Re:Balance -- Jim Peterson

Re-Allocating the Big Audit Market in the United Kingdom – Or Perhaps Not

"Two aristocrats are out horseback riding and one challenges the other to see which can come up with the larger number. The second agrees to the contest, concentrates for a few minutes, and proudly announces, “Three.” The proposer of the game is quiet for half an hour, then finally shrugs and concedes defeat.”

     -- Mathematics professor John Allen Paulos, “Innumeracy” (Hill & Wang 1988)

Regulators and politicians in the United Kingdom may well disrupt the Big Audit model – judging from inquiries launched recently by the Financial Reporting Council and the Competition & Markets Authority. The series that began here on September 25 and October 8, started to address the misguided nature of the purported “remedies.” It is making for pretty heavy going – so with thanks for the opportunity to write this as guest for Going Concern, this to lighten things up a bit.

Grave as are the UK threats to break up the Big Four, strip them down to “audit only” or impose government appointment of large-company auditors, it would take a comedy script-writer to capture the folly by which, it is suggested, the Big Four would “voluntarily” reduce their dominant market share of the FTSE 350 from 97% to 80%.

The head of assurance for Grant Thornton in the UK offered on September 14 that a nationalized appointment authority, which “would take the buying decision from the company … could split audits, say 50 for the Big Four and 50 for the non-Big Four.”

Seriously intended or not, the idea comes oddly from those with expertise in the assessment and comprehension of quantitative information. What comes to mind instead is the stateroom scene in “Night at the Opera.”

To expand and explain -- by 2017 revenue, the ten large firms in the UK array as in the table below (in £ millions). Of their £ 13 billion total, the Big Four garnered over £ 11 billion or 86%. The trailing six firms divided the remaining 14%.  

PwC	3,598
Deloitte	3,380
EY	2,350
KPMG	2,172
Grant Thornton	500
BDO	429
RSM	320
Moore Stephens	181
Mazars	173
PKF	130

If the notion of shifting fully half of the FTSE 100 audits were apportioned by firm revenue, Grants would take fifteen, BDO twelve, RSM nine, and each of the others four or five.

Collectively, how ready and capable would they be? BDO presently has only one such engagement -- Randgold Resources Ltd – actually on the bubble at # 101 -- and that one is likely to go away with the September 25 announcement that the company is to be acquired by Barrick Gold Corp, an audit client of PwC in Toronto.

Grants itself once had a FTSE 100 client, until the stock price collapse of Sports Direct dropped its ranking to # 181. And in any event, that job is to move with the upcoming displacement of Grants thanks to the UK’s mandatory tender and replacement rules. None of the other mid-size firms audits a FTSE 100 company.

As graphically displayed here on September 25, the impact of scale is critical. No number of hours at the controls of a single-engine airplane can qualify a pilot, however skilled, to command a wide-body jet – much less a helicopter or a space shuttle or a stealth drone.

No less, and without a whisper as to the relative work quality up and down the table, the requirement of experience at the Big Four level in performing large-company audits with global footprints and necessary industry expertise is compelling.

So despite the reams of paperwork that will be generated through the inquiries of the UK regulators, it remains a solid certainty that nothing like the suggested 50/50 re-allocation of the FTSE 100 will ever happen.

Sooner the proponents, like Professor Paulos’s mounted aristocrat, eventually “shrug and concede defeat,” sooner the discussion can move to steps of possible achievability and beneficial effect.

 

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While Steinhoff Teeters – Did Anyone Care What the Auditors Said?

Myths and fables are replete with urgent early warnings – only occasionally effective. The young shepherd who cried “wolf” -- the little Dutch boy plugging the dike -- the sharp-eyed lad to whom the Emperor was unclothed -- Chicken Little fearing skyfall – all the way back to poor Cassandra, doubly doomed to be disbelieved but proven right.

An emerging large-scale corporate scandal provides a vivid example – sprawling consumer conglomerate Steinhoff International NV, with its global operations based in South Africa, its principal share listing in Frankfurt, and its headquarters in the Netherlands.

As CEO Marcus Jooste put it in resigning on December 5, “I made some big mistakes and have now caused financial loss to many innocent people” – quite an understatement, with the company’s concession of “issues concerning the validity and recoverability of certain Steinhoff Europe balance sheet assets,” reported to reach an eye-popping € 6 billion.

