Re:Balance -- Jim Peterson

EY’s Project Everest and Stockton Rush’s Titan –- A Comparison of Two Wrecks

"The Defense Department regrets to inform you that your sons are dead because they were stupid.”

            Goose to Maverick, Top Gun, 1986

 An exam essay for my graduate-level course in Risk Management and Decision-Making, out of this spring’s two catastrophic implosions:

• Stockton Rush’s submersible Titan, crushed in a nano-second on its descent to take an expensive porthole peek at the disintegrating wreckage of the Titanic, lying 2100 fathoms deep on the floor of the North Atlantic.

• EY global chief executive Carmine DiSibio’s aborted Project Everest, by which he sought but failed to split and separate the accounting and consulting practices of the Big Four network.

Here it would be:

As an exercise in “failure study,” compare and contrast the attitudes and behaviors of Rush and DiSibio, and the sources of bias, error, mis-judgments and other factors contributing to the collapse of their ambitious aspirations.

This course seeks lessons for business, professional and personal choice-making. The semester has just ended and my terrific student cohort has scattered on their summer holidays, so here’s what I would have expected from them –- a comparative exercise in how central themes in human behavior are found and recur across a broad range of examples.

While the literature on flawed decisions is rich with guidance, it converges on the deadly combination of arrogance and ignorance. Over-confident commitment to a triumphal goal –- a visual close-up of the historic wreck site, or the cascade of riches anticipated from the EY separation –- would suppress any appeal to proceed with caution, prudence and counsel with the available expertise of others in the sector: hull design, incremental trouble-shooting, and inclusion of safety and emergency capabilities, on the Titan –- and for Everest, coherent strategic planning, globally functional leadership, and resolution of organizational inadequacies in governance and infrastructure.

Innovation, evolution and boldness of vision lie at the heart of great plans, to be sure. But not even unlimited financial resources can purchase a repeal of the inexorable laws of physics and metallurgy and marine engineering –- nor can boundless hubris and grandiosity evade or bypass the basics of economics and organizational dynamics.

The comparisons extend. The hydrostatic pressures on the hull of the Titan were calculable in terms of the water’s depth and density (P = pgh, for those interested) –- predictably catastrophic forces on a vessel of sub-optimal shape, inadequate testing, and fatigued by multiple descents.

As turns out, the formula has application, by analogy at least, to Project Everest –- the depth of its problems went unmeasured and untested, and the density of its leadership created destructive forces beyond recovery.

There’s one further comparison, grisly in its nature, in an expert engineer’s analysis:

• The Titan’s malfunction and loss of power, de-stabilizing and tipping it out of control to “fall headlong towards the seafloor,” meant that its five passengers –- helplessly piled in the nose of the cabin without lights, communications or workable emergency measures -- likely had about a minute of terrified awareness before its fatal failure.

• Likewise, the plain take-away for Carmine DiSibio in the failure of his head-to-head with EY’s American leader and deal skeptic Julie Boland was that the lights were out on Project Everest, a crash was imminent, and there was no available rescue plan or exit strategy.

Stockton Rush’s mis-adventure in “tourism porn” –- charging obscene ticket prices for a reckless project having no legitimate purpose within the protocols of real science, but induced by incentives lying elsewhere in egoism, emotion or ambition –- will be no more than a blip on the future of deep-water exploration. Further analysis is to come, but early post-mortem reporting on the recovered remains already indicates that the causes of the Titan implosion are well understood in the surfeit of flaws in its design and execution.

The same for Project Everest, and DiSibio’s frustrated conflicts as the would-be leader of a new, publicly-listed consulting enterprise. The debate will continue about the desirability of alternate models for professional services, as across the spectrum from integrated, full-service firms to “audit only” assurance practices completely separated from the expanding array of consultancies in Sustainability, cyber security, artificial intelligence and otherwise. But because history’s best example of the latter is the mixed outcome of the Arthur Andersen divorce of 2001 –- the immense success of the Accenture IPO and that company’s powerhouse growth thereafter, contrasted with the death spiral of the Andersen accounting firm in less than a year –- the next entrepreneur tempted to dive into these cold waters will be wise to study with care the uncharted hazards beneath the surface.

“What will kill you is ‘not knowing what you don’t know’” -- the maxim is captured by the academics as the Dunning-Kruger effect. Critically for lessons to be learned, any complex situation with a non-zero possibility of potentially fatal problems calls for pauses and consultation, analysis of emergent quality issues, and careful attention to dissenting views and disaffirming evidence.

Which apparently did not figure for either Rush or DiSibio –- meaning that the outcomes of both projects were fore-ordained. Titan and Everest are now reduced to rubble and mourning, for reasons traceable to the conduct and behavior of their sponsors and advocates. Further efforts in either area may benefit from their unhappy experience.   

 

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EY's Collapsed Split Attempt -- Questions for the Audit Model

The collapse of Project Everest, the doomed attempt by accounting giant EY to split its consulting and audit practices, leaves a landscape like a medieval battle-field -– strewn with casualties and be-set by looters.

The mood is dour –- a retired partner sees “a lot of animosity within the firm,” and an academic says that “short-term turmoil and leadership changes are probably going to happen.” Job cuts were announced for the local firms in the US and the UK.

Uneasy lie the heads that wear the crowns: Carmine Di Sibio, EY's global chief executive; UK managing partner Hywel Ball; their principal antagonist Julie Boland in the US. The tenures of EY’s leadership are in the balance, along with the cohesion of the network and its $ 45 billion of 2022 revenue.

Renewed questions are now aimed at the fitness of the Big Audit model -- see Bloomberg, the Financial Times, and The Economist. As reporters Amanda Iacone and Michael Rapaport put it (all emphasis added):

“Experts say some problems are baked into the very way audits are structured, and that the system actually provides incentives for auditors not to do a tough audit. It’s hard to change that without scrapping the whole system and starting from scratch.”

That view is not shared by the participants. The compensation packages of the partners are linked by golden chains to the unexamined verity of an outmoded product from the Victorian era. That they might willingly imagine a different world would be unthinkable.

Except that it’s not. The depth of EY’s wounding is yet to be felt, with the potential loss of clients, practice stagnation, and the poaching and flight of disaffected personnel. “Expedited hiring discussions” are initiated by opportunistic competitors, and at least two life-threatening litigations are looming –- NMC in the UK and Wirecard in Germany.

