Re:Balance -- Jim Peterson

Auditor Performance Metrics: The Deal Offered by the PCAOB

 

Even as the new year will likely bring the defenestration of Erica Williams, chair of the Public Company Accounting Oversight Board, that agency has tossed up to its over-seer, the Securities and Exchange Commission, proposed rules that would – in the unlikely event of SEC approval - require registered audit firms to bring forth volumes of details on their performance metrics.

Views differ on both the wisdom of the rules themselves and the extent of the capital markets’ appetite for details on the operations of the world’s large public companies’ auditors. But pass the basic question whether any of the proposed disclosures would guide investors in handicapping a “good” or “bad” audit. There are at least three reasons why the rules are untethered from the realities of the Big Audit model.

First is the expected SEC disapproval – either entirely, or in anything like the rules’ current form. Paul Atkins, nominee to succeed Gary Gensler as SEC chair, has made well known his hostility to the PCAOB and the recent scope of its activities. Spelled out in detail by Mark Maurer in the Wall Street Journal for December 9 is the likelihood that Atkins will return the agency into the deep retreat that marked its somnolence under Williams’s predecessor.

The coming months will tell whether chair Williams might get her way, in bringing live any of the expansive reporting and data collection, but it’s a reasonable wager that with the changing of administrations in Washington in January, she will be out of a job and her proposed rules will waste like flowers in the desert air.

Second is the deep divergence on the value of the information to be required. Chair Williams had put it that the cascade of information “would provide investors, audit committees, and other stakeholders with valuable information on firms and their engagements to help them make knowledgeable decisions regarding audit firms and investment-related choices.”

The accounting firms themselves are in vigorous opposition, set out by the Center for Audit Quality, speaking for the large firms,in a series of letters (June 7, November 11 and November 22, 2024), “based on public policy concerns, lack of cost-benefit analyses and the likely negative competitive impact to the US public company audit profession.” And the AICPA, with focus on the smaller firms, wrote in its letter to the SEC of December 19, 2024 that “these rules will have unintended negative consequences, including driving small and medium-sized firms out of the public company auditing practice.”

Chiming in was Bob Conway, whose credentials span his long tenure as a KPMG partner and senior staff positions at the PCAOB. In early December he brought to YouTube and to Francine McKenna’s substack, The Dig, his view regarding the familiar, standard and amply criticized auditor’s opinion required for public companies by the SEC, about which he says that “commodity pricing is the culprit.”

With respect, Conway’s endorsement rests on flawed premises, beginning with the problem that pricing power for a commodity product is limited. The language of an audit opinion, prescribed by and acceptable to the SEC, prevents differentiation even as it confines the auditors in golden handcuffs. The form of that opinion - the core product of the firms’ assurance practices, with wording compelled by law and regulation - is expected by a generally indifferent user population, invariant across the critically small number of provider firms.

In this market, not only do the firms lack pricing power. Neither they, their clients, nor the providers of capital have any incentive to change. Typical retail investors could not identify the auditors of companies in their portfolios, much less distinguish one firm’s opinion from another, while investment professionals and audit committees alike already have access to as much information as they may deem significant.

Nor does the limited scope of available auditor choice allow for what Conway calls “informed decision making (by audit committees and prospective employees) that will fuel competition on elements other than price.” As reported by Statista, in 2022 the Big Four networks gathered up fully 99.7 % of the audit fees of the S&P 500 companies. In this environment, large public companies lack a range of auditor options under the limitations of the four-firm Big Audit model.

And the prospects for expanding that tetrapoly are nil. If anything, the mid-tier and smaller firms are shrinking or giving up their positions in the public company audit market altogether, for various strategic reasons including the combined influence of private equity and other third-party capital and their own eager appetites for expanded non-assurance revenues.  

Nor does Conway’s position gain traction by his invocation of the 2008 activities of the Advisory Committee on the Auditing Profession, convened by Treasury Secretary Paulson in the second term of the younger President Bush.

The output of that group, so riven with discord and animosity as to challenge the leadership of amiable co-chair Donald Nicolaison (RIP 2019), would have been so inconsequential as to die on the vine in any event. The over-whelming impact of the credit crisis, however - already underway although not yet much recognized - was enough to erase from the sands of time any of the Committee’s footprints, faint as they were.

Third and finally, the fine-grained rules that Williams and Conway support would be inflicted on a franchise already confronting change at a more fundamental level for its very survival.

Not that the advocates are necessarily wrong in pressing for greater auditor transparency. It’s a sympathetic argument, that the providers of assurance on the corporate information required of their clients should, for the sake of their own reputations and professional legitimacy, offer the market at least the same disclosures about their own enterprises.

Indeed I have long advocated that the profession should have followed the lead of the Arthur Andersen organization in the 1970s, when for several years it published its own global financial statements, together with the unqualified auditors’ opinion of the firm then branded as Haskins & Sells. (Disclosure/reminder – for nearly two decades I was a member of the Andersen internal legal group and a worldwide partner, retiring the summer before its Enron-driven collapse.)

It's that the value of the standard commodity auditor’s opinion has been in demonstrable decline for years:

• Going back to the crisis in the US savings & loan sector in the 1980s.
• Through the negligible impact of the post-Enron passage in 2002 of the Sarbanes/Oxley law on the credit crisis that followed in 2007-2008.
• Lately with the ever-increasing volume of activity in financial markets outside the reach of the Big Audit model:
  • Manifest in such scandals as Theranos and FTX.
  • The passion with which activity in the crypto-sphere has exploded.
  • The outbreaks of dubious corporate behavior that back-footed the regulators in the form of the reverse-IPOs of companies in China and the groundswell of registrations based on mergers with special purpose acquisition companies.

While at the same time, the degree of enthusiasm for reporting and assurance under the broad heading of Sustainability has turned the heads of strategists and commentators, occupying energy and resources elsewhere than in the profession’s traditional practices.

Even assuming that in some revised form the PCAOB’s inspection and enforcement activities may trundle inexorably onward, the structure of its legislative mandate means that its reporting of inspection results and enforcement outcomes is at best partial and opaque, while actual improvement measurement remains elusive. Inspection deficiency rates as reported by the agency itself continue to attract the rhetoric of official dissatisfaction (as put by chair Williams herself, in 2023 and again in 2024).

Informative and useful academic research is still to be delivered, with adequate sample sizes and coverage at scale of the large public companies, by which to assess and evaluate any actual impact on audit quality over the history of the PCAOB. A catalogue of issues - partner naming and opinion signing, scope of practice limitations, reporting of key or critical audit matters, and (in the UK and the EU) mandatory auditor replacement or rotation - remain to be tested.

Participants with self-interests offer each other the predictable exchanges of mutual reinforcement - claims that “things are better than they were before.” What is not asked is the more disciplined question, “are things better than they would have been if Sarbox had never been enacted” – an alternative scenario under which a market-cleansing process could have allowed legitimate concerns over audit quality, corporate reporting and investor protection to be sorted out through performance criticisms, enforcement proceedings and damage claims under the still-salient application of the antifraud provisions of the core securities laws.

Simply put, the PCAOB’s proposed metrics disclosure rules might, if put into place, satisfy some bureaucratic appetite for data-gathering, in answer to a need that nobody really feels, in a flurry of motion in the guise of progress. As expressed in the CAQ’s skeptical letter of June 7, however, “without a sufficient understanding of how – or if – investors would use the information presented in the proposed metrics (and taking into account the risk of inappropriate use), it does not seem appropriate to suggest that investors would use such information to make investment and proxy decisions.” 

Instead, under a market-oriented test of utility or good effect, the fate of the proposed rules would resemble the shipboard orchestra mournfully performing on the sinking stern of the Titanic.

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Refuge from the Storm – Seeking Shelter in Troubling Times

 

“… but we must cultivate our garden”

                          - Voltaire’s Candide, 1759

This space has been quieter than usual for a while. As the season approaches for year-end meditation and review, there are two reasons.

