Re:Balance -- Jim Peterson

Chinese Companies in the US: The SEC Should Be Making American Foreign Policy?

Nearly a year into the Biden presidency, the breaks with his predecessor are stark and wide-ranging: the Paris climate accord, Iran, NATO, infrastructure –- and of course, the question whether success against COVID-19 should rely on the science of vaccinations or veterinary medicines for equine heartworms.

In that context, it bears wondering why America’s top securities regulator, Gary Gensler, chairman of the Securities and Exchange Commission, has with enthusiasm embraced one of the prior administration’s least coherent ideas.

By rules finalized on November 5 and December 2, Gensler committed his agency and the US audit regulator, the Public Company Accounting Oversight Board, to the Holding Foreign Companies Accountable Act, passed in May 2020, under which foreign companies would be punished for their auditors’ failure to allow oversight agency inspection and production of their working papers.

Aimed directly at the recalcitrant Chinese, who have refused, since passage of the Sarbanes/Oxley law in 2002, to submit to the enforcement processes of the PCAOB, the HFCAA perches Chairman Gensler on the pointed horns of a dilemma: What shall he do now? 

That’s because it is well enough, at the level of the cheer-leading rhetoric of Washington bureau-speak -- as Gensler’s latest press release put it, “the final rule furthers the mandate that Congress laid out and gets to the heart of the SEC’s mission to protect investors … to ensure that the auditors of foreign companies accessing U.S. capital markets play by our rules.”

Left un-addressed, however, are implications for international policy, well above the pay grade of a securities regulator. At the heart of the matter: is official Washington prepared either to de-register the uninspected Chinese member firms of the large international accounting networks, or to enact stock trading prohibitions and ultimate de-listing of non-compliant Chinese companies?

There are multiple issues:

• To start, application of the HFCAA could not please the bankers and other participants in the American-based portion of the world’s capital markets, putting at risk of exclusion an estimated 250 companies with market capitalization above $ 2.1 trillion and headed by such as Alibaba, Tencent and JD.com.

• The self-interest of the bankers would align with ex-China investors in preserving not only simple trading mechanics, but also the availability of information about Chinese companies, as required under the American regimes, incomplete as may be. There is no indication, for example, that an audit regulator in Hong Kong would be any more successful in achieving inspections and document production than its American counterpart.

• Consistency of approach should also drive attention to the unavailability of auditor information on the enormous China-based operations of the array of giant corporations based or listed in the US –- a simple example being Apple, which steadily generates about one-quarter of its revenue in China although the local Chinese firm of EY’s global network has never made available its personnel or its papers.

• China’s own policy intentions and desires are in play. It may indeed suit that country’s leadership to reel in the listings of its country favorites, bringing them home to the proximate bourses of Hong Kong or Shanghai. That step would be congruent with the evident arm-twisting wrought on the fallen darling, ride-share company Didi, which announced on December 3, in timing most likely coincidental, that it has repented of its US initial public offering and will take steps to de-list in favor of Hong Kong –- a move of scant comfort to the investors who saw Didi’s share price lift from its initial offering price of $ 14 to a high of $ 18.01, only to crash back last week to a range around $ 7.

Finally, the entire recent exercise –- passage of the HFCAA and the ponderous rule-creation process of the SEC and the PCAOB –- is redundant and duplicative of pre-existing authority and tools under Sarbanes/Oxley itself.

That is, as outlined here last May, since the time that law was passed in 2002, its framework has required that both domestic and foreign auditors of US-listed companies submit to the PCAOB; that sanctions for non-compliance would include a firm’s de-registration; that audit reports of a de-registered firm were not permissible for SEC filing; and that the consequences for a company would include trading prohibitions and de-listing.

That authority has gone unexercised for almost twenty years. Now, with the HFCAA lurching into place, its rules contemplate a three-year timetable before sanctions would fall on either a non-compliant company or its auditor. That is, commencement of meaningful enforcement consequences would not start before 2024.

Chairman Gensler having inherited a poisoned chalice of mutually conflicting policy goals and potential unintended consequences of uncertain geo-political scope, he stands before a wide-open opportunity window. There, a prediction may be made with confidence, that political exigencies will yet oblige him to hurl that chalice through the window and as far down the road as possible.  

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments and reactions are invited and welcome, and subscription sign-up is easy and free – both at the Main page.    

       

Cap the Big Four’s UK Audit Market Share? A Message From the Facts

It’s nearly four years since Carillion's collapse in the United Kingdom triggered the latest wave -– “Where were the auditors?” While that question is pursued in the Official Receiver's £ 1 billion lawsuit launched against KPMG on November 19, what passes for broader discussion on the Big Audit model has come down to this:

Proposals for “managed shared audits” -- by which the smaller audit firms would perform a material portion of the audits of the FTSE 350 public companies –- have failed to achieve any traction. Is there an alternative?

Still floated with varying degrees of enthusiasm is the idea of a “market cap” –- enforced reduction of the Big Four’s currently dominant share of the large audits -– cited by, among others, the financial press (here and here), the ICAEW, and the chief executive of the UK’s audit regulator, the Financial Reporting Council.

To be taken seriously?

Nope. A rude reality check would await an FRC ukase to forcibly reduce Big Four market share. However wishful or earnest the attempt, there is no other source.

For the multiple reasons why managed shared audits so lack favor, the same limitations exist no less for the unfortunately-described “challengers” –- BDO, Grant Thornton, Mazars, and the other smaller firms in rapidly-descending size –- and the even greater complexities of their taking on full audit performance and responsibility.

My practice in confronting such a conundrum is to consult my academic colleague, Professor A Fortiori.

