability to hold these securities to maturity was certainly a complex question, it was material to investors, and it is hard to see how liquidity was not a matter for discussion with the audit committee,’ said Mr. Baumann, who is also a former senior partner at Big Four audit firm PricewaterhouseCoopers.”

In a world where standards are well-designed and dependably applied, and where liability is imposed in a way that can be perceived as both predictable and fair, the two positions — disclosure decisions of the various auditors for group of small banks, and the attribution of liability to KPMG — cannot be reconciled. They cannot credibly co-exist.

That is, after years of disrespect for the audit profession’s attempts to improve the discipline in their processes, the distasteful choice is between elevating “box ticking” by hindsight to the status of a threshold for liability (insert sarcasm emoji here), or finding that the bar for liability has sunk so low that it requires a serious evaluation and re-set.   

That's not to say, at this point at least, that KPMG’s audit performance will be assessed as above reproach. We shall see as the litigation runs its course.

But in that context, it bears noting that back in a happier era before the hijacking of audit standard-setting by regulators under the pernicious influence of the Sarbanes/Oxley law of 2002, the term “generally accepted” had its literal meaning. That is, actual application of standards was observed in practice, tested for usefulness and practicality, and adjusted incrementally; opportunities for evolution and improvements could be taken without the querulous intrusion of censorious bureaucrats.

All changed, and not for the better. If the harshest allegations now brought forward are based on KPMG’s good-faith judgments to omit either a CAM or a going concern opinion paragraph, then — to borrow a metaphor from the world of the theater in that nostalgic time — the plot is so thin that this production should close in out-of-town previews.

 

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Wirecard Crashes – And Everything Old Is New Again

German payments processor and DAX market darling Wirecard AG has been revealed to have a € 1.9 billion hole in its balance sheet. Erstwhile superstar CEO Markus Braun found himself both out of a job and into police custody.

The company’s catastrophic implosion would have been no surprise to those alert to the depth of its problems as publicized over the last 18 months – not among them the credulous at German regulator BaFin, deeply interested DeutschBank, or a group of groupies among the executive team at SoftBank.

As for the missing cash? It appears never to have been there in the first place, suggesting that the inevitable up-coming forensic exercise may not be all that complex, to unpack an extended course of malfeasance.

Professors of literature teach that there are but a handful of great plot lines. So too, there are just a few basic financial fraud schemes, repeated with minor updating variations from one decade to the next. Among them, falsified operations and fictitious assets are persistent and recurring themes – tweaked in their sordid details by each new generation of white-collar criminals.

Two examples go back a half century – the first accounting scandals on which I cut my teeth as a rookie lawyer: the Salad Oil case, in the tank farm near Newark airport where Tino De Angelis used light-weight soybean oil to top off huge tanks filled with heavier water, fooling the auditors who climbed the ladders to open the lids but neglected to tap the valves at the bottom; and the Ponzi scheme at Equity Funding, where Stanley Goldblum’s minions falsified customer ledgers to create fictitious life-insurance policy holders who went undiscovered because not directly confirmed.

Back in those old days, fraudsters did real work to cover their tracks. Barry Minkow of ZZZBest tricked up dummy customer locations to pass as real work sites. Sam Antar at Crazy Eddie dissuaded the auditors from descending into the creepy basement vaults under his boutique-sized New York shops – never large enough to hold the bulky cartons of projection televisions shown on the fanciful inventories. Head counts of phantom cattle herds were inflated by multiple cycling of the same calves through corral gates, under the noses of naïve city-bred staffers, perched on fence rails and eager to escape the dust and noise.

The evolution over five decades means that such fabrications are of less need to the malefactors. Even the revelation in 2009 that one-third of the revenue of Indian software company Satyam Computer Services was bogus involved only non-existent customer contracts, although the inexplicable absence of physical evidence for 13,000 ghost employees – such as canteen turn-over and transport allowance cards and desks and telephones – remains a puzzlement.

In the case of Wirecard, the concentration of its business in a mere three shadowy “acquiring partners” and the ostensible location of its cash in two banks in the Philippines will figure. With their mission in hand, fraud examiners should not take long, peering at Wirecard’s business model through the guiding lens of hindsight, to reverse-engineer the plot line. Any treasure hunt is eased by having in hand a map with a large “X”.

William of Occam’s reductive principle applies no little to inform the design of a large-scale financial scam. In Wirecard, “the simpler, the better” is likely to have found a new application.

 

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Critical Audit Matters: The Games Are On

As a guest on Going Concern -- on October 27 and today -- I've been looking at the accumulating experience with extended auditors’ reports – the additional paragraphs that under international standards describe Key Audit Matters (aka Critical Audit Matters under the Public Company Accounting Oversight Board’s standards in the United States).

I'd first noted a major gap – nobody has yet asked whether investors actually pay any attention or give any value to the extra verbiage, while the evidence builds that they do not, notably the lack of indicative share price moves at Steinhoff Group in South Africa and the UK’s Thomas Cook.

If investors show no real concern for KAMs and CAMs, who does – and is auditor behavior affected?  

With those questions open, studies are emerging of the first wave of US CAMs – examples include Deloitte this summer, on 52 large companies with fiscal years ending on June 30, 2019; a second in September by Audit Analytics that looked at 65 large-company filings, followed up and expanded in November; and a third reported in November by Accountancy Europe, summarizing the recent experiences with KAMs in Europe.

The Deloitte study and its commentary focused on the substance of the CAMs – the most common are goodwill and intangibles (35%), revenue (19%), and income taxes (15%) – headline subjects also observed by Audit Analytics.

