Re:Balance -- Jim Peterson

Hazards in the UK Audit Market – A Parable for the Holidays

Bidding farewell to this dismal year, it’s my long experience with the holiday season in the United Kingdom that a significant matter open on the solstice will not receive attention through Christmas, Boxing Day and the New Years celebration, until after the arrival of the Three Kings.

So today’s news is welcome, that Boris Johnson’s beleaguered government actually has a candidate -- the seasoned Jan du Plessis, late of BT and Rio Tinto -- to chair the Financial Reporting Council. But the post requires parliamentary committee approval to head the audit regulator, an agency itself hostage to the absence of legislation to relieve its “ramshackle” condition. Further official delays and inaction look inevitable, well into 2022, in untangling the complexities contained in the depressing question, “Where were the auditors?”

While the prospects are slight that the arrival of du Plessis will herald a secular epiphany, there is at least a learning opportunity in the recent reporting that HSBC’s approaching obligation to put its audit out for tender may well attract no proposals save from incumbent PwC. 

That is, the needless distractions over auditor tenure –- under UK and EU rules that have been in place long enough to demonstrate the absence of discernible effect on either audit quality or competition and choice -- are relevant to the still-pending possibility that the UK government’s long-delayed action on its consultation of March 18, 2021, will include either “managed shared audits” for FTSE 350 companies, with the forced participation of the smaller firms, or attempts to impose “caps” on the Big Four firms’ market share.

Namely, with the indicated lack of enthusiasm among PwC’s three large brethren,  the unlikelihood of change at HSBC is further confirmed, according to the Financial Times, as “senior auditors at two challengers said mid-tier firms would not pitch to audit the entire HSBC group because of its size and the associated regulatory risk.”

No surprise at all. HSBC is the largest bank in the FTSE 100. PwC’s audit and related fees of $ 130 million last year are, as the FT put it, “more than the entire UK audit revenues of any challenger other than BDO and Grant Thornton.”

Which said, the story in the numbers is not the only way to consider the structural inability of the smaller firms to expand their large-company market share. For a perspective on such an attempt, here follows a first-hand experience, with implications if a “challenger” firm actually tried –- that is, had the chutzpah or the reckless courage -– to propose.  

It was a long time ago, in a galaxy far away –- so far in the past that all statutes of limitations on the telling are long since expired. A small-city office of a then-Big Eight firm wrenched the audit of a complex financial institution away from its main local competitor -- to be the successful aggressor’s only local client in the sector.

With abundant confidence and complete good faith, the newly-arriving firm cobbled together an engagement team headed by the office’s senior audit partner –- experienced and respected in the local community, known for his probity and his leadership, although with a blank slate of specific industry experience. His supporting lead manager’s briefing into the new role was to attend the firm’s internal industry training classes.

The first two years went smoothly enough, save for the weight on the engagement of the expected and greater than normal resort to the national office.

In year three, however, the client pushed into a major new product line, an ambition burdened by start-up operational glitches and accounting complexities beyond the experience and resources of its own CFO and staff.

As for the audit team, this new business went observed but unremarked. Hindsight was later to reveal that they failed to grasp or even recognize the risks and complexities of a business environment they had no way ever to have seen before. 

The finger pointing and blame attribution between client and auditor were intense and unpleasant. The inevitable rupture of the relationship was nasty, including extended litigation and ample unpleasant gossip in the city’s civic venues and country clubs.

Developments in behavioral psychology and economics provide the framework for this parable. At play is the Dunning-Kruger effect -– the cognitive bias under which catastrophically erroneous risk-related decisions are made, where the actors are ignorant of the scope of their own ignorance.

“Not knowing what they didn’t know,” in other words, both the client and the audit team were exposed to fatal defects in their decision-making capability.

Dunning-Kruger is wonderfully powerful as a means for better decisions, but only if recognized in the specific context:

• Applications start with the simple and entertaining -- if told to draw a picture of a giraffe, you have no chance if you’ve never seen one before.
• Scaling up the example to a multi-million-dollar business challenge -- even a highly-skilled professional, unless specifically trained and experienced, cannot conceive, much less carry out, the judgments involved, eg., in fixing and accounting for a realization reserve on the assumption of a portfolio of exotic financial instruments.

In the hypothetical future world of “managed shared audits” or capped market share, the engagement partner of a mid-tier audit firm with big-table aspirations would hang from a limb of uncertain length and weakness. The questions “who can I call?” and “where is my help?” would come back unanswered. 

The various versions of the clichéd doom that awaits those who forget history have even greater force for those never learning in the first place. For future problems of newly-presented scope and complexity, the consequences will be no prettier than they were in my old case a generation ago.   

  

Happy holidays everyone. Stay safe and healthy. Please share this with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free – both at the Main page.

 

 

Sports Direct’s Audit – Anyone Up For A Challenge?

If I were teaching my graduate course in Risk Management and Decision Making this summer, its final exam would pose the questions in this real-world dilemma, confronting senior management of the United Kingdom’s mid-sized accounting firms -- dubbed by the Competition & Management Authority the “challengers”:

High street retailer Sports Direct, mightily fallen from its brief stint as a FTSE large company but still listed and public, lacks a successor for long-time auditor Grant Thornton, which announced on July 29 that it would not stand for re-appointment.

The company’s CEO and largest shareholder, swash-buckling Mike Ashley, had postured, as its results were released on July 26: “we do not believe a firm outside of the Big 4 will potentially be able to cope with such an audit in the future.” Spurning Ashley’s come-hither attitude, each of those firms has explicitly demurred -- as has BDO, largest of the challengers.

First question: is another challenger willing to propose, or not? For a firm eager to push its way up the rankings, it could be a golden opportunity. Or else, the definition of a poisoned chalice, with risks and hazards of an engagement as large or larger than any in its existing client book.