He begins with the context: Under the indifference of the Boris Johnson government, and the functional absence of the secretary for business, energy and industrial strategy, Kwasi Kwarteng, the prospects for substantial change of any kind are minimal. Not least, the likelihood of Parliamentary attention, much less actual legislation, necessary to replace the shambolic history of the FRC with the mooted new ARGA, ranks somewhere below the chances that the British will return to Greece the Parthenon marbles looted by Lord Elgin two centuries ago.

Nor is there any real wrangling over changes in the audit model, attention having long dissipated to the post-Carillion trio of official reports and the admirable work of Sir Donald Brydon.[1] Rather than active engagement among the parties, the faint glow of the public discourse has not generated heat enough to brew a tempest in a teapot.

The estimable A Fortiori commends these points:

“Audit quality” being ostensibly the ultimate goal, commentators (as referenced above) point to the spate of recent company failures and regulatory investigations and sanctions against the auditors both small and large, needless to repeat here. With that list, the position of the head of audit at one of the “challengers” -– that “audit firm size isn’t necessarily correlated to quality” –- should bear the qualifier, “one way or the other.”  

The same holds for FRC audit inspections -– summarized by the Financial Times to “not help the challengers’ case” –- although caution in extracting conclusions from the numbers is always appropriate, when a compliance-enforcement agency can design and apply its own procedures and then grades the results of its own work.

More importantly, the inhibitions on the “challengers” actually to assume the up-scaled responsibilities of managed shared audits have not been answered. As sketched out here last April 21, those include: the difficulty for a reporting company to identify operations or subsidiaries to be audited within the capabilities of the smaller firm; the burden on a lead auditor of full responsibility for the work of a “challenger,” with the prospect of expensive duplication or re-performance of work; the geographic constraints on the smaller firms of the globalized operations of the large UK-based companies; and the auditors’ cross-border litigation exposure for companies whose securities trade in multiple jurisdictions, notably the lawsuit-friendly United States.

The glancing mention of market share caps has yet to address the yawning resources gaps of the “challengers” -- industry and technical expertise, geographic presence, experienced partners and managers at the line level, investment funding, financial and risk-oriented resources, that such explosive growth would require.

Further, those invoking the possibility of steps to cap the market share of the Big Four have yet to grasp the enormity of the numbers -– not to say, the practical impossibility of the task.

As outlined here on August 23, audit clients of the “challengers” presently comprise a mere 1.6% of the FTSE 350's total market capitalization of £ 2.219 trillion –- a figure undisturbed by the rapid rise of Grant Thornton client Darktrace from its April IPO through its prompt entry to the FTSE 250 and further October index bump-up. The available numbers indicate that the capacity building obligation of the smaller firms to take on a mooted 20% of  FTSE 350 audit work, over ten years, would require them to add clients with capitalization of £ 41 billion, each year if evenly spread, or if done gradually, at an unrealistic annual growth rate of some 29%.

With all that, a Big Four market share reduction is even less practical or achievable than managed shared audits –- so says the wry A Fortiori.

Although he also notes that continued inattention to the compelling facts on the market structure of Big Audit is likely, as the observably dreary environment in the UK makes it predictable that the entire topic will continue to be kicked even further into the tall grass.

Where it will lie, ignored and unattended, until the inevitable “next time.”

                

[1] Sir John Kingman’s Independent Review of the Financial Reporting Council (December 18, 2018).

The BEIS select committee report, ”The Future of Audit” (April 2, 2019).

The Final Report of the Competition & Markets Authority on its Statutory Audit Market Study (April 18, 2019).

Sir Donald Brydon’s Independent Review into the Quality and Effectiveness of Audit (December 2019).

 

Thanks for joining this dialog. Please share with friends and colleagues. Feedback and reactions are solicited and welcome, and subscription sign-up is easy and free – both at the Main page.  

 

Book Review -- “Noise: A Flaw In Human Judgment”

For those making group or individual judgments or decisions, on the job or personally: when Danny Kahneman has something to say, listen and learn.

His latest book, co-authored with Olivier Sibony and Cass Sunstein, is “Noise: A Flaw in Human Judgment” (Little Brown Spark, May 2021) –- deservedly long-listed by the Financial Times for business book of the year.

“Noise” extends a history of scholarship that goes back to Kahneman’s ground-breaking essay with Amos Tversky, his long-time and much mourned colleague, “Judgment Under Uncertainty: Heuristics and Biases” (Science, vol. 185, 1974), and was surveyed comprehensively in his encyclopedic work, “Thinking, Fast and Slow” (Farrar, Straus and Giroux 2011).

Standing on the broad shoulders of Kahneman and Tversky, and the two generations of scholars and practitioners who have refined and applied their insights, we look over a landscape of now-familiar concepts -- representativeness, familiarity and anchoring; sunk costs and loss aversion; misaligned incentives and the dangers of not knowing what you don’t know.

Studies of judgment errors have focused over a half-century on bias, with multitudes of strategies for its identification and reduction. “Noise” now offers an awareness of something distinctly different –- the all-too-frequent, under-recognized and undesirable variability of human judgments, in decisions and outcomes that are sub-optimal and costly at best and deeply unfair or unjust at worst.

A selection among the many colorful examples:

• The wide and perplexing range of prison sentences imposed for the same crimes by different judges, or even by the same judge.
• The amount of disagreement among diagnostic physicians, assessing the same case.
• The high-low spread of insurance premiums quoted by different underwriters for identical risks.
• The divergence of “expert” predictions on future events, from movie sales to interest rates to election outcomes.

The authors bring several surprises – one, that although decision-makers have been frustrated by the degree of noisy variability, they have not (until now) treated it as a subject for identification, analysis and pursuit of responses.

