Re:Balance -- Jim Peterson

UK Audit Reform: The Boris Johnson Government Flies A White Flag

Fifteen long months after launching its consultative White Paper, “Restoring Trust in Audit and Corporate Governance, the UK government of Boris Johnson has surrendered on the “audit “ portion.

That’s on reading the Response of May 31, 2022, from Kwasi Kwarteng, Secretary of State for Business, Energy and Industrial Strategy.

His Ministerial Foreward promises “ambitious plans to further strengthen the UK’s audit and corporate governance framework” (p.3). But a slog through its 197 pages reveals a mélange of delay, retreat, and withdrawal.

Four years and counting after the January 2018 collapse of Carillion that triggered this latest spasm of public dissatisfaction with the functioning of Big Audit, the Response devotes massive verbiage to corporate governance, but a mere nine pages to the only two topics with direct bearing on the performance of large-company audits.

Even for the former, the Response natters on, its proposals reflecting a “built-in scope for fine tuning” (p.4) that is euphemistic for “who knows what may work, or what the unintended consequences may be.”

Readers are largely left to speculate –- generously assuming that Johnson can stay in office in the face of a dramatic loss of confidence in his leadership -- on the particulars that may be expected in possible legislation to be put to an unspecified future session of Parliament, by way of possible legislation to replace the discredited Financial Reporting Council as the profession’s regulator with a new Audit, Reporting and Governance Authority.

Among the multiple examples of what the ICAEW generously called on May 31 a “half-hearted” Response:

• The absence of Sarbanes/Oxley-style corporate reporting and assurance on internal controls (§2.1.27).
• The absence in the new proposal for a corporate Resilience Statement of a similar statement by statutory auditors (§3).
• Leaving for the market the consideration of widened financial information assurance (§6.1.48).
• The absence of commitment to the new qualification of “corporate auditor,” as proposed in Sir Donald Brydon’s December 2019 report (§6.1.48-49).
• Leaving with the accountancy bodies the consideration of auditor training, qualification and skills (§6.1.54).
• Explicitly taking a “wait and see” view on the intractable problems with fraud detection and prevention (§6.2.16).
• Passing entirely on the existential threat posed under the existing regime for auditor liability (§6.1.70).

On the lesser topic bearing on the audit firms –- “operational separation” of Big Four audit and consulting (§8.2) -– the air has long since gone out of any energy for further change; authorizing ARGA to legislate on what is already in process would be inconsequential.  

On the second -- competition, market share and auditor choice -- the Response would inject the challenger firms into FTSE 350 audits by legislating ARGA’s power to set the terms: the percentage of a FTSE 350 audit to be performed by a challenger firm (§8.1.16), definitional metrics (§8.1.17), international reach (§8.1.18), and exceptions for the unavailability of a challenger (§8.1.19).

Importantly, such steps would phase in only over the ten years of the audit tender cycle under §C.3.7 of the FRC’s Corporate Governance Code (§8.1.2). Big Four dominance of FTSE 350 audits not having budged in the nine years since imposition of that requirement, however, suggests the passage of another decade over which evidence might emerge of market share changes perhaps supporting an enforced market share cap (§8.1.15 and §8.1.20).

The necessary conclusion -- implicit in the Government’s comprehensive passivity, and in the Secretary’s explicit readiness to “(set) market participants the challenge of shaping their own future” (p.4) -- is that developments over the next generation will be shaped by already evident market dynamics:

First, KPMG’s announcement of an intent to carry out a cull of its client list, if taken seriously, could open challenger opportunities, if only:

• To the extent its Big Four colleagues were to stand aside voluntarily in the tender process.
• Subject to the challengers’ resource development, risk appetite, and survival in the face of litigation and regulatory exposures.

Second, the roaring enthusiasm for extended corporate reporting and assurance on “Sustainability,” the catch-all adopted by the newly-launched International Sustainability Standards Board, has potential. Whether the advocates are rushing headlong toward a promised land of opportunity or a cliff-edge of disaster remains to be seen, however; there are such overhanging and unresolved issues as the extent of convergence of “standards,” the permissible scope and structure of the audit firms’ ESG resources and practices, and the impact of the litigation and regulatory exposures for which the SEC’s recent enforcement actions in America for ESG reporting deficiencies by both Vale and BNY Mellon are canaries in the mine.

Last, potentially most significant and least appreciated is the very viability of the large-firm assurance franchise itself –- now brought to the fore with the news of EY’s consideration of a global separation of its audit and consulting practices.   

Not for now to ponder pro’s and con’s -- the challenges facing CEO Carmine Di Sibio and his global team are dire. The prospects should not be minimized that the outcome –- rather than a clean global split with all pieces intact and a handsomely-financed windfall for at least some groups of EY partners –- may instead be the exposure of an organization riven with anxieties and antagonisms, ill-equipped for the stresses of publicly-visible divorce proceedings.

Arthur Andersen’s unhappy history is this movie’s prequel. Briefly put, EY’s leaders have put the entire enterprise into play, with the potential that critical numbers of partners in country firms and practices may opt to serve their local and personal interests.

Should that happen, the Government Response to the question of large-firm viability -- that “to provide ARGA with the ability to operate a market share cap in the event of the failure of a major audit firm” would be “intended to give the regulator the ability to react quickly and to limit further concentration in the FTSE 350 audit market in the event of firm failure” (§8.3.23) –- would be exposed as an empty and meaningless charade.

The environment of another large-network disintegration should instead recall the late William McDonough, preparing to step down as chairman of the American PCAOB in the fall of 2005, with his warning -- never since modified or disavowed by any of the profession’s regulators -- that “none of us has a clue what to do if one of the Big Four failed.”

In which case, the irrelevance of the Government’s Response will be well and truly evident. For readers with the fortitude to follow this dreary story, there will be reason for another installment, for this look:

At the level of energy, vision and intelligence brought by the Government to this highly relevant set of issues for the capital markets, its flaccid Response is probably the best it has the capability to deliver.   

 

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Audit "Reform" in the UK: Hello…Is Anybody There?

Does anybody really know what time it is?

Does anybody really care?