It is well to remember that kernels of supposedly eternal truth are ground to dust in the mills of the gods:

• Galileo’s 17^th century inquisitors were piously confident that heliocentrism was divinely condemned.

• “If God had meant man to fly, He’d have given him wings.”

• “I think there’s a world market for maybe five computers,” said IBM Chairman Thomas Watson in 1943.

Irony not being a Bloomberg characteristic, its writers’ question deserves serious and expanded treatment:

“Does the current way of doing things need to be scrapped and rebuilt from scratch, then?”

“What if” the disintegration or collapse of EY? And the unavoidable consequence: an unsustainable Big Three model that would make unavailable, at any price, audit reports for the world’s large companies.

Vexing issues gathered by Bloomberg confront the accountants, with hands wrung in angst and frustration –- here summarily re-cast as “the latest flare-ups of a rolling, seemingly intractable series of crises over audit quality, the role of consulting, and auditors’ integrity”:

• The firms pronounce that audit "is at the heart of the DNA of these firms…They all take very seriously their public interest role…”, and regulators assert that “We’re confident that audit quality has improved, at least at the biggest firms” –- despite persistent outbreaks that at minimum suggest the contrary.

• “The firms, their critics, and their regulators have tried for 25 years to solve the industry’s recurring problems -– but while some observers say audit quality has improved by some measures, failed audits and corporate collapses haven’t stopped.”

• “All of the Big Four firms have had significant audit blowups in recent years” -– see the current attention to KPMG as auditor for the “three-fer” of recently failed American banks SVB, Signature and First Republic.

• “(A)uditors maintain that they actually aren’t responsible for doing as much as investors think they are –- something the auditors call the ‘expectations gap’.”

• “Even as rulemakers contemplate setting high bars for auditors, regulatory enforcement of those rules historically has resulted in penalties that amount to a slap on the wrist…”.

• “In theory, an EY split could help alleviate conflict-of-interest concerns, but … a break-up could hamper EY auditors’ access to expertise, specialists, and technology from the firm’s consulting side.”

• Quoting a plaintiffs’ lawyer, “I don’t think anyone believes what the auditors say anymore…They don’t see any risk to being wrong or to not uncovering something, where there is a risk to uncovering something.”

Hypothesizing a failed EY and a future in which the traditional opinion is no longer obtainable -- resolution of all the above issues is available in that future:

Assurance providers would be freed from their shackled role as “statutory auditors” and enabled to provide targeted, bespoke assurance, extending to all or portions of company information, both financial and as to Sustainability.

The over-hang of death-threat litigation would lose its significance. The “expectations gap” would be closed, as opinions would be delivered under contracts defining third-party reliance and caps and limits on liability.

Firms freed to offer a full range of assurance would hire the equally broad range of required talent and expertise. Career paths would open up. Limitations of auditor independence and constraints on scope of service would have fallen obsolete.

Comprehensive global presence and scale no longer being essential, new providers could offer niche services under new structures and capitalized by new sources –- superseding current concerns for limited competition and range of choice.

Rather than answer to the narrow prescriptions of the regulators, disclosures and assurance would be testable and evaluated in the capital markets.

• Anticipating the anxiety of the bureaucrats, however, nothing in this brave new world would eliminate either issuer responsibility for appropriately defined disclosures to investors or suitable oversight of assurance providers.

No prediction, when or whether a Big Four network might collapse like Arthur Andersen in 2002. But it would be reckless to believe that it cannot or will not happen. 

That possible future, however, should not be so scary as to self-censor an exercise in scrutiny that needs be both thorough and candid. 

 

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Demise of EY's Project Everest Stems From Self-Inflicted Wound

No one should be surprised at the canceled split of EY’s audit and consulting practices following a confrontation between the firm’s global and US leaders. But a post-mortem period of recriminations, blame-mongering, and blood-letting is inevitable.

That's the lede of my guest post today on the home page of Bloomberg Tax, with thanks for the opportunity:

Carmine Di Sibio’s mountain has fallen to a pile of rubble.

The aspiration of EY’s global leader to separate the Big Four firm’s audit and consulting practices under the grandiose title of Project Everest was announced on April 11 to have failed. A post-mortem period of recriminations, blame-mongering, and blood-letting is inevitable.

No one should be surprised. Two weeks of silence on the resistance of EY’s crucial US firm after the late-March confrontation between Di Sibio and US leader Julie Boland spoke to the deal’s imperiled state. Project Everest’s trajectory went from a strategic imperative to re-engineer Big Audit to an abrupt collapse labeled “chaos” by EY’s own partners that will feature as a case study in business school curricula.

Preliminary conclusions are already available. The memorandum of capitulation by EY’s global executive team, which dangled the notion of a future revival, listed the requirements: “to adapt our governance, operating model, cost structures, capital investments, and go-to-market approach.” It didn’t acknowledge that each of these was identifiably inadequate when Everest was announced.

Looking back on the face-off between Di Sibio and Boland, the Americans’ stated concern was the allocation of EY’s tax practitioners—between a new consulting practice with its planned public listing and cascades of financial benefits, and the legacy audit firm staying behind in a traditional partnership structure.

There’s much more. The echoes of surrender were still reverberating on April 12, when Boland announced a US strategy and cost-saving program. It’s a complex aspiration on its own and clearly a card she held closely in the weeks of wrangling with Di Sibio.

Going forward, Di Sibio’s credibility must be fatally wounded despite global messages; Boland will be non grata among large and disappointed portions of EY’s various partnerships. But she has the US firm tagging $500 million in savings—a handy bucket she can claim by dropping the foregone costs of canceled recruits and staff defections.

Inside EY, there’s some sympathy. It’s to be hoped that the consultants anticipating multimillion-dollar IPO windfalls were restrained in their eager down payments on vacation homes, bigger boats, and fancier cars. Meanwhile, poaching will advance. Individual partners will test the waters to affirm the handsome valuations they’d been led to believe they represented. Some, at least, will be met with open arms.

And where now, for the contours of global Big Audit? Although EY posited that its practice separation would be a “road map for reshaping the profession,” and urged that it would “inevitably be copied” by its brethren, Di Sibio might regret the move.

Early reactions from other large firms ranged from quiet skepticism to downright disdain in an in-house video from Deloitte’s global leader, Joe Ucuzoglu. To say they’re having a moment likely understates the muted snickering behind closed doors. In Australia, KPMG’s leader Andrew Yates was quoted that “the deal’s collapse showed that clients still wanted a one-stop shop.” To the same effect, Deloitte’s Adam Powick said “we have been unwavering in our commitment to our multi-disciplinary and private partnership model.”