Another, the commonality of noise-inducing conditions across multiple environments:

• Single decisions are as much infected by noise as those that are repetitive or frequent.
• Individuals and groups or teams are similarly susceptible.
• Noise is no less present in predictive decisions whose future outcomes are unknowable, as in choices where simple research or fact-checking would have been relevant and valuable.

The authors readily recognize that variability in judgments is often desirable. Diversity of creative approaches and contrarian opinions are important across fields from film making to market making. But while diversity of views may benefit entrepreneurship and risk taking, it is detrimental elsewhere. If two doctors disagree on a diagnosis, at least one of them is wrong; errors in underwriting do not cancel or average out, but are cumulative; it does not inspire confidence that a job offer or a performance evaluation can be skewed by the time of day it is decided.

Space allows only a sampling of the authors’ analytic taxonomy:

• System noise is broken down between level noise – the variability of judgments due to process ambiguities – and pattern noise – differences in results based on the personal predilections of the decision-makers.
• A noise audit is proposed as the starting point for an organization’s systemic commitment to a noise-reduction effort.
• Decision hygiene encompasses noise reduction by analogy to hand washing in a hospital, reducing the presence of errors, even –- like germs -- without their precise identification.

“Noise” commends tailored and specific strategies to address and reduce unwanted variability, recognizing that the balance between the predictability of strict application and enforcement of rigid rules, and the elasticity of general standards at the discretion of an enforcement authority, is fraught with complexity. It is also at pains to recognize the necessity for trade-offs -- two in particular:

First, costs and benefits require evaluation. As an example, difficult as it is to predict the eventual success of newly hired employees, HR decisions can be improved, at least up to a point. Results improve with inputs from multiple interviewers, provided independence is preserved and the process is not subverted by committee influence or the urgings of a vocal advocate, or where sequential evaluations are passed along, so that an early rating takes on undue influence.

Similarly, noise in the grading of student work owes to the vagueness of evaluation criteria and the fatigue factor or even work hours of the grader. Research shows improvement where essays are ranked best-to-weakest –- a technique more dependable than the assignment of individual numeric scores. Having more than one grader reduces variability, although the time and cost are more easily justified for university admissions or graduate theses than for fifth graders.

Second, reduction in unwanted variability can implicate fairness and equity. Criminal sentencing, long and widely criticized as so unpredictable as to be a “lottery,” depends not only on the judge assigned, but also on such seemingly irrational factors as the time of day or day of the week of a sentencing hearing.

Which said, judges themselves and other critics have reacted negatively to rigid sentencing guidelines, with “three strikes” thresholds and mandatory prison terms, as removing discretion to consider extenuating circumstances or the prospects for rehabilitation.  

That challenge was on display at my boarding school, a very long time ago. The slender Students Handbook was simplicity itself. Strict prohibitions were few: curfews were explicit, attendance and punctuality were expected and enforced, alcohol and drugs were banned. Beyond that, judgment was expected. Alumni of those years recall and recite the central but unwritten principle, “There are no rules here – until you break them” – at which point, official wrath was swift, unambiguous, and unappealable.

Modern examples are available. Readers who share my long-running concern for the model by which assurance is provided on the financial statements of the world’s large public companies will know first-hand the impossibility of divining predictability, comparability or certainty from the pronouncements of purported authorities in such areas as accounting and reporting standards and auditor performance quality.

With its attention to the necessity for balancing and trade-offs, “Noise” has a somewhat provisional feel, especially compared with the notorious rigor that characterized the scholarship of team Kahneman/Tversky, who were unwilling to publish until they had tested themselves and their ideas in protracted scrutiny and debate. Instead, freely admitting the uncertainties and acknowledging the difficulty of generalizing across different domains, the authors both warn readers to proceed with caution and skepticism, and make explicit calls for further scholarship.

A message for my graduate students in Risk Management and Decision-Making who are staying in post-classroom contact: add “Noise” to your reading list, along with my other extra-curricular recommendations.

It’s not a summer beach book. But it will be rewarding, as you extend your studies and as your careers take shape.

(To other readers, if interested in the scope and themes of this course –- for questions, or a syllabus or reading list, drop me an email.)

The affectionate dual biography of Kahneman and Tversky by Michael Lewis, “The Undoing Project” (W.W.Norton 2016), includes the former’s simple test and measure of intelligence: the smarter you were, the faster you realized that Tversky was smarter than you. Modified here, for the sympathetic who have already over-come the natural resistance that inhibits best quality decision-making:

The concepts laid out in “Noise” are complex and provocative. The sooner those responsible for consequential decision-making become engaged, the sooner may come valuable changes in areas previously deemed intractable.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free, both at the Main page.

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free, both at the Main page.

Audit Market Caps in the United Kingdom – The Financial Times Fails a Math Test

 “The Glacial Pace of Audit Reform Needs To Speed Up”

The Financial Times might wish to reconsider this headline, above its editorial of late last week.

Global climate change considered, the metaphor may be more apt than intended, as the likely fate of the world’s glaciers is their tragic and accelerating collapse into muddy puddles amid massive fields of rocky rubbish.

The trope would match the UK government’s belated and sluggish response to the tumult surrounding Big Audit in the post-Carillion era. There are two main efforts in its consultation of this March, “Restoring Trust in Audit and Corporate Governance”: a floundering attempt to construct a legitimate audit regulator to succeed the shambolic Financial Reporting Council, and a single substantive proposal directly applicable to the audit firms -- “managed shared audits” for the FTSE 350 companies –- an unachievable idea that has failed to attract any measurable amount of serious support.  