-- The band Chicago’s debut album, 1969

 It’s one thing to discuss the breadth of the UK government’s March 18 consultation paper, “Restoring Trust in Audit and Corporate Governance,” with its 98 questions spread over 232 pages, as I did recently in a conference mixing academics and practitioners.

It’s quite another, and thoroughly dispiriting, to observe the public silence on the likelihood of sustainable change in the model for large-company audits, so roundly criticized since the fall of Carillion back in January 2018 – now more than three years ago.

On the available evidence, the Consultation is being kicked so far into the long grass that it would only be flushed by game drivers and a pack of hounds. One reason for pessimism is the absence of leadership and advocacy.

That’s disappointing, but no surprise. Transformative change always confronts the inertia, indifference, and resistance of those with self-interest in protecting the status quo.

For a list of those missing, start at the top. Kwasi Kwarteng, Boris Johnson’s cabinet secretary for Business, Energy & Industrial Strategy, has spent the last two months at photo ops and shout-outs on behalf of British business -- particularly life sciences, technology and renewable energy – without so much as a mention on his otherwise busy Twitter feed of the Consultation issued under his signature.

The flat-line level of commitment of Kwarteng and his boss at No 10 Downing Street is readable in the silence on audit reform within the legislative program presented by the Queen in her traditional speech on May 11 – an otherwise ambitious list spanning election schedules, national ID cards and NHS funding. That matters, because the Consultation would rely on Parliamentary action to address such major topics as the re-engineering of the audit regulator itself, extension of the duties and accountability of company directors, and the liability regime under which changes to the scope of assurance might be implemented.

Given the complex process in booking law-making time on Parliament's calendar, legislative silence today bespeaks extended future deferral at best, with likely default to indefinite inaction.

Further, while legislation for the replacement of the Financial Reporting Council lies in Parliamentary limbo, Sir Jon Thompson, chief executive of that discredited agency, has avoided taking the bully pulpit of his office to urge an activist role for his agency even under his place-holder leadership on the evolution of large-company reporting and assurance.

That multi-faceted topic, laid out in the perspicacious report offered in December 2019 by Sir Donald Brydon, “Independent Review Into the Quality and Effectiveness of Audit,” with its innovative proposal for the design and recognition of a newly-defined “corporate auditor,” lacks active sponsorship and looks unfortunately destined to gather dust. Sir Donald himself has done valuable and worthy service, but he speaks for no constituency – instead like Oscar Wilde arriving in America to confront its customs authorities, he has “nothing to declare but (his) genius.”

Elsewhere at the agency level, the aggressive position urged by the Competition & Markets Authority, that the dominant position of the Big Four in auditing the FTSE 350 should be forcibly reduced, is left for dead by the Consultation, while the author of that view, then-CMA chairman Andrew Tyrie, was defenestrated in 2020 and has since returned to his political consultancy with a London law firm.

Nor can minority support be expected from the political opposition. Acerbic Labour MP Rachel Reeves, who chaired a BEIS select sub-committee with an aggressive report of its own and who was razor-like in gutting evidence presented by the large firm leaders, has been booted up to the post of Shadow Chancellor.

As for the large firms themselves, sliced and diced at the Reeves committee hearings and on the receiving end of the perpetual scandal-driven question, “where were the auditors?” – it remains the case that ever since the firms locked up their public company assurance franchise with passage of the American securities laws in the early 1930s, the profession has been reactive and defensive in its uneasy relationship with the regulators – an attitude manifest in the UK today in their gentle maneuvering through the process of “operational separation” of their audit and advisory practices.

With all these players retreated to the wings – cometh the hour, cometh the man?

More likely, to adapt the query attributed to Richard Nixon’s secretary of state Henry Kissinger in his sarcastic frustration about talking to Europe – if in search for an effective audit reform advocate, whom should we call?

 

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RIP Senator Paul Sarbanes

Former United States Senator Paul Sarbanes (D-Md) has died, age 87.

No notice of his passing fails to lead with his co-sponsorship with the late Michael Oxley (R-Ohio, 1944-2016) of the legislation bearing their names that was passed in the summer of 2002.

With its creation of the Public Company Accounting Oversight Board and the far-ranging intrusion of government into what had for 150 years been a profession-led model for the content and issuance of corporate financial information, the Sarbanes/Oxley law fundamentally altered the relationships among US public companies, their auditors, users of their financial information including investors and other sources of capital, and the standards-setters and agencies of law enforcement.

My meetings with the man were occasional, brief, and correct. As for his signature legislative accomplishment, I have never had reason to modify the view, as put in my July 20, 2002 column, "Balance Sheet," that I had the privilege of writing for the International Herald Tribune (itself sadly RIP), that "any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective...."

As I put it in my blog post of August 7, 2012, commenting on the vigorous rounds of mutual self-congratulation on the law's tenth anniversary:

"...the challenge remains that the cyclical nature of market bubbles makes inevitable a post-scandal period of cleansing and temporary return to virtue – political dynamics notwithstanding.  

"Put another way, the storm of both scandal and outrage after Enron and WorldCom was bound to clear, no matter what. So instead of the wrong question, whether post-Enron corporate behavior is now improved, under both the Sarbanes-Oxley law and the law of unintended consequences, the proper operative question should be:

'Would financial reporting and assurance not be better if Sarbanes-Oxley had not been passed at all?'"

Approaching another decade later, all the issues I catalogued in 2012 still persist, and have only continued to deepen and spread world-wide -- ranging from the glowering dissatisfaction with the inadequacies in the basic form of large-company assurance represented by the traditional auditor's report to the on-going outbreaks of large-scale instances of financial malfeasance now globalized in such examples as Carillion in the UK and Wirecard in Germany, despite the inability of earnest but out-gunned regulators to achieve their deterrence.  

So in recognizing the passing of Paul Sarbanes, a man known for decency in his extended years of public service, the question I posed eighteen years ago remains unexplored, much less unanswered.  

 

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Fear and Loathing at the Airports – The Transportation Security Administration Brings Its Own

Which of these two scenarios at Chicago’s O’Hare Airport should be more distressing? The flight I missed by three minutes a week ago, in the midst of the nationwide chaos caused by the TSA’s managerial ineptitude and deliberate slowdown tactics, or my ten-minute breeze through their checkpoint yesterday, when a plethora of uniformed staffers were standing around giving attention so cursory as to make illusory the notion of “security.”