Which way the reputational effect? For better or worse the company’s governance is under fire, derided as “out of control” and “a total and utter shambles;” it faces such side complexities as the delayed accounts of Ashley’s personal holdings in Sports Direct and football club Newcastle United; its stock price has tumbled below 240p, from its 2014 peak of 922p, and is now below its 2007 listing price. Its issues will be highly visible in the already-inflamed Big Audit environment.

As for the economics? Grant Thornton’s audit fee for 2017, reported in the latest Accountancy Daily survey, was £ 1.4 million-- for an estimated profit on the order of £ 200-250 thousand. A projection from that figure would be hostage, however, to the doubtful assumption of no further developments. That is, the cost to address even a modest extension of necessary extra audit work, or a lawsuit or investigative inquiry – legal fees and diverted management time alone – would swamp any engagement profit within weeks.

And that’s without thinking of the potential fines or judgments. Could the revenue justify that risk? No fee can be set and charged that would protect an auditor in the fraught context of Sports Direct -- simply impossible. On the large-company scale, Arthur Andersen disintegrated in 2002 under litigation exposure to Enron’s $ 67 billion bankruptcy; in March 2019, PwC settled its judgment of $ 625 million relating to Colonial Bank by agreeing to pay out $ 335 million.

Even much smaller companies can inflict deeply painful consequences. Grant Thornton itself is experiencing its 2019 judgment of £ 21 million plus court costs of £ 5 million related to Assetco, and has pending its day of financial reckoning arising from the indicated falsifications estimated at £ 94 million and shareholder losses of £ 446 million at Patisserie Valerie.

Further, a challenger firm’s liability insurance deductible alone would exceed its annual profit from Sports Direct, while the modest ceiling on its insurance cover would trivialize that “protection” in the face of investor and enterprise losses if Sports Direct continues on its stumbling path.

Worst case, as applied to the 2018 revenues of between £ 500 and 160 million, for the next five UK firms smaller than opt-out BDO, the behavioral model for an accounting firm’s maximum survivable litigation hit, done for the EU commissioner for markets in 2006[1] -- a blow that would fatally de-stabilize and break up a firm would range from about £ 100 million down to perhaps £ 35 million – well under the threat levels lurking at Sports Direct.

Could a firm be arm-twisted by the authorities? The ability of a professional to exercise judgment in client evaluation and acceptance would be hostage to such unseemly over-reach – as would the integrity of the firm leaders’ professed commitments to improve their quality of performance and satisfaction of user expectations.

Meanwhile, the UK regulators are in no position to use force. Not only is it inapposite to consider the suggested but untested authority under Section 490 of the Companies Act 2006 to appoint an auditor if a company fails to act. Any official attempt to press-gang a reluctant firm into an unwanted audit engagement would further the diminishment of the profession’s stature and legitimacy that goes back to the inflictions of Sarbanes/Oxley in 2002.

This, then:

• The adverse consequences of mandatory auditor replacement and constraints on the scope of permissible auditor services are manifest.
• Equally apparent is the insufficiency of long-argued but unachievable “solutions.”
• Regulators and politicians are effectively helpless to impose non-consensual audit assignments.

Under these unhappy conditions, barnyard metaphors are irresistible:

• The chickens have come home to roost.
• The foxes have invaded the henhouse.
• And the capons are squawking around with their heads lopped off.

Students undertaking this examination are reminded that their analysis and answers to these questions are due before the company’s September 11 annual general meeting.

[1] Discussed in detail in my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (2d ed. 2017) at pp. 45 et seq., and a central theme of my recent book on the volatile state of the UK environment, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon May 2019).

 

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My New Book -- "DOA: Can Big Audit Survive the UK Regulators?"

It is a pleasure to announce the availability of my new book -- "DOA: Can Big Audit Survive the UK Regulators?" -- now available in paperback and e-reader versions through Amazon -- here. 

To summarize the story, which is little enough comprehended even in the United Kingdom, and both seriously under-reported and much misunderstood in the United States and elsewhere:

"The collapse of Arthur Andersen in 2002 reduced the large accounting networks to the Big Four – Deloitte, EY, KPMG and PwC. Can they survive, in a model fit for purpose?

 "Public criticism and the hostility of regulators and politicians are intense, especially in the United Kingdom since the January 2018 collapse of contracting giant Carillion. The debate is joined, the outcome is uncertain, and the consequences to the capital markets will be profoundly disturbing.

"The issues are complex: audit quality, the 'expectations gap,' competition and choice. Disruptive 'solutions' include breaking up the Big Four, stripping their people and services back to 'audit only,' and even nationalizing audit assignments. 

"DOA surveys the background to the current UK environment, examines the possible actions, and assesses the doubtful prospects for beneficial change." 

By its focus, in the current volatile British environment, on the political, regulatory and litigation risks that swirl globally around the Big Four, DOA is a sequel to the detailed scrutiny of these issues in my earlier and still-relevant book, "Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms" (Emerald Books, 1st ed. 2015, revised and extended paperback edition 2017 -- also on Amazon).  

The certainty of global implications for the continuing availability of assurance on the financial information of the world's large public companies, including the stability and viability of the Big Four themselves, makes broadly relevant the actions and decisions of the regulators and politicians in the UK. 

I invite your attention to the examination in DOA of these important issues. Please share with friends and colleagues. Comments here via the Main page, and reactions and suggestions to me at [email protected], are invited and most welcome.

 

Dominance in the Big Audit Market – Reality Meets Its Critics

"The girls all get prettier at closing time….”

