Re:Balance -- Jim Peterson

Big Data: Can the Regulators Handle the Big Challenge to Big Audit

I yield to no one in my respect for the intelligence and dedication of Public Company Accounting Oversight Board member Lewis Ferguson – whose deep involvement with the accounting profession I have known for decades.

But Ferguson recently came wrong on an issue for all parties involved with large-company financial information, that threatens to contribute to a re-ignition of the 1990’s brouhaha over the permissible scope of services deliverable by auditors.

As an adjunct to his day job in Washington, Ferguson is chair of the International Forum of Independent Audit Regulators – a global collection of bureaucrats whose agencies sprouted around the world in the post-Enron aftermath of the 2002 Sarbanes/Oxley law.

In that capacity, Ferguson was quoted recently that the auditors’ search to acquire expertise in the rapidly-evolving field of Big Data and its applicability to the practice of auditing “is a source of great concern to all regulators around the world,” and “raises serious concerns about differential levels of profitability in these businesses, differential rates of growth, where the economic incentives are and to what extent does audit quality suffer as a result”(IFIAR press conference April 10, 2014, at minute 17).

For Ferguson to suggest that auditors should be either inhibited or constrained from fully realizing the opportunities presented by Big Data is to be on the wrong side of its evolutionary trajectory.

Looking ahead today, the availability of Big Data – and the ability of management, auditors and financial information users alike to grasp and analyze all and every part of the recording and reporting of an enterprise – will shortly re-work completely the way in which assurance is performed and delivered.

With search algorithms and comprehensive analytics brought to bear, the very notion of audit by sampling – bedrock of traditional audit practice since its Victorian origins – will be rendered obsolete. Whole teams of audit staff, along with their elaborate and costly testing methodologies, will have no more raison d’être than buggy whips on an automobile, as incisive programmers scanning for irregularities will search the entirety of a massive data set with the push of a button.

A friend on the board of a global public company recently gave me a beginner’s Big Data lesson: a fraud-detection team, newly empowered with access to comprehensive data on the activities of the company’s entire employee base world-wide, was enabled through exception-searching analytics to identify – and to refer for prosecution – a manager who was routinely submitting expense claims that were both randomly different in amount and just below the policy threshold for supporting documentation – a detection task essentially impossible by traditional forensic means.

That and other extended Big Data assurance opportunities are nearly too rich to grasp – when a retail transaction at the cash register generates a stock replacement purchase order and a shipping invoice – when the nation-wide spread of epidemics is predicted not by laboratory results at the NIH but by web searches for symptoms and cures – when traffic snarls are reported not by eye-in-the-sky helicopters but by the pace of cell-phones carried by car-bound commuters.

This would not, of course, be the first time a regulator was behind the transforming consequences of change. Examples in the last decade alone included the unrestrained excesses started in the sub-prime mortgage market, and the unobserved invasion by the Chinese-based reverse mergers beneath the radar of the Securities and Exchange Commission. Most recently, regulators have been wrong-footed by the legal skimming of the high-frequency traders so entertainingly mapped in Michael Lewis’s spring book, “Flash Boys,” and the market-moving impact of Bank of America’s multi-year inability to do the sums required in the complex accounting for its capital.  

The point missed by Ferguson’s suggested handcuffs on the auditors’ ambition is typical of those failing to appreciate the implications of inevitable change: the genie of Big Data is out of the bottle, and will not be returned. If the audit firms do not develop the models and methods for its deployment in the assurance process, and re-calibrate their business models accordingly, then new players in the market surely will, with existential consequences for the viability of the audit firms and their existing franchise.

Just because Ferguson takes a retrograde view of the future of Big Data in big-firm hands, however, does not mean that the accounting profession itself has it right. At the very least, there is a huge barrier of vision to overcome, as seen in the profession’s failure to evolve the basic and obsolete “pass-fail” reporting model into assurance that the markets will actually value and be willing to pay for.

And at worst, unless the profession gains credible and active engagement in the public dialog on the compelling case to acquire and deploy the skills and practices needed to bring Big Data to bear in the next generation of Big Audit, they will be setting the stage for a reprise of the disruptions of the 1990’s that saw their unfortunate capitulation on permissible scope of ancillary services, nowhere more unfortunately exemplified than in the avoidable debacle of the Andersen/Accenture divorce.  

Questions deserving debate here are deeper and more profound than those of a narrow-focused regulator. So PCAOB member Ferguson deserves appreciation for opening a door to their exploration.

Thanks, Lew.

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Previewing the PCAOB’s Public Meetings on the Auditor’s Report – Where Can We Find the Bar?

How high should the bar of expectations be set, ahead of the meetings of the Public Company Accounting Oversight Board set for April 2-3, where a series of panels are to consider its proposal of last August addressed to the auditors’ reporting model?

Based on the modest heights scaled by the agency over the course of its dozen-year history, shin guards are recommended.

 Consider these steps, halting and slow:

• The PCAOB admits that its audit firm inspections are still barred by unresolved claims of confidentiality or national sovereignty in some 15 countries, importantly including China, Hong Kong, Ireland and Italy. 

• It also lists affiliated firms of the largest global audit networks that have not been inspected in these and such other major economies as France, Germany and Spain, for four or more years.

• Three years after re-launching its elaborate series of proposals, hearings and road-shows on the never-supported proposition for mandatory limits on auditor tenure, PCAOB chairman James Doty finally folded his losing hand in February – not with a forthright admission that the notion was ill-founded from the outset, but with the budgetary cavil that “We don’t have an active project or work going on within the board to move forward on a term limit for auditors.”

• The entire edifice of auditor quality evaluation lies exposed to PCAOB member Jay Hanson’s trenchant criticism of the agency’s basic measuring stick – its own peculiar definition of an “audit failure” – that is, in the agency’s view only, if “the auditor did not do enough to know whether (financial statements were fairly stated).”

As Hanson diplomatically summarized in his March 18 speech, the agency’s self-referential definition “appears to have caused confusion among investors, audit committees and others…,” because it is neither consistent with the same term as used, e.g., by the US Government Accountability Office, nor are its “findings”  causally related to actual problems in an issuer’s financial statements or restatements.

• And finally, the PCAOB shows such disrespect for the memory and acuity of its audience that its March 20 release actually touts the participation of members of the Bush-era’s long discredited Advisory Committee on the Auditing Profession. That callous exercise in political spin, by US Treasury Secretary Henry Paulson, yielded up a final report in October 2008, so tangled in internal posturing that it was unable even to achieve consensus on the existence of a stability threat to the very model for audit services to the world’s largest companies.

Instead, the Treasury Committee’s lack of credibility was measurable by its straight-faced but ludicrous suggestion that the partners of the large audit networks would, if facing existential threats from litigation or law enforcement, stabilize their firms by abdication -- surrendering their leadership to rescue teams of replacement management standing by in the wings.  

• Aside: to its modest credit, the Committee was not altogether lacking in substantive insights – high-lighting, for example, the stunning short-coming in the oversight of the audit profession, that “No formal forum currently exists where auditors and other market participants regularly share their views and experiences relating to fraud prevention and detection in the context of fraudulent financial reporting.”

Other significant business and professional sectors provide effective models for the opportunity to engage and learn from “failure study” – engineers, air traffic safety, emergency hospital procedures, for example. The crying absence of such a forum around the subject of “audit failure” dooms the entire community of financial statement users to the blinkered limitation that “You can’t hope to improve, if you can’t tell whether you’re good or not.”