(A detour from my usual topics of attention? The TSA muddle offers at least a teaching moment for my graduate students in Risk Management, as well as useful “how not to” lessons in strategy, communications and client service for those in business and professional services.)

A full hour and a quarter in the TSA scrum last week gave me ample opportunity to observe the agency's clear strategy of dilatory “work to rule.” Just one lane was open, which used the wretched scanner model that forces the emptying of pockets down to a chapstick. The single burly and surly TSA staffer had no back-up to handle any extra pat-downs, but was stripping and re-scanning frustrated would-be passengers one at a time, literally down to their cufflinks, while the waiting line stretched long enough down the concourse to deserve frequent traveler points of its own.

Yesterday, by utter contrast and at the same hour of the day, processing was so expedited that there were as many TSA personnel lounging around as there were passengers in the fast-moving queue. Three lanes were open, using the walk-through machines. The announcement was “coats and shoes stay on, computers stay in their cases.” Responding to “step right on through,” we moved so fast that the supply of plastic bins had all piled up on the other side.

Along with the rest of the flying population, I had planned ample extra time – with my own prior mis-adventure and taking seriously the reports of thousands of missed flights and rows of cots broken out for airport sleep-overs. There was one visible result of TSA’s tactical shift – the early-arriving crowds simply shifted the bottlenecks to beyond the scanners, forming lengthy queues at the Starbucks and McDonalds, and putting seats in the lounges at a premium while they waited out their now-excess margins.

Transparently displayed as was this wild variability in TSA staffing and tactics from one week to the next, the agency’s rapid ability to shift gears completely deflates the credibility of its assertion that a long-gestating problem requires long-term (and doubtless costly) fixes. To the contrary, post-9/11 inflictions at the airports have never been more than agency optics and the political manipulation of popular anxiety. Requiring plastic bags for toothpaste and hair gel has no more detected or deterred determined aggressors than has the bare-footing of grandmothers. Effective profiling and incisive algorithmic analysis have real effect; not so, the costly, annoying and pernicious disruptions of the national transportation system for the sake of TSA hiring figures or overtime budgets.  

Perhaps worst of all – when my bilious exercise of my First Amendment rights should trigger a full-body search the next time I fly, my chances of identifying the responsible bureaucrat will be the same as the utility of the entire exercise – exactly zero.

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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.  

Prescribed at Valeant: “Mr. Pearson, It’s Time to Take Your Medicine!”

It’s not considered good manners to speak ill of the sickly. Nor, for that matter, the other way around.

So all concerned would wish nothing but a complete and speedy recovery for Michael Pearson – the CEO of Valeant Pharmaceuticals until a sudden and severe attack of pneumonia forced him to take medical leave in late December.

Events at Valeant through the autumn would have been breath-taking for its leader at the best of times – not least, the 60 % fall in its share price since August, its need to rationalize revenue accounting policies for its frequently-adjusted relationship with specialty pharmacy Philidor, and the looming deadline to file its 2015 annual report.

While observers might question the potentially sinister implications of the New York Times report of January 6 that Pearson’s “whereabouts and details of his condition have not been disclosed by the company,” prudence for Pearson himself might counsel the desirability of a prolonged and low-profile convalescence.

That’s for three reasons:

First, governance at Valeant is, to put it kindly, unsettled. The company’s initial strategy, announced December 28, was to fill Pearson’s role with a three-person “office of the chief executive” – with that ménage abetted by another three-some made up of members of its board. Whereupon, the company’s stock price promptly tanked a further 10%. Thus was aptly fulfilled the axiom, that “You can take my job, but not my place.”

Instead, as any high school football coach knows, if you claim to have three starting quarterbacks, you really have none. That realization took a week to sink in at Valeant, until January 5 when the labor of slaying the Hydra-headed monster was given to Howard Schiller – board member, former CFO and now named interim CEO.

Second, then -- next in Schiller’s Herculean tasks is the effort to hose out the stables -- not easy, but made less complicated in retreat from Pearson’s strategy of massive price hikes for the binge of old drug acquisitions that had exposed the company in the first place. In other words, the more distance Schiller can keep from the publicly-vilified Pearson the better, especially in the cosmetically important area of dialog with the agencies of law enforcement and securities regulation circling the company.

As to Pearson himself, thirdly – it’s safe to assume that the pockets in his hospital pajamas are deep enough that he is funded for all the costly medications his recovery may require – a state of fiscal well-being perhaps less true for the angry Valeant customers forced to swallow his cost increases along with their re-priced pills.

Further, tactically timed medical events have a way of going poorly among the white-collar class who become ensnared in the legal system. Among a brief sample:

• Suspended FIFA autocrat Sepp Blatter’s hospitalization in November for a “small emotional breakdown” – although pumped up in Blatter’s unrepentant grandiosity to a claim that he was “close to dying” – failed to prevent his original temporary 90-day leadership suspension being extended by the soccer association to eight years – and likely into the far distant future.

• Ponzi schemer Allen Stanford resisted his prosecution with serial excuses -- a racing heart, injuries from a prison fight with a fellow inmate, impaired judgment from addiction to an anti-anxiety drug, and injury-related amnesia – all of which earned him no relief from a post-conviction sentence of 110 years.

• Following his guilty plea but before the sentencing scheduled for this February, former Speaker of the US House of Representatives Dennis Hastert was hospitalized with a stroke and complications – the impact of which by way of delay or mitigation remaining unknown.

• Notably more consequential, the heart attack suffered by Enron CEO Kenneth Lay in July 2006, following his conviction but before sentencing on multiple fraud counts, proved to be fatal – his demise thus voiding his conviction on the federal charges and, in effect, changing to a non-terrestrial venue whatever fire-and-brimstone punishment he is now bearing for his earthly transgressions.

As Samuel Johnson observed in the 18^th century, “when a man knows he is to be hanged … it concentrates the mind wonderfully.” More to the point for Pearson, as for the others noted, the looming presence of the law seems to impinge on the body as well, and not in a way conducive to good health.