As a topic for a day to come, it may be safely predicted that another year of experience will confirm these early indications of herding toward a converged set of common CAMs, and a booming bull market in boilerplate language. Meanwhile, there are implications simply in the number of reported CAMs and the potential for gaming involved – something worthy of attention by students of the dynamics between large-company auditors and the PCAOB.

The Deloitte study reported an average of 1.8 CAMs for each reporting company, with a distribution ranging from none at all or only one to an outlying maximum of seven or eight – figures consistent with the Audit Analytics finding of 1.9 each and the average of just over two each for the twenty largest US companies reported.

For the auditors themselves, the simple question of optimal CAM frequency has salience at each of two stages – both when a company blows up in scandal, and also as the auditors go through the antagonistic process of PCAOB inspection. The first is because when challenged in a courtroom, the entire CAM process will have generated hostages to the auditors’ fortune and a litigation nightmare, with hostile lawyers pressing the perpetual question, “Where were the auditors?”

That disputing will likely trace to one of the typically common CAM topics – goodwill and intangibles (see Steinhoff), or the legitimacy of revenue (see Under Armour) or the vexed question whether and when an audit report should have been qualified (see Thomas Cook). Closing jury arguments will be built on one of two themes:

• If a CAM had been issued: “They saw it – they addressed it – and they still botched it.”
• Or if not, on the other hand, a back-footed auditor defending a report with few CAMS or none would be called to answer for a client’s fraudulent concealment: “There were billions in falsified transactions – how could they have missed them all?”

In the second case, although the level of PCAOB compliance might be thought of quotidian nuisance, there is the unfortunate frequency of inspected firms to manipulate their working paper files ahead of the inspectors – all the way to the prison-bound criminality involved in the theft of PCAOB inspection lists by personnel of KPMG.

As played straight most of the time, however, the auditors’ CAM counts will be relevant in handling inspections, where commentators since Sarbanes/Oxley’s enactment in 2002 are recognizing that box-ticking and checklist fulfillment now rule (see here and here).

In that context, “zero findings” would plainly be the wrong answer. A PCAOB inspector would be understandably incredulous over a public-company audit where nothing rose to CAM-level significance. Likewise, the presentation of only a single CAM would open the auditor to a nit-picker’s prodding – “Out of all the issues you looked at, why only this one?”

Too many CAMs, of course, would provoke a different inspection issue –-triggering the familiar maxim, “if everything is important, then nothing is important.”

A Goldilocks strategy emerges—firms will identify two CAMs at least, maybe three at most. Those numbers avoid the tail risks – too many or too few – while the inspectors can be entangled in extended discussions, over competing priorities and resources, the interest level and reading tolerance of investors, and the length and complexity of audit reports. The gaming of that process and the accompanying negotiations can be prolonged until all players are cross-eyed with boredom and fatigue.

The result? Three or four years from now, a bright young PhD candidate will have an assured research topic and a glide-path along the tenure track, by compiling experiences under the rubric, “Who ever thought CAMs were a good idea?”

 

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Critical Audit Matters: Does Anybody Care?

It's always a pleasure to be a guest on Going Concern -- with thanks to Jason, this is up there as of yesterday:

As if the standard auditor’s opinion weren’t already sleep-inducing enough.

 

Standards in the United States now require auditors to identify critical audit matters (CAMs) in their reports on the financial statements of large public companies—things that, in the language of Auditing Standard 3101.11 of the Public Company Accounting Oversight Board, involved “especially challenging, subjective, or complex auditor judgment.” Here the U.S. begins to converge—cannot say “catch up”—with the Key Audit Matters (KAMs) accumulating around the rest of the world under International Auditing Standard 701, issued in 2016.

A wealth of research opportunities is opened. A starting point is the challenge to the data miners, to discern whether this evolution from the traditional one-page “pass/fail” opinion has any actual impact on investor behavior.

Put more bluntly, “Who cares?” So far the proposition is empirically untested, in the U.S. or elsewhere. Two large-company failures, however, point to the contrary.

First was with the complete absence of share price impact when Deloitte’s Amsterdam office included five KAMs in its eight-page report dated Dec. 6, 2016, on the 2016 financial statements of South Africa’s Steinhoff International Holdings NV, the year before the revelation of massive scandal gutted that company’s value and stock price, and led Deloitte on Dec. 13, 2017, to withdraw its report.

The second is of current front-and-center attention in the U.K.—the business cessation on Sept. 23, 2019, of the venerable travel operator Thomas Cook, that country’s most recent large-company collapse.

The blame game started the next day, with the Financial Reporting Council’s indication of interest, promptly followed by the kick-off of its investigation on Oct. 1—another reprise of the perpetual cry, “Where were the auditors?” The press quickly zeroed in on the absence in Ernst & Young LLP’s opinions for 2017 and 2018 of doubts about the company’s “going concern”—not expressed until its review report of May 16, 2019, on the company’s half-year results, which stated (page 33) that “a material uncertainty exists (that) may cast significant doubt on the company’s ability to continue as a going concern.”

But let’s go back—this being about whether investors value available information.

EY’s report dated Nov. 28, 2018, on Thomas Cook’s 2018 financial statements, while not qualified, did add a new and additional KAM to the prior year’s six—an essay of over 450 words specifically labeled “Going concern basis used in preparation of the Annual Report & Accounts” (page 112).

The issue, which EY identified (page 114) as “one of the matters that had greatest impact on the allocation of partner time,” detailed at length the attention by EY itself and the company’s management and directors to the company’s ability to borrow and continue to operate within its financial covenants, which as EY put it (page 112), “remain tight, but pass under management’s severe but plausible scenarios.”