First, with the cyclical state of the capital markets somewhere between benign and robust, the critics’ cries of “where were the auditors?” are muted, and the regulators are largely quiescent. Second, in a highly charged political environment that shows no sign of relief, “commentary overload” is real – for both providers and consumers.

So it’s not that I’m withdrawing – far from it. Real issues continue to be worthy of attention. But it’s well to re-calibrate the quantity and quality of information that can be absorbed and processed. 

Taking these in order:

Serious concerns persist, for sure, around Big Audit – the model that provides assurance by global accounting networks on the financial statements of the world’s large companies. That structure only exists and survives because auditors’ opinions are required by the major securities regulators; the uneasy “public/private” relationship traces to the passage in 1933 and 1934 of the foundational American securities laws, although it is threatened at least by these:  

• A litigation impact on the scale of Enron’s collapse in 2001, causing the immediate collapse of Arthur Andersen and reducing the population of firms with the geographic scope and expertise required for global-scale audits down to the critical minimum of the surviving Big Four.

• The accounting profession’s propulsive rush to the forefront with the rapid evolution in corporate recording and reporting on the topics under the expansive rubric of Sustainability, lurching toward the provision of expert independent assurance. That’s despite the unconverged and unready array of “standards” to be applied, and the yawning chasm between the investing public’s unrealistic demand for “zero defects” and the over-estimated performance capability of the aspirant assurance providers. Barring an unlikely outbreak of reflection and prudence, this new “expectations gap” will erupt into an entire new and potentially catastrophic outburst of professional liability exposure and litigation.

• The still-to-be-measured flood of private equity and other third-party capital directed at and eagerly embraced by firms in the tier below the Big Four – where uncertainty clouds the impacts:
  • On the personnel side, freshly-funded departures of senior leadership, career and advancement prospects for the next generation, and the questionable appeal of this new model to potential entrants to the profession from the universities.
  • On the service delivery model, the constraining effects of the independence rules that will inhibit the firms’ services to clients of their new third-party investors, and the potential constriction, discontinuance or disposal of their audit practices.
  • On the governance and structural side, the very viability of a multi-disciplinary firm having the breadth of skills and expertise to handle either complex audit engagements or the evolving scope of Sustainability assurance, as the pressures of new investors will incentivize the re-structuring and separation of practice lines deemed insufficiently profitable.

These all being noted, the environment is quiet for the moment. The wave of large litigations extending from the collapse of Carillion in 2018 appears receded, so far without the deadly consequences that their scale initially threatened – although as has been the case for the last half-century, a fresh threat of existential size is as imminent and predictable as the next and inevitable large-scale global scandal.

Meanwhile the regulators in the most significant jurisdictions lie becalmed. The post-Carillion sound and fury in the UK has gone silent, and the impending change of administration in the US augurs a return to the somnolence of its first term.

(With one supportive observation and one exception: The PCAOB just announced the shelving of its deservedly-criticized proposal to re-write the rules on auditor disclosure of client violations of laws and regulations. And its November 21 release, looking to impose a suite of information disclosure requirements on the large firms, is certain never to see final implementation. SEC approval is required, but unlikely to survive chairman Gensler’s resignation announcement the same day and effective in January; at the same time the vigorously dissenting member, Denise Ho, is tipped to become head of the agency in the new administration, which can in any event be expected to return to its first-term state of paralysis and inaction.

(And there is Australia, too distant to be audible or influential above a whisper, where PwC has managed to extend attention to its tax practice’s misuse of confidential government information into the maladroit handling of the political aftermath, providing fuel to a retaliatory slate of proposed “reforms” appearing to be cribbed from those proposed without significant adoption or effect in the UK.)

Last in this area, much ink is spilled over an asserted “pipeline problem” – that is, concern over the volume and quality of potential new entrants – with the youth either declining accounting majors at school, passing on the credential of the CPA or its equivalent, or opting out of practice altogether in favor of careers in consulting or finance.

As for the second of these themes – attention is urgent to the personal challenges of conserving and preserving mental health and emotional well-being. That’s because – with particular focus on the last American election cycle - the approaching new year threatens an extension and expansion of the soul-trying inflictions of the last.

That is, on the losing side, the bubbles inhabited by the politicians and their media enablers continue to look as opaque and resistant as ever to the necessary evolution in vision and messaging that outside influence might bring about.

As the election outcome so resoundingly demonstrated, those most visible and audible up through November 5 comprehensively failed to understand, appreciate or act effectively on the state of the American electorate. Falling so short, to use their own unappealing cliché, in “grasping the Zeitgeist,” they continue to serve up volumes of recriminations, tinfoil-hat conspiracies and outlandish “analysis” from the same tiresome and manifestly unsatisfactory perspectives.

Those are conversations I decline to join. Rather, while reserving the desirability of accessing legitimately reported news, my healthier choice is to forego the sterility of both the op-ed equivalents of toxic junk food and the social and conversational re-hashing by the unqualified of last night’s broadcast sound bites.  

Meanwhile on the other side of the trenches, the near-term future looks to be populated by knee-bending sycophants whose shortcomings in experience and competence are overlain by slavish devotion and ideological fervor. Confidence is not inspired – disruptions and break-downs in major areas of the nation’s political and bureaucratic institutions will quickly emerge under the mismanagement of those too ignorant or too blinkered to appreciate the extent of their “not knowing what they don’t know.”

In this dispiriting environment, under the two-fold influences here outlined, adjustment is indicated. As I have sought over two decades to respect both the patience of my readers and the credibility of my content, I have neither need nor desire to publish for the sake of a timetable or to keep up visibility for its own sake.

Ample opportunities will emerge soon enough, to dial up the energy and re-focus on matters deserving attention. For that, I look for perspective to Candide’s observation, after all the mayhem and violence in Voltaire’s satire - not the counsel of despair, but a call instead for the importance of optimism tempered by experience.

However you may celebrate this turning of the year, then – hug your loved ones, be grateful for your blessings, and keep the faith. 

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Assurance for Sustainability Reports – Risk Management Wants a Word

 

It was my pleasure this week to be a guest on Kevin LaCroix's D&O Diary, with these observations on the under-appreciated scope and scale of the exposures that will threaten auditors and other providers of assurance, as corporate recording and reporting in the Sustainability eco-system continues to expand. My appreciation to Kevin, whose readership is an important constituency in this dialog.

 

Advocates for expanded Sustainability reporting are having a global moment. As put by the panelists in a fulsome discussion re-printed in the June 2024 issue of the Accountability in a Sustainable World Quarterly (the “Panel”):

“Of the largest companies in the world, over 95% are reporting ESG, of which about two-thirds are obtaining some assurance…. (and there are) three major assurance standards: the International Standards on Assurance Engagements (ISAE) by the IAASB, AA1000AS coming through from AccountAbility, and the International Organization for Standardization, the ISO.”

The Sustainability train is gaining both speed and momentum. Anyone standing in its path may be left for roadkill. But a prudent perspective on the impending risks for assurance providers suggests that a flagman on the berm should raise a yellow caution flag. 

Recognizing “the need to take into account the danger of having information assured,” the Panel cracked open a door to expose a great gap in the dialog. Namely, while Sustainability assurance can be provided, under what limits and conditions should it?

For Context

The goals are worthy, the opportunities for the accountants to provide value are open-ended, and the broad endeavor deserves support. However, I bring a law practice perspective focused on their large-scale legal exposures – litigation and regulatory. Seeing the profession at its best, I have been in close proximity to many of its lowest moments and its gravest threats. That includes its persistent and costly inability to solve the conundrum often expressed about unruly children: “when you do good, nobody remembers; when you do bad, nobody forgets.”

Neither a pessimist nor a cynic, I observe that for the profession to achieve the Sustainability participation to which it legitimately aspires, it must confront, at a level not so far observable, the very real threats that could outweigh either its readiness or its ability to survive the potential for catastrophic consequences.