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Still Running on Hot Air – Sepp Blatter Is Smoking His Own Fumes

Richard Kimble: “I didn’t kill my wife!”

Deputy Marshall Samuel Gerard: “I don’t care!”

  -- Harrison Ford and Tommy Lee Jones, “The Fugitive,” 1993

 Is there a living soul, outside the shrinking and isolated circle around Sepp Blatter, so deluded as to believe that he improved his chances of escaping prison in either the United States or his native Switzerland, by imposing on indicted bagman Jack Warner a “lifetime ban” from the inner circles of the pervasively corrupt soccer overseer, the Fédération Internationale de Football Association?  

Or put in terms the long-surviving autocrat plainly does not comprehend, why should a prosecutor -- ready to bag as a trophy the head of one of the world’s great houses of corruption -- give any credence to an illusory act of virtue among this sordid gang of thieves?

This latest study in leadership decisions and behavior under the threat of law enforcement will occupy classrooms in business and law schools for years to come. And as I had predicted in May, it has come back to the fore, as I had the pleasure of discussing this week, with a welcoming audience about the anticipated November release by Emerald Publishing of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms.”

That’s because – like Blatter – back in the winter of 2002, under a storm of criticism over their proximity to the collapse of Enron Corp., the leaders of Arthur Andersen clung both to their offices and to a futile media campaign of proclaimed rectitude – allowing the US Department of Justice to form and hold the fatal perception that Enron’s auditors were a crew of unrepentant recidivists.

The consequences were fatal for the Andersen firm. Down to date, although no management team every willingly gives up its powers or its privileges, other recent examples support some post-Enron recognition that a prosecutor having life-or-death authority will expect credible action, and will react only with anger to sweet but arid talk or stubborn and self-righteous arrogance:

• In July, Toshiba Corp. promptly cleaned house of its president, vice chairman and senior advisor, on the revelation of multi-year accounting irregularities and earnings corrections upwards of 152 billion yen.

• Announced on September 8, United Airlines sacked CEO Jeffrey Smisek and two senior colleagues under the pressure of prosecutors’ inquiries into special flights arranged for the personal convenience of the chairman of the authority regulating Newark Airport.

• On September 23, Martin Winterkorn was cashiered as Volkswagen’s CEO immediately on disclosure of the global-scale manipulation of emission controls on the company’s diesel vehicles, with other senior executives thrown under the wheels and the company’s reputation and brand value reduced to so much scrap.

There is no single script for the crisis management of these or such earlier cases of executive decapitations as Tesco in the UK, Petrobras in Brazil and Olympus in Japan.

But one theme should be reaching through to the singularly obtuse Blatter: he has nothing with which to trade. The currency he had long used to purchase the fealty of his hierarchy of complaisant minions – handsome positions, lavish perks and abundant funds to lubricate the machinery of local and regional influence – is now debased and valueless in the personal calculations of Warner and his fellow criminal targets.

Pointing to his resignation from FIFA back in 2011, Warner perceptively observed that, “there is no such thing as a coincidence” in the timing of FIFA’s current move against him, the same week that Swiss authorities officially placed Blatter under criminal investigation.

Facing extradition to the US and extended incarceration unless persuaded to bargain with his valuable testimony against Blatter, Warner has much more to worry about than FIFA’s meaningless slap – and every incentive to deal.

The image that overlays Warden’s reaction to Blatter, then, is that of Sharon Stone’s posture in the police interrogation scene in Fatal Instinct (1992):  

“There’s no smoking in this building, Miss Tramell.”

“What are you gonna do? Charge me with smoking?”  

 

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Guest Post: “Where Were The Auditors?” –- Addressing the Inevitability of Behavioural Risk

 It was my pleasure this week to write this guest post for my friend in London, Anthony Fitzsimmons, the Chairman of Reputability -- the UK consultancy firm that educates and instructs corporate boards and senior leaders on behavioral, organizational and reputational risks. It is posted on their blog here, and in full below.

 Three immediate predictions were available, when British food retailer Tesco announced in September that its first-half profits were over-stated by some £ 250 million, because of irregular accounting for supplier discounts and rebates:

• The number would grow.
• The affected time period would extend.
• The four company executives promptly suspended would soon be joined by others.

It is still early days, but in addition to an investigation by the Serious Fraud Office and the predictable start of shareholder class actions in the United States, news from the company is that:

• The number is now at least £ 263 million.
• The accounting issues extend back at least to last year.
• The casualty count of suspended executives is up to eight, plus the announced resignation of chairman Sir Richard Broadbent.

And as shouted yet again, by the Financial Times, no less – “Where were the auditors?”

It’s the same hue and cry that has been raised with every outbreak of serious financial scandal since independent audit was invented in the Victorian era.

The business, legal and regulatory structure under which the Big Four accounting tetrapoly – Deloitte, EY, KPMG and PwC -- provides statutory assurance on the financial statements of the world’s large companies – the model of Big Audit – remains firmly in place. But with much current exploration of corporate governance and board effectiveness, the notion of “auditor effectiveness” faces this fundamental question:

Is the traditional form of audit assurance – a “true and fair view,” or its American cognate, “fairly presented in all material respects” – fit for purpose, if it only works generally well, most of the time – up to the point, as in Tesco, when it seems not to work at all?   

Lessons from my graduate-level business and law school course in Risk Management and Decision-Making are useful, going to the very nature of the core expectations and limitations of Big Audit, at levels deeper than have been plumbed to date.

Recent progress on the subject of corporate risk has been considerable -- chiefly on the company side of the complex relationships among issuers of financial information, the communities of information users both inside and outside those companies, and the auditors themselves – to identify such systemic threats as risk blindness, ambiguous leadership attitudes about ethos and culture, defects in communications, and skewed performance and compensation incentives.

Behavioural scholarship suggests that these concerns are no less present in the audit function – with its execution dependent on the behavioural limitations of fallible human beings. Which in turn suggests that, if deeper insights into the causes of financial failures were credibly brought forward into the standards and practices of Big Audit, progress might be made in areas that have long defied improvement.