At the core of the PCAOB’s current audit report initiative is its proposal that auditors should discuss so-called “Critical Audit Matters.” The main effects of this marginal exercise – as abundantly spelled out in comment letters already in the PCAOB’s hands -- would be disruption of the appropriate allocation of reporting and disclosure responsibility resting on public-company management teams and their boards and audit committees, the fostering of further boilerplate reporting language, and the propagation of hindsight second-guessing by regulators and litigants about whether a particular matter was indeed “critical.”  

Under all these conditions, those seeking to locate the expectations bar for the upcoming PCAOB meetings are best advised to approach it on hands and knees.

 

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The American Accountancy Regulators’ Report Card: Not a Pretty Sight

 

"Kee-rist. Seven years of college, down the drain."

Two “F’s” -- two “D’s” -- and one big, glaring “Incomplete.”

That is the grade report this winter for the American accountancy regulators and standard-setters. If they were already on double secret probation, like Bluto and his fraternity brothers in Animal House, they’d be in the Dean’s office and on track for expulsion.

Start with the failures. First was the low-visibility footnote during the February 5 love-fest by which the SEC rubber-stamped the PCAOB’s new budget. As part of his remarks, the latter’s chairman James Doty said, as of a mere missing line item, “We don’t have an active project or work going on within the board to move forward on a term limit for auditors.”

There’s an ignominious end to an unworthy project. Not that it hasn’t long been obvious that Doty lacked board support, legislative backing or a sound intellectual or empirical basis for his marathon flogging of mandatory auditor rotation -- an idea was neither new nor defensible even when re-launched by the PCAOB three years ago. Somewhere on the report card of the agency’s meager accomplishments, there should be accountability for the waste of time, energy and resources expended in the tedious meetings, road trips and public panels on this misbegotten effort.

A second similar stealth exercise involved the ever-elusive relationship between generally accepted accounting standards in the US and the globally-preferred International Financial Reporting Standards. There, the chimerical “adopto-vergence” -- or whatever mot du jour is now in vogue – received a double hit. The SEC’s February 3 issuance of its latest Five Year Strategic Plan confirmed its long-standing attitude of death-by-inattention – with the anodyne statement (page 8) that “the agency will work to promote higher quality financial reporting worldwide,” while undertaking only to “consider, among other things, whether a single set of high-quality global accounting standards is achievable,” but conspicuously remaining totally silent and without a word of mention of IFRS.

While on January 29, the Financial Accounting Standards Foundation, governing parent of the American standard-setter, actually announced the grant of $ 3 million to support the work of the International Accounting Standards Board in its development of IFRS. While this subvention was touted as supportive of four on-going IFRS projects, skeptics of the long-term dithering on standards convergence would understandably view such an exercise in cross-border funding as if the coach of the American hockey team at the Olympics had qualified his loyalty by supplying equipment and training to the Russians.

As for the two activities that do not enhance a resume, even if they barely pass muster: First, the PCAOB on January 30 punted its extended deadline for comments on the proposal to identify audit engagement partners – an idea of such long gestation and so little substance that its potential usefulness is inverse to the time of its exposure.

And second on the “D” list, the PCAOB remains mired without progress on its small-change proposal to amend the standard auditor’s report, to include among other things the requirement for disclosure of “critical audit matters.” Never mind the overwhelmingly negative reactions in over four hundred comment letters on the concept release and proposed rule. Issuers, users and the profession alike have submitted the dual messages that any expanded disclosure should come from management and audit committees, and that the PCAOB’s proposal would only generate more unhelpful boilerplate and a minimum of user-friendly information.   

Last and still open is the question what to make of PCAOB chairman Doty’s bravura assertion before the SEC, in his remarks but not in his published speech, that, “Based on recent discussions, I am also optimistic that we will be able, during 2014, to sign a long-sought agreement to inspect the audit work of PCAOB-registered firms based in China.”

There may be those so beguiled by Doty’s melodious Texas accent and handsome career gravitas as to believe that this remarkable hostage to fortune amounts to credible likelihood of PCAOB inspection of audit firms in China. They are entitled to their views -- and the maneuvering after the SEC Administrative Law Judge’s enforcement order of January 22 against the Chinese firms of the Big Four for failure to produce subpoenaed documents is at least not inconsistent.

But over a decade into the PCAOB’s shut-out from China, Chairman Doty’s actual record of diplomatic accomplishment – contrasted with the bravado of his speech in the friendliest possible home-court setting – deservedly recalls Winston Churchill’s description of Clement Attlee, as “a sheep in sheep’s clothing.”

This is especially true as Doty heads into his fourth year as agency chairman – a tenure not exceeded by any of his predecessors – making it a good prediction that he will be either gone or going by the time of next year’s SEC budget party, leaving his successor to hold the poisoned chalice of a still-pending Chinese impasse.

And that’s especially the case, when recalling that the Chinese approach to negotiations – reflected in Zhou Enlai’s long-view perspective as to the impact of the French Revolution[1] – “too early to say” – is measured not in the tenure of American functionaries but over eras of celestial duration.

 

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[1] For the purpose, resolution is not needed of the commentators’ question whether Zhou was referring to the storming of the Bastille in 1798, or to the Paris student demonstrations in 1968.

A Chinese Puzzle: What If Its Auditors Really Are Barred from Practice in America?

Do you have the patience to wait until the mud settles, and the water is clear?

       Tao Te Ching of Lao Tzu, Verse 15

What will be the impact on the rickety and shambolic audit model for large global companies, if the January 22, 2014, opinion of Administrative Law Judge Cameron Elliot of the US Securities and Exchange Commission becomes final and enforceable?

That opinion would impose a six-month suspension from US public company practice on the Chinese affiliates of the Big Four audit firms – putting China-based registrants at risk of trading suspensions and de-listings, strangling the pipeline of China company IPO’s into the US, and threatening the compliance of American and other public companies having significant business presence and reportable operations in China.

As found by the ALJ, the Big Four firms had “willfully” failed and refused to produce audit work papers relating to their China-based engagements, in response to SEC enforcement subpoenas, asserting that they would be in violation of Chinese legal and state secret restrictions – positions brushed aside by the ALJ as not “in good faith” and “not sincere at all” (page 105).

Reactions and perspectives differ dramatically. To sort them out, consider the fable of Asian origin, of the committee of blind men tasked to describe an elephant:

Each feels a different part of the animal – and they variously say that for its leg it is like a column, its trunk -- a snake, its side -- a wall, its ear -- a fan, its tail -- a rope.     

Start with the Chinese themselves. Resolute optimists might see a new era of cross-border bonhomie in the China Securities Regulatory Commission’s turn-over to the SEC of documents it had received from Deloitte relating to its engagement by Longtop Financial Technologies Limited. As announced by the SEC on January 27, 2014, that supported discontinuance of the SEC’s enforcement action commended against Deloitte in 2011 – the first of the actions leading to the ALJ opinion.

Is it the start of a climb-down by the Chinese? Skepticism, caution and prudence would all advise against betting the ranch.

That’s because the behavior of the Chinese remains inconsistent, incomplete and inscrutable. Reacting to the ALJ’s decision, the CSRC issued the lofty warning that “the SEC should bear all responsibility to possible consequences arising from the decision.

And noting that the ALJ’s order is subject to appeals, first to the full SEC and then to the appellate court, Chinese analysts and corporate spokesmen took the casually sanguine view that all current reports and filings are proceeding as scheduled.