             --Mickey Gilley, 1976 (lyrics by Baker Knight)

A series began here on September 25, to look at the agitation in the United Kingdom around the Big Audit model, and the proposals mooted by regulators, politicians, the government's Secretary of State for Business, and the accountants themselves, by which the dominance of the Big Four would supposedly be addressed.

Proposals include split-up of the Big Four, stripping the firms’ ancillary services to reduce them to “audit only,” joint audits with smaller firms, government assignment of engagements, and voluntary reduction of their 98% share of the FTSE down to 80% or, as urged by the Financial Times on September 2, even as far down as 60%.

That introduction looked at a graphic display of the Big Four’s market share – illustrating the impracticality of this array of so-called “solutions” -- at least so long as the world’s capital markets desire the survival of the current model of privately-provided assurance on the global financial statements of the world’s large companies.

Focus here on the achievability of a market share reduction. The FT on September 2 cited Barclays as a “prize” engagement to be taken up by a smaller firm. So consider the simple question of choice-making, and try to imagine a cohort of civil servants charged to evaluate competing proposals to succeed incumbent KPMG.

Of the total 2017 revenue reported by Barclays PLC for 2017, about two-thirds or some £ 14.4 billion was reported in the non-UK operations of Barclays International, conducted through 40 “main entities” in 22 different countries.    

Assume for the nonce that the Financial Reporting Council achieves a sufficient vote of confidence to survive the pending calls for its abolition or wholesale re-working as the UK’s audit regulator. If it is to be the appointment authority, would its remit run to the UK only? How would it address the global challenge that large UK-based companies derive only some 25% to 30% of their revenue inside the country itself?

Suppose the FRC engineered a UK-only shift of Barclays to a smaller firm – which would face the dazzling complexity that two-thirds of the client's operations are foreign-based and must be audited abroad. What would be the realistic likelihood of successful administration and integration of the multi-country non-UK work if still done by KPMG, into and along with the local reporting on the bank’s UK and headquarters operations?

Or, alternatively, suppose the FRC were bold enough to insist that a smaller firm’s global report and opinion would only be compliant if supported by the work of its own ex-UK member firms. All aside from the political challenges of forcing that decision down the throats of regulators around the globe, there would be the impossible challenges to the smaller firms competing for the job, to demonstrate a satisfactory breadth of geographic presence and expertise.

Of no less importance, the FRC itself would require the competence to scrutinize and compare the qualifications of the small firms and their competing applications, including their relative competence to audit complex international banking operations in countries speaking perhaps nine difference languages and using some fifteen different currencies.

The realistic prospects for the required army of functionaries are non-existent. Examples of dubious regulatory choice-making are all too common, and need not go beyond the current criticism of the FRC itself, to raise doubts about the ability of a government agency to supplant the "auditor choice” function now performed by corporate audit committees in the exercise of their own mandated duties.

On a related front, what is the likelihood of any beneficial impact from an attempted reduction in the Big Four’s dominant market share of the FTSE 350?

To start, what is meant? What metric would apply to measure a reduction to 80%, or 60%?

The FRC might seek to enforce auditor choice based on a financial basis. If so, observe that the FTSE 100 and 250 together have a total market capitalization of £ 2.448 trillion. A 20% shift in market share to the smaller auditors would involve re-assigning a portfolio of companies with aggregate market cap of some £ 490 billion – while a 40% share would involve some £ 979 billion.

The scale issue promptly enters, because corporate size, like that of the accounting firms themselves as graphically displayed, is distributed on a “hockey stick” basis. That is, of the total market capitalization of the entire FTSE 350, it takes only the 70 largest companies to make up 80%, while the companies making up 60% reaches down from BP as the largest only so far as Anglo American at number 25.

Practicality now screams at high volume. For firms outside the Big Four to audit a mooted 20% of the FTSE 350, by market capitalization, they would need to take up the audits of all the index companies smaller than about number 71 – an over-whelming total of some 280 engagements.

Or suppose the FRC were to pursue its goal by number of companies only. To move 20% of the 350 might mean displacement of about 70 audit mandates. Suppose briefly that the choice process would focus on the smaller end of the scale (a topic for further inquiry in any event). The total market capitalization of the 70 companies at the lower end of the index is about £ 60 billion. That, for context, makes up about 2.5% of the index total. To shift that number of engagements, for all the cost and disruption involved, surely has the appearance of a goal not worthy of the effort.

Moreover, audit experience and competence are not fungible across industry sectors. The issues and the demands differ, for example, as between banks and hotels and consumer products. By market cap or simple numeric measures, or any other metric passing a test of rationality, the proponents of the “market share reduction” proposition -- trying with straight faces to sell the notion that either competition or audit quality would be beneficially affected – should be obliged to demonstrate the availability of the resources by which the FRC could hope to carry out its charge, and the smaller firms could hope to achieve and demonstrate anything remotely like the necessary capability.

On both, skeptics are waiting.

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

 

 

 

The Big Four: Break-Up or Audit Only? Can They Survive the UK Regulators?

“Whining don’t get the hay in” was an article of faith for the family farms of my youth on the prairie of agricultural America. Surviving, alive to plant another year’s crop, required clear-eyed acceptance of the facts as found, and strategies that were realistic and achievable.

 It’s different these days in London, where the model for audits of the world’s large public companies faces a storm of perfervid criticism. The latest is a chapter in the full-throated screed, released on May 16, 2018, by two committees of the British parliament, broadcasting blame far and wide for last January’s collapse of Carillion.

The report (page 85) would refer:

“the statutory audit market to the Competition and Markets Authority. The terms of reference of that review should explicitly include consideration of both breaking up the Big Four into more audit firms, and detaching audit arms from those providing other professional services.”