Advocates for the large firms’ retention of the ancillary expertise necessary to carry out global-scale audits—tax and appraisal, and evaluation and crypto and cybersecurity--may not have won an outright battle. But those arguing that an “audit only” firm can hire or outsource those necessary resources are now disarmed.

Most important, the anticipated stream of defections hopefully will be moderate enough to leave behind a stable firm. The Big Four tetrapoly that survived Arthur Andersen’s 2002 collapse is down to a critical minimum. A three-firm model might be unsustainable under existing scope of practice limitations and uneven global distribution of resources and expertise.

The emergence from this dark period of a vital EY affects the survival of the Big Audit model itself, at least in its current form. However, EY’s survival as an essential player depends on its leaders’ ability to face and resolve a set of challenges:

• Satisfy its uneasy clients that engagement quality has not suffered;
• Recast internal messages to return to work after the massive distraction of nearly a year of speculation and uncertainty;
• Ramp down any misrule among the resident troops; and
• Reach out to recruits and applicants with whatever assurance can be mustered that adults are in charge and have their interests at heart.

As Di Sibio feels his once-shining star fade to a cinder, he may find a bit of solace in the emollient words of a niche London consultant: “The fact that this deal, as constructed, now seems unlikely to go ahead doesn’t mean that the thinking that underpinned it was wrong.” Translated from the jargon of someone angling to be hired in the future, this means, “Sorry, you blew it—perhaps another time, although not likely, and not on your watch.”

With EY facing a distinctly clouded future, the book-makers running the betting pool on the over/under date of Di Sibio’s retirement are no longer accepting wagers.

 

Reproduced with permission. Published April 13, 2023. Copyright 2023 Bloomberg Industry Group 800-372-1033. For further use please visit https://www.bloombergindustry.com/copyright-and-usage-guidelines-copyright/  

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The Endangered State of EY's Split-Up Strategy

As I am pleased to discuss today as a guest on Francine McKenna's substack, The Dig -- whether or not EY actually does split, there are big implications for capital markets and professional service providers.

 

#1 on Billboard’s Hot 100, August 1962

 

Nine months on since last May’s revelation of EY’s plans to break up its audit and consulting practices into AssureCo and NewCo, freshly reported opposition from its US leadership has thrown the entire project into disarray.

Ernst & Young has paused its plan to spin off its consulting arm, bowing to pressure from its U.S. partners to rethink how the tax practice will be divided when the firm is split into two, according to people familiar with the matter.

As I put it in August, global CEO Carmine Di Sibio’s Project Everest looks increasingly to be “a hill too steep to climb.”

Allocation of the firm’s tax practices is said to be the sticking point, with the Financial Times reporting “‘chaos’, ‘low morale’ and ‘infighting’ at the firm,” while both deal details and the necessary country-level partner voting have continued to slide. 

As fully unpicked in this weekend’s Financial Times, outstanding uncertainties include:

• Resolution as to which of the 150-plus country practices and who among the thousands of employees will participate.

• Resolving whether to cut retired partners into the expected pay-outs.

• Allocation of legal liabilities, notably for the overhanging large litigations.

• Reduced value for the mooted IPO of a newly-created consulting enterprise.

• Fundamental challenges to raise necessary capital and achieve handsomely-projected growth rates.

• Persuading both existing and prospective clients of the ability of the bifurcated businesses to be competitive for value and quality.      

Large-country partner votes have slipped from last November, reportedly to April, but with the latest news suggesting they are now delayed indefinitely. NewCo’s IPO still aspires for late this year or perhaps now into 2024.

It’s an understatement that grounds for skepticism about Project Everest persist. Irrespective, there remains a serious concern -- namely, the very stability of Big Audit itself — the franchise by which the four networks that survived the collapse of Arthur Andersen in 2002 emerged to dominate the provision of audits for the world’s largest public companies.

Whatever its outcome, succeed or fail, the very launch of Project Everest has put EY’s structure and stability in play. Either way, that presents an existential threat to Big Audit, under the inevitable degrading of EY’s capability, because the survival of the Big Audit model itself depends on the continued health of the entire quartet of providers. Its number cannot realistically be reduced below its current critical limit. 

Suppose the Proposal Fails

For whichever among the lengthy list of possible reasons, there will be an inevitable burst of snarky criticisms. There will be time enough to savor the business school case studies written about a deal conceived in weakness and bungled in execution. Rather, if the audit partners were forced to remain in hostile cohabitation with the disappointed consultants whose lofty NewCo aspirations failed to materialize, consider the state of AssureCo’s internal morale, mutuality of commitment, and operational dislocations.

Carmine Di Sibio’s days would be numbered. He and his team would be fatally wounded as leaders, and the replacement process would be immediate. At best an uneasy peace might hold, while the process unfolds.

With the deflation of their rainbow-tinged expectations, the consultants would be disgruntled. Many would be inspired to pursue smaller, achievable niche transactions, and it would be open season for poaching. (The Financial Times report that PwC has a target of up to 500 EY partners in the US reflects the atmosphere; Alvarez & Marsal has announced its appetite and has already picked up a large practice group from EY China.) 

On top of the need to massage uneasy clients, the environment in the audit practice would be fraught. The energy sucked away by Everest — at a cost reported by the FT “set to rise to about $2.5bn by completion even before banks such as Goldman Sachs and JPMorgan take their fees” — means that engagement teams would re-assume their battle stations under extended stresses of time and budget.

Audit teams would be obliged to reach out to their consulting brethren as in the past, for the ancillary expertise necessary to do complex audits. But strained relations and inefficiencies would be predictable, especially if a critical mass of consultants were primarily aiming to negotiate the best achievable departure terms.   

Recruiting would be challenged. On the massive numbers, the firm’s announced hiring spree may either simply reflect that the Big Four continue to be employers of first resort for whole battalions of entry-level cannon fodder, or cover for predicted levels of turn-over, or more ominously, a whistle past a dark and uncertain graveyard.

As for retaining both staff and targeted veterans at the partner and manager level (see Bloomberg’s Amanda Iacone on February 15),  there would be limited attraction in an offer to join or remain with an enterprise where career aspirations go to die.