By which they failed to see two problems: First, delay through this reporting cycle is not a strategy, but only a temporary expedient; next year will arrive, all too soon and with all the same issues. Second, in any event, it should inhere in Chinese companies’ voluntary choice of American channels to the capital markets that US regulators had the right to set their rules.

As well they should, considering that effective Chinese assurance remains an elusive if needed goal. Witness the potential impact of the ALJ’s suspension order on Peoria-based Caterpillar, with fiscal 2013 revenue of $ 56 billion. Asia was its second-largest region, of which China contributed $ 3.5 billion. On this financial and geographic scale, big-firm audit support plainly is required.

Moreover, as shown by the company’s fourth-quarter write-off of $ 580 million, or some 87% of its July 2012 acquisition of Hong Kong-listed ERA Mining and Machinery Ltd for $ 653 million, the production of reliable financial information from China fell victim to “deliberate, multi-year, coordinated accounting misconduct.” 

Assertions by Caterpillar of such issues as discrepancies between physical and book inventory, at an acquired company whose major product was hydraulic roof supports to prevent rock-falls in coal mines, raise the ominous prospect that both investors and coal miners in China alike should worry about their roofs falling in.

But there are only two equally unacceptable alternatives, if Caterpillar and other companies with significant Chinese operations are denied the services of Big Four firms there: either trading suspensions for otherwise all-American enterprises, or filing by their auditors of opinions with the deadly and impermissibly non-compliant “except for” language required by US auditing standards (see AU 508.22-26) for unresolved restrictions on the ability to perform audit work believed necessary.

In his China Accounting Blog, advantageously on the ground, academic Paul Gillis correctly observed the futility of attempts at replacement of the Big Four’s local firms: smaller firms in China would lack “the scale and skills to audit the Big Four’s clients,” and attempts to fly in non-Chinese audit personnel would fall afoul of local licensing and disclosure requirements. 

But the suggestion by Gillis that the Big Four could serve their six months in the penalty box after May 1, and then return to do 2014 audits, would be seen by the SEC and the PCAOB to show a nose-thumbing and recidivist attitude, such as fatally poisoned relations between Arthur Andersen and the Justice Department back in 2002. Fresh subpoenas and de-registration proceedings could be expected instantly, with the US regulators’ full wrath over-hanging any such evasiveness.

Meanwhile the Big Four themselves promised both full-out appeals and non-stop work for their clients, falling back on hope for a political solution and claiming to be “heartened by the significant progress on information sharing between the Chinese and US regulators over the past year.”

To which the jaundiced reaction of the ALJ must carry weight. With the negligible movement and long-term delaying capacity of the Chinese since the 2002 passage of the Sarbanes-Oxley law – Longtop developments notwithstanding -- anyone so “heartened” would have been similarly charmed back in 1912, that the lifeboat count on the RMS Titanic, cynically reduced to 20 from the planned and sufficient 64, actually exceeded maritime safety regulations.

As for the American regulators, blogger Jonathan Weil suggested that the SEC might simply back-burner the order, lacking either a deadline for action or the will to take on an issue of such intense political dimensions – an approach consistent with such persistent can-kicking as the SEC’s never-ending postponements of action on convergence of American and international accounting standards, and the PCAOB’s multi-year waving at the unproven benefits of mandatory auditor rotation.

Except that, for its very credibility, the SEC can do no less than vigorously affirm ALJ Elliot’s order. Now in the chair after making her reputation as a hard-nosed prosecutor, Mary Jo White has in two recent speeches stoutly declared the primacy of her commitment to the agency’s enforcement efforts.

Thus doubly required to show that she clanks when she walks as the meanest badge in town, she would check both reputation and priorities at the door if seen to be less than robust in support for the ALJ – to say nothing of the devastating impact of retreat on the morale and commitment of her staff.

Still, the potential for international regulatory antagonism and the likelihood of a major cross-border conflict have been in full public view, ever since Sarbanes-Oxley launched the PCAOB with its over-reaching jurisdictional aspirations and the ambition to operate internationally despite lacking the tools to do so.

And therein lies the SEC’s need to protect itself on judicial appeal. No less than the firms themselves, who in their PCAOB registrations consistently put down markers of possible conflicts among competing national regulations – the regulators accepted those markers with a blind eye to the potential for the type of stand-off now presented, leaving the SEC chargeable with a form of “agency entrapment” for its own decade of irresolution.  

Finally, as to ALJ Elliot himself – the public version of whose 112-page opinion consists of 47 pages of factual recitals followed by lengthy portions blacked out for its discussion of the Chinese laws and Chinese markets.

The ALJ plays to the five SEC commissioners who will be his initial reviewers on appeal – reciting that the audit firms’ “actions involved the flouting of the Commission’s regulatory authority” (page 102) and “failed to recognize the wrongful nature of their conduct” (page 103).

But, critically for the public assessment of his analysis, the ALJ refused to disclose much of his record, out of a seemingly punctilious concern that “some of my factual findings and legal discussion may interfere with any ongoing discussions” between the SEC and its Chinese counterpart (page 4).

If the theme has a ring of familiarity in its prim assertion – “trust me, but I won’t tell you why you should” – at least to the critics of the accounting profession – it would be in the similar opacity of the one-page standard audit report itself.

A jurist seeking credence owes a better standard of completeness, at least to the sighted if not to the blind, under the 1913 maxim of Justice Louis Brandeis, that “sunshine is said to be the best of disinfectants.”

 

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Dixon Illinois and Its Stolen $ 53 Million: The Dust Settles, and So Do The Auditors

Settlement of litigation with the auditors was both predictable and inevitable.

When announced in May 2012 that Rita Crundwell, long-serving controller for Dixon Illinois, had managed over twenty-two years to swipe $ 53 million of city funds from under the blind eyes of the town’s governing fathers, I wrote that “a nightmare of auditor litigation was inevitable…”

I also wrote -- riffing on Crundwell’s diversions that underwrote her luxurious, not to say, bizarrely ostentatious, quarter-horse hobby – that “those expecting a shoot-out at the Dixon corral should prepare for a damp squib instead – mainly because the prospect of an actual trial rather than an out-of-court settlement is so slight.”

Now, under a $ 40 million package of settlements reported last week, the City is to receive $ 1 million from the sole practitioner signing its audit reports since 2006 – a nice round number suggesting immediate capitulation by his malpractice insurer – and an all-in $ 35.15 million from the Midwestern firm CliftonLarsonAllen, providers of services that were – perhaps to its hindsight remorse – supposedly limited to theoretically low-risk compilation work.

The outward vision of piety expressed by Clifton’s chief executive, Gordon Viere -- “The right thing to do is reduce the harm experienced by the taxpayers of Dixon and put this matter behind us” – may to some degree soothe the pain this amercement will inflict on his partners.

Pragmatism figured large, however.

As I had calculated, using the consultants’ model I have applied for years to estimate the litigation impact that would disintegrate a large accounting network, a "worst case" result on a $ 53 million claim would have threatened the Clifton firm’s very survival – a collapse not unlike the litigation-driven bankruptcy of the mid-sized Laventhol & Horwath in 1990.

So, as I put it in anticipation of Viere’s predictable surrender:

“No management has the fortitude, much less the confidence – except under the most extreme duress – willingly to submit the quality of its work to a civil jury for such a price.”

There are two larger lessons in these sums, for those concerned about the viability of the private accounting partnerships’ franchise to provide financial information assurance.

First, as I wrote when the Dixon fraud first broke, compilation services are a miserable bargain:

“The accounting profession, mistakenly relying on disclosure of the limits on what a compilation report does or does not say, has traditionally looked on that work as low risk – which it mostly is. But consider the environment, and the typical level and quality of competence, governance and integrity in municipal government. What level of confidence should with safety be routinely reposed in those entrusted with management of a small city’s financial resources?” 