The latest: alleged multi-billion euro accounting irregularities, the company’s share price dropped by 90%, its credit rating cut to junk, predators circling its local operations, politicians and commentators crying for accountability, and rumblings from regulators in the three countries plus the inevitable shareholders’ lawyers.    

In this troubled context, there is this to ponder: Steinhoff’s 2015 financial statements bore the traditional and familiar “pass/fail” auditor’s report, issued by Deloitte’s Pretoria office. The next year, with the change in headquarters, the report by Deloitte’s Amsterdam office ran a full eight pages, over 3800 words with three paragraphs on “materiality” and five “key audit matters.”

Steinhoff thus offers a real-world test of the recent requirements imposed by the major regulators, that investors should receive -- and in theory might actually value -- auditor reports expanded to identify and discuss “critical” or “key” audit matters – see the IAASB’s 2015 International Standards on Auditing, and from the US audit regulator, the Public Company Accounting Review Board, its Auditing Standard on the Auditor’s Report, Docket 034, approved by the SEC on October 23, 2017.

The outgoing chairman of the PCAOB called its new standard “the first significant change to the standard form auditor's report in more than 70 years,” which will “breathe new life into a formulaic reporting model.”

Perhaps – although unlikely. My own skepticism – here – is mainly that the combination of liability anxiety and common if complex issues across companies will mean reversion to boilerplate language of anodyne simplicity.

The Steinhoff situation raises a different issue – namely, does anyone really care?

The United Kingdom is now in its third year of expanded auditor reports. While there has been a good deal of self-congratulation, the world of information users awaits an empirical study of whether extended report language in that country has had any effect on investor behavior – one way or another.

The Steinhoff saga should reinforce the doubts. From September 2015 when Deloitte South Africa issued its short report, the company stock had traded in a fairly narrow and stable range, through a series of large-scale acquisitions. The following year’s expanded report by Deloitte Amsterdam identified as two “key audit matters” the valuation of goodwill and intangible assets of over € 16 billion and the accounting for two major combinations for almost € 3 billion, and its balance sheet showed that long-term interest-bearing loans and liabilities had swelled from € 4.1 to € 7.1 billion – among the "critical" areas where the curious might have inquired for what are now the reported gaping holes.

So Deloitte’s expanded language might have been taken as cautionary. To the contrary, instead, media search fails to locate a single word on its extended opus – whether criticism, credit, or indeed comment of any kind.

Rather, impact if any among the investing public looks over-ridden by the animal spirits of the herd -- perhaps not incidentally including South Africa’s public employee pension scheme, the Public Investment Corporation – who all plunged together right up to this last December, when the bottom fell out and the company’s acknowledged if still unspecified accounting irregularities obliged Deloitte to withdraw its report altogether.

In addition to the apparent indifference of investors, history suggests that the affected legal systems will not be much impressed by protests of “we told you so.”[1]

As the blame-allocation exercise unfolds, it remains to be seen whether expanded auditor reporting will rank in importance at all – or whether defensive assertions will be credible that anyone relied on, or is bound by, the thousands of words by which Deloitte elaborated on the complexity of Steinhoff’s financial reporting.

Will it be shown that any of the expansive auditor verbiage mattered to anyone, more than the typical single paragraphs of audit scope and opinion?

The Dutch themselves would politely say, “vergeet do rest, volledig onnodig” (forget the rest, completely unnecessary). German and South African idioms would be similarly dismissive. The most printable American response would be, “couldn’t care less.”

There will be future developments -- watch this space.

 

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[1] As a model for the less-experienced jurisdictions, the American liability regime has for decades rejected the defense of compliance with professional standards. United States v. Simon (Continental Vending), 425 F.2d 796 (2d Cir., 1969).

If The Big Four Went “Ex-Advisory” – Déjà Vu? Or Worse?

Will this be the year that history repeats -- when the Advisory practice of one or more of the Big Four breaks away from Audit? What would a reprise look life, of the withdrawal from consulting they made between 1998 and 2001?

The inquiry is of interest, to the firms' partners, employees and clients -- and not least to all users of the audited financial statements of the world’s large public companies.

