Re:Balance -- Jim Peterson

KPMG’s Family Planning – Good Luck!

Last week I was pleased to guest-post on The Dig, Francine McKenna's Substack. For those who missed it there:

On March 10, 2025, Stephen Foley reported in the Financial Times that “KPMG is aiming to slash the number of ‘economic units’ that make up the international network to as few as 32 by next year, from more than 100 two years ago…”

A reader’s comment quickly followed:

“Consolidating audit entities across jurisdictions? That worked brilliantly for Arthur Andersen – right up until it didn’t.”

Because little enough is known, much less understood, about the organizational genius that made Andersen the profitability leader and structural envy of the profession for the last quarter of the 20^th century, the reader’s intent was presumably sarcastic.

And wrong. From one who was there – if intended as snark, the comment is unironically correct. Each of its two parts requires scrutiny in assessing what KPMG is up to.

If Andersen could not survive Enron, despite being the most cohesive and profitable of the large firms, what are the prospects for KPMG’s aspirations?

Some background will help.

In the early 1980s I moved from private law practice to join the Andersen organization, in its newly formed in-house counsel group. It was my privilege to be a partner in the Andersen Worldwide Organization until my retirement in 2001 – fortuitously enough, just months before the pervasive misfeasance at Enron triggered Andersen’s rapid disintegration.

As Andersen was collapsing, a fellow member of Big Audit’s in-house legal fraternity gave a more nuanced version of the FT reader’s comment, in a combination of jealousy and schadenfreude:

“The Andersen global structure was brilliantly designed for success; unfortunately it was also ill-suited to manage failure.”

In the mid-1970s, as it was extending its global footprint, Andersen with the assistance of a Washington-based international lawyer (RIP 2024), had adopted its unique global structure. At its core was an obscure form of legal entity peculiar to Swiss law - a Swiss “Société Cooperative” or S.C. for short - which provided that while country-level firms retained their separate legal forms and identities to comply with local laws and regulations, they along with individual country personnel – both accountants as well as consultants and others like myself – joined and made up its partnership.   

The ownership flexibility of an entity that was not an accounting firm, supported by internal accounting and book-keeping of eye-watering complexity, made it possible to capture costs at the global level for aggregation and re-allocation, so as effectively to enable true profit sharing among the worldwide partners.

Put more simply – unlike the approaches of the other firms, then and since – the financial fortunes of every entity in the Andersen organization had a direct impact on my compensation, for better or worse. It was to my benefit as a worldwide partner, housed in the headquarters function and with a world-wide remit, if the French practice had a boom year; if Italy or Mexico slumped, I felt it; if Brazil required global support through a rough patch, it came out of my pocket.  

It can be inferred from the FT’s reporting that at least for the moment, KPMG has a lower level of ambitions:

“KPMG is also insisting that, in any mergers, the profit pools for partners be at least partially shared across the countries involved, with the aim of moving to full profit-sharing over time…”

Or not. Let it be clear – without common commitments of financial skin in the game, it’s at best only a “merger” for optics and a level of administration. Andersen not only required world-class treasury and information management, across countries with dramatically different economic business models and costs of living and working. It was required to solve the logistics and the politics of multi-national engagement referral and performance, while achieving broad and acknowledged fairness in partner compensation, employee salaries, practice opportunities and career development.

With the incentive to cooperation created by common financial interests, referred work was not begrudged, but was recognized for the common good; training and quality initiatives were for shared purposes; personnel secondments strengthened both sides of a transfer. Democratizing and leveling followed from shared information – locally maintained fiefdoms and cookie jars were exposed, and closet doors were pried open to reveal long-concealed skeletons.  

Andersen was in funds for investment, in part but not entirely with the stunning profitability of its consulting practice, which acted to blunt the edge of the other challenges. That is, by definition, half of Andersen’s practices would in any year have earnings below the global average – but with earnings booming along, time and mutual support would give room and resources to turn the fortunes of a country needing support.

And with complete information sharing about both the financial results of the country practices and the individual ownership units allocated to the partners under a plan disclosed to and voted for approval by all the global partners, potential squabbles were swept up in the celebration of shared success.               

These were all achieved not only with the stunning quality of the people at the heart of its infra-structure, but because of shared commitments in the form of trust, transparency, patience, and a level of profitability that fueled an operation like no other.

“Until it didn’t.”

It was crucial at Andersen to centralize both the costs and the culture of practice quality, ethics and independence, and compliance including related insurance, litigation and law enforcement. The Andersen/Enron debacle provided the proof – when its leadership allowed a local office to sideline and evade centrally-provided expertise, the integrity of its once-robust and complex tapestry was revealed as frayed and tattered beyond repair.    

“Until it didn’t.” The FT comment is right – and rightly fingers the skunk at KPMG’s party. Which is, even if achieved with real profit sharing (as may be but is not disclosed), the KPMG “mergers” will have embedded at least two fatal flaws.