Second, there’s an even bigger lesson at the global scale of the Big Four. Which is that, unhappy as its break-up would be for the Clifton firm’s partners, personnel and clients, sentimentality must yield to reality: its loss would have no broader impact on the audit services market. 

But a similar fate for one of the Big Four would be fatal to the entire model – a Big Three system being unarguably unsustainable. 

I have in the works, and will shortly offer here, an update to my November 2011 calculation of the Big Four firms’ shockingly small break-up thresholds.

Until that is ready, it suffices to note that Deloitte’s US firm faces an ostensibly “hard” trial date next month on claims by the bankruptcy trustee of fraudulent mortgage lender Taylor Bean & Whitaker, where there is more than $ 7 billion at stake – a nightmare number large enough by several multiples to reduce that firm to rubble.

For failure to lock the barn, in other words, the wild horses loosed by Rita Crundwell’s unbridled rapacity are still on the roam. 

 

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The PCAOB's "Game Change" Proposal on the Auditors’ Report is Small Change

 Edith Orenstein’s FEI Blog is a vital resource on the antics in Washington affecting the financial sector. It was my pleasure and privilege this week to offer this guest post:  

“Audited and Approved”

Opinion of William Welch Deloitte dated 8^th February 1850, on the half-year accounts of the Great Western Railway as of December 31, 1849, in its entirety

It's been downhill for auditors' reporting ever since.(1)

Public Company Accounting Oversight Board (PCAOB) chairman James Doty described the changes proposed on August 13 to the long-standard auditors’ report to “mark a watershed moment.”

The releases from the large firms ranged from the straight-forward (PwC) to the enthusiastic (KPMG), with the expected cheer-leading coming from their flacks; muted criticism from Tony Catanach’s Grumpy Old Accountants and the corporate bar; along with a predictable flag of litigation risk from the Journal of Accountancy. 

With formal comments due to the PCAOB by December 11, and as the polite applause dies down, a cooler perspective should see this tinkering as no more a “game change” than raising the stakes from a penny to a nickel.

That’s because the PCAOB is playing it small all the way. Board member Steven Harris emphasized “the need not to change what auditors do, but to change how they report what they do” (The emphasis is his, not mine). Board member Lewis Ferguson concurred, noting that “the standard does not require the auditor to do any additional work.”

To focus on what auditors currently do, however, misses entirely the point of investor concern. The famous and misunderstood “expectations gap” has never been about what auditors do. The gap does not even exist, in the minds or the behavior of investors until it bursts forth after a major corporate fraud or failure.

Unfulfilled auditor “expectations” have emerged with every outburst of serious issuer performance, from McKesson&Robbins in 1940 to JP Morgan Chase’s “London Whale” today.

“Where were the auditors?” does not concern transparency or the disclosed detail of audit work, but the perceived dereliction of not detecting or preventing a manifest problem – whether the collapse of Enron Corp. or the thievery of Bernie Madoff.

Investors are not demanding more nuanced wordsmithing about, for example, the auditors’ attention to issuer information outside the financial statements – the impossibly elusive articulation of a distinction between “read and consider” and “read and evaluate.”

What they do want are answers to share price-moving questions that neither the auditors’ work nor the PCAOB’s changes can ever hope to reach. They include questions like these:

• Will a particular pyramid-structured company – Herbalife comes to mind -- turn out to be a Ponzi scheme?

• Can a particular company whose customer base is concentrated on a high-tech device – Blackberry, perhaps -- actually survive in a world of fast-paced and constantly evolving competition?

• Which financial institution will suffer the next rogue trader at its derivatives desk? 

Since securing the franchise to provide financial statement assurance for public companies, under the American securities laws of the 1930’s, the accounting profession has borne self-inflicted responsibility for the creation and expansion of the “expectations gap” – by such actions as:

• Over-selling the level of comfort its reports convey – going back to the inference of guaranty conveyed by the unfortunate and now-replaced terminology, “auditors’ certificate,” and the profession’s futile inability to escape its lingering shadow.

• Tolerating the misplaced label of “watchdog,” as applied by jurists and academics whose presumption of guidance exceeds their competence to pronounce.     

• Fostering the obsolete and intellectually fragile “appearance of independence” – a trope at odds with the “client pays” model in place since Mr. Deloitte’s era, which delivers neither protection for the auditors themselves nor enhanced comfort to users.

One thing is for sure – the PCAOB anxiety about creating a bull market in boilerplate language is well founded. Defensive file-stuffing will prevail, as the Big Four prepare for the double-layered second-guessing in their future PCAOB inspections. Not only “Why was this issue not deemed a ‘critical audit matter’?” – but also “How did you decide that this ‘critical’ matter did not require disclosure?”

So it may be safely predicted that every Big Four client will have some minimum number of “critical audit matters.”

Moreover, similarities across sectors and industries are far greater than individual differences between companies. Every bank has issues with provisions for non-performing loans. And the entire technology sector has been challenged by revenue recognition in all the years since IBM pioneered its manipulation.  So the pick-list of those items will quickly become standardized.

What is dispiriting is that, on such significant issues as those in the recent great collapses – think Bear Stearns and Lehman Brothers and Merrill, MF Global and Knight Capital and SAC --  it is right to question whether auditors might have contributed positively -- by way of targeted scrutiny and assurance – to management, boards and investors alike.

But it couldn’t have happened, and won’t -- not under the small-bore thinking of “no more work – only more words.”

And not so long as the assurance model is hostage to today’s binary “pass-fail” report – accurately described by PCAOB member Ferguson as something at which “they merely glance … to make sure that the opinion is unqualified….”

If anything good emerges, it is the end of the endless discussion of mandatory auditor rotation – a majority of the Board now accepting the absence of data even suggesting a relationship between auditor tenure and audit quality.

In a one-sentence summary – which propriety inhibited me from sharing with Ms Orenstein’s readers -- the PCAOB has acted on this one like the little boy in church, losing bladder control in his dark blue suit: the results don’t show very much, and he gets to feel relieved and warm all over. 

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1. Until supplanted by an earlier-dated example, this pioneering statement – which I found hiding in plain sight in the National Archives of Britain in Kew, on the outskirts of London – is the first expression of independent assurance by one of the profession’s founders, on the financial statements of a large publicly-held corporation.

Re:Balance Takes a Spring Time-Out -- Will the Silliness Please Take a Break Too!

For the first time since launching as a blog in 2008 after its run without a break from 2002 as “Balance Sheet” in the business section of the International Herald Tribune – “Re:Balance” is going to be dark for several weeks. 

Intense and nearly unbroken travel on three continents will impede staying current on all the mischief within the capabilities of the inter-locking participants in the structure by which assurance is provided on the financial statements of the world’s large companies: issuers, the large accounting networks themselves, users in the capital and investment markets, agencies of law enforcement and politicians and regulators.

Developments in this troubled world are likely to be consequential but cannot be predicted with any level of confidence – so there will be catching up late in the spring.

Three items in the last week head the list of topics to be monitored, however:

• The PCAOB announced consideration of a proposal for the reorganization of its auditing standards – something on absolutely nobody’s list of priorities -- while the agency has failed to get off the snide on either auditor rotation or the content of the auditor’s report – reinforcing the unavoidable conclusion that this body has lapsed into terminal inconsequence. 