The conditions are all present, and ominous, for two reasons.

First, taking the various regulators at their word, they have a distinct distaste for the growth of Big Four “Advisory” -- as consulting is now cosmetically re-labeled. In a Washington speech on December 9, 2013, PCAOB chairman James Doty observed that:

“We have, in recent weeks, seen publicly reported examples of a resurgence of audit firms into consulting to bolster revenue. Of what consequence are these developments for the audit function? What are the implications for independence of the audit function? ... What are the risks of other business lines and how do they affect resource allocation and investment in audit?”

In the same vein, PCAOB member Lewis Ferguson, in his then-capacity as chair of the International Federation of Independent Audit Regulators, was quoted at an IFIAR press conference on April 10, 2014, that the auditors’ search to acquire expertise in Big Data and its applicability to auditing “is a source of great concern to all regulators around the world,” and “raises serious concerns about differential levels of profitability in these businesses, differential rates of growth, where the economic incentives are and to what extent does audit quality suffer as a result” (emphasis added).

Second, the bureaucrats’ antagonism aside, there are sustainability implications in the continued growth rate disparities between practices. Audit revenue growth for the Big Four is stagnant in the low single digits, while their Advisory practices continue the trend of recent years, positive in the mid-teens.

As a model for the evolution of the practice mix of the large firms, Deloitte’s 2016 Advisory revenue, according to its global annual report, was absolutely $ 3.5 billion larger than Audit; its Assurance and Tax together only measured above 50% of its global total by including Risk Advisory on that revenue line.

Memories long enough will recall the large firms’ various exits from their consulting businesses, with their unfortunate capitulation to the regulatory and political pressures on permissible scope of ancillary services to audit clients:

• EY’s sale to CapGemini in February 2000.

• KPMG’s 2001 spin-off to create what became BearingPoint.

• PriceWaterhouse’s sale of its practice to IBM in July 2002.

• Most especially, the bitter and avoidable divorce between Arthur Andersen and Andersen Consulting, commenced in 1998 and finalized with the launch of Accenture on January 1, 2001.

Despite Andersen’s cohesion, profitability and market position – never matched even in the dreams of its peers -- its leaders were unable to overcome their structural stresses or resolve the issues of client service constraints, disparate profitability and allocations of authority and governance influence.

With the internal, regulatory and litigation pressures all mounting today, it is both too easy, and thoroughly dispiriting, to imagine a repeat – one that for all the public may know is percolating even as we speculate.

It is, to say, not difficult to picture a quorum of unhappy non-Audit partners, delivering ultimata to their leaders that demand structural revisions to compensation packages and promotion incentives and organizing documents. Meanwhile, other dissidents would be lawyering up and engaging teams of bankers to model the costs and opportunities of a practice line break-up or break-down.

Since the plausibility and possibility cannot be ignored, what would the model for Big Audit look like, if delivery were soon to be done by four firms comprising audit and tax practices alone?

First of all, Big Four rankings on a 2016 “audit and tax” basis would be (in US $ billions): PwC - $ 24.4; Deloitte - $ 20.4; EY - $ 19.05; KPMG - $ 15.7. The revenues of their US practices would array between $ 6.6 and $ 9 billion.

One element at the heart of the concerns is that of fragility and survivability. For this, the analysis is pertinent that I have done here in the past – calculations of the financial “tipping points” – that is, the size of a “worst case” litigation or law enforcement outcome that would destabilize and disintegrate a Big Four network.

No fun – although necessary in any grown-up discussion of what such a model for Big Audit might look like – that analysis yields indicated break-up numbers well below $ 1 billion. That is hardly enough to register, in an environment where VW has agreed to pay out some $ 22.5 billion to resolve only the US portion of its penalties for its diesel emissions “defeat” software; with Rolls-Royce’s penalties for twenty years of global bribery to include £ 671 million in fines to authorities in the UK, the US and Brazil; and where disclosure of the cost of irregularities in the Italian business of BT Group knocked the company’s value by over £ 6 billion in a single day.