Sustainability-Based Exposures are Already Here 

History’s lessons rest on the volume and scale of decades of claims based on allegedly deficient financial statement audits, and the inability of companies and their auditors to meet the investing public’s “expectations gap.” A sampling from this century alone is daunting enough: Enron, WorldCom, Adelphia, Parmalat, Carillion, Wirecard … and the list goes on.

In the same way, it is inevitable that a non-zero number of Sustainability reports and their related assurance opinions will go wrong, of which some will inflict harmful consequences of dramatically large magnitude. When they do, especially those reaching an audience in the capital markets who will claim reliance, the cries for accountability will echo the too-familiar plea – “Where were the auditors?”

Although most Sustainability reporting and assurance will be non-problematic, the exceptions are already visible. A list that will only grow in both length and scale has drawn the hostile attention and sanctions of regulators and litigants, even ahead of the arrival of assurance opinions:

• On March 28, 2023, the SEC announced its agreement with Brazilian mining company Vale S.A., by which the company would pay $ 55.9 million to settle claims of false and misleading disclosures about the safety of its toxic waste dams prior to the January 2019 collapse of the Brumadinho dam that killed 270 people.

• As announced by the SEC on September 25, 2023, the Deutsche Bank-controlled investment firm DWS agreed to pay $ 25 million to settle charges of green-washing its ESG disclosures and anti-money laundering policies.

• Investor class actions commenced in 2023 continue against ATT and Verizon, asserting damages in the billions, for claims that the telecommunications giants misled investors about the environmental risks and hazards posed to workers and the general public by the miles of lead-shielded cables long buried underground and abandoned rather than exhumed and removed.

• As discussed in the D&O Diary for August 8, 2024, the plaintiff in an action against units of the British publisher RELX Group claims both that he was fired in retaliation for his concerns about “greenwashing” and also that the defendants violated the American securities laws by misleading investors about its climate-related commitments and actions.  

To come, these and like examples could or will include the opinions of assurance providers. The circle of contemplated topics is expansively laid out, for example, in the International Sustainability Standards Board’s IFRS S1, General Requirements for Sustainability-Related Financial Information, or the International Accounting and Assurance Standards Board’s ISSA 5000, General Requirements for Sustainability Assurance Engagements. In which case, the assurance providers will not be spared the scrutiny applied to the issuers themselves. Therein lies the future.

The Environment is Not Yet Ready

Service providers in the Sustainability space will confront a dramatically different risk environment as their engagements evolve from consulting and advice on their clients’ processes, systems and controls for recording and reporting, to actual opinions on the content offered to investors.

At the most threatened end of the risk scale will the unqualified assurance opinions referenced or incorporated into the audited financial information filed by either US registrants or non-US companies listing in America.

That is, as foreshadowed by the proceedings involving Deutsche Bank and Vale, cited above, ex-US companies that elect the benefits of the American capital markets will assume the obligations of compliance with US standards and the exposure to American-style courthouse liability. 

Meanwhile the ATT/Verizon litigations are additionally instructive for other relevant reasons. The companies have pushed back with vigorous defenses, asserting that the claims greatly over-state the extent of buried cable, the level of health and environmental hazard, and the estimated costs of remediation.

But concerns remain. New approaches to litigation provide learning opportunities for future claimants and the class action plaintiffs’ bar. Here lurks the possibility of a trifecta of legal theories aimed at an assurance provider, under the core anti-fraud provisions of the federal securities laws (see the student note in the Columbia Journal of Transnational Law, March 25 2023, Vale and the Rise of Securities-Based Climate Litigation); the environmental laws and regulations; and the rules of the PCAOB, both as currently in place (AS 2405, Illegal Acts by Clients) and now proposed to be expanded and extended (Docket # 051, Amendments to PCAOB Auditing Standards Relating to a Company’s Non-Compliance with Laws and Regulations, released June 6, 2023)).      

Although optimism and “success bias” pervade the Sustainability dialog – no surprise, those attributes being deeply embedded in the DNA of the accounting profession - there is no likelihood of short or medium term reduction in the liability exposure for providers offering Sustainability assurance:

• Claims will be based on the broad association of the provider’s name and brand, despite and irrespective of any attempt to differentiate “limited” from “reasonable” assurance. Whatever the ostensible attempts at limitation of exposure, claims by unhappy investors will take one of two forms: either that the “standards” were deficient or unsatisfactory in protecting the interests of the users, or that if those standards had not been mis-understood and mis-applied, the allegedly deficient opinion would and should not have been issued.

• A prevailing default view is that assurance engagements other than statutory audit - that is, those involving compilations, reviews or agreed-upon procedures, or opinions in “limited” terms - are low risk. That is a view emphatically not shared by litigation lawyers having actual experience with the misery of attempting to defend in court a “limited” opinion, couched in the deadly double-negative language that “nothing has come to our attention that causes us to believe that the (information disclosed) is not prepared, in all material respects, in accordance with (described criteria).”

• Engagement contract provisions between auditors and clients, to limit or mitigate potential damages or exposures, have in general failed to achieve significant adoption, and are expressly not permitted for SEC registrants (see generally the February 9, 2006 discussion paper of the PCAOB’s Standing Advisory Group, The Effects on Independence of Indemnification, Limitation of Liability and Other Litigation-Related Clauses in Audit Engagement Letters.)

• Non-standard audit opinions for SEC registrants are disfavored and severely constrained if not expressly deemed non-compliant (see the SEC’s Financial Reporting Manual, Section 4200, Accountants’ Reports (S-X 2-02).

• Limited “safe harbor” provisions are now to be allowed by the SEC for “climate-change disclosures pertaining to transition plans, scenario analysis, the use of an internal carbon price, and targets and goals”(summarized at page 35 and set out at length at pages 386 et seq. of its Final Rules Regarding Mandatory Climate Risk Disclosures, issued March 6, 2024), such information to be considered as forward-looking statements for purposes of the Private Securities Litigation Reform Act. Tempting as it might be to view this development as helpful, however, the “safe harbor” is not available for such disclosures as included in a company’s audited financial statements (page 400), nor for Scope 1 or Scope 2 emissions disclosures (ibid.). And in any event, SEC-driven climate disclosures comprise only a minor patch of the entire Sustainability landscape, making unlikely any more extensive adoption. There is no public enthusiasm for relieving assurance providers from the generally unlimited liability imposed under the American securities laws, nor any realistic expectation of liability “reform,” caps on damages or other protection.

The Picture of the Future is Not Pretty

The consequences of an assurance opinion gone wrong, although mistakenly thought to be low risk in its undertaking, will be disproportionate to a provider’s risk assessment or to the resources and processes brought to the job itself. Consider these hypotheticals, by way of predictable extension from the real cases cited above, each of which would readily spawn serious litigation exposure to an assurance provider as well as its client:

• A global energy company, whose procedures for offshore oil well drilling and operations are covered by an opinion on its safety and environmental controls, suffers a blowout on the scale of the 2010 Deepwater Horizon. Timely damage control is difficult and extended; unquantifiable ocean pollution and damages to local business, wildlife and tourism run into the billions.

• A global manufacturing company offers an opinion on its supply chain and labor practices and its local factory conditions – directly after which a high-rise sweatshop in a developing country collapses with total destruction of the building, loss of its contents, and extensive fatalities among the workers including women and small children.

• A dealer in precious metals, whose SEC filings include an opinion on its controls and governance, is revealed by a whistle-blower to have engaged in widespread and systematic gold smuggling and money laundering. The company is shuttered and its principals are targeted for criminal prosecution.

• A manufacturing company includes in its SEC reporting an opinion on its worker safety program, including the number of vehicles needed for emergency evacuation of a factory location, specifically noting compliance with local country standards. A catastrophic event destroys the location with massive loss of life. Investigation reveals that the number of vehicles required by local standards would have accommodated no more than half the workers on site at the time of the attempted evacuation order, and in any event, one-third of the vehicles actually on-site were inoperable due to deferred maintenance.