• The vote of the European Parliament’s Economic and Monetary Affairs Committee to scrap a proposed requirement for mandatory auditor rotation, in favor of a less binding “directive” on periodic re-tendering, has potential to inflict a dose of reason and reality on a topic long threatening to float away on clouds of fantasy. 

• And the news from the UK -- that the move by Schroders to replace long-time auditor PwC with KPMG has foundered on the inability of the putative successor to satisfy the independence requirements -- provides early validation that even aspirations limited to periodic re-tendering are subject to the realities of a market for audit services too constrained to function under legislated mandates.

All of these challenges reinforce the over-arching need for fundamental re-engineering of the reporting and audit functions in their entirety. But this process is unlikely to advance in any significant way during my brief absence. 

Instead, there is every reason to be confident that these problems will all be here and awaiting attention when I return.

 

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The PCAOB’s Inspection Reports Nibble at PwC -- A Reader Asks, “Where’s the Beef?”

Food beyond compare

Food beyond belief

Mix it in a mincer

And pretend it's beef

Kidney of a horse

Liver of a cat

Filling up the sausages

With this and that

-- Thénardier, “Master of the House,” Les Misérables

The Public Company Accounting Oversight Board – overseer of the accounting profession in the United States – got in a snit recently, perceiving that PwC was lax in its efforts to remediate the “significant audit performance deficiencies” that the agency asserted in its 2008 and 2009 inspection reports.

Expressing pique as it only could, on March 7, the PCAOB released to an indifferent public the previously undisclosed “Part II” portions of those reports.

Did it arouse the aforesaid public to care? Or even to notice?

A predictable handful of the large accounting firms’ most reliably ardent critics did weigh in (here and here).

Meanwhile a measured comparison comes to mind – the teapot-scale tempest aroused in Britain and Ireland this winter, over the discovery of equine DNA in samples of meatballs and ravioli – not, enforcers emphasized, because of any actual consumer health hazard, but over alleged deficiencies in labeling and transparency.

On which my perspective takes from the attitude of my daughter, a situational vegetarian who, on assignment this last year in Southeast Asia, has extended her palate and appetite to include crickets, dog conch and scorpion.

In the European kerfuffle, a libertarian-oriented omnivore – believing in both cultural differences and regulatory intervention only to the minimum necessary – would favor a simple modified label: “May contain horsemeat”. 

As for the PCAOB, the question has to be asked -- How can an oversight function claim either legitimacy or effectiveness, that:

• Decides for itself how to define and identify not a legal or professional standards failure, but an elusive “significant audit performance deficiency.”

• Keeps score under its own methods and incentives, like a traffic meter maid sent on patrol with a book of tickets and a daily quota.

• Must under cover of confidentiality conceal both the names and the detailed particulars of its self-defined offenses.

• And then in a burst of ill-temper, decides for itself whether the undisclosed substance of a remedial effort is satisfactory within unmeasured and unarticulated standards.

It’s no wonder, for two reasons, that PwC saw no reason to pursue its right of appeal to the Securities and Exchange Commission.

First, because PwC negotiated the ability to append to the PCAOB’s release a pronouncement of its commitment to virtuous conduct, positively radiant with unctuous platitudes.

But second and more especially, because under the current model for compliance with the securities laws, under which there is no available alternative, the Big Four-dominated market for large-company audit services is armor-plated against the PCAOB’s pop-gun arsenal. 

Law enforcement, rules compliance and social norm-setting in general -- in contexts that are controversial, subjective and incomprehensible to the laity -- are subject to credibility challenges and diminution of the authority of their arbiters:

• The Supreme Court’s obscure definition of obscenity, “I know it when I see it” (Stewart, J., Jacobellis v. Ohio, 1964).

• The theological search for distinctions between mortal and venial sins.

• The nuances and complexity of sport, from soccer’s off-side and cricket’s leg-before-wicket to hockey’s high-sticking and baseball’s rules on balks and infield flies.

• The subtleties of line-drawing between shrewd and informed investing and insider trading, or the bribery of officials and accepted business facilitation.

Here -- the mutual hypocrisy in the whole sorry audit regulatory environment is pervasive:

The PCAOB gets to pretend it is engaged in a meaningful exercise, worthy of being taken seriously in the capital marketplace.

The audit firms are obliged to pretend that they take the cost and impositions of the inspection process as something more than the de facto license fee paid as a nuisance to maintain their franchise.

And to the limited extent they really care, financial statement users can only search elsewhere for meaningful assurance, beyond the model unchanged since the Victorian era and long since degraded into obsolescence. 

Critics of this dysfunctional structure are entitled to their finger-pointing cynicism. But their bile is misplaced – until and unless they unite in advocating an achievable effort to re-engineer the entire system of reporting and assurance that today only fosters ambiguity, inconsequence and disrespect.

Until which, at the foot of each PCAOB inspection report should be appended an adapted version of the suggested European meat label – “May contain horse-sh*t.”

 

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Auditor Liability for the Dixon Fraud - Scape-Goat Hunting in the Courthouse

A nightmare of auditor litigation was predictable, when the news broke last May that the comptroller of bucolic Dixon, Illinois, had helped herself to $ 53 million dollars of city funds (here). 

Having financed her luxury-level hobby horses on an apparently modest five-figure city salary, revealed as supplanted by twenty years of hand-over-fist embezzlement, Rita Crundwell now faces twenty years of federal prison time (here).

As of December, the town added Midwestern regional accounting firm CliftonLarsonAllen as a litigation target (here) – liability being asserted for its multiple roles including Crundwell’s own tax return preparer and keeper of the city ledger, as well as auditor of the town’s financial statements until 2006 when it dialed back to “compilation services.”

A full-out courtroom scuffle would be interesting. On the one hand, the accountability of Dixon’s own city fathers over the extended looting of an annual budget of only $ 8 to $ 9 million implicates their guardianship of the municipal barn door through which Crundwell cantered away with her bags of stolen loot.

But as I wrote at the time: 

“The accounting profession, mistakenly relying on disclosure of the limits on what a compilation report does or does not say, has traditionally looked on (compilation) work as low risk – which it mostly is. But consider the environment, and the typical level and quality of competence, governance and integrity in municipal government. What level of confidence should with safety be routinely reposed in those entrusted with management of a small city’s financial resources?” 

  On the recent reporting, the Clifton firm’s reliance on the limited duties associated with a compilation is exposed to collateral arguments about its deeper involvement: emails continuing to refer to “audits,” alleged working-paper support to the local sole practitioner putting his name to the opinions, and maintenance of a steady-to-increasing stream of fees even with the reduction in its stated scope of responsibilities. 

Limited as compilation work requirements may be, they continue to require fulfillment of professional standards of quality control, ethical principles of integrity, objectivity competence and due care.

And by way of reinforcement, commentators and standard-setters continue to press the importance of skepticism in oversight (here and here) – difficult enough to achieve, and hostage to fortune whenever tested under the harsh glare of hindsight.

However -- those expecting a shoot-out at the Dixon corral should prepare for a damp squib instead -- mainly because the prospect of an actual trial rather than an out-of-court settlement is so slight.

That’s because the Clifton firm’s exposure is life-threatening, and so unlikely to be tested in a trial.

Which is despite the fact that Dixon’s outside lawyers hold themselves out as personal injury lawyers, who do not publicize accountancy litigation as a practice area. So they are unconstrained outsiders to the culture of the traditional accountancy plaintiffs’ bar, which has long calibrated its high-end demands so as to wring only enough from the flock of Big Firm geese to enrich themselves while sustaining the steady supply of golden eggs.