These are figures disturbing enough to give serious pause. But even as the atmosphere of denial on this subject prevails, there are also disturbing implications for the ability of these reduced organizations to serve the assurance needs of the world’s capital markets. That is, as the case for the traditional “pass/fail” auditor’s report continues to erode, the prospect of reviving its value by “shrinking to success” would look increasingly dubious.

Here the concern is about the ability to evolve, when the personnel who would leave with the departing Advisory practices would strand the auditors without the support of such diverse talents as the data analysts and software designers, engineers and robotics experts, economists and lawyers and bankers alike – expertise lured away in a repeat of history by the enticements of unfettered stand-alone Advisory opportunities.

Both regulatory hostility and diminished professional capabilities would challenge the ability of an “audit only” Big Four to respond to the implications of the inevitable. The genie of change is already recognized as out of the bottle, and will not be returned. If the audit firms handicap themselves with a failure to stabilize, evolve and maintain truly full-service structures, business models and methodologies accordingly, then new players to serve the market’s demands surely and shortly will appear.

So – is another Audit/Advisory split on the horizon, with all the unpleasant consequences? No prediction is made here – but under today’s conditions, no bet against it either.

 

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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]

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

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

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

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

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

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

Pragmatism figured large, however.

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

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

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

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

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

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

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

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

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

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

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

 

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Re-Posting: Foreign Auditor Inspections? "China Syndrome" Strikes the SEC

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

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

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

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

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

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

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

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

It’s mainly that the US regulators’ only weapon of significance – banning Chinese affiliates of the large global accounting networks from qualifying to work on audits of American-listed companies – would ripple far beyond the toxic roster of China-based companies. There are potential consequences for global-scale companies with significant operations in China that go far beyond the inability of the PCAOB to inspect their local audit firms, whether or not maneuvered to keep below the 20% threshold.

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

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

Across the globe from KPMG in London and its top-level opinion on HSBC, to PwC in Peoria, Illinois for Caterpillar – unable to rely on their excommunicated Asian brethren – auditors would have no choice but to use the dread “qualify or disclaim” language -- never seen for a public company because anathema under the rules of the SEC itself. Or, in extremis, PCAOB de-registration of the whole of an audit network deemed non-compliant would render a company’s entire financial filing unacceptable.

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

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

 

My apologies for the re-posting, especially to subscription readers to whom the intended video clip did not feed -- a lesson learned in attempting to reach beyond competence with technology.

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HP - Autonomy: How Might the Auditors Survive the Fall-Out?

The toxic cloud spreads, from the implosion of HP’s $ 11.1 billion Autonomy acquisition, and the $ 8.8 billion write-off announced on November 20 by CEO Meg Whitman: 

• Whitman’s claims of pervasive accounting fraud have been vigorously denied by Autonomy’s ex-CEO Mike Lynch, and derided by critics as a mask for HP’s own faulty due diligence, gross over-payment and post-transaction mis-management.

• Prompt lawsuits followed, derivatively on behalf of HP and by shareholders as a class, against the usual targets including Deloitte as Autonomy’s statutory auditor in the UK and KPMG in its role for HP. 

• Referrals have been made to authorities in both the US and the UK, the scope of whose interest and enthusiasm has yet to be made public.

As to the various Big Four firms, pointed questions arise -- beyond those expected about Autonomy’s revenue accounting and HP’s due diligence – going to the structural heart of the traditional auditor-client relationship:

• Floyd Norris in the New York Times: “’Where were the auditors?’…They were everywhere.”

• Francine McKenna, “Re: The Auditors: “’To the victor’s auditor go the audit spoils’…is not how the Big Four audit industry is played now that consulting is again King.”

• Tom Selling, “The Accounting Onion”: “If Autonomy’s accounting practices were too aggressive, would Deloitte’s staff have had the gumption to push back given the stakes?”

Meaningful discussion of these issues, which unfortunately have proved intractable for decades, requires confronting two essential issues: 

First, because Autonomy’s accounting and reporting and Deloitte’s issuance of the standard commoditized auditor’s report are targeted as unsatisfactory, just when critically important, the question is raised yet again: what good are models having the appearance of utility, only up to the point of their unexpected exposure as insufficient, when suddenly they don’t? 

Second, the finger-pointing at Deloitte’s alliance relationship with HP and the scope of its non-audit services for Autonomy raise again the unresolved obsolescence of the notion of “appearance of independence.”