The MPs link arms with an entire chorus line of the like-minded – the competition authority’s own Andrew Tyrie, CEO Stephen Haddrill of the Financial Reporting Council, and City grandee Sir John Kingman as nominee of government itself – all abetted by the shrill voices of enthusiastic commentators.

What is conveyed in passion, however, is lacking in demonstrated comprehension of the target – that is, recognition of the limited ability of government to act in a benign and beneficial way.

Possibly – and in no way as apologist for the Big Four or their accountability -- well-informed information users in the capital markets may truly desire the continued vitality of the current Big Audit model, and the traditional single “pass/fail” audit opinion on the consolidated financial statements of global companies – although all the qualifiers loaded into that assumption should be taken with deep skepticism.

If so, consider the misguided requirement of mandatory auditor re-tender, imposed by the FRC in 2012, ostensibly for pro-competition reasons. The resulting cost, disruption and continued concentration have instead now driven Grant Thornton, the fifth-ranked firm in the UK, to foreswear future tendering for FTSE 350 audits – joined this week by BDO’s reported readiness to do the same if forced to shed its practice in ancillary non-audit services.

Demonstrably disruptive on the downside, the UK regulators have the power to kill a Big Four firm, or indeed the entire model, through failure to recognize the continued application of the law of unintended consequences. What their limited vision and authority shows no ability to achieve is a positive contribution to the stability of Big Audit.

Splitting up the Big Four in the UK would not only be ineffective on a global scale, because failing to reach the dozens of foreign jurisdictions where 75% of the revenue of UK-based FTSE 100 companies is derived. Neither would such a move add any new competition. Instead, the newly created smaller organs would each be partial in scope and limited in industry expertise and resources, hobbled by formidable cost inefficiencies in re-building duplicative infrastructure, and severely weakened in their financial ability to withstand the shocks of litigation and liability exposures that already threaten the stability and very survival of the Big Four.

As for attempts to force the firms into “audit only” structures, the issues of financial weakening and global impracticality apply no less. More importantly, reverting to the skeptical questions as to the dubious value of the current commodity-valued “pass/fail” report, the rapidly evolving environment of Big Data in all its various permutations means that every element of the assurance model that was invented in and survives anachronistically from the Victorian era will inevitably evolve as well.

Providers of that service in a form fit for future purpose will require precisely the skills residing in the advisory capabilities of the Big Four. And elsewhere, to be sure, which means that deployment by the UK regulators of a “neutron bomb” that would annihilate the Big Four’s ancillary services would achieve only one dramatically consequential result: After several years of sifting through the radioactive rubble of the disintegrated Big Four, new species of assurance providers would evolve from the wreckage, emerging out of the surviving niches and other consultancies capable of building the competencies and expertise to provide value in response to the needs of information users.

Asked in 2005 what he and his fellow regulators would do in the event of another Andersen-like failure, PCAOB chairman William McDonough was candid to say, “None of us has a clue.”

With the current whining, finger pointing and blame mongering that threaten the availability of assurance in the form that users profess to want, McDonough’s reality check remains a cautioning guide.

 

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 expanded treatment of these themes, please see my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”—summary information is on its Amazon pages in the US and the UK.

 

Should the Big Four Be Broken Up? The Discussion Sharpens

This coming Monday, April 30, London’s Centre for the Study of Financial Innovation is hosting an open public discussion – “The Future of Audit: Break Up or Shape Up?”

I am pleased to have a panelist’s seat.

Details and free sign-up are here. Mid-day timing is convenient – venue in the City at Armourers' Hall – wine and sandwiches served. Media are interested and will be there, but Chatham House Rule. Attendance is invited and welcome -- a lively time is promised.

Here’s the background: In late January Stephen Haddrill, chief executive of the Financial Reporting Council, Britain’s audit regulator, called for investigation of the audit market -- quoted by the Financial Times as telling a parliamentary committee that “we feel there should be more competition in the major accounting and audit area.” He extended his scope on March 16, proposing that “Britain’s Competition and Markets Authority should investigate the case for ‘audit only’ firms in an effort to bolster competition and stamp out conflicts of interest in the sector.”

The FRC’s strategic plan, released in March, doubled down on Haddrill’s advocacy (page 7):

“Competition – or lack of it – at the top end of the audit market remains a serious concern. As a regulator we cannot be content that just four large firms dominate the market for audit services.”

Public attention followed. The Financial Times on March 21 ran a “head-to-head,” in which Natasha Landell-Mills of asset manager Sarasin & Partners and I took opposite sides on a Big Four split-up. The FT published wide-ranging reader reactions, and the CSFI picked up the ball.

Careful moderating may keep the agenda on the rails. In the meantime, the FRC’s positions raise at least two serious issues.

First is the matter of its own record, on which Parliamentary attention has not been kind. The chair of the Commons business committee delivered the charge that the FRC was both “toothless” and “useless,” rounding on its attention to this winter’s collapse of outsourcing company Carillion, and a City grandee, Legal & General chairman Sir John Kingman, has been designated to lead a broad inquiry into the FRC’s performance, operations, governance and operations.

Whether the FRC deserves the epithets will abide Mr. Kingman’s inquiry. Meanwhile my own views are well recorded, that any attempts to split up or strip down the Big Four are doomed as ill-advised and ineffective to address the perceived issues.

Second and directly to the point, it is of no little irony that Mr. Haddrill’s lobbying on competition braced the March announcement by the UK firm of Grant Thornton – by size the fifth in the UK and in the network ranking seventh globally – that it would stop bidding for audit engagements among the FTSE 350, the UK’s large public companies.

On this shrinkage the FRC resoundingly scored an own goal, as the responsibility lies directly with its misguided 2012 requirement that UK public companies put their audits out for re-tender.