How Ready is the Profession

Although the Panel’s working text was its headline question - “Who will provide Assurance for ESG Reports?" -  neither the accounting profession nor the other possible providers are ready. The Panel was optimistic that “Most of our skills can be applied to sustainability and non-financial information, although additional layers of expertise are needed,” although it did recognize that “We have a lot of work to do as a group of standard setters, regulators and practitioners.”

In his insightful although unfortunately widely disregarded December 2019 report, Sir Donald Brydon’s “Independent Review into the Qualify and Effectiveness of Audit” defined and supported a new professional designation – the corporate auditor – which would contemplate a remit broad enough to include the expanded capabilities required for Sustainability assurance, “to encompass today’s auditors and others with appropriate education and authorization” (¶6.0.11).

The Brydon report is consistent with the Panel’s caution on the present scope of available qualifications, noting that “It is far from clear that an accountant is best placed to opine on many of the variables involved” (¶6.0.13), but opens a door of opportunity with an invitation: “Whilst in this new environment there may be environmental auditors, cyber security auditors and financial statement auditors, only some would need to have an accountancy qualification as known today” (¶6.0.14). 

An analogy is found in the tax consulting services that accountants have provided for decades. In the Sustainability environment, they likewise have a valuable and manageable consultative role to play, bringing expertise and discipline to support their client’s reporting and disclosures, without extending their opinions into areas where the risks are increased, unpredictable, and beyond quantification.

Beyond the overhang of liability exposures that, because of these uncertainties, essentially fail to meet the requirements for insurability, at least at their upper end, the providers facing the expanded need to embrace technical competencies and expertise in areas far beyond their traditional scope confront at least two structural issues:

First, these practice expansions have potential to clash with the rules of independence and permissible scope of services that already constrain the profession, especially as in tension with statutory audit. Second, to the extent Sustainability assurance is viewed by regulators as impermissible for statutory auditors, efforts to build those practices or to house them in separate parts of their organizations may be deterred or disincentivized.  

What Will the Future Hold?

Addressing directly the skunk of legal exposure that threatens the garden party of the Sustainability advocates – defenses will be required, when the legal claims arrive that will implicate the performance of the providers of Sustainability assurance. With the unpredictability of litigation outcomes, defendants will at minimum suffer extensive time, expense and settlement costs.

For the aspirational providers of Sustainability assurance, it would be reckless at a death-wish level to issue unqualified opinions on which investors will make capital allocation decisions, without protections in place to limit or mitigate their exposures.

To that end, engagement with legislators, regulators and law enforcement agencies could provide channels of communication by which those bodies might – if so disposed – contribute to a realistic and robust assurance architecture that would itself be sustainable. However, whether or not provisions such as safe harbors, liability limits and acceptable opinion qualification language will be within the vision of the authorities is a question to be anticipated and discussed.

 Otherwise, and absent satisfaction from officialdom, assurance providers will have little recourse beyond their own self-protection, by way of available liability-management tools and practices that would range from contractual protection provisions to outright refusal to accept engagements lacking appropriate liability boundaries.

The case for attention is presented – which to be useful should be approached with both skepticism and anxiety, rather than the prevailing mixture of optimism, indifference and naivete. Uptake is a matter of urgency, lest this fast-moving train hurtles unchecked toward collisions that might even still be avoided.  

 

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Should Trump Have Testified? A Tale of Two Trials

Should Donald Trump have testified in his own defense?

Would his performance as a witness have turned the New York jury who on May 30 found him guilty of 34 felony counts of falsifying as legal expenses the hush money paid to quash the threatened publicity of his one-off with porn performer Stormy Daniels? 

 Or was it a preferred strategy to avail himself of the unambiguous right to keep silent? 

It’s a good time to pursue the question, while Trump awaits sentencing and runs out his string of appeals. The debates are lively, even though now with hindsight the question lacks a meaningful answer. Its complexities will be assessed both by doubtfully qualified commentators and courtroom groupies, gassing around on the media platforms, but also by serious observers of trial tactics - defense counsel, academics and students. They will all try to slice and dice the nuances of the common if opaque cliché that while a jury wants to hear a defendant’s first-hand story, a choice to testify risks worsening an already difficult situation.  

Over a career involving a significant catalog of large-scale white-collar criminality, I have worked on, watched and studied enough trials to believe that, while prosecutors and defense counsel alike will do all they can to shape their best case, it is a fool's errand to predict a jury result. Every criminal trial has its own dimensions, every trial team its own quirks and quiddities, and every jury its own dynamic – partially knowable at best and then only to the first-hand participants.

Which said, my admittedly limited sample suffices to put forward a recent outcome where the jury came out the other way, as a comparison with Trump’s decision not to testify.

On June 6 in San Francisco, a federal jury acquitted UK tech entrepreneur Mike Lynch of multiple counts of wire fraud and conspiracy, arising out of his role as chief executive of software company Autonomy. The charges were that under Lynch’s leadership, the company used backdated contracts, round-trip deals to entice customer purchases, and software revenues mis-allocated to unprofitable hardware sales. With its financial reporting so manipulated, it was claimed that American company Hewlett-Packard’s 2011 purchase of Autonomy for $ 11 billion, led by Silicon Valley veteran Meg Whitman, for which HP took a write-off one year later of $ 8.8 billion, involved an overpayment that exceeded $ 5 billion. 

Lynch took the witness stand at his trial. As reported, his “calm and confident performance in his own defense on the witness stand appeared to have turned things in his favor.” 

By contrast, in choosing not to testify, Trump is unique among American presidents. Whatever the course of his future appellate strategies, he is a convicted felon – a label hung on him by a jury of twelve ordinary citizens.

While the American notion of the Monday morning quarterback seems not to have a colloquial British equivalent, Lynch has a prominent public profile there, and his acquittal has been well covered in the UK media. Both the similarities and the differences invite comparison.

The two defendants brought to their trials a common reputation of domineering and autocratic executive styles. Both professed disinterest in the details under their watch, left to subordinates in favor of attention to their avowedly higher callings.

The readiness to evade responsibility for the conduct of their minions invoked what one of my early mentors, a former federal prosecutor, called the “pure heart and empty head” defense – asserted by CEOs who claim to be above attending to the granularity of quotidian particulars. In Trump’s case, responsibility fell to Allen Weisselberg, his longtime financial wheelman who for his complicity earned both a two-million-dollar severance payoff from the Trump Organization and a five-month sentence for his guilty plea to charges of tax and other frauds. For Lynch, it was his chief financial officer Sushoven Hussain, who had earlier been convicted and served a five-year prison sentence for his role in Autonomy’s malfeasance.

Both defendants brought to their trials the baggage of collateral litigation exposures. Arising out of his personal and business affairs, Trump faces adverse judgments in New York in the actions brought by E. Jean Carroll for defamation relating to what a New York jury found to be his sexual assault, and by the state’s attorney general for his organization’ corrupt manipulation of its real estate valuations; related to his tenure in office are the three pending but stalled cases - for conspiratorial vote-rigging in Georgia, purloining and concealment of confidential government records documents in Florida, and the January 6, 2001, insurrection in Washington.

Lynch’s situation is rather simpler - he confronts the damages phase of civil claims by HP in the London courts, seeking recovery for the debacle on the back-breaking if implausible scale of four billion pounds.

Commentators have suggested that the prosecutor’s case against Lynch was over-complicated and confusing for the jury. As a non-participant and therefore unqualified to opine, I note only that juries are fully capable of following even complex financial and accounting narratives – as shown not only by the Trump verdict but also by the November 2022 convictions of Elizabeth Holmes for financial fraud based on the fictitious blood-testing technology of Theranos, and Sam Bankman-Fried’s November 2023 conviction for the wild excesses of crypto exchange FTX.