The FT continues to urge a forced reduction of the Big Four’s dominance of FTSE 350 audits: a cap of 80%, within ten years time –- apparently recalibrating its earlier push for 60%.

For the premier English-language publication addressing business and the capital markets, with “Financial” as its very forename, it falls between perplexity and disappointment that the FT’s support for audit market caps pays no attention to the numbers –- bluntly, that the very structure of Big Audit makes impossible the role that would be thrust upon the unfortunately-described “challenger” audit firms.

The facts matter. Here a summary, using the market capitalization of the FTSE 350 companies as a proxy to measure the demands of personnel and resources required to perform large audit engagements:

First the FTSE 100, whose constituent companies’ total market capitalization is £ 1.814 trillion. Of these, the share of the “challenger” firms is zero. Of the far-smaller companies comprising the FTSE 250, their share is about twenty -- in flux although modestly expanded in the last year to some 9% of the total market capitalization of £ 394.6 billion or some £ 35.5 billion.

Combined across the two indices, the "challengers" hold an audit market share of the FTSE 350 by market capitalization of some 1.6%.

Into that reality, the growth necessary for the “challengers” to reach the 20% target urged by the FT may be measured in two ways:

• Yearly for ten years, they would have to add as clients a book of companies with total capitalization of some £ 41 billion –- more than double the size of their collective total client base today. That’s each and every year.

• Or, as an English major with a calculator can compute, to spread capacity-building gradually over the decade, they would have to achieve a year-on-year compound growth rate of 29%.

To this bleak picture, little needs be added. The underlying reasons why the “challengers” have no growth path on that impossible scale do not implicate performance quality. It’s personnel, expertise, geographic presence, and financial and risk support.[1] The stark numbers themselves tell the story -- it’s not going to happen.

Giving these figures no recognition, the FT presses a set of unlikely premises (all emphasis added):

First, the FT assumes a ten-year process “once the reforms are in place” –- a benchmark unanchored to the unlikely fulfillment of the government’s plans at all. So far there is no evidence of the legislation necessary to transform the FRC –- described by the acerbic Labour MP Rachel Reeves as “toothless and passive” –- while her pungent description might well apply to the government’s own process, given its “glacial” –- not to say backwards –- movement on the basics of populating the FRC’s board of directors and filling the office of chairman.[2]  

Second, the FT urges that smaller-company audits might be “assigned” to the “challengers” –- a prospect inconsistent with the obligation on both auditors and companies that client engagement acceptance be at the mutual judgment and acceptance of each.

Third, the FT describes the Big Four as “themselves split on the best way forward, though none is enthused by the government’s proposal for managed shared audits.” This, while perhaps not reaching the level of misrepresentation, mis-conveys what was more forthrightly surveyed by the FT’s own Michael O’Dwyer on August 15, that the Big Four “have refused to back” the proposal for shared audits.    

As reported by O’Dwyer, their message is clear enough, although if bobbing and weaving were an Olympic sport, the Big Four would be medal contenders: with the candor permissible behind closed doors, the take on shared audits would be somewhere between “no” and “hell no.”

Fairly put, however, the Big Four need not go publicly beyond the perhaps characteristic British euphemism. Given the UK government’s paralysis, their simply expressed distaste for shared audits –- a position held in common with the business community and indeed at least some of the “challengers” –- will adjourn any real confrontation with the impossibility of audit market caps to the arrival of the next global ice age.

Finally and most egregiously, the FT leaps to the position that “a transition period where challengers start to mature and incumbents give up a part of their dominant position is inevitable.”

No –- it is not. Several scenarios, no less unappealing, are at least as likely.

A wager on the more likely to first occur: as between actual achievement by the “challengers” of a 20% market share, or (i) the collapse or failure of one or more of the “challengers,” under the weight of their over-hanging litigation and performance quality issues or otherwise, so that their sector falls below critical mass, or (ii) the disintegration of another of the Big Four, as doomed Arthur Andersen in 2002, which would bring about the total collapse of today’s Big Audit model.  

If offered a voice, the world’s glaciers would opt for relief from the malign effects of human interference. No less, the inability of the editorial writers at the Financial Times to appreciate the actual structure of Big Audit impairs the value of their contribution to the discussion.

 

[1] For the details, please see my blog posts of April 21, 2021 and June 1, 2021, and the extended treatment in my book, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon 2019).

[2] At this writing, the FRC’s interim chair is to leave in October, the full-time post being unfilled for over a year since its last occupancy for a mere eight months, while there are two new arrivals on the board and a second empty board seat (here).

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free – both at the Main page.    

 

“Managed Shared Audits” in the UK – The Largest “Challengers” Think Not

What – they expected gratitude?

“Managed shared audits” were at the center of the UK government’s March 18 Consultation paper on audit reform. The proposal, aimed to loosen the Big Four’s dominant hold on the audits of the FTSE 350, would specifically benefit the smaller, wretchedly-designated “challenger” firms, by mandatory carve-out of ten to thirty percent of each newly-tendered audit to be gifted to the latter.

For reasons outlined here on April 21, and detailed in my short book on the post-Carillion environment in the UK,[1] the imposition of shared audits across the FTSE 350, never realistic, was fatally flawed and doomed to rejection. Quickly summarized: for the companies themselves, the process would be unmanageable, while the Big Four would gain nothing but valueless inflation of their costs, effort and liability exposure, and the smaller firms could never provide the necessary skills, personnel and capability.