It will be for the FRC’s investigation to assess EY’s compliance with the technical and complex requirement of the professional standards.

However, those keeping track should observe the activity in the company’s stock price. That started with a drop (in pence) from 33.68 on Nov. 29 to 22.72 on Dec. 4, followed by a sharp rise to 34.40 on Dec. 5, all the way to 38.40 on Jan. 4. Not until after that five-week run-up, and five weeks after the KAM disclosures on the company’s going concern, in other words, did its share price begin its terminal decline, which extended steadily all the way to the company’s September collapse.

A scrubbing of the news archives for other possible price-moving information might shed light. Until then, advocates for the proposition that KAMs and CAMs credibly attract serious investor attention must meet the serious question whether and how a sentient reader could have resisted EY’s ominous language, repeated a second time for emphasis, that the company’s survival depended on fulfillment of “severe but plausible scenarios.”

There’s more to the CAM/KAM story—but enough for today.

 

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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.  

 

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 on the Main page.

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.

“Rise of the Robots” – It’s Time for Accountants to Be Afraid

             “They’re coming – for your job.”

That’s the ominous message for everyone benighted enough to believe in job security under the Big Audit model, as delivered by Martin Ford in last year’s Financial Times business book of the year, “Rise of the Robots.”

    It's my pleasure to take up this topic as a guest on Going Concern, Caleb Newquist's important platform for the profession.

Ford’s book brings focus to the question posed here at Going Concern in July, about KPMG’s partnership with Watson, IBM’s cognitive learning technology platform:

“What happens when the cognitive technology realizes that the bright human beings aren’t so bright?”

As a quick tour of the field increasingly occupied by the machines, “Robots” opens with a survey of the speed and spread of industrial robotics deployment – according to Ford’s source, the International Federation of Robotics, some 230,000 industrial robots were installed in 2014, with an estimated annual growth rate of 15% projected through 2018.

For additional context, these four pieces of recent news:

• Walmart’s June announcement that it is testing flying drones to handle its massive warehouse inventories – the goal to do “in a day what now takes employees about a month.”

• The use by a Lowe’s store in Silicon Valley of a prototype inventory checker built by Bossa Nova Robotics, that uses computer vision to recognize bar codes on shelves and a laser to show items out of stock, “automatically perform(ing) a task that humans have done manually for centuries.”

• The agreement of the British government, announced in July, to cooperate with Amazon’s exploration of drone delivery of packages of up to five pounds – 90% of its sales.

• PwC’s announcement in May of the launch in Poland of a commercial drone division – its leaders observing, with a complete lack of either irony or self-awareness, that “the addressable market value of drone powered solutions is over $127 billion.”

For the rest of the piece, please continue at Going Concern.

 

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Gaudeamus Auditors? Instead, the Vatican Casts PwC from its Temple

Because profound issues of governance and institutional politics pervade large entities, of all types and in all locations, it’s worth noting the recent flurry of activity at the top of the Catholic Church.

To start, the news wires lit up with the May 12 announcement by Pope Francis of a commission to study the possibility of women as deacons. With this start from scratch -- while the debate on women’s participation in corporate boardrooms, legislative bodies and university faculties has long moved to questions of real progress -- optimism must be tempered. The opening of formal dialog suggests that while full clerical participation will not be available for women any time soon, a long forward step has been taken.

As for more mundane matters of Vatican governance and finance, the news was less up-beat.

That is -- since the year 313 AD, when Constantine bestowed his imperial favor and benevolence on the early Christians, the Church has managed to render successfully unto Caesar, uninhibited by the assistance of outside auditors.

So after seventeen centuries, it would have involved both a real cultural shift and considerable internal dislocation in December 2015, when the Vatican announced its engagement of PwC to perform history’s first independent audit of the Holy See.

Political reality soon intruded, however, with the unsurprising news in April 2016, that PwC’s audit was being “suspended.”

Only the most naïve and credulous would take as gospel the official Vatican version, that “issues have emerged regarding the meaning and scope of certain clauses of the contract and their methods of implementation,” or the suspiciously explicit spin that sought to disavow any “considerations linked to the integrity or quality of the work initiated by PwC, let alone the intention of one or more entities of the Holy See to block the reforms in process.”

Background first. As known to experienced auditors, “first-time-through” can make the Herculean project to hose out the stables of King Augeas look like a once-over with a handi-wipe. The international standards on auditing require in part (IAS 510(6)), in the start-up work on a client’s opening balances, that:

“The auditor shall obtain sufficient appropriate audit evidence about whether the opening balances contain misstatements that materially affect the current period’s financial statement by:

(a) Determining whether the prior period’s closing balances have been correctly brought forward to the current period or, when appropriate, have been restated;

(b) Determining whether the opening balances reflect the application of appropriate accounting policies….”

That work would be especially daunting with no predecessor auditor on which to rely. In the Vatican’s case – where never done before – there would have been no telling what financial skeletons lay deep and restive in those ancient catacombs, only waiting to be discovered and released. Small wonder that those with incentives to avoid the process would resort to postponement, denial and evasion.

Consider the reticence and anxiety, on the part of the Vatican’s functionaries charged with the keys to its treasury, and now called upon to yield up their sacred confidences to a team of invasive outsiders.

In fact a full-blown turf battle has been revealed, since PwC’s “suspension,” between the reform-oriented Cardinal George Pell of the Vatican Secretariat for the Economy, who managed the mandate given to PwC, and the old-school leader of the Secretariat of State, Archbishop Angelo Becciu, who unilaterally and without notice to Pell informed the Vatican entities charged to cooperate in providing information that Pell’s authority was revoked.