A challenge for any defense counsel – assessing how a client defendant’s testimony may be perceived by a jury, for better or worse - is not just a hard call. Sooner or later as any litigation of consequential scale reaches its inflection point, whether criminal or civil, defense lawyers must make plain to their clients a highly simplified proposition – “You could lose this case.” It may happen on the eve of trial, as with the last-minute agreement by Fox News to settle the defamation claims of Dominion Voting Systems for $ 787 million. Or when a plea bargain is offered. Or when there is no further postponement of the binary decision whether to take the tactically risky but legally justifiable choice not to testify.

Mike Lynch may not have needed the lawyers’ speech. Trump, schooled by über-fixer Roy Cohn and pursuing for decades the tactics of “delay, deny and deflect,” may even now not have registered the reality.

Lynch may have dodged conviction by his act of courtroom salesmanship. Whereas if credence is given to Trump’s relentless self-promotion and unrestrained self-confidence, it would be fair to ask how he could resist the opportunity for a theatrical first-person courtroom display of his ability to market his own brand and his long-cultivated image of superior intellectual skills and behaviors both innocent and virtuous.  

Would the outcome of either trial have been different, if their choices had gone the other way? One reason the inquiry and the comparison are so tantalizing is precisely that we cannot and will not ever know.   

 

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Kristi Noem Shoots Her Dog, Wounds Herself

“Puppy killer” is not usually offered as a qualification for high elective office.

It’s a self-inflicted wound - the audition by South Dakota governor and farmer Kristi Noem as a MAGA candidate for vice president on Donald Trump’s ticket – choosing to publicize in a forthcoming campaign biography the story that she summarily executed a 14-month-old pointer puppy.  

As reported, Noem shot Cricket the puppy for its “aggressive personality,” disrupting a pheasant hunt and getting loose to attack her neighbors’ chickens. Showing neither mercy nor comprehension of a young dog’s behavior, Noem writes, “I hated that dog,” which to her was “untrainable, dangerous to anyone she came in contract with, and less than worthless…as a hunting dog.”

My credentials for the right to comment: I was born and raised in a farm village on Iowa’s black dirt prairie, one hour from the South Dakota border. My father was a large-animal veterinarian whose clients lived on the county’s family farms, raising the plant and animal crops that supported the post-war prosperity.

Farm life now as then is demanding, with little room for naïve romance or misplaced sentimentality. Which does not, however, justify or require the hardening of hearts or the constriction of feelings – my own experience was to the contrary.

Not only is Noem’s story repugnant, it goes from bad to worse. It is to honor the needless sacrifice of Cricket the puppy that Noem’s pathetic attempt to rationalize an impetuous execution is, as was spoken back in the country, “the dog that won’t hunt.”

The idea is offensive that Cricket deserved execution in a gravel pit, either for its supposed failure at a pheasant “hunt” or for biting a family member. To start, readily agree that a farm dog may well have a guard function – watchful for both predators threatening the livestock and strangers with unproved intent. If so, the farmer is responsible that a canine with ancestral lupine DNA be leashed or penned where it can protect its charges without itself being a hazard.

Further, any dog grown and large enough to inflict damage should be answerable to a “one bite rule,” whether a ranch-raised mongrel or an over-bred Doberman in an ill-suited city apartment, so the failure to secure the young puppy falls on Noem herself.

Nor does Noem’s story improve. In my youth, hunting was done less for sport than to determine the quality of protein on the supper table, and safe and effective use of firearms was basic in every household. 

By contrast to the context for Cricket’s youthful exuberance, bird hunting in the mid-20^th century meant a real contest between man and prey: could a wily pheasant taking cover in a farm grove or a roadside ditch be flushed by a hunter on foot with the help of his dog? Instead, today’s dubious “hunts” involve the pre-dawn planting of sleeping birds in the predetermined landscape of a high-ticket resort or gun club, only to be target practice for the shooters - degraded slaughter, not fit to qualify as “sport.”  

Noem amplifies her distressing behavior with two additions – first, that she also killed in the same gravel pit an unnamed but rambunctious male goat, deemed guilty of chasing her children and smelling “disgusting, musky, rancid” – and second, putting emphasis on the supposed vigor with which she would confront “difficult, messy and ugly” conditions, as in recent weeks she had been obliged to destroy three elderly horses.

My skepticism level is elevated. Modifying the observation of Oscar Wilde’s Lady Bracknell about parents, that while putting down a single horse may be a misfortune, to kill three may suggest a convenient and systematic cull in the Noem stables.    

I grew up steeped in the ethics of animal husbandry: putting down an animal for humane reasons was a painful if necessary part of farm life, done with restraint and respect. There was such emotion that my father and his veterinarian colleagues in our quadrant of the state shared an on-call reciprocal readiness to euthanize each other’s dogs, to mitigate and relieve the intensity of the feelings involved.

How will Noem’s performative display go down? For the broader population, the callous mentality that could conceive a farmstead policy - “this week let’s kill the three old horses”– disqualifies her from any proximity to the complexity of society’s complex problems.  

As for her presumptive one-man audience, the reaction of Donald Trump awaits, although any sense of optimism should be measured. Between his urban residences in mid-town Manhattan and Florida, the narrow range of his knowledge and competence, and his amply displayed lack of empathy or sensitivity, he lacks any qualifications to speak to a farmer’s decision-making. If he ever played fetch with a puppy or taught one to heel or stay, it fails to show in the published catalogs of his aggrandizement. It would confound him to tell hay from straw, or to assess the range of shotgun gauges, and he would well assume that a “branding iron” refers to a gold-painted golf club inscribed with his monogram and offered for sale to the faithful in one of his courses’ pro shops.   

Meanwhile Trump is reported to be one of only four American presidents not to have a dog. Harry Truman’s maxim, that a president in search of a friend in Washington should have a dog, is thereby reversed – the absence of a White House pet in the Trump years may be taken as indicative of his lack of friends of any type.    

Rejecting the investment of time and energy to bring Cricket from its under-trained and over-energized puppyhood to maturity as a hunting dog, or to find a suitable and loving home where its lack of field aptitude was irrelevant, Noem’s fatal choice suffices in its lack of empathy and judgment not just to confirm her antipathy for the needy and less fortunate but to see her removed and excluded from the political discourse.

Cruel and stupid behaviors are not specific to cultures or geography, of course. Animal abusers can as well be found in the cities and the suburbs as on farms and ranches, and claims of virtue should be assessed with care. Desirably, however, Kristi Noem’s self-proclaimed pattern toward the animals under her care should be kept firmly secured behind the closed gates of her South Dakota farm – thus confining to her family and her livestock her ability to inflict the consequences of her barbarities.   

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Private Equity Sings the Siren's Song; Grant Thornton Answers

It's always a pleasure to be a guest on Francine McKenna's Substack, The Dig. This from March 18 on a story where developments will be consequential:

The United States accounting firm of Grant Thornton, seventh largest of the global networks, announced on March 15 that it was selling a majority interest in itself to the investment firm New Mountain Capital.

Why the date was chosen will likely remain a mystery. Shakespeare’s invocation of the Ides of March to dramatize Julius Caesar’s bloody assassination in the Roman forum, however, suggests a comparison: Grant's forswearing its traditional partnership structure with the dazzling spin management of Marc Anthony’s funeral oration.

O judgment! thou art fled to brutish beasts,

And men have lost their reason.

As the partners/owners of Grant Thornton — the latest and largest of the mid-tier firms to embrace private equity — surrender their traditional status to become employees, it’s time to praise, not bury, the vexing challenges to maintaining professionalism when CPAs accept the golden chains of outside capital.

Where will Grant Thornton spend the money? What are its real ambitions?

The announcement itself is a word salad, the epitome of company-speak. “Quality” is referenced six times in seven paragraphs, “strategy” five, and “value” three. Grant's leadership provides no specifics regarding the expanded service offerings to be funded with its new wealth. Instead, it sticks to conspicuous vagueness, better to retain the flexibility to claim success whatever the future might bring.