One deservedly skeptical response to this offer –- another version of “We’re from the government, and here to help you” -- is now essentially confirmed. Instead of thankful appreciation, the UK firms of BDO and Grant Thornton – ranked fifth and sixth in the league tables – have recognized and spurned the government’s poisoned chalice. Their “no thanks” -- reported in the Financial Times of May 25 –- was spun diplomatically, as their “considering not pitching for work on shared audits of FTSE 100 companies….”

Their demurrer echoes the mordant humor of Abraham Lincoln, who captured the pain and frustration of the American presidency by likening his position to the man tarred and feathered and carried out of town on a rail – who, asked how he liked it, replied that “if it were not for the honor of the thing, he would much rather walk.”

As put to the FT by Grant Thornton’s head of audit, “If the challenger firm is just going to get what’s left at the bottom of the barrel, that’s not interesting and doesn’t help….”

Although the FT coyly suggests that the two firms “are considering focusing on increasing the number of FTSE 250 companies they audit,” Grant Thornton’s shared audit stand-down aligns with the reasons that underlay its 2018 decision “to stop bidding for audit contracts from Britain’s largest companies after concluding it is too difficult to compete with the Big Four firms that dominate the market.”

Clear perspective on the scale necessary to perform large complex audits reveals these implications, too important to ignore:

• First are the size comparisons illustrated by the 2020 revenues of BDO and Grant Thornton (globally $ 10.3 billion and $ 5.76 billion) –- fractions of the Big Four which range from KPMG at $ 29 billion to Deloitte’s table-topping $ 47.6 billion. The inhibitions on the “challengers” are not (necessarily) those of performance quality. Rather, as one FT reader incisively commented, a house carpenter may be perfectly competent to build a single-family home, but could not possibly qualify to build a high-rise tower.

• Second, in the other direction, BDO and Grant Thornton –- as the largest among the smaller -- were noted by the FT to “earn more UK audit fees in aggregate than the next 14 challengers combined.” Not only should their strategically rational risk and capacity assessments compel a reality check for their brethren down the size chart. In addition, their opting out of a shared audit regime emphatically rebuts the possibility that the remaining firms, however willing, could make up a critical mass of delivery capacity.  

The Consultation’s move for “managed shared audit” took a deliberate pass on even less achievable proposals, to enforce Big Four caps or market share re-distribution of the FTSE 350 audit sector. Its single idea so discredited, whither now?[2]

Fundamental re-engineering of large-company information assurance, guided by the insights of Sir Donald Brydon in his December 2019 “Independent Review Into the Quality and Effectiveness of Audit,” requires attention to the dysfunctionalities embedded in the current model. Those include the archaic and outmoded constraints on the scope of permissible auditor services, and the potentially fatal litigation impact on the firms’ financial and business structures, awaiting with the inevitable financial failures on the magnitude of Enron that disintegrated Arthur Andersen in 2002.

Assurance sufficiently extensive and flexible to be fit for today’s demands will remain beyond reach, until and unless the public dialog embraces discussion of these issues. Otherwise, as BDO and Grant Thornton have now confirmed, the dominance of the Big Four as presently configured –- even inhibited as they are by the golden handcuffs of their franchise -- is the only game in town.    

 

[1] “DOA: Can Big Audit Survive the UK Regulators” (Amazon 2019)

[2] One of the aggressive voices for mandated sector re-structuring was that of the Competition & Markets Authority, then led by since-departed Sir Andrew Tyrie. Even with its bust-up advocacy, the CMA’s April 2019 “Statutory Audit Services Market Study” gave legitimacy to the strategic reluctance of Grant Thornton to pursue FTSE 350 audits, conceding (¶ 3.135) that it “may be a rational reaction….”  

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free – both at the Main page.   

 

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

Does anybody really know what time it is?

Does anybody really care?

-- The band Chicago’s debut album, 1969

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free, both on the Main page.

 

Audit “Reform” in the UK: Much to be Modest About

“Parturient montes, nascetur ridiculus mus”

 (The mountains labored, and a ridiculous mouse was born)

            -- Horace, 1^st century AD Roman poet

On March 18, the UK government produced its paper, “Restoring Trust in Audit and Corporate Governance” (the Consultation”), eleven chapters and ninety-eight questions, spread over 232 pages plus an additional 300-odd of Impact Assessment and Key Facts and Trends.

Most of its hefty bulk addresses matters of worth, even in respects beneficial, but at two or three removes from actual large-company auditor performance -- the core of public discussion since the failure of Carillion more than three years ago:[1]

• The re-purposing of the UK’s audit regulator.
• The performance and accountability of corporate directors.
• The potential to re-engineer the purpose and scope of corporate information assurance itself.

On these, the right honorable secretary for Business, Energy and Industrial Strategy has borrowed a “conservative” strategy from the medical field. Retreating from or pushing off for later days a lengthy list of more aggressive actions -- none unachievable or likely to have positive effect -- BEIS Secretary Kwasi Kwarteng’s Hippocratic approach is at least likely to “do no harm.”

Although the Consultation introduces itself with chest-thumping self-confidence, aspiring to proceed “quickly” (¶ 1) with “decisive changes” and “significant, targeted measures” (¶ 1.1.2), its substance is almost resolutely modest. In the tones of Wilde’s Lady Bracknell, no manifesto this watery could possibly be accidental – perhaps reflecting both the inevitable push-back from the affected parties, and the limits of the Johnson government’s own available energy.

Space constraints do not permit an exhaustive catalog of the Consultation’s “less is more” approach, but only examples:

Rather than broadly advocating advanced exploration of the “purpose of audit,” as detailed in the December 2019 report of Sir Donald Brydon on his Independent Review Into the Quality and Effectiveness of Audit, and taking on such thorny issues as the interpretation and applicability of established case law (¶ 6.1.16), the Consultation would content itself (¶ 6.1.19) with asking issuers for a “non-binding purpose statement that could evolve over time.”