(Developments will leak out, from day-to-day and highly managed, on these internal structural struggles; for now, see the Guardian, the Catholic News Agency, and the National Catholic Register.)

Briefly put, when he blessed PwC’s presence, Pope Francis mis-read his subordinate administrators’ readiness to cooperate -– that is, that the auditors’ archeological excavations in the Vatican’s books and records at least threatened to open ancient tombs and sarcophagi where had rested ledgers and records permeated with rot and decay.

Further at the level of actual job performance, a client so insecure and defensive as to pull the plug, at the earliest stages of the engagement, would pretty well meet an auditor’s definition of “an engagement from hell.”

To an outsider, the Vatican’s unseemly internal scrum at the foot of St. Peter's throne might not reach the scale of the Great Schism between Rome and Avignon in the Middle Ages -- perhaps more resembling the scene in Woody Allen’s 1971 “Bananas,” where rival teams of cross-bearing monks degenerate into a melee over a parking place.

In such a fragile environment, hostile factions within the client that could scupper the job at the outset would have ominous implications for PwC’s ability to report in any event. It is difficult enough to assess the veracity of client representations with the skepticism required by professional standards. More so, to raise questions of credibility when the client holds over an inquisitive auditor the potential invocation of celestial fury or the unleashing of eternal hellfire and damnation.

It would suggest no dishonor to PwC if the warfare inside the Vatican obliges them to cap their pens and close their bags and make a diplomatic retreat -- so long as their withdrawal can be sold to the waiting faithful as a professional matter, and not under the threat of excommunication or anathema.

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The PCAOB Hates Altered Documents – Stop Giggling, and Listen Up

 

“(W)hoever, in any matter within the jurisdiction of the executive, legislative, or judicial branch of the Government of the United States, knowingly and willfully—

(1) falsifies, conceals, or covers up by any trick, scheme, or device a material fact;

(2) makes any materially false, fictitious, or fraudulent statement or representation; or

(3) makes or uses any false writing or document knowing the same to contain any materially false, fictitious, or fraudulent statement or entry;

shall be fined under this title, imprisoned not more than 5 years….”

-- 18 US Code Section 1001

What part of this venerable provision of the American criminal code is hard to understand? When government agents come calling, they expect the whole truth. It will not go well – however irritating may be an authority’s intrusions -- to mess with a power that holds hostage your license, or your liberty.

So what could have been behind the Public Company Accounting Oversight Board, the American audit regulator, with its April 21, 2016, announcement of a Staff Alert, expressing “concerns about auditors improperly altering audit documentation in connection with a PCAOB inspection or investigation”?

Since its birth with the Sarbanes-Oxley law of 2002, the PCAOB has punched below its weight, with a history of small-bore initiatives of marginal credibility and nominal effect: after years of effort it finally caved on the foolish notion of mandatory auditor rotation; its requirement of a new form by which to identify lead audit partners satisfies nobody; it remains impotent and unable to function in China; and the scalpel it is taking to the basic language of the standard auditor’s report cuts not to the jugular but to the capillary.

What point is there, then, in another exercise in admonitory finger-pointing – unlikely to be of any more impact?

The practice quality and risk guidance of any accounting firm subject to PCAOB oversight should already be clear, beyond any possibility of ambiguity or misinterpretation, on the vital importance of the integrity of working papers – it demeans the expertise and the responsibility of the firms’ senior leaders to suggest otherwise.

History should teach, after all, that the cover-up is often worse than the crime. Gangster Al Capone went down not for his years of violent bootlegging, but for tax evasion; for Alger Hiss it was perjury, not espionage; Richard Nixon’s record of presidential malfeasance in office lay exposed by a bungled burglary in the Watergate apartments.

And right at home – it was the financial impact of Enron’s collapse that rendered Arthur Andersen a terminal patient on life support, but it was the shoddy exercise of document shredding in its Houston office by which the Justice Department pulled the plug.

And the Alert says the same:

The consequences of providing improperly altered audit documentation to PCAOB inspectors or investigators may in many cases be far more severe than would be the consequences of the PCAOB staff identifying the audit deficiency that the revisions to the documentation attempt to obscure.

Which said, fallible humans operating complex systems will suffer inevitable short-comings in performance. There is no perfect set of audit working papers, and the inspectors are well known as fine-screen fuss-budgets. So when the PCAOB comes calling, it’s as with Samuel Johnson’s observation that “when a man knows he is to be hanged, it concentrates his mind wonderfully” – the temptation is intense to buff up and polish the files. Especially for audit teams in subsidiary or foreign locations, who lack first-hand experience with the consequences of being caught out.

Properly advised, however, auditors under inspection pressure have an explicit avenue to both forgiveness and redemption. The Alert itself quotes the PCAOB’s standards (emphasis added and footnote omitted):

Audit documentation must not be deleted or discarded after the documentation completion date, however, information may be added. Any documentation added must indicate the date the information was added, the name of the person who prepared the additional documentation, and the reason for adding it.

With such an emollient invitation to transparency, recourse to file-fixing should be a non-issue.

Which does however go back to the PCAOB’s motives: has it so little respect for the auditors it inspects, or does it launch such an inflated warning signal for the sake of puffing its own modest enforcement authority?  

Either way, audit firms are well advised to treat the Alert with serious sincerity – because lurking behind the PCAOB’s evident self-regard, it has sanctions available that are far more emphatic than the disciplinary tools in its own Lilliputian kit – namely, the option to refer cases up to main Justice for criminal prosecution under the above-quoted provisions of 18/1001.