The first is the questionable extent to which firms with dominant profitability will sacrifice to sustain their brethren. The growth orientation in the years of Andersen’s expansion lasted only to the turn of the millennium, and the recent signals are to the contrary – the trust-busted Accenture divorce, the failure of EY’s Project Everest, and the arrival of third-party equity capital with the questionable alignment of its strategic objectives for the mid-tier firms.

The second is the unsolvable weakness that was fatal to Andersen - as emerged with the corrosive and ultimately fatal consequences to its accounting practice of the divorce with the practice that became Accenture – namely that there is nothing in the strongest contractual commitments or optimistic year-on-year results that will sustain a global network under the imposition by a legal system of a multi-billion dollar litigation or law enforcement impact.

Even though uniquely cohesive and the envy of its fellows, Andersen blew apart in weeks in the tempest of Enron, as its separate national practices disavowed their contractual obligations, voted their local interests, and left the US firm alone, isolated, and financially bereft.

Lest I be charged with misleading by incompleteness, brief mention here of what I hope is the diminishing myth that Andersen was killed by the Justice Department’s indictment over the destruction of documents in its Houston office. As laid out at pages 56-60 of my book, Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms (Emerald Books 2d ed. 2017), the large firms are not organized nor do they have the financial resources to withstand claims from misfeasance on the order of Enron’s $67 billion bankruptcy. Andersen was like a terminal patient on life support in an ICU. Its demise was inevitable – DOJ was just the nurse that pulled the plug.

This is neither a prediction nor a voice of doom. KPMG deserves credit and respect for its aspirations, and may indeed make it happen. Andersen’s run of success, after all, extended across a generation.

There is however a corollary to movie mogul Sam Goldwyn’s attributed view that an oral contract is not worth the paper it’s printed on.

Which is that under stress, neither are the written versions.    

 

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Silicon Valley Bank -- When a "Standard" is not a Standard

Guest-posted on April 19, with pleasure, on Francine McKenna's sub-stack, The Dig:

KPMG, auditor for failed Silicon Valley Bank, has been included as a defendant in a securities fraud case filed April 7 in the federal court in San Francisco — along with directors and officers of the bank and its underwriters Goldman Sachs, Bank of America and Morgan Stanley.

It won’t be the last. SVB failed back on March 10, and the only surprise is that it took so long.  

KPMG’s clean audit opinion on SVB’s 2022 financial statements was delivered February 24, three weeks before the bank’s closure by the California Department of Financial Protection and its takeover by the FDIC as receiver. The firm and the other defendants are charged with misrepresenting SVB’s balance sheet, liquidity and position in the market and by understating and concealing the magnitude of the risks it faced.

The plaintiffs, led by the City of Hialeah Employees Retirement System, claim that auditor KPMG did not qualify its opinion for doubts as to the bank’s ability to continue as a going concern, and did not identify as a “critical audit matter” the impact that rising interest rates could have on the unrealized losses on the bank’s bond holdings and its ability to hold those bonds through what was the potential, and eventually destructive, flight of customer deposits.  

If it feels like a somewhat geeky sequel to a movie we’ve all seen before, it should.

The comparison has long been available that — just as professors of literature teach that there are a small number of great plots that have been revised and recycled through the history of Western culture — so too the inevitable periodic outbursts of financial malfeasance come in cycles with a handful of recurring themes.

A partial list of examples — paired up so that by squinting and some flexibility, parallels may be drawn:

A hero comes to save the people from a monstrous threat: David v. Goliath, Rashomon and The Magnificent Seven, Jaws, Blazing Saddles 

Schemers loot the savings of the credulous: Charles Ponzi, Bernie Madoff, Elizabeth Holmes, Sam Bankman-Fried

The comic effects of mistaken identities: Plautus’s Menaechmi, Shakespeare’s Comedy of Errors, Oscar Wilde’s The Importance of Being Ernest 

Assurance providers fail to properly “count the stuff”: The mis-weighed beans in the 1920s, Tino DeAngelis’s fictive tanks of vegetable oil in the 1960s, the € 1.9 billion found in 2020 not to exist at Wirecard

Inter-generational conflict: The House of Atreus in both Greek myth and the plays of Aeschylus, Shakespeare’s Henriad and also King Lear and his fractious daughters, Coppola’s Godfather trilogy, today’s Succession

Accounting principles tortured into misapplication: the netting of accounts at Continental Vending, the Arctic oil leases held by Investors Overseas Services, the special-purpose entities at Enron, the long-term contracts at Carillion

Over the centuries, the rocky course of young love: Hero and Leander, Romeo and Juliet, the romantic mis-adventures of Emily in Paris

The devastating effect of mis-matched interest rates in the strategies of financial institutions, going back to the American savings & loans of the 1980s and the sub-prime mortgage portfolios of 2007-2008, and now erupted at, among others, KPMG clients SVB and Signature Bank

It is, of course, no less predictable that fresh outbursts of financial chicanery will re-trigger the usual reactions, just as authors, playwrights and scriptwriters will reprise the classic themes:

• Hand-wringing accompanies the cry, repetitive but hollow, “Where were the auditors?”
• Regulators and oversight agencies spring into action.
• Lawyers for investors sprint to the courthouse, lawsuits in hand.
• Academics and other commentators get attention from the business media, while jostling to be engaged by plaintiffs as well-paid “experts.” 
• Renewed rounds of recrimination, blame-mongering and futile attempts to alter human behavior capture public attention but only briefly and with minimal effect.