Regulators have the large accounting firms’ expansion of non-audit services in their sights – most recently at the recent AICPA’s SEC-PCAOB conference:

Acting Chief Accountant Paul Beswick: “I question whether accountants' expanding practices into areas unrelated to their primary competencies weakens public trust.”

PCAOB Chairman James Doty: “Audit practices have shrunk in comparison to audit firms' other client service lines — not all of which are schooled in, or depend upon, the fundamental exercise of skepticism. This threatens to weaken the strength of the audit practice in the firm overall.”

If the accounting profession is to survive what will otherwise be another generation under this radioactive rhetorical cloud, fundamental adjustments are in order. 

The first would be a robust defense of the “client-pays” model: however much criticized, it dates to the invention of independent assurance in the 1850’s, and is the only approach ever to stand the test of actual adoption and use.

“Client pays” being irreconcilable with “independence in fact,” however, the HP-Autonomy fiasco is a reminder of the profession’s long-standing inability to articulate intellectually stable support for “independence in appearance.” 

So it is time to renew the proposition I have advanced for years (see my March 24, 2006 column in the International Herald Tribune) -- that, “the sacred cow of auditor independence should be led off and humanely put out of its misery.” What I said there remains vital:

“The concept of auditor independence does not serve the interests of investors.

“Audit performance - and more immediately, the survival of the large firms to serve their global clients and the capital markets - would be better achieved if the current independence requirements and constraints were scrapped altogether.

“Auditors should be free to provide their clients with any services within their skills. The only thing that should be required is comprehensive disclosure of all relationships, to be evaluated and decided by the voting power of the marketplace.”

At the same time, clearance of the radioactive debris of independence inhibitions would free the marketplace once for all from the entire sterile debate over permissible services by auditors.

The community of financial information users is capable of defining, engaging and valuing the scope of services available from its gate-keepers -- whether bankers, lawyers, rating agencies or auditors.

If the trade-off for the large accounting firms, for release from a system of constraints that has long lost its value, is a downward re-assessment in the value of their traditional core product – which would only acknowledge a reality long suppressed or denied in any event – that is an exchange worth making. 

For their future as legitimate participants in the world’s capital markets may well hang in the balance.  

 

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HP-Autonomy: A Red-Ink Bath for Everyone

       “Either nobody in this deal understood the Company’s business, or someone was committing a fraud.”

-- Big Firm audit manager’s file note

Such language doubtless lurks in the working papers of the Big Four accounting firms, concerning this Thanksgiving’s biggest corporate turkey – HP’s announcement on November 20 of the whopping write-off of  $ 8.8 billion of the $ 11.1 billion paid a year earlier to acquire the UK’s FTSE 100 Autonomy.

How the blame-mongering cost of this fiasco will be allocated will depend, since each member of the large-firm tetrapoly touched the deal – Deloitte as Autonomy’s independent auditor, E&Y in the same role for HP, KPMG as part of HP’s huge buyer-side due diligence team, and finally PwC, brought in to pick over the forensic wreckage.

The quoted memo itself goes back a generation, to an investigation into sketchy high-tech revenue accounting – where it figured prominently in the investor litigation and the company’s SEC consent decree, an exhibit to the hazards of recording ideas that were both prescient and dangerous.     

That’s context for these thoughts responding to my investment banker friend and regular reader, “waiting for commentary on the Hewlett-Packard news and how it will affect Deloitte.”

Happily for the global supply of bandwidth, this story broke in a holiday week, absorbing in turkey, shopping and football the perfervid reactions of the most strident critics and their demonizing of the audit franchise as systemically venal and corrupt (e.g., here and here).

It is pointless now – time enough as the process evolves – to judge the predictable protestations of virtue of ex-CEO Mike Lynch, or Deloitte’s statement that it “categorically denies that it had any knowledge of any accounting misrepresentations….”

The Autonomy claims involve aggressions as old as IBM’s practices under the Watsons in the 1950’s – long stale and banal, and at best only interesting as an undergraduate classroom exercise in the endlessly elastic opportunities for revenue manipulation.