The consequences of that empirically unsupported initiative may have been unintended, but they were not unforeseen. As I blogged in August of 2013, while the regulators' timetable for mandatory re-tender was still to be fixed, these results could be expected:

“Mid-tier firms withdrawing from tenders for inability or unwillingness to sustain the impact on their personnel and their business models.

“Further intrusion of the Big Four into the client lists of the mid-tier firms, with resulting increase in the market concentration among that tetrapoly, based on their ability to deploy superior resources against uncertain defenses.”

As we will explore at the April 30 event, any further such tinkering by the FRC is hostage to the global scale on which multi-national audits are undertaken – even as its strategic plan concedes (page 18), “the FRC, like other audit regulators, has no authority over the audit firms’ international networks.”

In looking with concern and skepticism at the viability and sustainability of the current Big Audit model – including in my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – I am not an apologist for the accounting profession or its members, who are legitimately answerable for the quality of their performance.

But if participants in the capital markets are genuinely interested in audits provided by private partnerships that will deliver single reports on the globally consolidated financial statements of their clients – with serious emphasis on the if – then discussion needs to be fact-based and focused on the market realities and the achievability of whatever steps may be offered.

Which said, please join us on the 30^th.

 

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Will the Bank of England Change Auditors -- Again? And Why?

 

"I know a bank where the wild time blows.”

             Oberon to Puck, “A Midsummer Night’s Dream” (II, i, 250)

With a minor tweak to update Shakespeare’s Elizabethan orthography, Oberon’s invitation to mischief captures the Bank of England’s intention to seek tenders for its audit, done since 2006 by KPMG.

Who knows about the whispering in the back corridors of power, but no issues of dissatisfaction or performance have been displayed in public. So for now it is safe to see the process as another insubstantial solution in superficial search for a non-existent problem.

Readers here know my skepticism on mandated auditor replacement -- as expanded in my recently-published “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – that it is an ill-considered, highly disruptive and above all unproven non-fix for the quite legitimate but intractable issues of audit quality.

That is, there has never been a showing that auditor tenure is in any way related to audit quality – much less as a matter of causation. Lacking actual evidence or even a decent empirical study, it has been foisted by regulators -- mistakenly believing that motion can be sold as progress, and heedless of the unintended consequences. At the same time, the challenge of finding replacement auditors in the Big Audit sector is already problematic, across examples from BT’s struggle to replace PwC on the heels of the scandal with its subsidiary in Italy, to Toshiba’s currently fraught relationship with PwC after EY’s scandal-driven sacking in 2016.

The dynamics of the Bank’s call for tenders will be interesting, to say the least. To start, it is clear that no firm will be motivated to act for the fees involved. With the Big Four’s global revenues in 2016 averaging over $ 30 billion apiece, it would be generous to describe as inconsequential the Bank’s payments to KPMG in 2016 -- £ 262,000 for the audit and £ 327,000 for other work.

In the politicized environment of the City of London, however, proximity counts mightily. Outward through the Bank’s revolving door, for example, passed its John Milne to EY in 2014, and Andrew Bully to Deloitte in 2016. Meanwhile, Deloitte consulted for the Bank on its Value for Money review in 2013 and the disruption to its Real Time Gross Settlement System in 2015, while EY is to provide an assurance report on the compliance of the Bank’s SONIA interest rate benchmark reforms with IOSCO’s principles for financial benchmarks.

As KPMG is expected to re-tender, the intensity of its competition will be measured by the appetite of the other Big Four to foreswear those non-audit opportunities, with their associated and decidedly low-risk cachet, to take on the potentially poisoned chalice of the statutory audit.

Sky News put it on November 5 that “Critics of the big auditors are likely to press for the work to be handled by a firm which has not been tainted by regulatory findings.” The politically-minded will see shadows over KPMG in the criticism it has attracted for, among others, its work for the Gupta family interests in South Africa and its role as auditors for the collapsed HBOS as examined and passed – so far at least – by the Financial Reporting Council.

Yet that firm’s exposures are hardly unique. There are no large firms not proximate to serious charges of corporate malfeasance. Each of the Big Four is so burdened; no listing here is needed -- the outcry “Where were the auditors?” echoes around the world.

A first-order question is the degree of compromised virtue that will be tolerable in the tender process. And a realistic follow-up is this: “How long before any or all of the Big Four are tarred afresh by the inevitable outbreak of large-company financial wrong-doing?”

In the end, this optics-driven tender exercise in the City of London reveals the Old Lady of Threadneedle Street – known for the Bank’s headquarters address since 1734 – as an inconstant and irascible biddy.

Leadership of the Big Four might reasonably ponder the desirability of wooing her and soliciting her favors – as well as the cost of succeeding.

 

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“Count Down” – The Second Edition Is Published

The second edition of my book -- “Count Down: The Past, Present and Uncertain Future of The Big Four Accounting Firms” -- is, to my pleasure, just released by Emerald Books.

Deliveries are available – see Amazon. Up-dated, revised and extended, this trade edition is now designed -- and priced --  for readers in accounting and other professions, corporate management and governance, finance and investing.

The new “Count Down” brings into its updated narrative important developments since publication of the December 2015 first edition, affecting the Big Four and the threats facing their business model:

The Big Four’s growth to collective global 2016 revenue of $ 128 billion, and the structural implications of the continued growth disparities between their Audit and Advisory practices.

The imposition and implications of mandatory auditor rotation under legislation and regulation in the European Union; and in the US, the PCAOB’s requirement to name lead partners on public company audits.