Put another way, Voltaire may have had it right back in 1759, when he mused that it would be good from time to time to kill the occasional malingering admiral, “pour encourager les autres” – and that’s a risk no auditor should run.

 

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The PCAOB on Partner Naming – Late News from the Devil’s Playground

 

And the earth was without form, and void;

And darkness was upon the face of the deep.

-- Genesis 1:2

After His six efficient days of work, “the heavens and the earth were finished, and all the host of them” (2:1), and the great Creator took Sunday off.

Whereas the Public Company Accounting Oversight Board labored fully six years to issue its December 15 release – new rules and a new Form AP by which auditors of US public companies must identify their lead engagement partners.

As examined in my recently-published book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”[1], partner naming is a half-baked solution in search of a real problem. In the world of finite regulatory energy and resources, the project has never been worthy of the effort.

To start -- engagement partners in Europe and elsewhere have signed their firms’ reports for years, with no visible evidence that audit quality has been affected one way or the other – much less for the better -- and abundant examples that quality there is not demonstrably above that in America.

Conversely, for all the to-and-fro, the profession’s resistance based on liability concerns was always doubly undercut: First, by the absence of increased partner exposure outside the US. And second, by the lack of a significant history of claims against the firms themselves, under Section 11 of the Securities Act. The prospect of suits against individual partners must be remote – especially as investor plaintiffs have generally forgone those claims under other legal theories. On the other hand, partner identity has always been readily discoverable in US litigation, so the new Form AP will be insignificant in elevating whatever current exposure a partner may have.

As for this new form, rather than a forthright requirement to sign the audit opinion itself, the PCAOB takes a halfway approach that only a bureaucrat could love – a new required filing, on its own unique timetable – creating one more compliance box to tick and one more item for the inspectors’ checklist. Unmentioned in the discussion is the principle, well known to safety and compliance experts, that even the best-intended quality measures add additional complexity: “one more thing to go wrong” injects an unavoidable if unintended increase in the opportunity for cascading mistakes.

Examples are readily available. A key factor contributing to the Three Mile Island nuclear plant “accident” in 1979 was the confusion between a concealed warning light and the failure of an emergency pressure relief valve. And the highway safety studies are instructive, that while safety barriers and rumble strips may reduce the number of collisions, they also incentivize higher driver speeds, meaning that deaths and damages are greater for those that do happen.

Nor does it withstand scrutiny, that public naming somehow raises the level of partner care or concentration. As noted, Europe’s experience does not include evidence of a quality effect. Instead, partners have never lacked for adequate reasons to be focused and motivated. PCAOB member Lewis Ferguson had it right back in 2011, “As a practical matter, in larger accounting firms, a failed audit or major error in the audit of a significant client, particularly a public company, can be career ending for the audit engagement partner in charge of the audit.”

Advocates of partner naming – Re: The Auditors and Going Concern among them -- point with enthusiasm to the SEC’s orders of December 2, 2015, against the Grants firm and two of its partners – noting that one had kept active engagement responsibility after the emergence of performance quality indicators including the eruption of a major client fraud.

If not outright mistaken, this view misses the proper location of incentives and accountability. That’s because, as I was quoted in Francine McKenna’s blog, “one of the many unlearned lessons from Enron/Andersen is the hostage to fortune that a firm leaves by keeping a problem partner on-line either on the same job or as moved around.”

There’s history. Back in the Enron era of 2001, Andersen had left a senior-level audit practice partner in an on-going performance-related role, after (and in spite of) his prior SEC proceeding -- contributing to the inference drawn by law enforcement officials that the firm was an unrepentant and unresponsive repeat offender.

Further back in my own experience, my law firm defended a Big Eight firm in a whole series of lawsuits, involving the client roster of a single audit partner. He was genial but inept, a virtual Typhoid Mary of exposure – exposures that the firm could have avoided by promptly quarantining this viral at-risk partner whose every job was subject to infection.  

On top of all of these reasons, the PCAOB has long had more important fish to fry. Its own member Steven Harris flagged two of them, in his remarks in favor of partner naming – namely, “Modernizing the outdated audit report model, and improving auditor going concern reporting….” Add two more to these, at least: the persistently elusive topic of “audit quality indicators,” and the agency’s long-running exclusion from the ability to inspect audit firms in China.

Until the PCAOB acted at last to resolve the lucid question of when and how its Docket 029, pending from 2009, was ever to end – only knew God.

Now, in context of a full menu of complex tasks, six years of effort only to bring forward the new Form AP has the feel – pardon the oxymoron – of a topic deemed importantly high on a list of the inconsequential.

Perhaps more apt than the Genesis comparison, then, to the PCAOB’s misplaced aspiration, is the 1st century BCE challenge issued in Horace’s Ars Poetica:

What could he produce to match his opening promise?

Mountains will labour: what’s born? A ridiculous Mouse!

 

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Wishing a Merry Christmas to all – or whatever solstice-oriented celebration you observe – and a New Year of peace, prosperity, and compassion for those less fortunate.

 And as a holiday gift for your favorite CPA, financial officer, board or audit committee member or financial adviser – “Count Down” is available from Amazon, optimistically for delivery before the 25^th, or with only its elves’ short and manageable re-stocking.

 

[1] Available from Amazon or direct from Emerald, the publisher.

Specially-Designed Auditors' Reports: A Noble Gesture – If a Futile One?