HP’s allegations do not, so far at least, involve such classics as the empty boxes at Miniscribe (1989) or Crazy Eddie (1987), nor yet the bogus contracts of Lernhout & Hauspie (2000) or Satyam (2009), but only the dreary familiarity of channel-stuffing and phantom contract dates – activities perpetually inviting to companies creatively striving for sweetened earnings, and elusively beyond the persistent efforts of standard-setters, regulators or law enforcement. 

More to the point, given the long-running criticism of Autonomy’s reporting by hedge funds and short sellers, is that it defies acceptable practice for HP CEO Meg Whitman to attempt the lay-off, that “the board relied on audited financials – audited by Deloitte – not Brand X accounting firm but Deloitte.”

Sorry, Meg. Not for a generation has an effective due diligence team done any more with a standard audit report than throw it onto the compost heap at the back of the document repository.

The HP team, said to comprise three hundred people from KPMG, bankers Perella Weinberg and Barclays and a quintet of law firms, surely had ample experience to sniff out any issues deemed significant. Why it did not will abide further finger-pointing.

But collective memories should not have been so short as to miss the red alert flag that the Autonomy deal was being flogged by Qatalyst Partners in the person of Frank Quattrone.

Whose earlier heady days in Silicon Valley had ended with one hung jury, a conviction reversed on appeal and a deferred prosecution agreement. So to say as did Reuters that Quattrone “specializes in tech deals” is like saying that Typhoid Mary was just going about innocently looking for work.  

Surer proof that HP will fail to spin its Autonomy debacle as an Enron-scale accounting fraud, is its assessment by Lynn Turner, who in 1998 was levitated to the post of Chief Accountant at the SEC from his position in a since-disappeared high tech company, after two decades at Coopers & Lybrand where he had emerged as national leader of its High Technology Practice.

Turner – whose background would presumably recognize dubious practices in the sector –- resisted the chance to pile on his erstwhile large-firm brethren --  for whom he forsook any affection upon his extraction from their ranks, his animosity more typically achieving the zeal of the mad monk in The DaVinci Code. Asking how the Autonomy policies “translate into a $ 5 billion write-off?” he demurred, that “the big issue isn’t the fraud they’re talking about. The big issue is that HP has made acquisitions that have turned out to be a disaster.”    

And so to my friend’s question, who might ultimately be liable to whom? The news is unhappy for HP’s long-suffering shareholders, whose claims -- either as a class (immediately launched) or on behalf of the company – under either British or American jurisprudence will offer little recourse, against HP or its management, Autonomy’s sellers or Deloitte.

Direct HP litigation against Deloitte would seem unlikely, given their existing ten-year consulting relationship as global alliance partners. Nor could Meg Whitman relish hostile courtroom scrutiny of the acquisition decision of her predecessor, Leo Apotheker, given – on her watch -- the year of pre-disclosure operating experience HP had with Autonomy, its string of prior write-offs including the $ 9.2 billion charge related to EDS, and the skeptics’ suspicion that HP’s write-off is a “big bath” overstatement of Autonomy’s illness to the forward benefit of HP’s balance sheet.   

If the impact on Deloitte and the other gate-keepers is likely “not much at all,” it is also likely not zero -- depending on where the “smoking gun” memos of the quoted variety might reside and be discovered – since a multi-billion dollar claim is beyond the Big Four firms’ financial capacity or risk tolerance to take to trial (here) – however enthusiastic their press-office protestations of innocence and scorched-earth defenses. 

What this latest dreary escapade does portend is several years of uncontrolled legal and litigation costs, and a flurry of inconclusive regulatory and oversight investigations – the end results of which will be inconsequential.

And finally, a wager is offered here, that Meg Whitman will not survive in place at HP to see it through.

 

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RIP Daniel Pirron -- Deloittes Mourns the Loss of a Partner -- And We Should Too

What internal demons impel a suicide?

No reaction but sorrow seems appropriate, for the self-inflicted gunshot death on August 13 of New York-based Deloitte partner Daniel Pirron.

Limited attention has been paid in the accountancy media (here and here). Of which, some comments are tracking his family’s suggested linkage to Deloitte’s UK client Standard Chartered Plc, and the Iran-related money-laundering scandal in which, the week before, the bank had agreed with the New York Department of Financial Services to a $ 340 million fine.