Suppose the Deal Succeeds

Suppose Di Sibio does achieve his plan to lead EY’s consultants toward a promised land of unconstrained opportunities and munificent rewards. He'd take with him as many A-players as the negotiations would tolerate from among the experts in tax, valuation, cyber security, blockchain, crypto, and all else under the broad heading of Sustainability.

Future events would determine both whether optimistic sources of public or private capital will splash out to enable the much-touted paydays, and whether a newly free-standing consultancy might rocket to success as the next Accenture, or achieve mediocrity in a crowded and competitive field.

That’s a matter of indifference to the capital markets, whose concern must be for the future of AssureCo.

Left behind in that legacy practice would be a rump of tax and other resources, staffed by those either uninterested, unwilling, or uninvited to join the exodus in search of greener pastures. AssureCo as a critical player in Big Audit would find itself challenged to retain, hire, or engage from the outside the resources needed to serve its book of large-company audit clients. 

A key challenge would be the simple one of execution, which has two parts.

The first is in carrying out large-company audits, where audit teams rely of necessity on their colleagues’ ancillary expertise. Consultants at NewCo would not be eager to be re-engaged as audit support, having forsaken EY’s network structure precisely to avoid the constraints of audit. Nor would third-party providers be in ready supply — having no more appetite to limit themselves under the rules of independence and practice limitations that they presently avoid.

And while a part of the pro-split messaging has been that AssureCo would set out to rebuild, replace and grow the practices departed to NewCo, the logic breaks down. That’s because the building of any new non-audit practice would confront the same limitations that are now driving Project Everest. That is, all those who believe that a successful consulting practice is incompatible with auditors would either have exited a combined practice in the first place or would shun a re-building effort in the second.

As for additional factors affecting what must be an atmosphere of uncertainty for EY’s audit partners, there are several.

Those of a certain seniority will be weighing their readiness to hand-hold a portfolio of uneasy clients, against the personal appeal of promptly cashing out whatever incentive payments emerge from the deal and heading for the retirement door. Non-competes, lock-ups and clawback provisions would be only reluctantly enforced — the morale impact of keeping an older cohort “retired in place” would be too gloomy to contemplate.  

The legacy firm will presumably be negotiating to retain the assets and liabilities appropriate to its practice — relevant if relatively inconsequential interests in real estate, methodologies and intellectual property, together with properly identified pension commitments and funding obligations.

But under an estimated reduction in global revenue from $45 to $18 billion, AssureCo would confront its future litigation and law enforcement exposures in a seriously weakened condition. In raw terms, its on-going capital structure and liquidity would have been severely eroded in the negotiations to deconstruct the EY global balance sheet.

Nor is there any reason to think that the departing consultants might agree to a “golden good-bye” adequate to satisfy EY’s current overhang of audit-related litigation, much less to assume any responsibility for the inevitable future outbreaks. For one specific, a matter of current attention and likely contention would be EY’s captive insurance program — a “cookie jar” funded by the willingness of the partners to make sacrifices in their current earnings, and not likely to be surrendered gratuitously by those departing.    

To conclude, the 17^th century French storyteller Jean de LaFontaine put the caution against hubris and over-confidence:

“Ne pas vendre la peau de l’ours avant de l’avoir tué.”

“Don’t sell the bearskin before you’ve killed the bear.”

The Americans’ opposition will not be the end of it. The mischievous energy of disruption has been released, and will not be tamed easily or without consequences.  

 

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“Fall and Slip” -- The Uncertain Timetable of EY’s Separation

“Sell while you can – You are not for all markets”

             Rosalind to Phebe, “As You Like It” (III,v,60)

Summer holidays are ended, schools are re-opened, the seasons turn. And the waiting continues, with no end in sight, since the news in May of EY CEO Carmine Di Sibio’s plan to separate the global network’s consulting and audit practices into NewCo and AssureCo.

Project Everest’s mountain-top remains shrouded, and Di Sibio has not descended. The timetable is reported to slip through the autumn, and the list becomes longer of issues that could de-rail the project.  

“Waiting” is a culturally familiar device. Interests are focused, and tensions build. In movie Westerns the anxious town-folk wait for John Wayne and the cavalry. Theatre-goers wait for Samuel Beckett’s eponymous Godot. Investors salivate for monthly government statistics. Cult devotees await saviors or, perhaps, an apocalypse.

In mid-August I drew contrasts between the structure and organization of EY and history’s benchmark, the 2001 IPO of Accenture, newly liberated after its divorce from Arthur Andersen’s audit practice –- views that, still hostage to fortune at this writing, will eventually be tested.

This supplement looks further at some of the questions beneath the masses of numbers generated by the hordes of banker/advisors feeding at the trough of the EY project. Reactions to the relevant uncertainties will have multiple impacts: on the entire sector including EY’s competitors around the globe, and –- centrally –- for the EY partners’ career-defining decisions as they assess their professional goals and options.   

For EY partners considering a future with a NewCo consulting firm:

Without the anchor of a legacy audit practice, what are the real prospects for NewCo and the mélange of country-scale consulting practices that last year gathered in some $ 25 billion in revenue? To compete for both work and personnel, NewCo would confront not only the other Big Three and their commitment to continued full-service practices, but also the broad-service consultancies with long and well-established global brands and market presence –- Accenture itself at 2021 revenue of $ 44.5 billion, and the deep pockets of Bain, BCG, and McKinsey -– reportedly offering compensation packages for new MBAs in the US approaching $ 250,000.

For consulting partners on the fence and able to choose between the two:

Considering the fluid and evolving state of the global regulators’ views on the provision of ancillary services to audit clients, is there a preferred choice between jumping to NewCo with its uncertain future, or opting for AssureCo, where client development and service expansion may be constrained in a practice focused on that legacy firm’s book of audit clients?

To illustrate the depth of this question -- the SEC’s March 2022 proposed rule-making on greenhouse gas reporting and assurance, mired as it is in critical comments and political wrangling, still makes clear the agency’s view that the intended assurance would fall within the permissible scope of the statutory auditors. Well and good, except a sourcing question for EY: would it be an appealing career path, for a GHG expert, to accept a practice confined to the portion of the annual audits of AssureCo’s US registered clients, against the opportunities to work across the entire sector?

For audit partners who might choose a future home in AssureCo:

• How would the audit-oriented practice of AssureCo either employ or engage the diverse scope of expertise necessary to carry out the complex audits of global-scale clients?