A sound inference would be, however, that expansion of the Grant's audit practice is highly unlikely. There is a lengthening list of smaller firms withdrawing from the audits of publicly-listed companies in the US. Grant Thornton's United Kingdom firm has been winding down its presence in the large company sector (here and here). In 2018, it specifically said it was no longer interested in auditing large listed UK companies. The same should be assumed for the US, given that multinational companies require inter-connected global networks to deliver their audit services.

That leads even the casual observer to conclude that its growth ambitions – drawing on what the Financial Times says knowledgeable sources called an intended “war chest for investment” – are focused on the possible spectrum of non-audit consulting services.

Recall that the recent failed attempt to separate EY’s audit and consulting practices – the ill-fated Project Everest – was animated by the aggressive ambition of the EY consultants who dreamt of billions in return for launching an IPO of the consulting practice. (It would not have been the first time EY monetized its consulting practice in the last twenty years.) Feeding the downfall of the Everest mis-adventure was the absence of solutions to at least two parts of the necessary architecture. Answers to both challenges are reportedly included in the Grant Thornton project: provision for the partners’ pension rights, and separated “alternative practice structures” for the auditors and the consultants.

All this suggests at least the hint of a deeper agenda – that the outside capital for the Grant Thornton partners, which EY failed to secure, could be a down payment for a separation strategy. That possibility is not presently visible and even likely to be denied, but perhaps just over the horizon in the vision of at least some of the deal's advocates.

It’s not a crazy idea. Grant Thornton's modestly-scaled audit practice would be an appealing merger partner for another mid-tier firm bold enough to see a future in a traditionally-structured practice, while an independent consultancy underwritten by an angel investor could freely pursue its own path to possible growth and prosperity. 

Concern would be legitimate, however, for a worm lurking in this Edenic apple. There is prior unhappy history with “alternative practice structures,” for example, notably the short-lived cohabitation of H&R Block with McGladrey. And the SEC has warned about alternative practice structures and private equity investments in public accounting firms, in general:

...as some accounting firms may be considering changes to their capital and firm structures, we expect accounting firms to keep as their top priority a focus on their vital gatekeeper function.

The usual metrics that drive the private equity model do not align comfortably with the auditors’ duty to the public and obligations to public company shareholders. It would be an ill fit for the auditors’ exercise of prudence, skepticism and independence alongside the motivations of their new owners to seek and exploit investment opportunities with value to be unlocked through cost-cutting, dispositions and head-count reductions. 

It also sounds odd that the Grant Thornton press release describes the deal with New Mountain Capital as “subject to regulatory approval.” That's because neither the Securities and Exchange Commission nor the Public Company Accounting Review Board has a remit or any record of intruding into the structure, organization, or mergers and acquisitions activity of the audit firms operating under their oversight. Perhaps the comment was related to the role of state boards of accountancy?

Alternatively, it could reference the federal securities law and SEC/PCAOB rules on independence, particularly those involving bright-line prohibitions on financial interests in audit clients on the part of the firms themselves and their associated personnel and related and affiliated entities.

If so, it would be a warning shot across the bow of New Mountain Capital, because this new investment together with its April 2022 investment in the Citrin Cooperman firm would establish a three-way linkage for independence-impairment concerns.

It would surely make the regulators’ nerve ends quiver to think that the private equity sector, whose very business is the identification of otherwise underappreciated financial and economic advantage, would put itself in a role of dominant ownership of firms that benefit from the mandate in the securities laws that provides a protected franchise for those licensed to provide audits for public companies. Consider the temptations – an auditor knows a company’s strengths and more importantly its weaknesses – inherent in access to audit firms' access to all the skeletons and dirty laundry and, too, the existence of those financial cookie jars.  The value to an investor of a peek behind the curtains of auditor confidentiality would be enormous, and amply concerning to attract regulatory attention. Appeals to good behavior would be followed by official after-the-fact wrath when the inevitable lapses are discovered.           

Finally, however, this current version of Marc Anthony’s silver tongue may contain an irony worthy of his dissembling rhetoric. That is, it has been clear for years that neither the auditors’ traditional opinions nor their sprawling networks of inter-related country-level partnerships are robust in response to the current needs of the world’s capital markets.

The latter is displayed by the lack of interest of private capital itself in what the auditor does. The former lies with the clamoring public enthusiasm for different and extended forms of reporting and assurance, most dramatically in the crypto arena and now in the open-ended area of sustainability. The SEC’s wobbling on rules for climate risk disclosures, drawing lawsuits from both advocates and fierce critics of more disclosure, shows that neither the standards nor the approach to assurance are ready for prime time.

And yet, I have been urging for years that outside capital will be a necessary element for assurance to be fit for future purpose (on my blog, Re:Balance, back to August 7, 2011, and in my book, Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms, Emerald Books, 2d ed. 2017). I did not predict private equity to be the source. But, at the same time that its emergence — to fund the accounting firms’ desires to further expand services — further de-legitimizes the traditional definitions that undergird the long-accepted professionalism of the audit function, the consequence is to enable new services actually responsive to the needs of the marketplace.

In other words, Grant Thornton may – like it or not - be showing us the shape of the future.

 

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The CPA Pipeline: Half-Empty – Half-Full – or a Conduit No Longer Fit for Purpose?

       

  “It’s your kids. We’ve gotta do something about your kids!”

                    Doc (Christopher Lloyd), Back to the Future, 1985

 

Commentators of all stripes are alarmed at a possible impending shortage of young accountants. They cite diminishing university enrollments, declines in candidates for the qualifying examinations, the time and cost commitment for a fifth university year, and post-COVID lack of enthusiasm for the long tradition of burdensome working conditions.

The AICPA’s biennial survey of graduation rates in American universities reported a year-on-year 7.8% decline for 2022 in the number of undergraduate accounting degrees, raising concern, as put by the Wall Street Journal on October 12, “as more workers in the profession retire without an adequate pipeline of entrants to fill the gap.”

The December issue of the estimable Accounting Today pitched “the pipeline problem (as) the most vocalized concern” of its designees as the profession’s 2023 top 100 most influential people (p.16).

To address the angst and agita, the Illinois CPA Society lauunched a survey on October 5, as reported by Going Concern on October 11, “to figure out why modern day accounting students and professionals are so uninterested in pursuing the CPA credential.”  

As always prudent, scrutiny is indicated – of the history, the data, and the perspectives being put forward.

To start, history’s long view is that, going back to the invention of trade and commerce, society has recognized and valued the functions of recording, reporting and assuring its quantitative information:

• Verifying for the pharaohs the costs of pyramid construction by matching the size of the labor force with the measures of wheat on which they were fed – an early example of the still-vexing problem of fraud detection and prevention.
• Keeping the books and calculating the profits and losses for the ocean voyages and spice route caravans of the Age of Discovery.
• Inventing independent audit in Victorian England to inform the complex pools of investor capital that funded the corporations building the infrastructure of the Industrial Age – a model that survives to this day.

Those needs are evolving, not going away.

A menu of concerns is offered. The WSJ cited “more onerous workloads … pay and burnout, mundane tasks, lack of meaningful work and the threat of new technology….” 

Brutal hours, trailing compensation, dubious advancement opportunities within the firms’ partnership structures, stresses of efficiency and performance quality under the looming presence of regulators and law enforcement – the environment is fraught.

Gen Z aired a plain and simpler view, with two comments in response to the Illinois CPA survey: “Everyone knows compensation is the issue,” and “the pay is crap and the life sucks.”

Notably, however, there is nothing novel in the persistence of the Dickensian work model – the current debate on mandatory return to the office has nothing on the Victorian vision of Bob Cratchit, toiling with quill and ledger on his high stool at Scrooge & Marley, obliged to grovel for permission to spend Christmas Day with his family. 

At the same time, inquiry is called for, whether the data cited in ostensible support of the “pipeline problem” are indicative of short-term fluctuations or longer-term trends.