That is – forty years of research have identified sources of bias that are hard-wired into our human DNA, because of which they are pervasive, inevitable and unavoidable. These are shared along with the rest of humanity by auditors who are no better genetically designed or equipped than anyone else to address them. As an effect or consequence, they work to suppress the exercise of professional skepticism, to inhibit the delivery of negative or critical messages and, conversely, to default in favor of confident agreement with management’s upbeat assertions. 

Inquiry quickly goes beneath the customary charge that auditors are incentivized to accommodate long-standing clients – a facile assertion yet to be supported by anything like credible research or evidence. Examples among the catalog of broadly-observable instinctive and dangerous shortcuts  -- “heuristics,” to use the term explored since the 1970s by, e.g., Nobel economics prize-winner Daniel Kahneman and his late lamented research partner Amos Tversky -- are:

• Confirmation bias: The readiness to accept that premises are valid as presented, rather than do the harder work of seeking out and evaluating disaffirming or contrary evidence – in the audit context, the too-ready willingness to agree with submissions and judgments of management.

• Over-Confidence: Good news is simply preferred over bad; as John F. Kennedy quoted the Duke of Wellington, “Victory has a thousand fathers; defeat is an orphan.” So too, a bullish quarterly earnings estimate or a Goldilocks reserve calculation will be preferred over the pessimistic alternatives.

• Representativeness: Giving credence to that which is familiar and ready to hand – e.g., “this year’s results look much like last year’s – so the trends and estimates can be taken as acceptable.”

• Herding and Groupthink: The convergence of individual conclusions with those of the group, especially as led from the top – influenced, for example, by pressures from peers or superiors of time, budget, and engagement evaluations – perniciously seen in the message unsubtly conveyed to junior staff, that “If you raise a problem, then you become the problem!”

From the persistent ubiquity of these influences it would follow – and the regular recurrence of financial irregularities over the decades would confirm – that Big Audit as now designed and performed is of seriously diminished value and effectiveness.

But, with the auditors apparently fated to operate under seemingly universal human behavioural constraints, it is not either necessary or helpful to demonize them by ascribing either malign intent or corrupt motives.

If they are instead doing as well as their human limitations allow, even if not to the level of expected systemic satisfaction, then whole conferences and symposia should be convened, to design and explore the application of new tools and approaches, and to bring these limitations out from the academic shadows into the realms of daily inter-actions among the auditors, their clients, users and the regulators. 

In other words, auditors may very well be able to bring their competence and expertise to bear on issues of real importance. But not while they – and all the other players involved in Big Audit – are shackled to a model that demonstrably fails to allow for the ever-present and increasingly well-recognized frailty of human beings – a group that (sometimes reluctantly acknowledged) does include the auditors.

 

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In Print: Professionally Responsible Decision-Making

Although I do not have a classroom this fall, with the graduate-level course “Risk Management and Policy Decision-Making” that I have been teaching in business and law schools in Chicago and Paris, I have just made a modest offering.

The short piece below appears in the October 2014 issue of the Revue Internationale de la Compliance et de L’Éthique Des Affairs (International Review of Compliance and Business Ethics).

The Revue is a bi-lingual journal led by Roxana Family, the formidable dean of the law school at the University of Cergy-Pontoise, where I have taught the last three years – published as a supplement to La Semaine Juridique – Enterprises et Affaires. (For subscription access, see  LexisNexis out of Paris.)

My central theme is that the modes of rapid instinctive decision-making inherited from our ancestors – "fight or flight" and "friend or foe," which were good enough for the survival of the tribe, most of the time -- are gravely unsuitable for the complexities of modern life.

In context of the Revue, that theme illuminates the limitations on training and incentives for ethical behavior and good governance.

It also extends to such areas, within the core topics of this blog, as the ways in which the pressures and incentives that constrain the basic audit model operate to suppress the exercise of professional skepticism, and the crying need to re-engineer assurance processes to overcome the “good enough” approaches that are inherently both inefficient and ineffective to detect or prevent serious financial irregularity or manipulation. 

Congruence between academic theory and potential practical applicability being a sometimes elusive proposition, I aim – with my students’ help – to continue giving attention to these themes.

Readers are invited to chime in. 

A link is here, as formatting and reproducing the image is proving a bit complex -- Download Actualite -- or print a version, which should work, or drop me a line and I will send a copy.

 

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Preserving and Re-Building Trust -- An Event Preview

On October 2, the Consortium for Trustworthy Organizations at Fordham University in New York sponsors “The Summit on Restoring Trust in Business,” on West 60^th Street in Manhattan. 

An A-list of participants from major companies and consultancies will be there. Those with professional or academic interest are invited – program details and enrolment information are here.

I have the pleasure of bringing my perspectives on risk management, litigation and disputes to a great panel, “Effective Trust Repair,” led by Charlie Green (for whom, see Trusted Advisor Associates and his blog, Trust Matters).

With the quality of gathered credentials and experience, the discussions will be seriously substantive – with more nuance and value than the sometime platitudinous slide-decks of the typical Trust-Building 101 curricula.  

Because a forum of this sophistication can dig far beyond the “easy stuff,” we expect to probe some of the conventional attitudes. Three such topics are sketched below -- in no more than the possible appetizer-sized portions.

“Trust Survival” May Be the Best There Is

Run-of-the-mill literature on trust in business strongly features its preservation and maintenance. But take note: when corporate times are rosy, the language of trust gets subsumed within the overall anodyne vocabulary of feel-good success. 

And after the fact of a disaster, it’s too late.

At the only time it truly matters – when an enterprise faces existential crisis –– continuity of trust is at best a problem of second-order importance. And the small circle making life-and-death decisions -- those directly reporting to the chairman or the CEO –- are the only people with real influence.

Examples:

• As Arthur Andersen spiraled into disintegration in 2002, it was the peeling away of partners, clients and its non-US firms – trust was implicated, to be sure, but at stake was the immediate impact on the firm’s very viability.

• At MF Global last fall, Jon Corzine would have cared less for the preservation of customer or counter-party trust, when what really mattered was a Hail Mary scramble for survival that turned into $ 1.6 billion in missing customer funds.

• And at Knight Capital over the weekend of last August 4-5, virtuous concerns for trustworthiness, following the $ 440 million loss inflicted by a trading software glitch the week before, would have been subordinated to the search for friendly rescuers – surrendering ownership to investors prepared to salvage the firm’s ability to open for business that Monday. 