• • These skills extend to valuation, financial instruments, sustainability of all kinds –- where practitioners may for the sake of their own career ambitions be unwilling to confine themselves within the limits of independent statutory audit.

• • Would an independent GHG expert consider it an appealing engagement to support an AssureCo audit, if obliged to demonstrate SEC-level independence and therefore be forced to foreswear sustainability consulting for that company, whether GHG or otherwise?

• How would AssureCo’s limitations in practice scope respond to the market’s evolving needs for broadened and more complex forms of assurance?

• How would it compete not only with the other Big Three firms, which remain committed to multi-disciplinary practice models, but with the new providers eager to expand especially into the world of Sustainability reporting and assurance?

In addition to the already-mooted issues of liability exposure, pension funding, and retention of experienced staff, these questions are of sleepless-night importance for the EY partners, wherever their current location in the EY global structure. 

For them, the wait must seem endless.   

 

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EY’s Project Everest – A Hill Too Steep to Climb

Guest posted this weekend on Francine McKenna's substack, The Dig -- to which, for the breadth and depth of her topics of interest and relevance, readers here are always referred and invited:

Don’t throw the past away

You might need it some rainy day

Dreams can come true again

When everything old is new again

 -- Peter Allen (1974)

The skeptical half of a half-skeptical world has been waiting for details from Carmine Di Sibio, global chief executive of EY, on Project Everest, by which he proposes to bifurcate EY’s consulting and audit practices into, respectively, NewCo and AssureCo.

Di Sibio and EY Global are advised by Goldman Sachs and JP Morgan; EY UK partners have themselves engaged bankers from Rothschilds; Lazard, Evercore and Mercer are reported to be signed on as well. Others are sure to be announced in at least the US, France and Germany.

The interests of those partner groups are far from aligned either globally or with each other, although buy-in from them all is essential for a deal with global aspirations. Arm-wrestling already under way is certain to intensify –- of which early signals are spilling into public view.   

Among other issues, comes word from the WSJ that the whole deal may be hung up on $10 billion in promised but unfunded pension payouts that could rest primarily on the shoulders of US audit partners, who would live in the much smaller entity after the split.

No surprise then, reporting from inside EY is “that the timeline for a decision on whether to proceed appeared to be slipping,” quoting an unnamed EY partner that its leadership “had ‘underestimated the amount of work required’.”

The business school case is now being written in real time: Di Sibio and his team look to be firmly in the grip of the “planning fallacy” –- simply put, as identified by Daniel Kahneman and Amos Tversky in 1977, it's the the natural human bias towards over-optimism that under-estimates the time, costs and pressures of a complex project.

The consequences can be grave, as projects on a timeline subject to slippage fall further into difficulty at each succeeding slip –- examples include the cascading delays in an airline’s flight schedule, the ten-year $ 100 million over-run of the Sydney opera house, or the multiple escalations in the futile American military effort in Vietnam.

For the nonce, Di Sibio himself projects confidence, if as yet little substance.

His model is plainly the breach between Arthur Andersen and Andersen Consulting (AA and AC), the re-branded emergence of the latter as Accenture as of January 1, 2001, and the success of its IPO that July. Tempting as the saga is for Di Sibio’s Everest-scale ambitions, comparisons suggest caution.

More than usual disclosure -- I was a member of the Arthur Andersen in-house legal group from 1982 to 2001, privileged to benefit from the firm’s unique global structure and to enjoy the profitability of its single worldwide partnership. I was there through the divorce, an outside observer of the Accenture IPO, and a retiree all-too-painfully affected by AA’s complex spin into collapse the next year.

That’s a discussion for another day and outside today’s scope. Today’s elephantine question is whether either proposed EY off-spring has the ability to be globally competitive, along with two questions that are narrower:

• How believable is it that the proposed break-up is done under pressure from the regulators?

• • Not very. The accounting regulators in the US and UK, two of EY’s largest and critically important markets, are more than pre-occupied elsewhere. There is no meaningful pressure beyond the large firms’ optics-driven and non-substantive push for “operational separation” in the UK.

• Is it credible that the EY proposal is not motivated by the pressure of litigation?

• • Nope. EY and its partners today face at least two sets of ominous litigation claims -- “bad case” exposures are in the billions, and either would threaten the viability of the EY local firm in the UK (NMC Health) or Germany (Wirecard), with implications for the cohesion of the entire global network. The existential anxiety of the erstwhile EY partners in a much-reduced, audit-focused AssureCo would be darkly mirrored by the enthusiasm of partners with the option of moving to the consulting-focused NewCo to be free of these and other legal claims and exposures.  

Post its 2000 consulting split off to Cap Gemini, EY re-grew as an aggregation of separately built and purchased practices and country entities. By comparison, Andersen’s consulting practice had grown organically since the 1950s within its integrated worldwide structure, until the firm reorganized into two separate business units in 1989. AC’s consulting partners, employees and practice delivery capabilities had ten years of globally coherent operating history by the time of the divorce, identified under a single organization and strategy.

In particular, the transparency of the Andersen worldwide profit-sharing model -- long in place, uniformly applied and agreed by all its partners -- allowed for evaluations and compensation comparisons between and among partners across all lines and borders. 

As a consequence, when the arbitration was commenced in 1997, leading to the August 7, 2000, ruling, the infrastructure was fully in place –- for better or worse, depending on individual perspective. All participants in the entire Andersen partnership knew where they fit, and how they were valued and paid. However distasteful the separation proceedings were, they served to manage –- indeed, to finesse and avoid –- questions or issues of individual loyalty, identification, or opportunity, all of which had been previously addressed.

Moreover, the arbitrator’s award in effect settled two key matters at a stroke:

• First, it set the consultants’ exit price -- $ 1.2 billion, paid by AC to AA –- eliminating any negotiating opportunity for the AA partners, or any further access to whatever value inhered in the freshly-organized consulting venture –- a value handsomely redounding to the AC partners as the new shareholders of Accenture.

• Second, it firmly lodged the issue of partner pensions, evidently the cause of some disturbance among the EY interests, directly as the separate responsibilities of the two newly-defined businesses.   

To Di Sibio, the “success bias” of Accenture as a benchmark would be both unavoidable and irresistible. Accenture’s revenues have grown in twenty years from $ 10.8 billion to $ 50.5 billion, while its initial offering price of $ 14.50, peaking last December above $ 415, still remains above $ 300. The AC partners received Accenture stock with an average post-IPO value of $ 4.8 million each, with added sweeteners in the form of accelerated distributions of pre-IPO partnership earnings and re-payment of their previously paid-in partnership capital.