If this sounds like a tragicomedy, it’s not as if we haven’t seen this show before. Rather, if the implications of “same old, same old” are so obvious, why haven't we learned from the past?

One place to look for an answer is the hindsight perspective of the critics. Pinning it on the expectation of a “going concern” warning is futile. Good guidance for practitioners has been an intractably elusive challenge for standard-setters for decades. Such an opinion qualification is a “nuclear option” that auditors are passionate to avoid because the company may immediately be in breach of loan covenants. Or worse, for lack of a plan to recover, the qualified opinion becomes a self-fulfilling prophecy.

As for CAMs —and their analogs elsewhere in the world where “key” is substituted, thus KAMs — their availability and use have been gradually creeping into practice since introduced via the International Auditing Standards in 2016 and imposed by PCAOB requirements with application starting in 2019.

Wider use, however, has not made C[K]AMs more illuminating, reliable or demonstrably useful to information users. The limited available scholarship on their ability to signal future issues is no better than mixed, since there's no good research proving up the questionable hypothesis that investors actually pay attention to CAMs or make real-world decisions based on their inclusion in corporate disclosures. And there is at least anecdotal evidence that, in fact, they do not. That includes instances where fresh inclusion of a CAM or KAM was met with the typical indifference of investors and negligible effect on the reporting company’s share price. 

Reporting in the Wall Street Journal is provocative with regard to the prospects for the SVB litigation, and whether it will be persuasively argued that KPMG’s professional judgments deviated so far from acceptable practices as to sustain a successful claim for the plaintiffs.

WSJ reporter Jean Eaglesham writes that, on the one hand (emphasis added):

“Auditors for nine other U.S. banks most exposed to bond losses also didn’t flag this as an issue…"

“The Journal reviewed the audit opinions for the 10 small to midsize U.S. banks that last year reported the highest losses on held-to-maturity securities as a proportion of their shareholder equity… Silicon Valley Bank ranked second on the list."

“None of the auditors included a critical audit matter related to the bank’s treatment of the bonds. Instead, nine of the 10 reported a critical audit matter for estimated losses from loans or other bad debts.”

And, on the other hand:

“Silicon Valley Bank’s unrealized losses in its bond portfolio appear to ‘meet every definition of a possible critical audit matter,’ said Martin Baumann, a former chief auditor at the PCAOB who had a leading role in designing the new measure.”

And further:

“That appears to tick all the boxes for the auditor to highlight this issue as a critical audit matter. ‘The judgment as to whether or not Silicon Valley Bank had the ability to hold these securities to maturity was certainly a complex question, it was material to investors, and it is hard to see how liquidity was not a matter for discussion with the audit committee,’ said Mr. Baumann, who is also a former senior partner at Big Four audit firm PricewaterhouseCoopers.”

In a world where standards are well-designed and dependably applied, and where liability is imposed in a way that can be perceived as both predictable and fair, the two positions — disclosure decisions of the various auditors for group of small banks, and the attribution of liability to KPMG — cannot be reconciled. They cannot credibly co-exist.

That is, after years of disrespect for the audit profession’s attempts to improve the discipline in their processes, the distasteful choice is between elevating “box ticking” by hindsight to the status of a threshold for liability (insert sarcasm emoji here), or finding that the bar for liability has sunk so low that it requires a serious evaluation and re-set.   

That's not to say, at this point at least, that KPMG’s audit performance will be assessed as above reproach. We shall see as the litigation runs its course.

But in that context, it bears noting that back in a happier era before the hijacking of audit standard-setting by regulators under the pernicious influence of the Sarbanes/Oxley law of 2002, the term “generally accepted” had its literal meaning. That is, actual application of standards was observed in practice, tested for usefulness and practicality, and adjusted incrementally; opportunities for evolution and improvements could be taken without the querulous intrusion of censorious bureaucrats.

All changed, and not for the better. If the harshest allegations now brought forward are based on KPMG’s good-faith judgments to omit either a CAM or a going concern opinion paragraph, then — to borrow a metaphor from the world of the theater in that nostalgic time — the plot is so thin that this production should close in out-of-town previews.

 

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Dispatch from the UK: KPMG Settles Carillion –- Whiners Are Not Happy

Guest posted today on Francine McKenna's Substack, The Dig -- a pleasure as always.

 

KPMG has settled the £ 1.3 bn claim brought against it by the liquidators of its client Carillion, the UK outsourcing behemoth whose spectacular collapse in January 2018 triggered an outpouring of the too-familiar criticism, “Where were the auditors?”

Five years on, the entire sorry story is playing yet again to the same tired script.

When the long-anticipated claim was officially commenced, in February 2022, the reaction from KPMG’s leadership was the usual attempted bravado and blame-shifting:  

“We believe this claim is without merit and we will robustly defend the case. Responsibility for the failure of Carillion lies solely with the company’s board and management, who set the strategy and ran the business.”