Only if the enterprise survives, in other words, do the re-builders of trust have a chance at an invitation to the table.

And even then, trust-related advisors in a post-breakdown environment risk relegation to the same role as the medieval camp-followers after battle – executing the wounded and looting the corpses.     

“Trust Building” May Not Always Really Matter 

The constraints of a cartel or the impositions of regulation affect whether trust in business is relevant at all.

Nobody loves the indifferent service of the local cable company or the lock-step piracy of the neighborhood filling stations. But subscription and consumption continue.

As Michael Corleone was reminded by Frankie, the disaffected mob soldier in The Godfather II (1974), “Your father did business with Hyman Roth. Your father respected Hyman Roth. But your father never trusted Hyman Roth.”

Bond offerings require ratings, despite the agencies’ consistent behind-the-curve performance during times of crisis, from the savings-and-loans of the 1980’s to the subprime mortgage and sovereign debt calamities of this decade. Audit reports are required by law on the financial statements of public companies, despite manifest dissatisfaction with their content or their usefulness to readers.

The result in these contexts is narrowed relationships and skeptical doubts about value. Notions of “trust” are conspicuously absent from the dialog.    

“Trust Repair” May Be Non-Strategic 

Finally, when business trust is broken, and a supplicant comes around to plead for another chance, symmetry requires a response by those asked to re-affirm their faith. What conditions should apply? 

In other words, “fool me once…” – and then what?

Consider the frequency with which a large-scale fraudster gives early signals of his corruption – Bernie Madoff’s unbelievable golf scores evidenced his flim-flam. Or even confirms, like the recently re-jailed Barry Minkow of ZZZZ Best, the overwhelming rate of recidivism among white-collar criminals.

What combination of sentiment and compassion, or venality and credulity, blinds the risk processes of those charged as fiduciaries for their stakeholders, such that the victimizations continue?

Salience does enter in, of course. A single disappointing meal at a favorite restaurant should not kill its reputation, nor an explicable one-time lapse in service by a supplier or payment by a customer. Some tolerance is required, for the inevitable breakdowns that inhere in complex systems of human design.

But while repentance and forgiveness have their place in a caring society, prudent risk management counsels against re-admitting a known fox for a return visit to the henhouse.

These are among the complex issues, and they have no simple answers. Reactions here are invited and encouraged. And those able to extend the discussion in New York on October 2 are most welcome.

 

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Mandatory Auditor Rotation -- The PCAOB Bites Off More Than It Can Chew

            “The unspeakable chasing the uneatable.”

Oscar Wilde’s description of English fox-hunting captures the spirit of the two days staged in Washington on March 21-22 by the Public Company Accounting Oversight Board – in aide of illumination on mandatory auditor rotation.

(The PCAOB’s release of August 2011 announced its initiative; it links to the overwhelmingly negative public reaction. My own long-standing pessimism is partly here, here and here.)

Thankfully unable to attend, due to classroom commitments, I salute those brave and durable enough to have done – although the tedium of the webcasts accuses anyone without handsome compensation of not having enough to do.

Which is to say, the offerings from the 47 speakers crammed into the panel sessions were entirely predictable. The maxim was reinforced conclusively that the amount of intelligent substance in any agency proceeding is an upwardly-bounded constant -- the only variable being the number of witnesses among whom it is thinly spread.

Examples included the panels of academics and “investor representatives,” whose perfervid but anecdotal pro-rotation rhetoric was untroubled by the continuing absence of any relevant empirical evidence associating auditor tenure with audit quality; Paul Volcker’s plangent if irrelevant reminiscence of his brief and inconsequential association in 2002 with Arthur Andersen’s terminal state; and Jack Ciesielski’s attempt to revive the notion that insurance might backstop the auditors – a fantasy lacking credibility and long discredited (here) by the insurance industry’s manifest lack of interest.

Careful assessment of the PCAOB house-party reveals neither an empirical case for mandatory rotation nor the supportive votes among its members – leaving this question:

What will political pressure oblige the PCAOB’s members to bring forward by way of action?     

Between the poles of the speakers' antagonisms, there are the faint outlines of plausible mid-range approaches:

To start – noting a plain truth by former SEC general counsel David Becker, that individual cases for mandated auditor rotation are “intensely situational”– support now emerges for the PCAOB’s use of enforcement-based mandated rotation (e.g., Harvey Pitt).

Well -- “right on,” but also “about time.” Having written to this effect way back in August 2011 (here), I put it this way:

“…In a specific case, if the PCAOB can sustain its proof that long audit tenure was causally related to its definition of “audit failure,” it could include rotation in its toolkit of post-inspection sanctions.

“Since the PCAOB looks annually at a sampling of engagements for each of the large audit firms, and claims to target its inspections on the basis of perceived engagement risk and exposure, the agency’s experience base should bring to light cases – if any – where audit quality might be affected by length of tenure.  

“In which case, rotation could be proposed, and if necessary, imposed.” 

The other way forward comes in two flavors – either of which would allow PCAOB chairman James Doty to declare victory; would be tolerable to the profession; and, unlike mandated rotation, would actually be achievable in the large company audit market.

The first would be by way of periodic mandatory re-tender, with the incumbent auditor eligible to be re-engaged. The estimable Bob Pozen, one of chairman Doty's "rock stars," proposed 14 years (here), so as to allow for three individual partner rotations. Others proposed far shorter periods, although five or seven years would be too short, causing the profession to spend endless time and waste prodigious sums in a musical-chairs chase for business.

Compromise should be possible. If potential replacement auditors had the commercial choice of giving up ancillary services for their clients – tax, consulting, valuation – in order to be eligible to take up the audit, the market itself would determine the range of choice and competition. That has to be better than leaving such bright lines to be drawn under the dim vision of the regulators.

The second alternative places focus on the responsibilities of corporate audit committees – supported by former SEC chairmen Richard Breeden and Harvey Pitt among many others. That body would be obliged periodically to justify the continued engagement of a long tenured auditor – a process of “comply or explain” -- not difficult for a good quality committee.