The picture was of course very different on AA’s audit side. Bereft of the consultants’ revenue and profitability, Arthur Andersen spun into disintegration less than a year later –- with financial damage reaching well into seven figures across its partnership by way of lost profits, evaporated capital, and dissolved retirement expectations.

As for EY’s Project Everest today, fully 2,000 people are said to be beavering away on such questions as these:

• Who goes to NewCo?
• Who stays at AssureCo?
• What are the incentives?
• What about the outside alternatives?
• Who has the scope, the wisdom, and the power to make and enforce decisions that will persuade and secure the votes of individual partners in separate local firms that span 150 countries, whose career-shaping decisions will have personal impacts measured in the millions?

Centrally, what ownership or benefits if any can partners in AssureCo have in NewCo, either before or after an IPO? Considering the accountants’ rules and constraints on independence, the apparent answer is “none.” What price then makes it worthwhile for EY’s audit partners to remain housed in AssureCo, an enterprise reduced in capabilities and capital resources, with global revenue shrunk from $ 40 to perhaps $ 18 billion? Do the partners have the strength and the savvy to pull together, negotiate, and then to vote to accept another break?

The culmination of the Andersen break-up was consequential for both sets of its partners: for those in the Accenture family, a major leap in immediate personal wealth -- for those left in the legacy practice, a wounded organization, a damaged ethos, and a rapid decline into collapse.

For the EY partners now facing their choices, the question of “what to wish for” must loom large, while the longer the process takes, the less likely its achievement. To outside observers, the plausible outcomes of Project Everest include either a break-down and failure of the entire deal, for reasons including those sketched here, or a globally patchy and uneven transaction that pleases nobody -- either of which would risk an unfortunate further weakening of the entire Big Four model itself. 

 

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Bubble-Wrap Around Sealed Air's Auditor Change -- Punctured by the SEC's Blunt Tool

It's a pleasure to be a guest again at Bloomberg Tax, which on August 25 published my views on this topic, reproduced here with Bloomberg's kind permission:

It’s not disputed. Sealed Air Corporation’s replacement of KPMG with EY for its 2015 audit was corrupt.

The Securities and Exchange Commission so found. In proceedings dated Aug. 2, 2021 (here and here), the agency barred from practice and fined William Stiehl, the company CFO at the heart of the scheme, censured and fined EY $10 million, and imposed fines and practice bars on three of its partners (Paragraph 2):

“EY solicited and obtained from (Stiehl) competitive bid and other confidential documents and information on multiple occasions in an effort to secure the audit engagement.”

Alert to readers: This is not to question whether a selection of professional advisors should be tainted by the abuse of company confidences. It shouldn’t. This is not to defend or condone the conduct involved.

Instead, it is puzzling why the SEC should invoke its creaky, inefficient, and unpredictable rules for auditor independence (Paragraph 3):

“the manner in which EY obtained the engagement would cause a reasonable investor to conclude that EY was not capable of exercising objectivity and impartiality upon becoming (Sealed Air’s) independent auditor….”

The SEC approach was characterized as “weird” by a Bloomberg News columnist on Aug. 3, as he explored the unexceptional notion that auditors share common ground with lawyers, bankers, and other consultants:

“the actual service that these firms provide is basically ‘wise trusted advice,’ and to provide that service you really do need some relationship of personal trust.”

The columnist rightly notes that by opining on their clients’ financial statements, auditors bear a differentiating obligation from other advisors to public companies. Two observations address his perplexity:

First, consistency should matter. Both the misled but honest senior executives and directors of Sealed Air, and later the SEC alike, would have been no less insulted by a selection of lawyers, bankers, underwriters, or other advisors if perverted in the same way.

Second, which follows, the SEC had an available enforcement tool of broad and consistent application. Under its Rule of Practice 102(e)(1)(ii), it has authority to sanction any person in SEC practice, found “to be lacking in character or integrity or to have engaged in unethical or improper professional conduct.”

Full stop. Proceedings under that provision would lie, with analytic consistency, against professionals of any stripe. Putting them all on notice would spike whatever “weirdness” the columnist may find in Sealed Air.

On the flip side, the SEC’s lumbering invocation of the next provision of Rule 102)(e)—subsection (1)(iii)—goes astray, in its assumption that investors gave any importance to the Stiehl/EY machinations. Investor indifference to auditor performance in general is long-standing; the torpor is disturbed only if an outbreak of malfeasance is grave enough to animate the cry, “Where were the auditors?”

Which was not this case. On June 20, 2019, the company’s Form 8-K publicly announced Stiehl’s termination for cause, “relating to the process by which the company selected its independent audit firm for the period beginning with fiscal year 2015, and relating to the independence of that audit firm.”

So informed, the market reaction that day was a modest share price decline, from $43.67 to $41.70—just under $2 per share and less than 5% —on about four times typical volume.

Even that reaction was fleeting. By July 1—seven trading days later—the share price had recovered to $43.61—above which it stayed—while trading volume retreated to prior levels.

Put bluntly—the investor community, to whose interests the SEC is purportedly devoted, took a look for itself at the auditor environment at Sealed Air, yawned wearily, and returned to business as usual.

History provides another example—the Ventas affair of 2016. There, the SEC defined and applied the scope of Rule 102 to a “close personal and romantic relationship” between an audit partner and his client’s CFO—although, as discussed here, a senior agency official’s contemporaneous speech expressed the SEC’s lack of any appetite for rule-making to provide “bright lines and explicit guidance.”

As in Sealed Air, investor indifference to the audit turmoil at Ventas was reflected in its stock price: In the three-month period between the withdrawal of the incumbent auditor and the filing of an amended Form 10-K with the successor’s opinion, the company’s stock price increased by 3%.

In my youth, growing up in an agricultural village, I was schooled by mentors such as my grandfathers—a farmer and a country dentist—that a proper job requires the proper tools. For the SEC to deploy the elusive “principles” of independence in aid of its unhappiness is like weeding a field with a snow shovel, or using a spoon as a toothbrush—it could be tried, but the result would be sub-optimal in both theory and result.

It’s for fuller inquiry another time that the independence principles and rules for auditors—and their ill-formed and unloved offspring, the limitations on scope of practice for audit clients—have outlived whatever value they might once have had. Independence has no demonstrable upside; since the delivery by William Welch Deloitte of the first modern auditor’s opinion in February 1850, no companies, investors, or other sources of capital have aggrandized an auditor as an exemplar in observing the independence rules.