Noble Group Limited, the Asian commodity trader -- based in Hong Kong, listed in Singapore and sporting a US$ 15 billion balance sheet -- has a large problem. Under serious pressure since early this year, from short-sellers and critics of its mark-to-market accounting practices, it has seen an unrelieved decline in its share price, from S$ 1.43 last September to S$ 0.41 today, with no bottom in sight.

The company took a less-than-usual step this summer. In an attempt to stop the bleeding, it reached for outside accounting expertise – going not to EY, its regular auditor whose Hong Kong firm issued its standard “pass-fail” opinion dated February 26, 2015, on Noble’s 2014 financial statements (see page 64 of Noble's annual report), but to the Singapore firm of PwC.

Whether or not Noble's maneuver can restore investor confidence, the jury is out – figuratively -- and eventually, as a fair prediction, literally as well. Either way, its enlistment of PwC illustrates two major themes:

• First, an auditor’s brief, traditional and long-familiar opinion is ineffective for credibility when issued on financial statements having the complexity, opacity and level of management estimates and judgments used by Noble.

• Second, focused accounting expertise and tailored reporting on the issues that drive investor agita can have great potential value -- only if deployed in a timely and credible fashion. 

Looking at the latter – the skepticism that met PwC’s report was altogether understandable, for several reasons:

First, PwC was able to conclude, as its report dated August 10, 2015, put it, only that Noble’s practices comported with criteria “based on the relevant requirements of (the international financial reporting standards) and standard practices in the industry.”

That might have been persuasive, in an anodyne environment. The guidance in the United Kingdom from the Financial Reporting Council on expanded detail in auditors’ reports – such as that of KPMG on the 2013 financial statements of Rolls Royce -- may show promise, although further experience and study will be needed and are called for. But once public support is eroded, a claim of virtue because “everybody does it” lacks force.

That is, the assertion of compliance with standards is of doubtful effect under stressed conditions. On April 15, 1912, it should be recalled, RMS Titanic was carrying the full number of lifeboats strictly required by the applicable maritime regulations. And in 1973, facing the public outcry that would lead to his expulsion from office, President Richard Nixon persuaded nobody at all with his claim, “I am not a crook.”

Nor does it avail much for the accountants themselves. PwC’s report is addressed strictly to the Board and management of Noble; it rigorously disavows duty, responsibility or liability to the public, and lays out strict limitations on any rights of third parties to rely.

None of these disclaimers would have been available had PwC’s work been done as part of a statutory report. Put another way, valuable as it may yet prove to be, this type of customization would have fallen outside EY's permissible scope as part of its function as the company’s regular auditor. 

Nor can PwC’s report be expected to help either Noble or EY defend against claims waiting to be asserted by shareholders – in the United States at least, where compliance with professional accounting standards has been rejected by the courts as a “safe harbor” since the 1960’s.

In any event, the confidence reposed in overly-complex accounting standards was measured by the withering criticism of one of the giants among the fraternity of white-collar courtroom lawyers, the late Peter Fleming: “Forget all the verbiage. Unless your story can persuade a jury with an average tenth-grade education, it’s worthless.”

Little wonder Noble’s share price continues to erode – dropping a further eleven percent on the day following release of PwC’s report, and still sliding.

Noble may survive this onslaught. I would not be betting on it – the portents are to the contrary – but for purposes of a “learning moment,” it doesn’t matter.

What it does drive home is a third theme – that the current model of Big Audit is antagonistic and ill-suited to the problems on display at Noble – because traditional reporting by EY observably supplied no value, while the late-arriving efforts of PwC were only in a context “too little, too late.”

 

The still-evolving Noble story is a good way to return this space toward a regular schedule. My thanks here for readers' widespread and generous reactions to my recent announcement that, scheduled for late October, Emerald Publishing will release my book, “Count Down – the Past, Present and Uncertain Future of the Big Four Accounting Firms.”

There will be interruptions, mainly for red-pencil efforts when the proofs come over from the type-setters, and to spread the word on pre-publication ordering that can now be done through either Emerald or Amazon.  But I look forward to getting back on pace. 

 

 

 

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Book Announcement: "Count Down -- The Past, Present and Uncertain Future of the Big Four Accounting Firms"

For those who may have wondered -- my reduced schedule here in recent months had a reason: completion and readying for publication of my book, "Count Down -- The Past, Present and Uncertain Future of the Big Four Accounting Firms".

I am pleased and proud that the book is next in the Emerald Publishing Group's series, "Studies in the Development of Accounting Thought," edited by Gary Previts, E. Mandell de Windt Professor of Accountancy at Case Western Reserve University, member of the Accounting Hall of Fame and past president of the American Accounting Association.

Its scope -- bringing together themes long explored here and going back to my column in the International Herald Tribune -- is summarized in this from Emerald:

The post-Enron disintegration of Arthur Andersen in 2002 reduced to the surviving Big Four the number of international accounting firms that audit nearly all of the world’s largest public companies -- Deloitte, EY, KPMG and PwC.

 Despite their strengths -- market dominance, double-digit annual growth in non-audit services and continued revenue expansion to a global total above $ 120 billion in 2014 – the viability of the Big Four and their business model faces serious threats:

• Widespread dissatisfaction with the standard form and language of their core product -- the traditional “pass-fail” auditor’s report.

• The persistent “expectations gap” between their perceived performance quality and the stated desires of information users.

• Difficult relations with regulators and oversight agencies.

• And especially, the questionable ability of the Big Four and their partners to survive a “black swan” financial shock – a litigation judgment or law enforcement sanction on the scale that destroyed Arthur Andersen.

"Count Down" looks at the complex challenges facing the Big Four, questions the feasibility and achievability of the various proffered “solutions,” and proposes an evolved model for Big Audit that would be both sustainable for the large firms and fit to serve the capital markets of the 21^st century.