Failing which the PCAOB, challenged to focus its inspection attention on long-lasting relationships, could determine that a dysfunctional audit committee amounted to a material corporate control weakness, justifying the requirement of a re-tendering.

I have crawled out on numerous shaky limbs, and survived. So I am prepared to predict here that some variant of these ideas will emerge at the seemingly endless end of the PCAOB’s process.

(Other and deeper problems would remain untouched, much less unresolved by this outcome, unfortunately, such as the basic value and usefulness of today’s accounting and reporting model itself, the relevance of audits, and the very existential viability of the private audit franchise – all subjects postponed to other days.)

Meanwhile, audit committee leadership on either re-tendering or “comply or explain” would not cause the world of audit to come crashing down. The actual effect would be modest at most.

Which in a world of knee-jerk critics and short-sighted regulators would be no small thing -- and one the community of financial statement users could very well live with.

 

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The Next Home for International Financial Scandal? If You Can Find It -- It's Malta

I recently made my first visit to the tiny island nation of Malta – once the Mediterranean crossroads of crusaders, smugglers, pirates and profiteers, now better known as a way-stop on the marine route of refugees fleeing coastal North Africa for near-by Sicily and mainland Italy.

My impressions -- of a country and people with much to be modest about -- leave me uneasy, with Malta now touted as headquarters to a rapidly-expanding roster of European-based hedge funds – e.g., here and here.

This is not good news. Because if true, the fuse is lit and sparking on the next explosive weapons of financial destruction.

For all its storied history, today’s Malta is a backwater. The country’s low-wage economy survives on limited tourism for history buffs, and second-language schools serving a heavy demand for English because the native tongue with its Arabic origin and Latin orthography is unlearnably complex, marginalized, and disappearing.

In by far the smallest country in the Euro zone, with a population of 400,000 mainly unprepossessing Catholics, the focus of governance is limited to the legality of divorce. While, as I was told by the under-employed college graduate who drove our taxi from the airport, ”You’ll probably never see a policeman during your visit. There’s so little crime, they go into the parks and sleep in their cars behind the trees.”

Transport on Malta until last summer’s upgrading was dominated by fleets of clapped-out orange and yellow buses, of a vintage more worthy of pre-Castro Cuba than a full-fledged member of the European Union.

The inevitable question asked by a tourist looking over the pervasively sand-colored Italianate architecture is, “Doesn’t a country with aspirations to be taken seriously care enough to wash its cars and clean the dirt off its windows?” To which the prompt and unashamedly self-deprecating answer, “who cares?” is that the prevailing winds off the African desert make a daily layer of dust as inevitable as the sunrise itself.

After centuries of outside dominance, latterly in the form of British colonial oppression until independence in 1964 and eventual troop withdrawal in 1979, a legacy of brain drain and talent flight assures a vacuum of local vision and mediocrity of leadership.

“Maltese” evokes several things – post-Crusade centuries of knightly influence, toy-sized white dogs in the laps of ladies who lunch, and the elusive avian statue that so bedeviled Humphrey Bogart’s Sam Spade in the eponymous 1941 re-make of Dashiell Hammett’s noir novel. 

What it does not call up is a legitimate industry of well-regulated financial institutions.

So what is nascent, with the explosive growth of a Maltese hedge fund sector, is dangerous regulatory arbitrage – the potential for a rush to the bottom not seen since “regulatory capture” in Antigua and Barbuda laid the foundations for Allen Stanford’s Ponzi scheming, through his purchase of a tin-plated knighthood along with the compliant gate-keepers’ keys to that country’s thatched-cottage banking industry.

The cases are legion that even big-country regulators have been asleep on the watch – from the SEC’s failure to finger Bernie Madoff, to OFHEO’s late-arriving blinking at the sub-prime mortgage trainwrecks of Fannie Mae and Freddie Mac, to the PCAOB’s belated discovery of something rotten in reverse-merger Chinese public companies coming to America to list on its exchanges.

So the chances that the Maltese have the competence to escape a worse fate, in response to the invading hordes of hedgies in their private jets and sharply tailored suits, are precisely nil.

I have been bold in this space to make an occasional prediction about the expected times and places for outbreaks of unpleasantness – in Islamic finance, a Madoff-related suicide, or the rates of white-collar recidivism exemplified by Barry Minkow’s return to prison – with a record that is almost distressingly robust. 

Readers prepared to files these views on the likelihood of serious mischief erupting on Malta into a time capsule with a three-to-five year seal are invited to check back with me then.

In the meantime, pending the passage of time sufficient to prove me right, prudence suggests that investors seek a home for their hot and mobile Euros other than Malta.   

 

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Accounting Standards: Rules or Principles? Lessons From the UBS Dress Code

Goldman Sachs has snatched from its US clients the windfall chance to front-run Facebook's IPO, by limiting access to the potential of its $1.5 billion special-purpose fund to foreigners -- while professing no influence from the fuss-budgets at the SEC (here). So it seems a good time to ask:

Should regulatory compliance and accounting standards be expressed as detailed codes of precisely-drawn rules? Or as broadly-articulated principles?

There are lessons to be taken from the 43-page dress code issued by Swiss bank UBS in December (here).

The debate needs help: endless, pointless and fruitless, it feeds the conclusion that much-touted but never progressed “convergence” between international accounting standards and country-level codes in Europe, the UK and the US is as distant, elusive and unlikely as ever.

Popular reaction is that only a Swiss mentality could perpetrate the obsession at UBS, with its meticulous prescriptions on suit fabrics, cosmetic colors, collar points and hair care both facial and cranial.

Although, a dress code did appear late in my own corporate life – no less ridiculous but also raising non-trivial dissonant issues about the boundaries and effectiveness of guidance.

I was the senior member and titular head of a team based in Paris – an expatriate American amongst colleagues from the major European countries. To a man and woman, all were immensely talented and hard-working. They were also urbane, stylish and beautifully attired.

Global headquarters in the US published its requirements for the new “business casual.” It was only six single-spaced pages, compared to the fulsome 43 pages of UBS – but who’d have expected better from the sartorially challenged Americans?

It went into gruesome detail on necklines and sleeve styles and degrees of elasticity; it proscribed denim and gym gear and athletic branding; and it forbade flip-flops and open toes and footwear of any aerobic provenance.