To the contrary, the elaborate machinery by which the “appearance of independence” is applied, regulated, and defended, becomes visible only with negative impact, in the inevitable and unpleasant handful of cases found non-compliant with hindsight.

Corporate reporting is under pressure to expand disclosures under the rubrics of environmental, social, and governance—lately extended to diversity, equity, and inclusion. Auditors will require expanded and diversified skills to offer meaningful and informative assurance. For which, the constraining influence of an archaic and obsolete independence structure is out of place at best.

In that context, the SEC’s awkward and unnecessary approach in the Sealed Air case is unfortunate.

 

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COVID-19: Florida’s Inexcusable Fiasco Goes National

 “There are no words” is not a default available to those presuming to take a public platform. Today, though, I struggle to express my anger and dismay over an experience with the corona virus – one that both strikes close to home and exposes the multiple consequences of the cascading failures of our country’s office-holders.

It falls specifically on Florida governor Ron DeSantis – incited as he has been by the abject failings of the bunkered White House, whose occupant from the emergence of the pandemic has confirmed on a near-daily basis his apt if vulgar characterization in July 2017 by then Secretary of State Rex Tillerson as a “f***ing moron.”    

It’s about an elderly friend in Chicago – a woman both indomitable in her fortitude and among the world’s most caring, sensitive and empathetic – always accessible, wise and perceptive with friends, clients and all who know and love her.

While bravely bearing a lifetime of severely compromised immunity, this gentle soul undertook in early June to fly to Florida. She was generously motivated by the desire to give care and support to an even-older relative. Regrettably too, she was credulously enticed by the attitude and messaging of DeSantis.

By then the consequences had long been evident of the blinkered failure of the Trump administration to appreciate the intelligence widely available – the literally vital necessity to stock up, close down, and take seriously the certain aggression of a novel virus that cared not the slightest for the disrespect and denial shown by the comprehensively ignorant. It was unleashed and spreading, to be affected only by drastic measures with social and economic consequences unknown to modern societies.

Sadly, she bought the governor’s blind-eyed optimism. Despite compelling evidence in the data and the science, DeSantis – along with his minions and enablers in Florida and his cretinous coevals in other states -- had resolutely opposed and resisted calls to close churches, parks and beaches. His wildly premature phase 1 re-opening in late April covered indoor dining, and his June 5 phase 2 extended to bars, theaters, and most retail.

For all of which, as wryly put by the Los Angeles Times, where that state too “for a brief moment … returned to bars, beaches and botox,” the still-developing extent of DeSantis’s tragic recklessness has been thoroughly validated as ill informed and deadly in its consequences.

So it falls on DeSantis, that my friend in all her innocent misapprehension spent three weeks in Florida within the scope of his misbegotten policies – nurturing her relative, and in close social contact with his community of the aged including a now highly suspect birthday celebration.

From which, there is this horrific added complication: My friend was robust and asymptomatic as she left to return to Chicago – taking a flight last Saturday evening. The next day she was immediately overcome with classic indications of COVID-19. Promptly hospitalized and tested positive, she is as I write released and isolating at home with her quarantining spouse – feeble, depleted, and barely able to speak.

At this point -- like the many other states that were too late to close and far too hasty to open, and which as of July 6 will be subject to the emergency order announced by Chicago’s mayor Lori Lightfoot that imposes fourteen-day quarantine requirements on travelers to our city -- Florida is over-whelmed. Under the incompetence of the DeSantis administration, there is no chance of tracing the source of my friend’s infection, or calculating the extent of its spread among the groups of at-risk elderly with whom she shared contact – not to mention the likelihood that she herself could have been a virulently infectious spreader on her airplane and in the airports she traversed.

Up to this week I had already been managing proximity with three early-stage cases – a college student, a millennial of world-class athletic stature, and a previously robust, marathon-qualified Gen-Xer whose very survival was at risk and who likely confronts long-lasting adverse pulmonary effects. These suffice to confirm that the virus has no respect for age or politics, or for the wishful thinkers or the deniers who would cry “hoax” or wish that it should miraculously “disappear.” They are instead enough to raise my anger level that even these cases could have been mitigated by competent policy-makers prepared to respect the intelligence and pay attention accordingly.

With that, what additional reaction is possible now, to the multiple threats in my beloved friend’s situation, both to herself and to all those to whom she was exposed due to the compounding negligence of DeSantis and his fellows? Frustration and outrage are insufficient, that she and others are sacrifices to the ignorant political optics of elected officials and their devotees.

Last night I made a no-contact delivery of a get-well card and a bouquet of flowers. That -- along with my heartfelt wishes for her recovery and this telling of her story, which I invite you to share – is what I can do, for my friend and for us all.

Because nobody who has bought into the hoax and conspiracy theories will have stayed to read this far, I need not advocate for changes of views; if there is a message to the sympathetic from this pulpit it would be one of simple encouragement:

Pay attention – be cautious – keep distances – keep wearing your masks. Brave people are putting their lives on the line for us. Respecting them and each other is the least we can do.  

 

 

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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Open Letter to EY’s Mark Weinberger: Do the Right Thing – Resign

I’ve just sent this letter to Mark Weinberger, the global Chairman and CEO of EY – third largest of the Big Four international accounting networks – and a member of President Trump’s Strategic and Advisory Council.

Dear Mark –

Somewhat uncertainly attributed to Winston Churchill, on the belated shift in US policy to support Britain in advance of the outbreak of World War II, is the sentiment that, “the Americans will always do the right thing, after exhausting all the alternatives.”

President Trump, in his unhinged press conference earlier today, put on enough spin to nauseate a dervish in re-doubling his repugnant position of Saturday that “many sides” were to blame for the murderous racially-motivated violence in Charlottesville the day before. In doing so, he just handed you the perfect second chance to do what you should already have done – resign from his Strategic and Advisory Council.[1]

Your anodyne tweet of yesterday (@Mark_Weinberger), that it is “time for business leaders and government to unite to help ensure we become stronger through our differences” no longer will wash. Having inherited both his money and his bigotry from his father Fred, and going to school on the ethics and tactics of that epitome of corruption, Roy Cohn, Donald Trump is not about to tolerate your unifying aspirations, however nobly intended.