The WSJ article compares, for example, the 65,305 accounting graduates in the US in 2021-2022 with 51,622 in 1994-1995 – a 25% uptick over a generation, with the percentage of universities projecting next-year enrollments to be the same or higher for 2024, increasing to 75% from 58% in the prior report.

Further, Purdue University’s highly-rated undergraduate business program is reported in Accounting Today as “defying the trend and seeing accounting enrollments growing dramatically.”

So it is in order to consider the possibility that there is special pleading in at least some of the hand-wringing.

Over in the UK, Sir Donald Brydon proposed in his lucid but unfortunately disregarded December 2019 “Independent Review Into The Quality and Effectiveness of Audit,” that the future of assurance will belong to professionals whose qualifications are drawn from multiple disciplines, beyond the traditional accountancy curricula. That’s a message for the academics: declining numbers of accounting majors might be viewed as canaries in the mine – signals of necessary academic re-engineering, however traumatic that may be to the career plans of department administrators, entrenched faculty, and tenure-aspirant PhDs.

Sadly, the Brydon proposals were met with indifference by the professional societies, lingering behind the curve of evolution, blinkered at the opportunity to broaden their scope and influence, fixated with the idea that the market should come to them, rather than the other way around.

As one head-scratching alternative instead, the Center for Audit Quality on behalf of the auditors of US public companies announced on October 10 a perhaps unique collaboration – a multi-year partnership with the Pittsburgh Steelers of the National Football League, to foster support of student interest in the field of accounting. 

Imagination stirs. The financial statements of a football club could include topics of real-world relevance and also pedagogically engaging: estimating a contingency provision for the impact of unpredictable career-ending injuries, or the amortization period for the cost of player contracts, or the timing of revenue recognition for advance payments to secure season tickets and VIP boxes.

Or, because such arcana might not suit student appetites and attention spans, if given game-day tickets they might apply in the stadium the skills needed as staff auditors - tracking between plays the net effect of in-and-out substitutions to assure that each team had precisely eleven players on the field - reinforcing the core proposition that debits always equal credits.

Student-worthy prizes and inducements might include the opportunity to audition for a Heisman House commercial, or the ultimate, to bring Mean Joe Greene back to Pittsburgh to re-enact his iconic jersey toss to the kid in the Coca-Cola commercial.

As for entry-level and early career compensation, the market would appear to be capable of adjusting. At the top of the curve, Deloitte as the largest of the Big Four announced on September 7 its global 2023 revenue of $ 64.9 billon - under-writing an increase in the percentage of US revenue going to staff compensation to 55.4%, up over four years from less than 50% (Financial Times, October 10, 2023), while at the same time sustaining handsome individual average partner pay, as reported, e.g. in the UK to be £ 1.06 million (about $ 1.3 million). 

The agility enabled by Deloitte’s robust results will not translate universally down the size curve. Instead, business models evolve. The structure of the modern profession was developed in the generation after Mr. Deloitte’s pioneering of the now-standard auditor’s opinion in 1850. Public company audits in the post-war decades were provided in the US by the then-Big Eight and Little Eight, now reduced to the surviving Big Four and a smaller handful.

With every other part of the world’s economies fundamentally altered beyond recognition over that period, it would be unthinkable that the long-established assurance delivery model should be expected or entitled to immunity from equally disruptive change.

Professional recognition, respect and legitimacy are not bestowed as of right or entitlement. Instead, the creaking survival of a model fundamentally unchanged for 175 years, when no other sector is recognizable over the same period, suggests that tectonic forces are at work, grinding slowly but building to an inflection point. 

That is especially the case because, sitting beside any supply-side concerns for the availability of new CPA feedstock is the symmetrical likelihood that developments in technology and artificial intelligence will influence the demand side. Impacts are coming, from re-definition of the functions and qualifications of the coming generations of accountancy professionals to the elimination of many of their current activities altogether.

The status quo will change. Opportunities will continue to be rich and varied. If there is a clear road to the future, however, it is tracked today on nobody’s map.      

 

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A Reality Check at the UK Audit Regulator: The Big Four Are Here to Stay – For Now

“If the fans don’t want to come to the ballpark, you can’t stop them.”       

Hall-of-Fame baseball player and philosopher/sage Yogi Berra

 And if the audit regulators don’t want to grasp an issue beyond their reach, you can’t stop them either.

Although, a problem postponed is not one avoided, but only kicked temporarily into the ditch.

That’s why it matters that Richard Moriarty, newly installed chief executive of Britain’s Financial Reporting Council, has accepted – as reported by the Financial Times –  that “it would not be a failure if Deloitte, EY, KPMG and PwC still audited almost all of the FTSE 100 by the end of his term.” 

In other words, quits at last for the ill-founded rhetoric, since Carillion’s collapse back in January 2018, that reductions in the Big Four’s dominant share of the large-company audit market would somehow be desirable or beneficial.

The position was blared to the skies: Labour MP Rachel Reeves, on her own and as chair of Parliament’s select Business, Energy and Industrial Strategy Committee, the Competition & Markets Authority as then led by Sir Andrew Tyrie, the FRC itself in its strategic plan of March 2018, and the Labour party’s shadow chancellor John McDonnell. 

Generously read, Moriarty’s fresh perspective can be taken for recognition that the challenges of auditor scale, geographic coverage, and distribution and accessibility of industry and other expertise – all left unaddressed by the cited critics as they kept silent on the means by which the mooted market disruptions might be accomplished - mean the end of the threats to displace the Big Four tetrapoly any time soon.

Or viewed slightly aslant, the persistent lack of political will, official energy and legislative attention to the accounting profession – manifest in the passage of nearly six years of inaction post-Carillion, and the acknowledged retreat by the government of Rishi Sunak from attempts to overhaul either the audit sector itself or its regulator – has intersected with the dawning realization that officialdom simply lacks the tools by which to re-shape the Big Four’s share of FTSE 350 audits.

In the months after Carillion’s demise, I addressed the vigorous hostility aimed at the auditors. A series of blog posts (here to here) came together in my short book, DOA: Can Big Audit Survive the UK Regulators? (Amazon 2019). There I laid out in detail the impossibility of re-distributing large company audits, whether by forced participation of smaller firms in joint engagements or in actual re-allocation of full-fledged lead auditor execution and responsibility.

In summary, the data starkly demonstrate the limits of the smaller firms – most succinctly captured in their global revenues:

• Although increasingly trailing its brethren, KPMG as it pushes toward $ 40 billion is still three times larger than BDO, at $ 13 billion the largest of the so-called “challenger” firms.

• And at $ 65 billion at the top of the table, Deloitte is some fifty to one hundred times larger than the firms implausibly included in the “challenger” roster.

My central points of four years ago were straightforward:

• “Concerns over the suitability of the Big Audit model cannot be addressed by attempted forcing of shrinkage on the large firms” (page 36).

• “Conceding the legitimacy of the concerns over audit quality, these will not be addressed by moving either clients or personnel from the Big Four to the smaller firms” (page 38).

• “The challenges of scale – geographic coverage, depth of expertise, personnel demands and financial resources – represent barriers to the emergence or creation of new players of Big Four size that are both natural and insurmountable. Those limitations – definitive on the prospects for either market share re-distribution or imposition of joint auditors with the involvement of the challengers – are no less conclusive on the question of ‘split up’” (page 49).

• “The demands of complex multi-country engagements will outstrip the capabilities of networks oriented to serve a small-country client base with limited personnel resources” (page 43).

• “The impact of scale is critical. No number of hours at the controls of a single-engine airplane can qualify its pilot, however skilled, to command a wide-body jet – much less a helicopter or a stealth drone or a space shuttle” (page 41).

• “No network smaller than the Big Four has a prayer of achieving the scale and resources to clamber into a competitive position” (page 37).

Looking back, what matters now is not the arrival of relief after years of Cassandra-like messaging, against a wall of denial, ignorance, and animus toward the Big Four. Rather, it’s what is to come. From the foreword of DOA: 

“Outbreaks of financial malfeasance and scandal are nothing new. They are both cyclical and inevitable in the operation of the capital markets – functions of the frailties and cupidity of human nature and the pendulum effects of less-than-efficient market mechanisms.”