Now has followed the latest and fully predictable statement of capitulation, from UK CEO John Holt on February 13, 2023 --- which could have been drafted in 2018 and sealed in an envelope marked “Open when needed”: 

“I am pleased that we have been able to resolve this claim. Carillion was an extreme and serious corporate failure, and it is important that we all learn the lessons from its collapse.”     

For want of Mr. Holt’s specification of those “lessons,” let us ask what has been learned –- if anything?

To start, what is not disclosed for the public’s learning is the amount of KPMG’s exit price –- the UK firm using the frequent American tactic of costuming its settlement in a shroud of confidentiality (see the trustees’ claims against KPMG in New Century and against Deloitte in Taylor Bean & Whitaker, and MF Global / PwC).    

Next, depressingly, although there are surely specific lessons available from Carillion about improvements in the technical and complicated reporting, accounting and assurance for large, long-term contracts, none have emerged to inform investors and the capital markets. Not least, that is because the accounting profession has never developed a common forum or other means by which such catastrophes can be put to expert analysis, to be shared for the benefit of all concerned, as is widely done across the business spectrum -- e.g., in aviation safety, structural engineering, medical care, and manufacturing processes.  

One thing we do learn is that the expedient Mr. Holt has reduced by one the number of pending litigation threats against the Big Four that, at their worst, are large enough to be life-threatening. That population now includes, at least, Wirecard in Germany and NMC Health in the UK for EY, and for PwC, Evergrande in China and Americanas in Brazil.

With that small comfort, we also are reminded –- not having needed to learn -– that despite the massive volumes of perfervid critical rhetoric, nothing has been done over the last five years to have any substantive impact on the actual operation of Big Audit, the model by which the Big Four audit all but one of the FTSE 100 and 87% of the FTSE 250.

What has been learned instead is that across the entire body of players, there is a complete lack of will to alter the model:

• The large firms themselves display no discomfort with the current structure of their franchise –- their single gesture having been ready agreement to “operational separation” -- the optically appealing if substantively negligible evolution of expanded disclosure of the organizational and operating distance between their assurance and consulting practices.

• The comprehensive and insightful report and recommendations of Sir Donald Brydon’s “Independent Review into the Quality and Effectiveness of Audit” (December 2019), which recognized the necessity of evolving the assurance model and the qualifications of its professionals, failed to achieve any traction but instead sank without a trace.

• The Financial Reporting Council as the UK’s audit regulator has been shifting its furniture around within what Sir John Kingman described in his December 2018 “Independent Review of the Financial Reporting Council” as its “ramshackle house.” But the prospects that Parliament will actually legislate to re-name and re-configure the FRC as a new Audit, Reporting and Governance Authority –- dead-on-arrival through the years of Boris Johnson and the weeks of Liz Truss –- show no signs of life in the early but distracted and pre-occupied government of Rishi Sunak. Meanwhile as long mooted, Jon Thompson, the FRC’s leader through these fallow years, has chosen to swap one poisoned chalice for another by taking the chair at troubled rail link HS2.

None of this has stopped the whiners, whose petulant voices are heard yet again:

• Annop Rehal of the Haines Watts audit firm (14^th in the UK table -- at £ 105 m in revenue, approximately 2% the size of leaders PwC and Deloitte): the “issue of negligence at the top of the market (is) caused by the lack of ‘real competitors to challenge them’.”

• Gavin Hayes of the Chartered Institute for Internal Auditors: “there is no doubt that there are fundamental issues around a lack of competition in the market.”

For this topic, what has not been learned, or at least is not acknowledged, is the sterility of the discussion on auditor choice and competition, as the advocates for enforced re-structuring of the Big Four’s market dominance have yet to face the reality that the smaller firms lack the capacity, scope of expertise, and risk tolerance to make achievable any such aspirations.

Instead, the complexity of large-company audit and the required range of skills and global presence defy the challenge to carve out for the small firms a portion of such engagements –- either by line of business or by geography, and whether on their own or by forced job-sharing. No assemblage of the firms below the Big Four, singly or in the aggregate, has the necessary capability:

• Performance evaluations by the regulator, and the mix of investigative and enforcement actions involving the smaller UK firms, both caution the prospect of degraded audit quality, should actions be taken to force those firms upon the FTSE-indexed environment.

• A significant reminder regarding audit quality, if needed, is that the case has never been seriously advanced –- much less established –- that “smaller is better.” To the contrary, flares of financial and corporate misfeasance are reported around the globe, all involving the smaller firms: the crypto fiasco of FTX, the Gupta companies in the UK, Lex Greensill’s far-flung structure of companies, and the Adani group in India.

Neither the accounting profession itself nor its hand-wringing critics are heard to advance the difficult if realistic and achievable actions by which to re-engineer a model for large-company assurance that is fit for future purpose. The necessary holistic discussion among all the players awaits.  