You’ve known his character for years. Ernst & Young in 2004 qualified its opinion on the financial statements of Trump Hotels & Casino Resorts Inc., for its “substantial doubt about the company’s ability to continue as a going concern.” As your lawyers will tell you, the likelihood of recidivism for a huckster and a charlatan is essentially 100%.

That is today no more plainly displayed than in the reported absence of “self-discipline, control and personal honesty” in Trump’s golf game. Give credence to the observation of P.G. Wodehouse, that “to find a man’s true character, play golf with him” – as applied to the description of Trump’s game by former ESPN columnist Rick Reilly: “This guy cheats from start to finish…It was just one free mulligan after another.”

It should be a no-brainer. Not only do you have ample cover – at this writing there are already five other departures, led by Merck CEO Ken Frazier's departure from the President's American Manufacturing Council.

Moreover, you’re practically immune from any threat of blowback from the bloviator-in-chief, because you and your Big Four colleagues have a lock on the world’s large-company market. That presents you all with other very grave concerns (for which, see my recently-published book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms.”) But the legal requirement for public-company audits means your collective client base has nowhere else to go.

The call for you to act first went up yesterday – Caleb Newquist at his Going Concern clipped your own words, “We have to back up our rhetoric with action.”

Not all will agree, of course – but Newquist with his massive readership among the youngsters of the profession has his finger on its pulse – and you would be wise to give heed.

If you expect credibility with your young workforce, who drive your firm’s prosperity today and will one day inherit your mantle of leadership, then “back up your rhetoric.” The legacy for which you will be remembered will be marked by your behavior in response to the unacceptable dog-whistling now shrilling out of the White House.

Respectfully yours –

Jim Peterson

[1] Corrects earlier version which mistakenly referred to the American Manufacturing Council.

 

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The EY/Ventas Affair – In the End, Who Really Got Bonked?

“When I married an accountant, I always thought his eyes would go first.”

            -- Same Time Next Year (1975)

In the poignant Broadway play and later film, romance originating on an audit engagement could include a touching laugh line.

Less so today -- see the penalties for what the SEC’s enforcement release of September 19, 2016, delicately called the “close personal and romantic relationship” between the chief financial officer of Ventas, Inc., the Chicago-based REIT, and an audit partner on the team at Ernst & Young LLP.

Both were sacked in July 2014 when their affair became public. EY’s opinions for the two prior years were withdrawn, and it was replaced by KPMG. The recent order now censures EY, requires disgorgement of $3.2 million in fees plus interest, and adds a civil penalty of $ 1 million. The package of sanctions also includes fines of $ 25,000 each and SEC practice bans on the CFO (one year) and the EY partner (three years), with a similar ban on her superior to boot.

Time to revisit what I wrote back in 2014 – here.

First, as I predicted, the PCAOB’s then long-running project -- Docket # 029 -- at long last resulted in rules to name the lead partner, ultimately effective in May 2016. Under an awkward process satisfactory to nobody, those so inclined may now comb for the new Form AP, to obtain information of no discernible value or consequence.

A brief quibble: the EY partner involved did not lead its engagement for 2012 or 2013, so would not have been identified had the PCAOB’s rules then been in place. This annoyingly trivial regulation is not only unappealing under justifiable libertarian hostility. To the contrary, believing in the salutary role of government policies if effectively designed (see my review of the late Tony Judt’s achingly passionate 2010 book, Ill Fares the Land), I find all too depressing the ill-considered distractions of agency actions passed off under the guise of progress along with their unintended and frequently malign consequences.

Second, the Ventas action is companion to a second SEC enforcement release of the same day, under which EY and its personnel are also penalized for lack of independence – in this case based on “an inappropriate close personal relationship” between an EY partner and the client CFO – the former having generously plied the latter with “frequent social trips, gifts, and overnight out-of-town trips” along with shared family vacation trips and mutual visits.

Other commentators have risen to charge the SEC with an opaque failure of guidance on the independence impact of these personal auditor/client relations -- Matt Levine at Bloomberg and Caleb Newquist’s Going Concern; see also Tammy Whitehouse at Compliance Week and Francine McKenna at Marketwatch – beyond the high-level language of SEC Rule 2-01(b) under Regulation S-X as to what a “reasonable investor…would conclude.…”

In this area on which the SEC’s examples are silent (see Rule 2-01(c)), its senior associate chief accountant recently bailed out on an opportunity to clarify. Speaking before the American Law Institute conference on September 22, 2016, he disavowed any “appetite” for rulemaking, instead observing that, “I don’t think this is an area where you can really come up with bright lines and explicit guidance.”

Response to this default would well be that a government agency responsible to enforce rules it is unable to articulate is hardly in a position later to criticize those left in the dark, or to argue failure to comply.

Instead, the gist of the SEC’s message is that, “although we have no detailed rules, you did violate them -- so we censure and penalize you $ 9.3 million and ban your partners from practice.”

There is, however, another way to clear the SEC’s fog of uncertainty – by noting forthrightly the investor community’s clear indifference to the entire Ventas affair, including a lack of concern with bedrooms as compared with board rooms or audit rooms.

That is, between EY’s withdrawal of its opinions in July 2014 and the September 4 filing of the company’s amended 10-K with a fresh opinion by successor KPMG – in other words, while the company lacked audited financial statements – the company’s stock price actually increased by 3 %. And, flipping to the period that followed, after KPMG’s opinion became available to relieve any investor anxiety about the company’s non-compliant status, its stock price went into a brief but sharp decline, not recovering its early September price until October 17.

In brief – no stock price punishment for the absence of an independent auditor, nor any reward for re-achieving a state of virtue either. QED, the complex of rules regarding “auditor independence” is delivering nothing on which investors place value. As I put it in 2014:

The entire anachronistic edifice of “appearance of independence” rests on shifting and unstable sands, and deserves to be washed away with the tides of modernized assurance performance.

Until that day should arrive, these proceedings display once more the illusion of effective agency behavior – the infliction of penalties with only the most general guidance to the affected issuers and auditors, who are left to fulfill their compliance obligations even while forced to pretend that their regulators are offering something helpful.

 

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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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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?”  

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free, both on the Main page. And “Count Down” is available for pre-publication order, directly at the Emerald Bookstore or through Amazon.

 

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

 

 

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

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

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

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

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

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

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

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

• Difficult relations with regulators and oversight agencies.

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

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

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

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

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

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

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

     From Emerald Books

     From Amazon

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