Rather than endorse and design a properly composed and well-staffed expert forum for detailed lessons-learning from incidents of audit performance deficiencies – “failure study” as well known in other fields such as aviation and medicine – it would timidly establish a “register” (¶ 6.4.10), picking up the high-level suggestion of the Brydon report (¶ 14.3-.4).

A first step this may be, optimistically, although unless designed and authorized to overcome the resistance expected from all quarters, the likely prospect is another mere repository for notifications of non-compliance – a place where opportunities for real learning will go to die.

Rather than examine the reasons why liability limitation agreements have not been used in auditor-client engagements, the Consultation’s abbreviated four-paragraph attention to auditor liability (¶ 6.8) foregoes the opportunity, making only the (concededly useful) suggestion (¶ 6.8.4) that auditor liability in the up-coming expansion into new forms of assurance ought not to be extended beyond that presently in place for statutory audit.

Rather than obliging the large international accounting networks to demonstrate their “resilience” for the benefit of information users, the Consultation would take a tentative and partial step – namely, to charge the anticipated Audit, Regulatory and Governance Authority to seek information from the large UK firms on their financial resources, including their capital and insurance (¶ 8.3.15).

This is in context of the absence of publicly disclosed global financial statements for the large networks, leaving them like the cobbler’s barefoot children, although full-fledged audited statements would be both achievable and informative, as was the several-year experience of the Arthur Andersen global network in the 1970s.

Rather than take up the aggressive critics’ urgings for forced re-structuring of the Big Four dominance of the FTSE 350 audit market – here, credit where clearly due – the Consultation effectively takes the “market cap” notion off the table.

A future review is contemplated (¶ 8.1.14 and ¶¶ 8.1.27-.30), but only after five to nine years of experience (¶ 8.1.26) that would not even commence until regulations had been in effect during the early years of tender and rotation. Thus any such review would not occur until the early part of the 2030s – by which time all current participants will have left the stage, and market and economic conditions will have evolved entirely beyond today’s ability to predict.

Rather than get deeply to grips with the long-running and intractable problem of usable guidance on the prevention and detection of corporate fraud, the Consultation quotes and endorses (¶ 6.4.4) the position in the Brydon report (¶ 14.1.5) that “it is the obligation of an auditor to endeavor to detect material fraud in all reasonable ways.”

Compare. International Standard on Audit 240 states (¶ 5) that the auditor “is responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error.”

In the US, the PCAOB’s Audit Standard 1001.02 provides that “the auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

None of these three articulations is self-operating as a matter of auditor liability. The significant scrutiny of an auditor’s actual response to indicia of fraud or malfeasance comes in a litigation context, with hindsight allegations of some form of shortcoming. Judges must parse these pronouncements like the medieval theologians debating the number of angels dancing on needle-points. Was an “endeavor (done) in all reasonable ways”? If under the US standard, was “plan and perform” done to a level acceptable in the legal system? Under what standard was the performance “reasonable”?

Information users and practitioners have been dissatisfied for decades. And the language of the Consultation offers no improvement.

Rather than -- to conclude, for now at least, with the subject of internal corporate controls – imposing on UK companies the American requirements under the Sarbanes/Oxley law of 2002, by which controls are signed off by senior executives whose assessments are then attested by the auditors (¶ 2.1.4), the Consultation’s preferred position would leave as optional the question of auditor views on the company’s own assertions (¶ 2.1.41).

Here again, credit where due for restraint. In the 19-year history since the passage of Sarbanes/Oxley, enforcement proceedings and litigation under its provisions on controls have been rare to the point of non-existence. That’s because the Sarbanes/Oxley layering of additional company representations is essentially redundant of the antifraud provisions at the core of the American securities laws, which since the 1930s have made illegal the making of materially misleading statements in the purchase or sale of securities – including in the financial statements required to be signed off by senior corporate executives – making it a doubtful model for the UK’s emulation.  

In sum, over the longer run, the timetable and future prospects for change under the temporizing strategy of Secretary Kwarteng extend down a lengthy road to a dim and misty future.

In the short run, any immediate effect will be akin to that of the little boy in the church pew, suffering loss of bladder control in his dark blue suit: the result is scarcely visible, and does no permanent harm, but it allows the lad to feel relieved and warm all over.    

 

[1] On the two topics that would have direct effect – “operational separation” of the Big Four audit and advisory practices, and the threat to impose “managed shared audits” on the FTSE 350 -- please see my post of April 21.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free, both at the Main page.

 

 

 

Vax Resistance? Gimme A Break

This is the effort a white-haired Chicago veteran went to, to get his Covid-19 shot this morning, at the VA hospital’s vax site where I volunteer:

In addition to the indebtedness that we all owe him for his service, he now enjoys the protection delivered by the best of science, medical research and good leadership.

And we share in common the attitude that Tucker Carlson is both scum beneath contempt, and an active and dangerous menace to the health and safety of our society.

 

Please share as you may be inspired. Comments are invited and welcome, at the Main page.

 

Audit “Reform” in the UK – the Government Finally Speaks, and Says Little

On March 18, the UK government weighed in with its long-promised consultation paper (the “Consultation), “Restoring Trust in Audit and Corporate Governance.” Ninety-eight questions, spread over 232 pages, contain much that is cautious and little that is innovative. The problem is, what is cautious would not innovate, and what would innovate is not cautious.