New examples of corporate financial malfeasance, regulatory and law enforcement proceedings and potentially disruptive auditor litigation, involving each of the Big Four and their large global clients – of which a partial sample here:

• Deloitte’s Brazil firm in December 2016 incurred an eight million dollar penalty, the largest ever imposed by the PCAOB, and practice bars and other sanctions against twelve partners and employees, over confessed alteration of documents, false testimony and lack of cooperation with the PCAOB’s inspections and investigations.
• EY in September 2016 was the target of two SEC enforcement actions, involving censures, fee disgorgements, fines and practice bars against its personnel, over charges of loss of independence based on “close personal relationships” between engagement partners and client personnel -- in one case a romantic relationship and in the other, significant expenses paid for travel, entertainment, sporting events tickets and family vacations for the client CFO and his family.
• KPMG in April 2017 fired five partners and an employee, including its Vice Chair of Audit and its head of Audit Quality and Professional Practice, over its receipt and handling of advance inspection information leaked by an employee of the PCAOB.
• PwC’s delivery of the wrong “best picture” envelope, and the resulting tumultuous ending to the February 2017 broadcast of the Academy Awards, evoked public ridicule -- although the significance of the debacle was pale compared with the potentially fatal financial impact of two multi-billion dollar lawsuits, relating to its audits of Colonial Bank and MF Global, where jury trials in process in August 2016 and March 2017, respectively, were discontinued in favor of settlements for confidential amounts.

This new edition also expands in scope and detail on the required re-engineering by which – with the necessary but unlikely mutual cooperation among financial statement issuers and users, the accounting profession, legislators, regulators and agencies of law enforcement – a sustainable structure for financial reporting and assurance might emerge -- that is, a Big Audit model truly fit to serve today’s global capital markets.

The issues here have meaning and impact not only for professionals in the Big Four and the smaller but no less affected firms, but also for those working with and for public companies and their clients, and investors who rely on robust audited financial statements, as well as individuals and institutions holding the securities of public companies in their savings and retirement funds, Keoghs and IRAs, pension and endowment funds.

The story of the fragility of the business model of the Big Four retains its importance. In that spirit, I hope it is worthy of your attention. I invite you to order -- read -- enjoy (or at least be stimulated). Reactions are invited. Comments on Amazon are welcome and encouraged -- as are "likes," "shares" and RTs on Facebook and Twitter, messages on LinkedIn, and especially, recommendations to friends and colleagues. As for any disagreements or criticisms -- feel free to write me directly at [email protected].

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Published Elsewhere: Dialog on the Auditor/Client Relationship -- Accounting Today

On June 14, Accounting Today had an on-line piece by Jillian Rojas -- "Auditors: Friends or Foes" -- that was, putting it mildly, robustly critical of the model by which public company auditors are selected, compensated and motivated.

Believing that the issues raised by Rojas deserved some additional context, I offered my thoughts to editor Michael Cohn, who (with my thanks and appreciation) published them today -- "In Defense of Auditors".

Readers here will recognize the breadth and scope of the challenging questions around the structure and suitability of the Big Audit model, as I have been addressing in this space and elsewhere for a dozen years, and recently in fuller detail in my book, "Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms." I invite you to have a look at our exchange -- and to offer your own reactions and ideas.

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Le Monde and I discuss: "Quand les « Big Four » s’écrouleront"

 

While in London last month to promote my recently-published book on the fragile and threatened state of the Big Audit model, under which the four big international accounting networks provide audit services to the world's largest public companies, I had the pleasure of an extended discussion with Eric Albert, correspondent for the prominent French newspaper Le Monde, whose "Lettre de la City" appeared in the paper's edition for April 6 (below and here). Albert's lead requires translation, not only for vanity's sake, and his concluding paragraph captures the essential message of "Count Down":

"Quand les « Big Four » s’écrouleront"

Jim Peterson n’a pas franchement l’apparence d’un révolutionnaire. Nœud papillon, costume impeccable sur des souliers cirés, cheveux blancs tirés en arrière, l’Américain incarne parfaitement ce qu’il a longtemps été : un avocat d’affaires de haut vol, qui a très bien gagné sa vie en défendant les grands cabinets d’audit.

("Frankly, Jim Peterson does not have the appearance of a revolutionary. Bow tie, impeccable suit and shined shoes, white hair combed straight back, this American perfectly incarnates what he has always been: a high level business lawyer who has made a great life by defending the big audit firms.")

Derrière ses allures policées, son message est pourtant explosif.

Lui qui a longtemps été un homme du système, qui a connu de l’intérieur tous les rouages de la comptabilité des grandes multinationales, tire la sonnette d’alarme : les « Big Four », ces quatre grands cabinets d’audit internationaux (PwC, Deloitte, KPMG, Ernst & Young) risquent de s’effondrer à tout moment. « Ils sont plus fragiles qu’Arthur Andersen en 2002 », nous expliquait-il lors d’un récent passage à Londres, faisant référence à la faillite retentissante de l’ancien cabinet d’audit.

Urgence

Selon lui, l’urgence est réelle : « On ne peut pas survivre avec seulement trois auditeurs. Tout le système financier mondial se bloquerait si on arrivait à ça. » Pour tenter d’alerter l’opinion, il a récemment publié un livre ardu mais important sur le sujet (Count Down : The Past, Present and Uncertain Future of the Big Four Accounting Firms, Emerald Group Publishing, 2015).

Dans une première vie, Jim Peterson a longtemps enchaîné les emplois dans les grands cabinets d’audit. Son travail : les défendre à chaque fois que ceux-ci étaient attaqués en justice . Son dernier poste : avocat chez Arthur Andersen, justement. Sa chance a été d’atteindre l’âge de la retraite
en 2001, juste avant le scandale Enron.