 

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PwC’s UK Head Is Unhappy -– There Could Be Relief

“When sorrows come, they come not single spies, but in battalions.”

                    -- Claudius, Shakespeare’s Hamlet (IV, v)

How much concern do we feel for Kevin Ellis? He should sit pretty -- senior partner of the UK firm of PwC, which in 2021 clocked up record global revenue of $ 45 billion. The average profit of his UK partners was a league-leading £ 868,000, and Ellis himself in 2020 took home a handsome £ 4.4 million.

Instead, this week’s press attention finds him in a double bind, triggered by the UK’s audit regulator, the Financial Reporting Council. Even in paralysis over its structure and its remit, with the whole topic of “audit reform” on hold as the Boris Johnson government totters for survival between the fiascos of Brexit and COVID, the FRC has seen fit to widen its investigation of PwC’s audits of Babcock International –- expanding from 2017 and 2018 to sweep in the last two years before the firm was replaced by Deloitte.

In the usual grim ritual, the firm’s response was the expected if defensive pledge of obeisance and cooperation:

“We will cooperate fully with the FRC in its inquiries,” said PwC in a statement. “Audit quality is of paramount importance, and we remain committed to our ongoing program to enhance audit quality and to the delivery of consistently high-quality audits.

“The FRC’s annual reviews of our audit work, policies, and procedures show a continued trend of improvement in our work, and we use their insights, together with our own reviews, to continuously improve how we deliver high-quality audits.”

Ellis chose at the same time a gratuitous reprise of his frustration as previously aired to the Financial Times:

“(C)riticism of the audit industry from politicians and regulators was harming the profession and risked making it more difficult to attract new recruits.

“Retaining qualified auditors also ‘becomes much harder, if there’s a current of external negativity,’ he said.”

PwC’s prosperity in the COVID era considered, critics would be tempted to charge Ellis with tone-deaf ingratitude, except that his distress lies in the inability of Big Audit to accommodate two conflicting positions: The profession’s leaders self-confidently resist the recognition of atypical but inevitable instances of sub-optimal performance, while the public’s pointed question in any case of significant scandal is, “Where were the auditors?” 

Little wonder, there is skepticism about the profession’s legitimacy -- among investors and other users, with new graduates exploring their career paths, and as maturing staff decide where to commit their energies and their fortunes.

History teaches that the accounting profession has never rested easily in its relationship with its regulators. In the 1860s, the nascent profession -- counting among its leaders both Messrs. Price and Waterhouse -- fought off legislative attempts to require that government should audit the UK railroads. Its franchise of privately-provided audits of public companies was only later secured with passage of the core American securities laws of 1933 and 1934.

It’s been downhill since. Indeed, with this month’s fourth anniversary of the collapse of Carillion, Ellis might appreciate the FRC’s pointing its limited artillery at KPMG’s former partner and staff, who have turned on each other under charges of manufacturing and post-dating Carillion working papers and other engagement documentation.

Possible relief for Ellis’s dour pessimism is available, although it would require legislation, cooperation, and deep changes in attitude on the part of all the players –- starting with the auditors and including companies, information users, legislators, and regulators.

That is, it is to the profession’s discredit that Big Audit lacks a forum in which audit performance quality can with credibility be investigated, evaluated, and if necessary sanctioned. The available tools are not serving. The FRC -- derided in the post-Carillion studies as “a ramshackle house,” and “toothless and passive” -- is perceived as non-transparent, inefficient, and ineffective. And the legal systems that continue to threaten “joint and several” liability on the scale that destroyed Arthur Andersen in 2002 are seen as ponderous, erratic, and unpredictable.

To address these issues, a tribunal could be designed for “audit failure study” -– drawing on a long and successful history among the other professions. In hospital surgeries and emergency rooms, engineering studies of infrastructure collapse, assembly line disruptions and air and rail accidents, learning emerges in the study of catastrophe, from the inadequate number of lifeboats on the Titanic to the construction deficiencies in the World Trade Center.[1]  

The outputs of a well-constructed body -- given a broad remit, a legislative mandate, and the necessary expert and staff resources –- would:

• Enhance the credibility of corporate issuers’ commitments to quality reporting.
• Support the accountants’ legitimate aspirations and claims of improved performance.
• Provide guidance for standard-setters.
• Offer clarity and transparency to investors and agencies of government.

Resistance would of course be expected. Inertia and preservation of the status quo are never easy to displace. The profession’s leaders and the communities of information issuers and users would all be required as willing participants –- endorsing the value of such a tribunal as a matter of mutual trust and appreciation of its value.

As for Kevin Ellis and his concerns, a credible body for the study of his profession’s quality issues would provide a point of reference to which he would steer the interests of his audiences –- sparing himself the impossible task of preaching to the unconverted and allowing him to focus on more productive efforts. 

 

[1] For an extended examination of the complexities, challenges, and benefits of “failure study,” please see pages 285-292 of my 2017 book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books 2d ed.)