For another day, the Consultation’s fulsome treatment of such worthy topics as the re-purposing of the UK’s audit regulator, the performance and accountability of corporate directors, and the very purpose of corporate information assurance. On the central topic of public concern since the failure of Carillion back in January 2018 -- the structure and performance of Big Audit itself -- the Consultation offers on only two items.

These are the “operational separation” of the Big Four’s audit and advisory practices, and the threatened imposition on FTSE 350 companies of “managed shared audits” – a novel concept unknown to either professional standards or actual practice.

The first is easily disposed of, as an insubstantial exercise in optics. The second, to be further discussed, is ill-conceived and deeply flawed.

“Operational separation” should have been recognized as a trifling matter the instant it was mooted (see § 6 of the April 2019 Final Report of the Competition & Markets Authority on its Statutory Audit Market Study).

That’s because the UK critics have neither the will nor the authority to force the Big Four networks to expel either of these core UK components from their global structures – disruptions that would disable them from the breadth of services demanded by the complex auditing of the world’s large public companies. Attempted “full legal separation” at the UK level, in other words, would be either or both legally impossible and globally inconsequential.

Moreover, it’s no surprise that the Big Four would accede to the Financial Reporting Council’s quest for public display of their audit leadership, governance and financial reporting. The simple reason was that they already had such structures and metrics in place -– essential tools for managing these four large businesses -- audit practices having published 2019 revenues of between £ 453 and £ 713 million.

Back to “managed shared audits” -- the Consultation contemplates (¶¶ 8.1.15-.16) that a FTSE 350 client of the Big Four would be obliged in its audit tender process to identify a “meaningful proportion” of its statutory audit -- not less than 10% and desirably closer to 30%, by metrics including audit fees, group revenues, assets and profits – to be performed by one of the so-called “challengers” – that is, a firm below the Big Four in size, yet brave enough to deem itself qualified to propose.    

Whisper who dares: in a triangular relationship among an issuing company, its lead auditor and a “challenger,” such an arrangement could satisfy none of the three.

Because the Consultation would not allow for joint bidding (¶ 8.1.17), a Big Four firm preparing to take the lead would start from an untenable position –- not even knowing the identity of the smaller firm, much less its qualifications, reputation or resources by either industry or geography. Despite which, that lead auditor would, under applicable professional standards and the liability regimes to which its global-level work and overall opinion would be exposed, bear full responsibility for the results of the group audit including the work performed and up-streamed by the “challenger.”

Passing for the moment whether such inhibitions would implicate a scope restriction on the lead auditor’s acceptance and planning (see International Standard on Auditing 300), a lead firm’s risk manager would have cardiac arrest at any lesser level of involvement than essentially 100% re-performance of the work of the “challenger.”

As for the company under audit, its management and audit committee could scarcely with comfort identify between 10% and 30% of its operations to be devolved for audit by a “challenger” whose capability and experience at the FTSE level would range from untested to non-existent.

Complicating the risk assessments of both the company and the lead auditor are two issues that inhere in the globalized nature of the large-company environment. First, a recent study estimates that 62% of the sales of FTSE 100 companies (and 35% for the FTSE 250) are generated in locations and operations outside the UK – beyond the geographic scope of a UK-based audit team. That means either that a “challenger” would be obliged to bring its own global resources to bear at the same level of multi-national scope and scale as its putative client – as the Big Four do now -- or that a company would essentially devolve what it could of its UK-based operations, leaving the lead auditor to carry out the ex-UK work and perform the eventual audit and reporting on the consolidation.

Also on the global front, affecting each leg of the triangle is the FTSE 350’s trading of their securities not just in the UK but in other major markets – especially the US where, as put in a recent cautionary article, American Depository Receipts are offered to investors “for over 200 UK companies including most of the country’s large cap companies.” The long US history of high-cost shareholder and other lawsuits presages liability exposures for which the “challengers” are woefully unequipped, and for which the Big Four would have no appetite to carry the burden of their smaller brethren.

Finally there is the unavoidable but compelling matter of the scale and capability of the “challengers” themselves – who audit none of the FTSE 100 and but ten of the next smaller FTSE 250 (see Figure 38, p. 48, of the Financial Reporting Council’s “Key Facts and Trends in the Accountancy Profession,” October 2020).  

In a 210-page Impact Assessment accompanying the Consultation, a model is cobbled together to support an aggressively optimistic position on the growth potential of the “challengers.” Using historical audit fee income for the five largest, ranging from 1% to 4% (page 127), a “conservative assumption (is made) that annual capacity growth of 2-4% can be safely sustained by challenger firms.”

Two problems – one of method and one of supply – are fatal.

For the first, the model disregards the Big Four-dominated growth of overall FTSE audit fees, as shown by two relevant data points: the 2018-2019 growth in Big Four audit fee income of 6.9% (page 46 of the FRC’s “Key Facts and Trends”) and the UK audit practice growth figures for 2020 reported separately by the Big Four, ranging from 3% to 8.7%.

Bluntly put – at the “challenger” growth rates assumed by the Consultation model, and the faster rates actually achieved by the Big Four -- the “challengers” would be losing market share, not gaining. Not assumed, but indeed omitted, would be the inability of the challengers in this zero-sum environment to grow relatively, enough faster than the Big Four to achieve an actual shift in their market share.

To which must be added a further and final point -- the supply side problem of the “challengers” to grow their necessary rosters of experienced partners. Within the Consultation’s timetable, their only available recruitment sources are the Big Four themselves, where individual partners would understandably question a poacher’s overture: reduced profitability and lower compensation, lesser industry experience and technical support, and uncertain financial resources in the face of expanded liability exposure.

The “managed shared audit” proposal would exacerbate those concerns -- because the partner-level obligations and responsibilities at a lead firm would expand in the execution of an engagement involving a “challenger.”