Instead, using the model on which I have previously explored the shockingly small size of a litigation threat that would disintegrate a global-scale accounting firm (here), the Clifton firm’s reported $ 570 million of annual revenue is a fragile base from which to defend against a worst-case impact on the order of $ 53 million. [1]  

No management has the fortitude, much less the confidence – except under the most extreme duress -- willingly to submit the quality of its work to a civil jury for such a price.

Existential threats from litigation are an unconfronted daily reality for the Big Four firms (here). But no less for their smaller brethren, where the threat is on a “one-and-done” basis. BDO’s ability to withstand the adverse jury verdict in the Bankest case in Florida was a fortuitous combination of persistence, favorable court rulings and an eventual settlement – still not publicly disclosed (here and here). And the Baker Tilly firm’s $ 50 adverse verdict in Wisconsin in the Aqua Finance matter – unhappily including a coverage dispute with its insurance carrier (here) – surpasses its resources on a worst-case basis as well.

None of which bodes well for the strength, sustainability or long-term future of the assurance function – professed to be important to society’s ability to rely on audited financial statements.

Instead, the clock of doom ticks toward midnight.

 

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[1] Write me for the details if interested. My pencil pushing suggests a break point of around $ 50 million, but precision is impossible. Insurance coverage and deductibles have relevance, but only as a measure of the pain that might be inflicted on future generations of Clifton partners.

The Great Maple Syrup Caper -- A Sticky Mess in Quebec

While bidding farewell to the old year and welcoming the new, this Christmas Eve story out of Canada should not be lost in the holiday news cycle: 

“Over a one-year period during 2011 and ’12, some 6 million gallons of maple syrup – about $ 18 million worth – were stolen from the ‘strategic maple syrup reserve’ controlled by the Federation of Quebec Maple Syrup Producers (FPAQ)…. Last week, three men were arrested in connection with the heist.”

The Mounties have ridden to the rescue, the arrest total reportedly has reached 18, and weightier issues can now be on the table than a supply threat to the breakfast calorie count. Namely:

Producers around the world closely protect their strategic assets – whether Middle Eastern petroleum (OPEC), Japanese agricultural products (Nokyo), Colombian narcotics (Cali and Medellin) or American professional football and basketball players (NCAA). So it should not be surprising that the question is debated about Quebec, why our typically mild-mannered northern cousins maintain a government-run cartel to promote market stability in the supply and pricing of gourmet pancake toppings.

A better question, though, is just how fully one-quarter of the national stock – the equivalent of 16,000 barrels of syrup – could have been siphoned out of a warehouse described in the FPAQ’s own press release as “secured by a fence and locks, and visited regularly.”

The question must inevitably be asked, in short, “Where were the gate-keepers?”

Fortunately for the appetites of the world’s luxury crepe-and-candy consumers, the thieves were undone because they chose the hard way, working their felonious little scheme on the liquid commodity itself. Their sticky footprints left a trail, because to monetize their scheme required a disposition infrastructure – trucks and warehousing, a processing facility in neighboring New Brunswick and a sales pipeline through which to channel their slippery merchandise into the sweets-addicted US market. 

In this, they suffered the detection risks of scams like that of India’s Satyam in 2009 – where maintaining a roster of 13,000 phony employees would arouse the curious to wonder about the absence of ancillary evidence – the ghost workers’ non-existent desks, telephones and withholdings and remittances for health care and benefits.

Simpler, harder to detect and far less messy, would have been the time-honored creation of inventory that was fraudulent and fictitious from the outset. Consider these classics:

• The great Salad Oil Scandal of 1968, by which Tino DeAngelis floated only enough vegetable oil on bulk tanks of water to fool auditors who looked and tasted from the top rather than tapping the tanks at the bottom.

• Equity Funding in 1970’s Los Angeles, with over-stated death benefit liabilities under fictitious life insurance policies turned into cash through a Ponzi scheme of cessions to reinsurers.

• The South American coffee shipper, showing tons of stock on its balance sheet and available for collateralized borrowings, in reality comprising only camouflaged piles of sand under thin layers of beans.

• Over-stated Texas cattle herds, sold to unwary urban tax-shelter buyers – it being no great trick to run the same calves repeatedly through a maze of corrals, past the clip-boards of credulous city slickers unwilling to dirty their suits to exercise the control of chalk-marking the forehead of each passing animal.

• Or the related German scheme by which a fleet of trucks was over-counted in their repair sheds by auditors distracted from the back parking lots, where the vehicles were re-cycled by simply switching their license plates and dashboard bar codes.

The examples are as endless as the ingenuity of the criminal mind. Had the light-fingered Canadians only thought through the vulnerabilities of their targeted provincial cartel’s control system, they’d have kept their hands far cleaner while moving phony paper rather than hot syrup.

And they’d have made their illegal fortune while avoiding not just the brown sticky stuff, but what will now be extended stays in government custody, where the pancakes in the prison cafeteria will not be flavored with so much as a drop of down-market Aunt Jemima’s.

 

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Foreign Auditor Inspections? "China Syndrome" Strikes the SEC

 

Confidence in the American securities and accountancy regulators was not raised, when a press release on December 3 announced -- under the headline “SEC Charges China Affiliates of Big Four Accounting Firms …In Refusing to Produce Documents” – a proceeding against the five largest global networks.

For the first time in its eleven-year history, this column calls upon a graphic to illustrate the folly of a gang that couldn’t count straight:

 

   The PCAOB has been stymied for a decade in its futile attempts to enforce in China its asserted mandate under Sarbanes/Oxley to inspect and obtain working papers from auditors, including those in foreign countries, which audit more than twenty percent of a registrant’s assets or revenue (here). And the SEC itself has been piddling along with company-specific subpoena enforcement and administrative proceedings against Deloitte and its Shanghai affiliate.

So now they have called in the heavy artillery, in the person of Robert Khuzami, director of the SEC’s Division of Enforcement, who says that non-complying firms “face serious sanctions.”

Khuzami cannot be faulted for zealotry. He arrived on the scene of an agency whose Cox-era somnolence had missed not only Bernie Madoff’s predations on the domestic front but the internationally destructive tsunami of “reverse mergers” by which Chinese companies gained access to the world’s capital markets. That scorecard, a decade late and billions short, now includes more than 50 de-listings by the SEC and 40 fraud actions – and, elsewhere, a flurry of civil litigations, and most recently an agreement by Ernst & Young to settle civil litigation (but not a disciplinary proceeding) relating to Sino-Forest, by agreeing to pay C$ 117 million, the largest auditor settlement in Canadian history.  

(As an aside, those disposed to see darkly conspiratorial revolving doors in the place of Chinese fire drills will note that this is the same Khuzami whose predecessor at SEC Enforcement from 1998 to 2001, Richard Walker, thereafter went in-house at Deutsche Bank, where he hired Khuzami in 2002. So the latter, before becoming the top American securities cop in 2009, was on-scene at DB when the bank – as now reported – according to three whistle-blowers concealed losses of up to $ 12 billion for failure to “mark-to-market” the exposure gap on a notional $ 130 billion of exotic derivatives known as “leveraged super-seniors.”)  

Calling in Khuzami’s troops may look like the last act of desperate regulators – but it will actually play as the next act in “The Comedy of Errors.”

That’s not because it’s so little so late. Or because frustration of the PCAOB’s aspirations to access Chinese auditors and work papers would attract retaliation against their own ambitious plans to re-structure the global audit market by building and unleashing global-scale Chinese audit firms – an ambition otherwise unachievable both for want of competence in personnel and standards but also because, in reciprocal hostility, other countries will be no less protective of their local prerogatives.