 

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What Price Wrong-Doing? Sanctions Against KPMG Are Complicated

It's always a pleasure to be a guest at Going Concern -- where the post below appears as of this morning, looking at two front-burner topics this summer in the US and the UK. For a detailed review of the threatening and volatile environment in the UK, where official actions threaten the stability of the Big Four business model and the viability of their franchise to audit large public companies, I invite you to my new book, available on Amazon in paperback and e-reader formats -- "DOA: Can Big Audit Survive the UK Regulators?

“Sell in May and go away” was an investors’ adage invoked as vacation strategy in a more genteel era. Returns in the summer were said to lag the rest of the year—and in any event, that’s how brokers justified their holiday cottages on the eastern seaboard.

This year the maxim has twice failed my attempt to stay off the grid. Most visibly, the SEC on June 17 ordered a $50 million fine against KPMG LLP; the penalty was a two-fer: both a complement to the criminal proceedings against senior personnel of the firm and the PCAOB for the theft and misuse of agency inspection information, and also for the firm’s gaming of internal training and tests, including those done under prior orders of the SEC itself.

Also there is the inquiry in the U.K. into the “purpose of audits,” led by former London Stock Exchange chair Sir Donald Brydon, under a charge from Greg Clark, Secretary of State for Business, Energy and Industrial Strategy—latest in a series of official proceedings involving the Big Audit model, inspired by a series of scandals originating with the January 2018 collapse of the giant public contracting enterprise Carillion.

Sir Donald’s convocation of two diverse advisory groups, and his upbeat Twitter note that his Call for Views in April elicited 110 responses, provide optimism that the project will not only look at the expectations of the capital markets for an audit model fit for modern purpose, but also assess the realities, weaknesses, and challenges in the existing market dominance of the Big 4.

Uncertainties around KPMG’s punishment connect the two. The link is the under-appreciated fragility of the Big 4—the shockingly low ceiling on the financial capacity of the firms to survive a fine or judgment on the scale that Enron inflicted on Arthur Andersen, because another collapse would put at risk the entire model.

A $50 million fine against KPMG is not itself of that magnitude. Spread among the roughly 2,200 partners of the U.S. firm, with its 2018 revenue on the order of $9 billion, the bearable impact is about $23,000 per partner. (The LLP does not disclose profits per partner, but a comparison with the disclosed 2018 partner profits of the KPMG network’s firm in the U.K.—£601,000, or about $765,000, is probably reasonable.)

Skepticism about the size of the hammer wielded by the SEC has come from well-recognized critics: in the U.S., Jason Bramwell at Going Concern, Matt Kelly at Radical Compliance, Francine McKenna at MarketWatch; in the U.K., twittering academics @premsikka and @atulshah among others.

Which is not unfair. A fine of even $100 million would not raise the individual impact above $50,000 each for the average KPMG LLP partner.

But the critics’ argument for a fine of $1 billion, nearing $500,000 per partner, would be another matter. That would be seriously painful and, if doubled, would raise the existential challenge that insecure partners would swallow their loyalty, withdraw their capital, and vote with their feet—throwing the firm and its entire global network into an Andersen-like death spiral.

Theoreticians and policy-makers concerned with crimes and punishments have agonized over the complexities: What level of sanctions properly balances society’s desire for deterrence with the appropriate pain on a wrong-doer? How well is justice served, where collateral concerns—here, the survival of the Big Audit model itself—put a practical ceiling on the ability to punish?

If the problems with money fines are intractable, what other tools are available? The SEC’s June 17 order (paragraphs 65 to 82) includes a basket of multiyear reviews, reports and undertakings by leadership of KPMG LLP, and requires the engagement of an independent consultant.

Enough to satisfy the critics? If those impositions are too light to be credible, suppose creation of an office of the CEO, with C-suite presence of outsiders on a day-to-day supervisory basis.

The idea that senior management be supplanted by outside leadership has been advanced at least twice—first in 2002, as Arthur Andersen lurched to its collapse, with the non-starting notion that the eminent Paul Volcker should step in, and again in 2008 as a proposal of the Advisory Committee on the Auditing Profession convened by Treasury Secretary Henry Paulson.

Both met understandable ridicule and rejection. The powers of a newly-arrived corporate CEO to hose the stables might be effective—wholesale firings and reorganizations would be well within scope. Not so, as Andersen’s experience demonstrated, where a partnership’s viability depends on retention of the skills, votes, and mutuality of trust and confidence among a committed collection of partners.

“Solutions” either facile or intemperate being unhelpful, here are offered two desires:

First, that for the sake of their credibility, the critics should be obliged to annotate their harsh rhetoric with constructive proposals by which to replace the current Big Audit model, which the draconian penalties they urge would threaten to destroy.

Second, that Sir Donald Brydon’s review will have sufficient breadth to embrace the entire array of inter-connected issues, including the survivability of the Big 4 model for privately provided large-company audits.

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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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

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The Rolls-Royce of Audit Reports Hits The Road: Test-Driving KPMG’s Latest Model

“So tell me what you want – what you really really want.”

            -- Spice Girls, 1996

“But if you try sometimes, you just might find, you get what you need.”