“ This book lifts the lid on the story behind the financial statements of the world’s major companies. If you want to understand the system that is allegedly validating the reported data - and why the system is a clone of the Maginot Line - expensive, obsolete and irrelevant - read on. Weak as the present system is, there is a solution. It will take a major change in regulatory attitude and a fresh approach, unfettered by history. The section on the imaginative use of Big Data is worth study by itself. “

     -- Duane R. Kullberg, Arthur Andersen & Co., S.C. Chief Executive Officer, 1980-1989

“Illusions of safety in size doomed allosaurus, empires, and auto makers. In his Count Down, Jim Peterson examines the fragility of the ineffectual audit regime, and the imminent threats to its survival. Peterson combines the insider’s knowledge with an outsider’s critical but sympathetic perspective and suggestions in this fascinating and insightful volume—a must-read for accountants and students of accounting.”

     -- Shyam Sunder, James L. Frank Professor of Accounting, Economics, and Finance, Yale School of Management

Scheduled release date is October 15. For information, and to order:

     From Emerald Books

     From Amazon

Please share with your friends and colleagues. For questions and other inquiries -- and for Emerald's pre-publication discount -- please write me: [email protected]

Sifting the Fly Shit Out of the Pepper – The PCAOB Comes Back on Partner Naming

After eighteen months of inactivity, other than frequent promises of further action, Chairman James Doty of the Public Company Accounting Oversight Board, in a Brussels speech on June 22, 2015, announced that a release was coming, on a date still not specified, to consider a separate new form by which accounting firms would provide the name of their lead engagement partner on the audits of US public companies.

The final outcome of a yet-further comment period remains pending. But the triviality of the approach is visible in the vacuity of Doty’s announcement: rather than solve the substance of the American profession’s concern with enhanced individual partner exposure, the form would, in his words, “reduce auditors’ perception of litigation risk” (emphasis added).

Doty has trod this rocky path at tedious length for years, and the ground is familiar – see here on October 17, 2011, April 11, 2013 and December 4, 2013 – and with those references, re-plowing is not necessary. Instead, in a few words, it’s still all about the optics – and the topic is still one that diminishes the stature of the agency and distracts its energy from serious issues:

• The user community is indifferent to partner naming, as shown by the absence of distinction between practices that vary among countries.

• At the same time, audit quality differentiation based on partner naming is, to be generous, elusive. Careful reading of the “research” cited by Doty shows the “confirmation bias” built into his invocations, while there is no study at the large-company level of share price effects or financial statement quality differentiation between US-based companies that do not provide partner names and European ones, including those listed in America, that do.

• Exposure of engagement partners to real litigation will not be reduced, because their identity is readily knowable through the discovery process and complaints could, if strategic for plaintiffs, be readily amended to add them as defendants.

• But at the same time, that exposure is largely illusory. Plaintiffs’ attorneys have never made a practice of naming individual partners, because their evidence for use against their firms is always available, and their personal assets are insignificant in context of multi-million dollar damage claims.

• While cutting the other way, lead partner careers are impaired by litigation in any event, whether they are named in the suits or not, by the combination of reputational effect and protracted distraction while dealing with the time and emotional demands of participating in a large pending lawsuit.

All of which means that partner naming is not a real issue for most investors – in the US or elsewhere -- who could get the information if truly desired -- but only for the voyeuristic critics of the profession who want named individual villains for their finger-pointing.  

 

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The PCAOB Asks the Auditors an Unanswerable Question: Do Company Controls “Work”?

“Measure twice – cut once.”

            -- Quality control maxim of carpenters and woodworkers

If there can be a fifty-million-euro laughingstock, it must be Guillaume Pepy, the poor head of the SNCF, the French railway system, who was obliged on May 21, 2014, to fess up to the problem with its € 15 billion order for 1860 new trains—the discovery after their fabrication that the upgraded models were a few critical centimeters too wide to pass through many of the country’s train platforms.

Owing evidently to unchecked reliance on the width specifications for recent installations, rather than actual measurement of the thirteen hundred older and narrower platforms, the error is under contrite remediation through the nation-wide task of grinding down the old platform edges.

That would be the good news – the bad being that since the nasty and thankless fix is doubtless falling to the great cohort of under-utilized public workers who so burden the sickly French economy, correction of the SNCF’s buffoonish error will do nothing by way of new job creation to reduce the nation’s grinding rate of unemployment. 

The whole fiasco raises the compelling question for performance quality evaluation and control – “How can you hope to improve, if you’re unable to tell whether you’re good or not?”

This very question is being reprised in Washington, where the American audit regulator, the Public Company Accounting Oversight Board, is grilling the auditors of large public companies over their obligations to assess the internal financial reporting controls of their audit clients.

As quoted on May 20 in a speech to Compliance Week 2014, PCAOB member Jay Hanson – while conceding that the audit firms have made progress in identifying and testing client controls -- pressed a remaining issue: how well the auditors “assess whether the control operated at a level of precision that would detect a material misstatement…. Effectively, the question is ‘does the control work?’ That’s a tough question to answer.”[1]

So framed, the question is more than “tough.” It is fundamentally unanswerable – presenting an existential problem and, unless revised, having potential for on-going regulatory mischief if enforced in those terms by the agency staff.

That’s because whether a control actually “works” or not can only be referable to the past, and cannot speak to future conditions that may well be different. That is, no matter how effectively fit for purpose any control may have appeared, over any length of time, any assertion about its future function is at best contingent: perhaps owing as much to luck as to design -- simply not being designed for evolved future conditions -- or perhaps not yet having incurred the systemic stresses that would defeat it. 