It’s mainly that the US regulators’ only weapon of significance – banning Chinese affiliates of the large global accounting networks from qualifying to work on audits of American-listed companies – would ripple far beyond the toxic roster of China-based companies.

There are potential consequences for global-scale companies with significant operations in China that go far beyond the inability of the PCAOB to inspect their local audit firms, whether or not maneuvered to keep below the 20% threshold.

Consider just two examples: Caterpillar, whose annual filing with the SEC does not set forth results by geography but discloses total 2011 sales of over $ 60 billion and elsewhere reports its China sales to be 3% of its total. Or HSBC, which does report by region including $ 3.6 billion in profits from China in 2011 and whose mainland Chinese operations include 133 outlets including 27 branches, even after the announced sale of its interest in giant insurer Ping An.

A barrier to the use of Chinese audit firms would make it impossible for those companies to include audited results from their Chinese operations in their global accounts. The result would be top-level consolidated financial statements with a huge unaudited portion, and auditors forced in their opinions to confront the professional standards for limitations on their audit scope.

Across the globe from KPMG in London and its top-level opinion on HSBC, to PwC in Peoria, Illinois for Caterpillar – unable to rely on their excommunicated Asian brethren – auditors would have no choice but to use the dread “qualify or disclaim” language -- never seen for a public company because anathema under the rules of the SEC itself.

Or, in extremis, PCAOB de-registration of the whole of an audit network deemed non-compliant would render a company’s entire financial filing unacceptable.

Restoration of adult-level expectations and the pursuit of a non-litigated resolution process is essential, although a fading hope – since calling in the police as a last resort means an escalation of hostilities due to the one-dimensional DNA of their approach to problem-solving.

For good reason, then – under the latest blows from SEC Enforcement – the large accounting firms must feel like a bunch of nails in a hammer-testing factory.  

 

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The Pre-Election Mood: Enervation Over Innovation

 I awoke last night in the cold sweat of nightmare terror – my own version of Bill Murray in the 1993 film, “Groundhog Day”-- that CNN moderator Candy Crowley saw her shadow, and we were cursed with six more weeks of Presidential debates.

And PCAOB chairman Jim Doty kept scheduling “public meetings” on the exhausted topic of mandatory auditor rotation – the last in Houston having dragged through October 18 with no observable contribution to our wisdom – until he held one in the junior high school gym in Punxsutawney itself.

A tour of media, commentators, and those knowledgeable, confirms the prevailing sense of lassitude and ennui – owing much to the nationwide American paralysis ahead of its November 6 elections, but also to the absence of any credible display of energy, much less urgency, around the issues overhanging the accounting profession.

The usual crabbing continues, of course – ranging from the ineffective if age-old grousing about auditor skepticism -- vented by the PCAOB chair himself, webinars from the private sector, and such bloggers as the Grumpy Old Accountants – to the commenter on my last posting, about the British regulator’s new policy on re-tendering, stating mistakenly that I “ask for ‘proof’ that lack of auditor rotation is a cause of fraud,” when I want no such impossible thing, but only recognition, as I have often said (see here) of the absence of “any evidence of a link between auditor tenure and audit quality.”

In the gathering gloom and darkness of late autumn, then:

Nothing good can be expected from the Securities and Exchange Commission in Washington, where Chairman Mary Schapiro is said to be packing for her post-election departure, having in her light-touch tenure realized nothing of effect on the structure or stability of the assurance function. 

On the globalization of accounting standards, the dialog is if anything more sterile than ever: The SEC has only an interim chief accountant in place; the griping about non-convergence includes the hand-wringing of IASB trustee chairman Michel Prada and the sideline irrelevancies of AICPA president Barry Melancon; while FASB chair Leslie Seidman should be plainly tired of the censorious Dutch-uncle utterances of her counterpart at the IASB, chairman and non-accountant Hans Hoogervorst.  

While on the auditing standards side, the intellectual heft brought by the International Auditing and Assurance Standards Board to its project on Improving the Auditor’s Report is unmatched by the political skills or horse-power necessary for action in the face of entrenched resistance. At the same time, the PCAOB’s parallel Concept Release, going back to June 2011 – which by rights should be cooperative and complementary – wallows becalmed for lack of any readiness to re-engineer a reporting system in which all interested parties are invested in preserving the status quo.

Even what should be a bright spot – the launch earlier this month by seven joint sponsors of an assessment tool for audit committees, “Annual Evaluation of the External Auditor” – designed to support “an informed recommendation to the respective board of directors whether to retain the auditor,” has the taste of very thin gruel.

That is, it says precious little about the skill level of an audit committee, to think it requires such an anodyne checklist as these “get-to-‘yes’” examples: 

• “Was the cost of the audit reasonable and sufficient for the size, complexity and risks of the company?”

• “Was the audit engagement partner able to explain accounting and auditing issues in an understandable manner?”

Enough with the softball treatment. For a committee obliged to justify itself, why are there not such substantial questions as:

• “What qualifications and training does the audit committee itself have in the exercise of skepticism and the avoidance of bias?"

• “If forced to rotate or re-tender the audit, does the company have a realistic alternative choice?” 

• “What other or different forms of assurance, beyond the current standard audit report, would company management and its community of information users find useful and valuable?”

Historians of the evolution of knowledge teach that systems on the cusp of obsolescence – inherently resistant to the disruptions of fundamental change – evolve only when those contributing to the prevailing inertia are forced into confrontation. 

But that when they are, the realignments are highly disruptive, in ways unpredictable in advance.

Meaning that the groundhog’s looming shadow is long, dark and ominous.

 

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Watch This Space -- The Academics are Coming

 August in Washington? You’ve got to be kidding. Not even the national politicians are dumb enough to hang around that malarial swamp. 

So what could be better?

Answer: three days in a monster convention center in suburban Maryland, at the annual meeting of the American Accounting Association. At least my own registration is now in and official.

Of my two gigs there, the heavy lifting will be a panel on August 6 on “Rationalism in Accounting.”

Okay, stop the snickering! Just because such cringe-inducing pronouncements as the joint mash-up of the IASB and the FASB on lease expensing make the title of the panel sound as oxymoronic as "Jamie Dimon on risk management” or "François Hollande on French political leadership.” Teaser: leading the roster of smart people among whom I will struggle to keep up is always thoughtful Shyam Sunder of Yale – recently readable on this topic here. So at least have the good manners to hold your derision until you’ve sat in on the session.

The second should be more relaxed, and worth sticking around until the last afternoon – Dave Albrecht of The Summa hosting on the fun and games of blogging about the interesting issues that convene this group of party animals. 

Hope to see many of you there. Until then, enjoy the summer.

 

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Dixon Illinois: Fifty Three Million Dollars Go Missing -- So Who Let the Horses Out?

 

    Trust – but verify.

            -- Ronald Reagan 

The revelation of a $ 53 million embezzlement by the treasurer and comptroller of the city of Dixon Illinois – home of the 40^th American president – once again brings this to the fore:

“Why are the accountants still so bewildered that there should be an ‘expectations gap’?”

According to her criminal indictment released on May 1, Rita Crundwell went undetected since 1990 in accumulating all the appurtenances of a life of rural luxury – not only the typical clothing and jewelry, but trucks and trailers, Liberty Coach motor home and Ford Thunderbird convertible -- all supporting her sideline prominence in the boots-and-bling world of quarterhorse breeders (here).