            -- Rolling Stones, 1969

Insiders within the accounting community are falling all over themselves in congratulatory admiration of the Independent Auditor’s Report signed in London on February 12, 2014, by Senior Statutory Auditor Jimmy Daboo on behalf of KPMG, on the financial statements of Rolls-Royce Holdings plc.

Running to six full pages starting at page 130 of the company’s 2013 annual report, single-spaced and double-columned, Daboo’s opinion implements with a vengeance the guidance published in June 2013 by the United Kingdom’s Financial Reporting Council, requiring auditors’ reports to describe the greatest risks to material misstatements, explain their application of materiality in audit planning and performance, and summarize their audit scope as responsive to the assessed misstatement risks.

This is not about motor cars. Rolls-Royce ranks number 28 on the FTSE 100 list of large UK companies, with £ 15.5 billion in 2013 revenue from its gas turbine and reciprocating engine sales to the civil and defense aeronautics sectors, along with marine, energy and power systems -- all spelled out in its report running a handsome 144 pages.

The interesting question is whether the world was really waiting for essays of 500-word-length on such eye-crossingly complicated topics as revenue and profit measurement, measurement of liabilities from sales financing arrangements, or the concept and presentation of non-standard “underlying” profit on foreign transactions. Or would information users have preferred the traditional, simple and comfortable anodyne opinion in the first paragraph, that a “true and fair view” was presented?

Early indications -- based on the conspicuous silence of the investor community and commentators outside the precincts of those with self-interest -- significantly suggest the latter. To be sure, the company’s stock was pounded by its largest price drop in thirteen years with the profit warning of its February 13 announcement of 2013 results, largely since recovered, but blame was placed on forecasted reductions in defense-related revenues, and the financial press made no connection with KPMG’s opinion, either then or since.   

If proved out over the rest of the annual reporting cycle for UK companies and their own broad adoption of the FRC’s requirements, the investor community’s “ho-hum” would implicate the long-running efforts to re-engineer the standard auditors’ report – by both the PCAOB in the US and the IAASB globally.

Not, as can be observed, that either of these bodies is proposing changes on the scale of the KPMG treatise – but have rather confined themselves to the identification of the kind of “critical” or “key” audit matters that may predictably elicit generic box ticking and boilerplate, rather than KPMG’s sophisticated mini-seminars delivered on Rolls-Royce.

Which would be unfortunate indeed, especially in the litigation-prone United States, the jurisdiction most likely among the world’s major large economies to inflict a death-blow jury verdict for an auditor’s “getting it wrong.” There, under the disclosure-based policies of the American securities laws, adoption of the emerging UK protocols for actually quantifying audit and reporting materiality, and for explicating the range and uncertainty of complex company decisions and judgments, would go far to draw the teeth of the beast lurking in the courthouse.

For this, those arguing for a sustainable model for privately-provided assurance could only be grateful.

But there being no sign as yet of any leadership or initiative in that direction, grounds for optimism are hard to come by.

Curious readers in the US are invited to have a look at the Rolls-Royce report including the KPMG opinion, and send in their reactions. Readers in the UK – especially actual or potential investors in Rolls-Royce, on whom the KPMG report may have made an impact or had any influence -- are invited to identify themselves and share their thoughts.

 

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

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

“Audited and Approved”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Auditor Re-Tender Every Five Years? Concentration in the UK Gets a Fresh Squeeze

 Attitudes differ about the ingredients in a ham-and-eggs breakfast. To a chicken, it’s a matter of interest. To a pig, it’s a matter of life and death. 

Which makes puzzling the reactions of the accounting firms to the provisional decision of the Competition Commission in the United Kingdom, that public company audits should be put out for mandatory re-tender every five years – which would halve the doubly permissive ten-year “re-tender or at least explain” promulgated last fall by the Financial Reporting Council.

The large firms complained that the five-year period is too short, while others argue that the provision is still too soft. 

Considering the interests of the chicken and the pig, these reactions of both the Big Four and the next smaller firms seem wrong-footed. Regulators being masterful at failing to identify the likelihood of highly-disruptive unintended consequences – of which the statement of the Chairman of the Competition Commission’s Investigative Group, that “the audit function is too important to be left undisturbed for longer than five years” will likely prove an example -- here’s why:

Although there is no research or empirical evidence to indicate any causal relationship between lengthened auditor tenure and audit quality, there is wide and credible belief and research that the early years of an auditor-client relationship, on the steep slope of the learning curve, are fraught for issues of risk and irregularity.

So what is to happen in – say – years three and four, just ahead of the expensive and demanding re-tender process in year five.

A Big Four firm, prepared (and obliged) to invest both time and personnel, as either incumbent or outside competitor, would draw on its depth, from its broad client roster and its ranks of people and industry resources.  

Indeed, an incumbent Big Four firm’s tactic would implement its obligatory engagement partner rotation in about year three -- providing that new partner with experience and seasoning, and selling its then-familiarized engagement leadership as a stability message in the re-tender competition in year five.