Nor should the views here be taken as advocacy for the immunization of the Big Audit model from either criticism or the forces of change:

“The question is not whether the Big Four can survive in a form still fundamentally similar to that invented by their Victorian namesakes. It should be plain that under the combined public, regulatory and legal exposures, they cannot. The large firms have no inherent right to the preservation of their franchise in its current form – they are no more immune to the inevitable forces of evolution than were the dinosaurs or the steam locomotives.”

What deserves present recognition – although unlikely to be officially registered or acted upon – is that fresh financial scandals are gestating even now within the darker corners of the capital markets, only awaiting the conditions for their delivery. When the turn of that next predictable cycle does come, as it will with the certainty that has marked its predecessors for decades, the howls of public protest will sound as if fresh, “Where were the auditors?”

• The still-emerging impacts of the COVID pandemic and the dramatic uplift in interest rates are combining to put stresses on companies struggling to survive. They foreshadow a dramatic increase in company failures and bankruptcies, with resort by the unscrupulous to manipulations and chicanery aimed at evading reality, and with painful impact on investors and other sources of capital.

• Increasing numbers of auditor changes are the result of both adjustments of their client rosters by the larger firms and the expansionist ambitions of the smaller firms – all in the context of history’s lesson that problems in audit quality and performance are most frequently seen in the early years of a replacement auditor’s engagement.

• The current disengagement of the regulators from the basic issues will assure that the unlearned lessons available from the recent past will be sprung as if newly-invented when they befall a fresh generation of inexperienced bureaucrats.

To conclude – Richard Moriarty’s recognition of the structural imperative of the Big Four – under the current model – is a helpful and welcome step.

But there’s a basis for the emphasized qualifier. What Moriarty has achieved should not be over-stated. Critical concerns remain over both the value and the sustainability of the Big Audit model. And all the warnings remain vital and relevant.   

 

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NOCLAR: The Auditors' Impossible Task Under a PCAOB Proposal

 

"Why, sometimes I've believed as many as six impossible things before breakfast."

-- The Red Queen, Lewis Carroll's "Through the Looking Glass," 1872

As I was pleased to address today for Bloomberg, the American audit regulator is at it again:

The Public Company Accounting Oversight Board is promoting a flawed plan to escalate the responsibility of auditors for their clients’ noncompliance with laws and regulations, called NOCLAR. As proposed, the auditors’ duties would be new, expanded, and impossible to fulfill.

For context, current standards recognize that “whether an act is, in fact, illegal is a determination that is normally beyond the auditor’s professional competence.” Reflecting reality, the standards have provided since 1988 that an audit normally “does not include audit procedures specifically designed to detect illegal acts.”

The PCAOB’s draft rules would both raise the bar and obscure its height. On top of the standard for fraud detection (AS 23401), auditors would:

• “Identify the laws and regulations with which noncompliance could reasonably have a material effect”
• “Assess and respond to risks of material misstatement” caused by “noncompliance with those laws and regulations”
• “Identify whether there is information indicating noncompliance with those laws and regulations has or may have occurred”

Supporters of the proposal include PCAOB chair Erica Williams, who said, “We’ve seen far too many examples of investors getting hurt due to noncompliance with laws and regulations. And we’ve heard calls from investors for auditors to live up to their responsibilities. It’s time we answer those calls.”

The new standard “is a great step forward for auditor responsibility and empowerment, and for the protection of investors and the markets,” board member Kara Stein said.

However, opposition from corporate America and the large and small accounting firms on whom the burden will fall comprised the bulk of the now 137 comment letters posted to date. The comment period ended in August.

PCAOB member Duane DesParte, one of the two dissenters on the five-member board, said the “expanded scope raises concerns when coupled with the additional proposed requirement for auditors to ‘plan and perform procedures to identify whether there is information indicating noncompliance.’”

The lines of disagreement are drawn with a sharp and simple reason to be wary: The Big Audit model isn’t designed to meet the proposal’s expectations or to bear its consequences.

The only meaningful assessment of auditor performance is in the small number of cases that “go wrong,” with the inevitable question—"Where were the auditors?”—tested in the litigation or regulatory actions that arise with serious corporate malfeasance.

NOCLAR reporting has challenged audit practices for decades. In the courtroom, the plaintiffs’ script follows a crisp and successful template: The “audit plan” was incomplete or inadequate - the auditor’s “search” was insufficient to catch the illegality at issue - even assuming thorough planning and search, the auditors failed to identify and mitigate this particular wrongdoing.

The auditors’ defense is that as non-lawyers who aren’t trained in substance or procedure of criminal law, they were fooled by the concealed criminality of their malfeasant clients—no less than general participants in the capital markets.

DesParte flagged what would be a changed and more threatening environment: “While the proposal focuses the auditor on those ‘laws and regulations with which noncompliance could reasonably have a material effect on the financial statements,’ the filtering threshold of ‘reasonably could’ is not adequately explained in the proposal and is not addressed elsewhere in PCAOB standards.”

Under the proposed standard, the plaintiffs’ updated playbook would argue that a particular illegality or noncompliance should have been identified as material and that indicators of noncompliance that may have occurred were overlooked.

Translating DesParte’s diplomacy into the ruder language of litigation exposure - if anything, the proposed standard’s ambiguities and imprecision would mean that defense of the auditor’s work would become even more difficult, not less.

Compounding their difficulty, the auditors could expect little help from their clients’ in-house or outside counsel. The lawyers’ long-running protection of their privileged client communications (see the US Chamber of Commerce’s comment letter) enables a black hole in corporate reporting, by which the lawyers pretend to be unable to quantify their litigation and contingency assessments, while the auditors and information users pretend to believe them.

Going forward, the deserved scrutiny of the PCAOB’s proposal would compare the proposed standards with expectations under the old. A useful exercise would back-test recent examples. If the proposed standards had been in place, would there have been any difference in PwC’s audits of Colonial Bank? Or in Deloitte’s audits of Taylor Bean & Whitaker?

Those exposed illegalities may be the easy cases. What if the inquiry were more nuanced? Would KPMG’s procedures have differed in its audits of Silicon Valley Bank, where the question of legality still needs unpacking?

Or this: Verizon and AT&T recently have been sued in investor class actions over their failure to recognize the remediation costs of lead-clad cables, long since abandoned underground.

While no auditor’s risk assessment would wish exposure under both the environmental and securities laws, the auditors are flirting with the former—see the International Auditing and Assurance Standards Board’s advocacy of its proposed Global Sustainability Assurance Standard—while the scope of auditor diligence under the NOCLAR proposal is hardly likely to extend to ancient cables long buried and forgotten.

Comment letters on the proposal urged further public input, whether by task force, roundtables, or field testing. These might gracefully allow for reconsideration and retreat from the backward formulation of the PCAOB’s motivation, even as Williams contends the board’s majority is “simply making sure that the protection investors think they are getting today matches what the standard requires.”

That articulation should be concerning. A standard based on what one of the affected constituencies “thinks they’re getting” has it the wrong way around, even if the auditors are too delicate to say forthrightly, “we can’t” or too timorous to step up with “we won’t.”

For the sake of its credibility as it strives to show its value, the PCAOB should demonstrate better diligence over a proposal with potential for such dramatic unintended consequences.

 

Originally published at Bloomberg Tax Insights & Commentary, September 8, 2023, and reproduced with permission. Copyright 2023 Bloomberg Industry Group, Inc. (800-372-1033) www.bloombergindustry.com.

Alert for readers here, although too late to footnote in the Bloomberg version: on September 1, Francine McKenna provided a fulsome tour of the history of company reporting for litigation and other contingencies on her substack, The Dig -- both a helpful primer for new arrivals to the NOCLAR topic and a useful reminder for veterans of the long and tortured relationship between auditors and lawyers.    

 

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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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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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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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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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