Extractions of that magnitude, from the coffers of a city with an annual budget of only $ 8 to $ 9 million, might have required her full-time devotion to shoveling the cash with both hands. But the self-efficient Ms. Crundwell did not scruple to observe four full weeks of paid vacation each year, and was evidently only caught out when she extended her absence to an additional twelve weeks.

Separation of employees’ duties? Back-up authority that someone else should glance at the city’s checkbook? Allowing her family members to pick up the city’s mail while she was on her holidays? Could the demands of minding the city’s affairs be so simple, naive and blasé, even in the exurban Midwest?

As for the expected queries (here and here) – what about the gatekeepers at the corral?

A large regional accounting firm is reported to have done compilation services for the city since 2006, having done audits in prior years.[1] But the distinction has so far not been explored.

Which, borrowing a metaphor from Ms. Crundwell’s expensive equestrian hobby, is to beat a sad and very dead horse. Because, as the professionals are in the process of learning to their sorrow, simple proximity and association are enough to attract whole worlds of grief.

The International Auditing and Assurance Standards Board – source of auditing standards on a global basis – on March 16 issued a new version of guidance on the performance of compilations:

"Since a compilation engagement is not an assurance engagement, a compilation engagement does not require the practitioner to verify the accuracy or completeness of the information provided by management for the compilation, or otherwise to gather evidence to express an audit opinion or a review conclusion on the preparation of the financial information."

The IAASB also speaks to the intended use of compiled financial statements, however, posing the question whether: 

"External parties other than the intended users of the compiled financial information are likely to associate the practitioner with the financial information, and there is a risk that the level of the practitioner’s involvement with the information may be misunderstood …"

What the IAASB does not offer – understandably, considering the many settings in which full-blown audits are not worth the cost or effort involved – is aide to either the profession or the user community on a necessary risk-based inquiry:

“Just because a service can be done, does it make any sense and should it be done?”

The accounting profession, mistakenly relying on disclosure of the limits on what a compilation report does or does not say, has traditionally looked on that work as low risk – which it mostly is. But consider the environment, and the typical level and quality of competence, governance and integrity in municipal government. What level of confidence should with safety be routinely reposed in those entrusted with management of a small city’s financial resources?

A typical compilation report – while offering no opinion – does recite that the accountant has performed with appropriate skill, ethics and the exercise of appropriate professional judgment. But that is all it takes to get burned.

I have tried to get across, both to my students in Risk Management and to my friends and clients in the profession, that for one caught holding an empty gasoline can, while standing next to a suspicious conflagration, it is not easy to avoid suspicion of arson. The explanation goes down hard, that the container was an innocent impulse purchase at the local hardware store.

As both an exercise for law and business students, and a message in the real world: there is no harm in not wearing a seatbelt, most of the time – or in not locking the barn door. Except for the rare time when it isn’t okay – and then it really matters. A long record of “being lucky” or a history of “getting by” counts for nothing when a bad event exposes the devastation wrought by casual habits.

How accountable the good townsfolk of Dixon will hold their city fathers for the quality of their stewardship – and whatever the exit cost may ultimately be, for a blinkered exercise in the assessment of risk and exposure to Crundwell’s plundering – it is once more made crystal clear that the accounting profession continues to market services that are under-comprehended and over-sold.

 

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[1] My requests to the firm’s media contact for an opportunity to converse have not been answered.

The PCAOB Wants to Name Audit Engagement Partners: Would Its "Red A" Really Matter?

As if it didn’t have real work to do, the Public Company Accounting Oversight Board in its October 11 release has revived its 2009 project, looking to require audit firms to disclose the names of their responsible engagement partners.

 With its persistent instinct for the capillary, the PCAOB presses for information that is:

•  Of no consequence to financial statement users sophisticated and informed enough to appreciate the complexity of a large audit.

• Of indifference to the bulk of the investor population already hard pressed to identify the firm auditing their portfolio companies.

•  Of interest mainly to the unremitting critics of the profession, for whom access to individual names would only fuel their continued antagonistic and unproductive axe-grinding.

Here’s a message for both sides: It’s a bogus issue, and not worth the distraction from serious matters.

Such as, first, the PCAOB’s own release of June 21, re-visiting the scope and content of the recognizably obsolete standard auditor’s report. A substantial discussion is now ready to start, that should include the responsibilities of issuers’ management and audit committees (some 150 comment letters are accumulating here). If only the PCAOB could align with the parallel undertaking of the IAASB, a truly coherent and comprehensive international dialog might constructively emerge (see here).

Second, it may be that the division in views of the PCAOB members on mandatory auditor rotation means that this time-worn subject was served up yet again, on August 16 (here), only to be killed off once for all. Here the problem is that, as selectively leaked, EU markets commissioner Michel Barnier has not only tabled mandatory rotation himself; in his enthusiasm, he threatens also to require joint audits with responsibility shared among multiple firms, and would also strip all non-audit services from the firms’ business models (here).

Time enough, when the details of Barnier’s proposals emerge for public scrutiny next month, to probe the fanciful and unrealistic nature of his expectations. That will also be the time for more vigorous and effective responses than are usual by all those concerned – large and small audit firms alike, along with their clients with whom in this area they have common cause -- to the destabilizing and dangerous effects of Barnier’s combined naïveté, ignorance and political zealotry.

Meanwhile, back to the naming of names:

Those charged with auditor selection already have access, on request, to the details of personnel identity and qualifications.

While over on the side of public “transparency,” branding individual auditors with the scarlet letter “A” might give satisfaction akin to that of the censorious townsfolk around Nathaniel Hawthorne’s Hester Prynne.

But to what end? As recognized at least by PCAOB member Lewis Ferguson (here), any engagement partner whose work is caught up in multi-year civil litigation and regulatory enforcement effectively suffers the end of his productive career – even if judgment-proof and indemnified – not only because of the overwhelmingly distracting time demands but because the emotional toll of defending even high-quality performance is ruinous to the capacity to exercise complex professional judgment.   

Which does not, on the other hand, mean that the US profession’s resistance to partner identification is a “hill worth dying on.” Partner signature is the practice around Europe, and some European filers so disclose in their NYSE filings, as chairman Doty has noted (here). As the world is not coming to an end thereby, a proof-seeking skeptic might well ask this: Are European shareholders really so “favored” over their American counterparts, as Doty suggests, or is it rather that the markets have compared the availability of partner names, and yawned with boredom?

Beyond partner names, the PCAOB goes off into another disclosure area, although reflection may suggest it has left a major hostage to fortune – namely, the proposed requirement that auditors disclose the names and work efforts of other firms, in their networks or otherwise, participating in their engagements.

Again, this is a matter on which investors have shown indifference – it being impossible to imagine that they are really engrossed on the subject, when they must suppose that local country rules on professional qualifications and rights to practice would be no less applicable for auditors than, e.g., for lawyers or doctors.

But given the back-footed positions of the SEC and the PCAOB on such matters as the recent scandals among the Chinese reverse-merger companies coming to the US capital markets, and the still-lengthy roster of ex-US firms and issuers not subject to the PCAOB’s halting efforts beyond its native soil (re-capped by Francine McKenna here), it might seem a dubious judgment for the PCAOB to encourage public airing of the gaping holes in its inspection and enforcement regime.

In other words, “be careful what you ask for” – advice perhaps not high on the list of commentary welcome in the halls of the PCAOB. But then, an agency capable of addressing mandatory auditor rotation with a straight face is equally liable elsewhere to trip onto its chin and mistake the pratfall for forward progress.

 

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