By contrast, a smaller firm would be hobbled in a five-year regime as either incumbent or as outsider. As incumbent, its profitability would have suffered – like a Big Four firm, to be sure -- from the first-time costs of a new engagement, against fee levels influenced by a multi-firm competition. Then, instead of benefitting from the stable middle years of a ten-year incumbency, firms would immediately face the costly defense of the engagement – against Big Four competitors assembling competitive proposal resources from available stock.

And as an outsider, a smaller firm – by definition lacking the “bench strength” in personnel and industry competence that only a Big Four’s roster of Footsie-350 clients provides – must, for each potential but very uncertain potential proposal target, find and marshal the people and invest the costs of proposing – not once but twice each decade.  

Unhappy consequences can well be imagined for budget-cutting, ever-higher pressures of time and execution on engagement personnel, and threats to performance quality – with the associated prospects of audit breakdown and failure.

Defenders of the five-year timetable assert that the re-tender process could become routinized, and the costs therefore mitigated – an anodyne position that is wrong for two reasons:

First, the assumption is fragile. The pace of change in the global large-company environment will demand fresh, detailed and widely-researched attention every year. Attempted “off-the-shelf” proposal methodologies will obsolesce with the relentless speed of the business cycle.

Second, audit committees offered the easy default of incumbent retention would only be persuaded to change on the basis of compelling and well-customized advocacy. A box-ticking proposal process would only reinforce and increase an incumbent’s advantage.

In summary, five-year re-tender as proposed by the Competition Commission would portend these results:

• Even less auditor switching than under the FRC’s ten-year cycle.

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

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

On top of all of this, the FRC’s ten-year rule seems already to be generating increased auditor switching – as I predicted last fall it might – with such large UK parcels reportedly to be passed as Unilever and the London Stock Exchange (both PwC), and PwC replaced by EY at both Land Securities and BG Group (here) – the discomfort of which no doubt being eased by PwC’s capture from KPMG of banking giant HSBC, the UK’s most lucrative audit engagement. 

On the race-track of an August 13 deadline for comments, and with conditions in place not manifestly broken, Chairman Carstensen and her colleagues should re-think with care the warning to “be very careful what you wish for.”

 

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KPMG's Independence, Herbalife's Stock Price, and the Game of Name Blame

What does this say about the value placed by investors on the independence of outside auditors: 

Two trading days after KPMG withdrew its audit reports on the financial statements of its Los Angeles clients Herbalife and Skechers, because of inside information shared by its promptly sacked and criminally charged engagement partner Scott London, the stock price of both of those stocks has actually risen!

The consequences of London’s passing on, to the million-dollar benefit of his golfing pal Bryan Shaw, will be swift and nasty:

• Ratted out by Shaw, London will cut the fastest plea deal the prosecutors will offer.

• KPMG will hurl its checkbook at every dollar of costs incurred by its ex-clients to obtain replacement auditors.

• Aggressive plaintiffs’ lawyers will fashion some theory of shareholder harm – despite the stock price upticks – doubtless spinning a conspiratorial connection with the long-running spat over Herbalife between raider Carl Icahn and shortseller Bill Ackman, and eventually coercing a nuisance-level settlement.

• And the American securities and accountancy regulators – the SEC and the PCAOB – will vie with each other in a pell-mell rush, recalling the unseemly post-Enron haste with which the Sarbanes-Oxley law was passed in 2002, to push a requirement that auditors of US public companies identify by name their partners signing client audit reports.

This last has been opposed with intensity by the American accounting profession, although long in place in much of the world without measurable adverse effects.   

Nor, it should be noted, with measurable benefits either – as client managements and audit committees in the US have never lacked access to the decision-qualifying information necessary about the engagement personnel at their audit firms.

In the wishful search for magic bullets aimed at the structural weaknesses in the auditor-client business model, “partner naming” is a distinctly small-bore and ineffective weapon. 

But London’s downfall does require re-framing my opening question, this way, heretical as it may seem:

What value to the operation of the capital markets – if any -- is actually delivered by the entire structure of auditor independence? 

London’s professional position was destroyed, and his liberty put in jeopardy, not because he violated the elaborate dictates of the auditor independence rules, but because of his multi-year violations of the insider-trading prohibitions of the American securities laws.

And on the other hand, despite KPMG’s immediate and apologetic resignation and report withdrawals, the stock market has given credence to the assertions that the substantive content of the Herbalife and Skechers financial statements are unaffected (even given the charges hurled in the Icahn/Ackman dust-up).

In short, the indifference of equity investors to the state of KPMG’s independence speaks volumes.

I’ve long been saying (here and here) that – under the “client pays” business model for financial statement assurance, invented back in the Victorian era – the accounting profession has gained nothing positive for years, by way of reputation, stature or risk and exposure mitigation, from the intellectually unsatisfactory edifice of “appearance of independence.”

Now, the stock price non-event of Scott London’s misadventures equally shows the converse – that investors impose no downside price penalty on even a slam-dunk independence violation.

Conclusion: the time, energy and cost of maintaining the outmoded and anachronistic structure of “independence” should be re-directed to the long roster of topics legitimately worthy of the effort.

 

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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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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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