On a given day, probably one-third of our Paris team would have been out of compliance. But, making their own individual decisions about skirt lengths, or pantyhose in July, or whether to match an Armani T-shirt with a differently-branded suit, my young charges were always impeccably turned out and appropriate for client premises and boardrooms anywhere.

For the purpose, they were capable of proper judgments under the lightest of guidance. At our annual group party our solicitor from Edinburgh was elegant in his formal tartan kilt, dirk and sporn – but for court he was always in proper dark grey suit. On warm spring days the length of limb on display among our lanky cadre of legal assistants was a substantial percentage of their average 1.8 meters – but they all donned decorous trouser suits when the visiting firemen arrived from America.

Which has what to do with the challenge of setting international accounting standards? The answer starts with the extent of mutual trust and confidence shared by a community seeking for mutually-acceptable guidance and limits.

Our Europeans rightly expressed derision and ridicule for the US code, just as most of the world feels for the pathetic efforts of UBS, because of our expectations for what was important: discipline, dedication and execution of first-quality work. Under broad principles of professionalism and good taste, their public face was virtually one of self-regulation.

Whereas if constrained by punctilious trivialities, they would have wasted both their morale and my goodwill, along with countless hours of productive time, on manipulation of the rules in rebellious search for boundaries and exceptions.

It’s no different with financial reporting standards and regulations. History teaches that bright-line limits are pushed to excess by the creative and the aggressive: the depreciation lives of mainframe computers in the 1970’s, the elastic retained ownership requirements for special-purpose entities exploited by Enron in the 1990’s, the investor limits skirted by Facebook under the counsel of Goldman Sachs.

It is the human condition that some deviance from codes of behavior is inevitable – society decides the amount, by voting its willingness to allocate resources to law enforcement and sanctions.

The range across cultures can be vast – from the de facto legalization of recreational drugs in urban America at one end, to the use of flogging in Singapore to punish the consumption of fast food on the public streets.

At the extreme, drunken driving among teen-agers could be eliminated: raise the driving age to 25 and impose capital punishment on first offenders. No less, accounting manipulations could be wiped out – by outlawing commercial transactions in more than one currency or that fail to settle for cash within 48 hours.

But the compromises required of society would never go so far. Instead, the certainty of occasional lapses and excesses is accepted. Limits are broadly defined, and enforcement mechanisms are calibrated -- for both better andworse -- in both the capital market’s use of financial information and the fashion decisions of a business office.

Judged by my experience in the latter, a global environment is far more seemly and operates with more success without the heavy hand of excess regulation.

That will soon be learned, I wager, in the halls of UBS. Whether the new leaders of the Financial Accounting Standards Board and the International Accounting Standards Board will agree is a matter of greater doubt.

 

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Dodd-Frank Lets Small-Company Auditors Off the Internal Controls Hook: Putting a Partial Lid on the Sarbox

At least one piece of the Dodd-Frank legislation now has a ribbon neatly tied around it: the Securities and Exchange Commission has issued its rules to exempt small companies – generally those with less than $75 million of common equity – from having a separate independent auditor’s report on their internal control assurance under Section 404 of the Sarbanes-Oxley law.

(For her customarily concise and lucid summary, see Edith Orenstein’s FEI Blog.)

I’ve been quiet on Dodd-Frank. Why not? Unmanageable in its creation, incomprehensible in its enactment, unpredictable in its consequences, as it was. Who could work up an appetite to ingest such a pigs’-breakfast of law-making?

Small companies may say, with the night watch in Hamlet’s Elsinore, “For this relief much thanks.” But marginal tinkering with the mis-begotten obligations of Sarbox 404 will matter less, and for different reasons, than are usually put on view.

To start, the toxic post-Enron environment in which Sarbanes-Oxley was enacted in 2002 has effectively immunized its impositions from critical cost-benefit evaluation. Persistently asking the wrong question – “Has the quality of corporate reporting actually improved since the days of WorldCom and HealthSouth?” – not only ignores the built-in cyclicality by which outbursts of scandal are purged by self-cleansing returns to virtue. It also leaves unasked the proper question: “Is that reporting better than if Washington had done something else – including doing nothing at all?”

More importantly, can any scarred survivor of the last three years of Bear-Lehman-Fannie-Freddie-AIG-Merrill – the most disruptive economic period since the Great Depression – argue seriously that auditors’ reports on the “out-of-controls” of those fallen industry giants actually made any positive contribution to systemic safety, stability or credibility?

In that dreary context, of course, it makes perfect rational sense to give small companies a “Get Out Free” card.

That’s because, as I was advised about parenting strategy when our daughter was born: “Little kids, little problems; big kids, big problems.” A new father’s worries escalate, from the essentially trivial inconvenience of an infant’s colic or spilled oatmeal, on to little league injuries and a teenager’s driving safety, up to college admission and the launch to the challenges of adulthood.

In the same way, the fewer zeroes on a balance sheet, the lessened likelihood of systemic impact of mis-behavior that makes a difference. “Out-of-control” at a Koss or an American Apparel may be inconvenient for a limited constituency, and provide grist for the mill of the plaintiffs’ securities class action lawyers – but otherwise doesn’t matter in the great scheme of things. It’s altogether different when the entire global financial system can seize up under the effects of a threatened, undetected and undeterred collapse at an AIG or a Lehman.

History and experience teach that regulatory systems designed and applied under motives of political correctness over the fat part of the compliance curve are wasteful and ineffective – whether aimed at school truancy, auto emissions or corporate disclosures. Instead they will fail to identify and address the “outliers” that actually prove disruptive – the SEC’s sorry performance in regard to Bernie Madoff and Allen Stanford make the case. 

Section 404 reports on small companies were never any more likely to be effective by way of detection or deterrence for small companies than they have proved for the large. So it was an inevitability that inflicting Sarbox 404 auditor reports on small companies would have been largely an exercise in even further futility. If regulation has not worked for the big and dangerous, in other words, how can it be good or useful for the small and irrelevant?

Drab as it may seem, finding negative comfort that at least our legislators have stumbled into a way to avoid making a weak situation even worse, there is both logic and benefit in leaving bad enough alone.

 

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