Quelques mois plus tard, le géant américain de l’énergie s’écroulait, une vaste fraude comptable étant mise au jour. L’auditeur ? Arthur Andersen, qui s’était montré complice actif. Risquant les poursuites judiciaires, le cabinet a lui aussi fait faillite. « Il s’est écroulé en moins de deux semaines, rappelle Jim Peterson. Les associés situés à l’étranger ont été les premiers à partir , et tout le système a chuté derrière. »

Les scandales se succèdent

Cette faillite, qui a fait passer le monde du « Big Five » au « Big Four », a mis en évidence l’extrême fragilité financière des grands cabinets d’audit. Cela peut paraître paradoxal. En apparence, Deloitte, KPMG, PwC et Ernst & Young sont d’énormes réseaux internationaux, qui dominent le monde . Pratiquement aucune grande entreprise n’échappe à leurs tentacules : les quatre grands sont les seuls à savoir auditer des multinationales présentes dans des dizaines de pays, jonglant entre les paradis fiscaux et les lois du commerce international .

Pourtant, ils n’ont pratiquement aucune réserve financière. Ce sont des réseaux, sans holding centrale, qui appartiennent aux associés. Ironie du sort, les Big Four sont particulièrement peu transparents sur leurs propres comptes et il est très difficile de connaître leur état financier. Mais selon les calculs de Jim Peterson, il suffirait d’une soudaine perte de 1 milliard à 6 milliards de dollars, suivant les cas, pour provoquer une faillite : le genre de somme parfaitement réaliste par rapport aux énormes amendes ou aux poursuites judiciaires que subissent les banques depuis quelques années.

Or, les scandales comptables se succèdent avec la régularité d’un métronome. Les supermarchés Tesco ont révélé en 2014 avoir surestimé de plus de 300 millions d’euros leurs profits. Au Brésil , le scandale Petrobas pourrait bien avoir de sérieuses conséquences pour son auditeur, PwC (la Fondation Bill et Melinda Gates, actionnaire de Petrobas, le poursuit actuellement en justice). Et Deloitte a aussi eu très chaud en 2013, quand il a été poursuivi pour 7 milliards de dollars pour ne pas avoir vu venir la faillite de Taylor Bean, l’un des plus gros prêteurs immobiliers américains : un accord à l’amiable a finalement été passé.

Éviter la connivence

Mais après tout, pourquoi craindre une faillite de l’un des Big Four ? Contrairement aux grandes banques, leur survie n’est pas essentielle à la bonne conduite du système financier mondial. Faux, réplique Jim Peterson. Il rappelle que de plus en plus de pays obligent les entreprises à changer régulièrement d’auditeur, pour éviter la connivence.

Dans le même temps, les cabinets n’ont pas le droit de fournir des conseils aux entreprises qu’ils auditent, toujours pour la même raison. Résultat, avec seulement quatre grands cabinets, le choix est déjà extrêmement limité. « Récemment, une grande multinationale avait l’obligation de changer d’auditeur, pour respecter la loi. Elle avait donc le choix entre les trois concurrents : mais deux d’entre eux ont dû se retirer parce qu’ils lui fournissaient déjà des conseils », raconte Jim Peterson. Il n’en restait plus qu’un. « Si on arrive aux Big Three, beaucoup d’entreprises n’arriveront plus à trouver d’auditeur, alors que la loi les oblige en a avoir un. On risque de se trouver dans une situation complètement bloquée. »

Pour l’instant, à son grand désespoir, le sujet ne semble ne pas intéresser grand monde. Mais quand une crise éclatera, et que le système financier sera confronté au problème, le monde aura comme d’habitude réagi trop tard.

("At the moment, much to his chagrin, the subject does not seem of interest to many people. But when a crisis breaks out, and the financial system ends up facing this problem, the world will -- as usual -- have reacted too late.")

 

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

 

A New Entry in Charlie Munger’s Daily Journal

The usually sharp-tongued Francine McKenna was the very vision of under-statement in her Market Watch for March 3, describing the auditor merry-go-round at the Daily Journal Corporation (DJCO), the odd public company controlled by Charlie Munger – himself better known as the long-time advisor, consigliere and general-purpose wheelman to investor legend Warren Buffett.

In September 2014, Munger had loudly replaced EY with BDO, intolerant of successive annual auditor letters criticizing the internal controls and identifying potential weaknesses at the Daily Journal and snarling, about what he called an “audit from hell,” that EY had been “like the doctor who wanted to cure the nosebleed by fishing around in the groin.”

BDO promptly proved itself no more tractable, in Munger’s view – sacked on this February 17 after two years of “material weakness” letters, to be replaced considerably down the audit firm food chain by the Squar Milner firm.

Slightly re-wording Oscar Wilde’s Lady Bracknell:

“To lose one auditor may be regarded as a misfortune; to lose two looks like carelessness.”

Or something else. Twice within two years, it’s a double-barreled validation of the diminished role of independent auditors, at least as seen by Munger as board chairman and major shareholder.

That is, the language of the Daily Journal’s next auditor’s report will look precisely the same, whether signed by EY, BDO or Squar, wherever they may fall on the profession’s size tables.

Of the Squar Milner firm it expresses no disrespect to note that its handful of offices in southern California (plus an outpost in the Cayman Islands showing one resident), 19 audit partners and $ 55 million in annual revenue make it approximately 1/500^th the size of EY, third largest of the global Big Four and reporting 212,000 world-wide employees and $ 29 billion in 2015 revenue.

The lack of auditor value as perceived by a company chairman as confident and self-regarding as Munger should come as no surprise. The greater point is that the public holders of the 38% of the Daily Journal’s stock not in the hands of insiders also showed their complete indifference.

That is, the company’s stock price in the week of BDO’s firing and Squar’s arrival held rock steady at the news ($ 189 - $ 190, and since risen to $ 194) – just as it had done 18 months earlier (between $ 181 and $ 182) with the firing of EY.