Examples are both legion and unsettling:

• The safety measures on the Titanic were thought to represent both the best of marine engineering and full compliance with all applicable regulations, right up to the iceberg encounter.

• A recovering alcoholic or a dieter may be observably controlled, under disciplined compliance with the meeting schedule of AA or WeightWatchers – but the observation is always subject to a possible shock or temptation that would hurl him off the wagon, however long his ride.

• The blithe users of the Value-At-Risk models, for the portfolios of collateralized sub-prime mortgage derivatives that fueled the financial spiral of 2007-2008, scorned the notion of dysfunctional controls – nowhere better displayed than by the feckless Chuck Prince of Citibank, who said in July 2007 that, “As long as the music is playing, you’ve got to get up and dance… We’re still dancing.”

• Most recently, nothing in the intensity of the risk management oversight and reams of box-ticking at Bank of America proved satisfactory to prevent the capital requirement mis-calculation in April 2014 that inflicted a regulatory shortfall of $ 4 billion.  

Hanson is in a position to continue his record of seeking improved thinking at the PCAOB -- quite rightly calling out his own agency, for example, on the ambiguous and unhelpful nature of its definition of “audit failure.”

One challenge for Hanson and his PCAOB colleagues on the measurement of control effectiveness, then, would be the mis-leading temptation to rely on “input” measures to reach a conclusion on effectiveness:

• To the contrary, claimed success in crime-fighting is not validated by the number of additional police officers deployed to the streets.

• Nor is air travel safety appropriately measured by the number of passengers screened or pen-knives confiscated.

• Neither will any number of auditor observations of past company performance support a conclusive determination that a given control system will be robust under future conditions.

So while Hanson credits the audit firms – “They’ve all made good progress in identifying the problem” -- he goes too far with the chastisement that “closing the loop on it is something many firms are struggling with.”

Well they would struggle – because they’re not dealing with a “loop.” Instead it’s an endless road to an unknown future. Realistic re-calibration is in order of the extent to which the auditors can point the way.

 

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---

[1] Emphasis added.

The Rolls-Royce of Audit Reports Hits The Road: Test-Driving KPMG’s Latest Model

“So tell me what you want – what you really really want.”

            -- Spice Girls, 1996

“But if you try sometimes, you just might find, you get what you need.”

            -- Rolling Stones, 1969

Insiders within the accounting community are falling all over themselves in congratulatory admiration of the Independent Auditor’s Report signed in London on February 12, 2014, by Senior Statutory Auditor Jimmy Daboo on behalf of KPMG, on the financial statements of Rolls-Royce Holdings plc.

Running to six full pages starting at page 130 of the company’s 2013 annual report, single-spaced and double-columned, Daboo’s opinion implements with a vengeance the guidance published in June 2013 by the United Kingdom’s Financial Reporting Council, requiring auditors’ reports to describe the greatest risks to material misstatements, explain their application of materiality in audit planning and performance, and summarize their audit scope as responsive to the assessed misstatement risks.

This is not about motor cars. Rolls-Royce ranks number 28 on the FTSE 100 list of large UK companies, with £ 15.5 billion in 2013 revenue from its gas turbine and reciprocating engine sales to the civil and defense aeronautics sectors, along with marine, energy and power systems -- all spelled out in its report running a handsome 144 pages.

The interesting question is whether the world was really waiting for essays of 500-word-length on such eye-crossingly complicated topics as revenue and profit measurement, measurement of liabilities from sales financing arrangements, or the concept and presentation of non-standard “underlying” profit on foreign transactions. Or would information users have preferred the traditional, simple and comfortable anodyne opinion in the first paragraph, that a “true and fair view” was presented?

Early indications -- based on the conspicuous silence of the investor community and commentators outside the precincts of those with self-interest -- significantly suggest the latter. To be sure, the company’s stock was pounded by its largest price drop in thirteen years with the profit warning of its February 13 announcement of 2013 results, largely since recovered, but blame was placed on forecasted reductions in defense-related revenues, and the financial press made no connection with KPMG’s opinion, either then or since.   

If proved out over the rest of the annual reporting cycle for UK companies and their own broad adoption of the FRC’s requirements, the investor community’s “ho-hum” would implicate the long-running efforts to re-engineer the standard auditors’ report – by both the PCAOB in the US and the IAASB globally.

Not, as can be observed, that either of these bodies is proposing changes on the scale of the KPMG treatise – but have rather confined themselves to the identification of the kind of “critical” or “key” audit matters that may predictably elicit generic box ticking and boilerplate, rather than KPMG’s sophisticated mini-seminars delivered on Rolls-Royce.

Which would be unfortunate indeed, especially in the litigation-prone United States, the jurisdiction most likely among the world’s major large economies to inflict a death-blow jury verdict for an auditor’s “getting it wrong.” There, under the disclosure-based policies of the American securities laws, adoption of the emerging UK protocols for actually quantifying audit and reporting materiality, and for explicating the range and uncertainty of complex company decisions and judgments, would go far to draw the teeth of the beast lurking in the courthouse.

For this, those arguing for a sustainable model for privately-provided assurance could only be grateful.

But there being no sign as yet of any leadership or initiative in that direction, grounds for optimism are hard to come by.

Curious readers in the US are invited to have a look at the Rolls-Royce report including the KPMG opinion, and send in their reactions. Readers in the UK – especially actual or potential investors in Rolls-Royce, on whom the KPMG report may have made an impact or had any influence -- are invited to identify themselves and share their thoughts.

 

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