That speculation is unfortunate, for reasons only starting with Pirron’s scope of work itself, in the office of Deloitte’s general counsel, and the firm’s statement that “he was not involved in any way” with its work for Standard Chartered.

Focus here on suicides proximate to financial and corporate wrong-doing – an area of my concern long-predating my unhappily accurate prediction on December 16, 2008, that it was a "safe but unfortunate bet…that at least one remorse-driven suicide will further color the already tawdry (Madoff) tale” – coming only too true a week later with the suicide in his Madison Avenue office of Rene-Thierry Magon de la Villehuchet, the founder of a fund whose investors lost millions with Bernard Madoff. 

That context is difficult enough – initially because the sample size is miniscule, making attempts at meaningful generalizations intensely hazardous. The conditions are, however, readily distinguishable from the impulsive acts of the emotionally immature – fortunately most often not effective – or the reasoned acts of the gravely ill – movie director Tony Scott’s recent fatal leap being perhaps explicable by a report (since disputed) of his terminal brain cancer.

A non-comprehensive survey of scandal-related suicides starts with one point of interest – that with the exception of the recent failed attempt by Peregrine CEO Russell Wasendorf Sr, those driven to act are not the principal perpetrators.

Which should be no surprise. The necessary level of introspective regret and remorse would not be in the DNA of the typical white-collar criminal. Think of the egos both of those actually brought to book – a sample including Bernie Cornfeld, Bernie Ebbers and Bernie Madoff – and those of tattered moral fabric although escaping the formalities of prosecution – “Chainsaw Al” Dunlap and Donald Trump and Angelo Mozilo and Dick Fuld.

Instead it’s the secondary players – the lower-level executives and the gate-keepers – Frank Shuch, the least of the accused triumvirate at Connecticut’s Colonial Realty (1992); Cliff Baxter at Enron (2002); Bernie Madoff’s son Mark (2008); or the reported attempt by Satyam CFO Srinivas Vadlamani (2009).

Even so noted, extreme personal acts are not in character for those choosing careers in professional services, particularly accountancy – there being perhaps some dignifying comfort behind the tradition of ill-founded ridicule of the bean-counters’ brown shoes and green eye shades.

True enough that accountants are neither saints nor angels. As with any fallible system of human design, the firms’ best-tuned screens for personal quality will let slip the rare exceptions – those challenged by intelligence or discipline, the addict or the abuser, the venal or the pliable. And while public accounting is not a vehicle for great wealth accumulation, those shifting to entrepreneurship or the executive suite are on occasion seduced or suborned.

But in the four decades of my broad experience across the profession, only a handful have met the defined standards of the criminal mind. Practitioners of independent assurance -- first delivered to Victorian-era public companies starting in 1850 with the report by William Welch Deloitte himself on the accounts of the Great Western Railway -- have overwhelmingly been people of stability, intelligence, good faith and honorable intentions.

The best scholarship on human behavior and choice-making counsels us to resist the instinctive impulse to construct simplistic stories in a futile search to comprehend the irrational.

So – rather than press an inexplicable coincidence, genuine mourning by the profession is in order – joining with his family, friends and colleagues – for the sad death of troubled Dan Pirron.

 

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Guest Post at the FEI Blog: When Litigation Kills the Accounting Profession -- Don't Say You Weren't Warned!

Edith Orenstein's FEI Blog is a "must read" -- a thorough and lucid map of the goings-on in Washington among the  legislators, regulators and agencies of law enforcement. I have the pleasure this week of taking up Edith's kind invitation for a guest post, while she is on vacation:

With the devilish details of the Dodd-Frank Act now to be worked out and many special interests weighing in, legislative activity in the American financial sector returns to a standstill – probably until after the elections of November 2012.

So what would bring to the forefront a topic that to most is sleep-inducing, although it keeps some few from sleep: namely, the very viability of the large accounting firms and their fragile franchise to audit the world’s global companies?

Nothing less, presumably, than an existential shock to the stability of one of the Big Four tetrapoly – an unresolvable criminal investigation or a “bad case” outcome in one of their nightmare civil cases. . . . . For the entire post, and to see the scope and quality of Edith's own work -- please see here.

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