Put somewhat differently, the entire episode makes plain again that the identity of the audit firm placing its name to the commodity language of the traditional “pass/fail” report as required by the SEC is a matter to which investors attribute no value at all.

Those continuing to extol the value of privately-provided assurance, at least in the form currently prescribed by the world’s securities regulators, are just as entitled to their views as is Munger.

As the evidence continues to mount, however, that their position is belied by the real behavior of the participants in the capital markets – Munger providing the latest example – a more valuable exercise would involve a fundamental re-examination of the premises underlying that self-serving proposition.  

 

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And please see here for access to and a synopsis of “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”—my recently published book where these and other concerns for the large-company audit model are fully explored.  

“Count Down” Is Published

It’s out. Emerald Publishing has this week released my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms.”

With my hearty thanks to those who voted their confidence by ordering early, and who should be expecting delivery – Amazon promptly reported itself to be “temporarily out of stock.” Based on that under-estimate, optimism seems in order, that this story -- the fragility of the Big Audit model -- will appeal across the broad audience for whom it is intended.

To my valued readers – if you find the themes engaging, please share with your friends and colleagues -- and a kind word or two by way of review on Amazon would be appreciated as well. If the topics are somewhat disturbing – I will take that for success, as the threats to the status quo and the complex future of Big Audit present daunting difficulties. And on the other hand, if you may feel I have got it all wrong, write to me directly – [email protected]; in due course I will be taking all reactions into the work on the paperback edition that is to come.

And by the way, receipt of your feedback will be noted and allow me to relieve your inbox by shortening the list for future mailings.

 

 

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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]

Deloitte's Audit Ban in Saudi Arabia -- And Its Global Effects?

This week’s report that the Capital Market Regulator in Saudi Arabia will ban Deloitte’s firm from auditing public companies there as of next June 1, on account of its work for the targeted loss-making company MMG, will not be going down well for the largest of the global Big Four accounting networks.

Much more ominously, a collateral outcome of the Saudi black-ball may be the long-feared destabilizing of the Big Four’s trust-based franchise to audit the world’s largest companies, by a disruptive event in a location mistakenly assumed to be peripheral.

It has been well-enough recognized, since 2002 when Arthur Andersen’s leaders fatally failed to placate the US Department of Justice over conduct related to Enron, that it hurts to be on the wrong side of angry life-or-death power. Conversely, there are ample examples of the Big Four’s escape from scrutiny in settings too small to be consequential.

It’s the combination that is dangerous: an authority without a mature history of regulatory predictability, but with enough influence to unsettle the Big Audit model.

For some illustrations:

• In 2000, the Italian antitrust authority had the then-Big Six firms dead in its sights, with charges of price-fixing and other coordinated anti-competitive conduct. Lacking either the will or the motivation to push for practice prohibitions or other changed behavior, however – and who knows about “Italian justice” -- the agency was content to tap the firms gently on their wrists.

• PwC’s firm in Russia spent several years in litigation over its 2002-2004 audits of Yukos, under potential threat to its license to practice. But as now reported, PwC having remitted its fees to the government in settlement, it is comfortably persona grata, as shown by its engagements for Gazprom and Sperbank.

• PwC also suffered the inconvenient protracted incarceration of two of its Indian partners and their lengthy criminal trial, over the billion-dollar “ghost employees” scheme confessed in 2009 by Ramalinga Raju, founder and CEO of Satyam Computer Services. Results of the trial are expected at the end of this month. But it would seem unlikely that PwC‘s global chief Dennis Nally would have travelled to Delhi last month to head up his firm’s vigorous pimping a Goldilocks view of the country’s economy under Prime Minister Modi, unless he was thoroughly comfortable that the expected outcome would not disturb his firm’s presence there.

What is important is that none of these countries are large and important enough to matter. The Big Four’s global networks could survive worst-case exclusion from local practice in Russia or Italy or India.

It could have been a different and life-threatening story, by contrast, if in 2006, the sanctions imposed on PwC in Japan for its work on Kanebo had not been so flexible. With the size and global connectedness of the Japanese economy, PwC dodged a fatal bullet, permitted to survive the forced closure of its local firm by organizing a new local affiliate – which came to absorb many of its personnel and, vitally, by which it was able to continue both local work for foreign clients and ex-Japan work for its clients there.   

Which comes back to Saudi Arabia – where, incidentally or not, Deloitte also audits the Saudi-listed telephone provider Mobily, another investigation target after profit cuts, a stock price collapse and the suspension of its chief executive officer.

What is now unknowable is how far abroad the Saudi sanctions will run. In mature regulatory environments, official enforcement would not cascade into private sanctions across a Big Four client list. Leadership of a CalPers or PIMCO or Vanguard would resist imposing a ban on one of the Big Four that would cause self-inflicted disruption to the companies making up their massive fund portfolios.

Could the same be said of the global holdings of the Saudi royal family?

Demonstrably sensitive to any suggestion of lack of transparency, Prince Alwaleed Bin Talal is the chairman of the Kingdom Holding Company. On his watch, Deloitte’s consignment to pariah status in his country must be of concern, for example, to Deloitte’s firm in the UK, as auditor of one of the Kingdom’s premier real estate holdings, the massive Canary Wharf development in London.

More’s to the point, it might safely be predicted that, if the Prince has any say in the matter, only if Riyadh freezes over will Deloitte compete successfully against the incumbents for audit engagements of such prize Saudi holdings as Citigroup (KPMG), EuroDisney (PwC) or News Corp (EY).

The rippling effects of Deloitte’s Saudi-originated punishment may be grave enough. Further, with the acute pressures on auditor choice and replacement arising from mandatory re-tender requirements in the UK, and the rotations mandated under new legislation in the European Union, the structural impacts beyond a single unpredictable country can only be … well … unpredictable.

 

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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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