That is, in a single-firm engagement, a signing partner (and the other partners on a complex job) have the benefit of the coherence, cohesion and efficiency of working with a team of subordinates sharing a common set of methodologies, documentation, vocabulary and communications. Delegations can be made, and expectations set, in the relative confidence of shared membership in a common enterprise.

Not so, where that lead partner would be obliged to receive, review, and accept ultimate responsibility for ten to thirty percent of an engagement as staffed and performed by strangers – for which there could be no solution but to increase dramatically the level of partner time, energy, and attention.

At the broad market level, such a shared-audit concern would anticipate major partner-driven fee increases at the lead firm. At the personal level, Big Four audit partners would expect to see their value enhanced, not diminished, by the forced carving out of portions of their FTSE company portfolios – with a concomitant further reduction in a poacher’s attractiveness.

Shot through as the Consultation is with other failures and short-comings of vision – to be addressed here anon – it is earnestly to be hoped that its proposal of “managed shared audit” will promptly and deservedly be dismissed as impractical and unachievable, lest it crash in unintended consequences if an attempt is actually made to put it in place.

 

Thanks for sharing this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sigh-up is easy and free, both at the Main page.  

 

  

Remembering Bernie Madoff -- His Character Was Provable on the Golf Course

Bernie Madoff, the Ponzi schemer who died in prison yesterday while serving a 150-year sentence, provided great wealth for this blog, if not to the broad array of credulous customers from all levels of society,  from whom he extracted over $ 17 billion. One of my favorites, from March 27, 2009, is re-offered here in full, lest the memory ever fade of an irresistible pedagogic moment for my graduate students in Risk Management and Decision Making:

Teed Off at Bernard Madoff?

Bernard Madoff was observably crooked, and his long-running swindle could easily have been stopped, early on. Except that those in the know either didn’t care, or had their own interests to be served.

Calling a halt to his scheming did not require a wake-up call at the soporific SEC, so thoroughly outed after the fact by whistle-blower Harry Markopolis, or performance of the due diligence that the feeder funds promised their customers, for which they and their gatekeepers will now pay the litigation cost.

Instead, it was as simple as the questionable honesty of Madoff’s golf game – and the mutually corrupted readiness of his country-club set of investors to subvert the integrity of that ancient sport.

Deep in “Madoff’s World,” Mark Seal’s delicious piece in the April 2009 edition of Vanity Fair, Seal observes that in the catalog of Madoff’s obsessive-compulsive mannerisms, his golf game was as tightly managed as the rest of his life. He quotes Donald Trump: “Out of hundreds and hundreds of rounds, he never shot lower than 80 or more than 89.”

Although the former guy may not top everyone’s list of character witnesses, there’s an unmistakable clue to Madoff in his throwaway line, “Experts say he’s either the most consistent golfer in the world or he’s cheating.”

In golf as in most other endeavors, whether recreational or professional, there is simply no way to avoid the occasional bad day. A weekend duffer with no hope of approaching par will still have the rare round where the gods smile, drives are straight and every putt drops. Still, there are two tails to every bell curve. Symmetry teaches that there are days when the sand traps eat up approach shots and the cup seems to have a lid – and an honest scorecard shows it.

So the only way Madoff could have shown his reputed consistency would have been through all the available manipulative devices: improved lies, do-over shots and disregard of the whiffs and the penalties for landings in the water.

Golf being an activity where integrity relies crucially on self-reporting, that brings up the role of Madoff’s interested enablers -- the playing partners who would have seen his doubtful conduct in the bunkers and on the greens – but who if they called him, stood to lose their privileged access as early beneficiaries of his Ponzi scheme.   

Regular readers know that I have neither aptitude nor appetite for golf (here), choosing instead to keep the game safer for everyone by staying in the clubhouse. For its culture and protocols I rely on my friend Joe, who played scratch in college and still posts a handicap in the single digits.

He tells of a now-retired professional athlete of epic dimensions, who receives a guest's celebrity welcome on courses worldwide, but who will never be invited into serious club membership – because he is known to fiddle his scores, stiff his caddies and welsh on his bets.

That measure of the seriousness with which the game’s code is taken, and the apt phrase from the fractured Latin of the law schools – falsus in unum, falsus in omnibus – point the finger of accountability at Madoff’s companions. Facing the disrepute of Madoff’s violations, they evidently elected to accommodate their source, lest the promised stream of their investment returns be closed off.

Joe taught me that the dour Scots who invented the game called it “golf” because the more pungent four-letter words were already taken – “hell” or “damn” or the stronger alternatives, muttered or shouted in exasperation at the shanked drive or the malignly placed tree branch.

Would that Madoff’s blind-eyed followers had had the honesty to call “foul.”

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free, both at the Main page.

 

 

Bernie Madoff, the Ponzi schemer who died in prison yesterday while serving a 150-year sentence, provided great wealth for this blog, if not to the broad array of credulous customers from all levels of society,  from whom he extracted over $ 17 billion. One of my favorites, from March 27, 2009, is re-offered here in full, lest the memory ever fade of an irresistible pedagogic moment for my graduate students in Risk Management and Decision Making:

Teed Off at Bernard Madoff?

Bernard Madoff was observably crooked, and his long-running swindle could easily have been stopped, early on. Except that those in the know either didn’t care, or had their own interests to be served.

Calling a halt to his scheming did not require a wake-up call at the soporific SEC, so thoroughly outed after the fact by whistle-blower Harry Markopolis, or performance of the due diligence that the feeder funds promised their customers, for which they and their gatekeepers will now pay the litigation cost.

Instead, it was as simple as the questionable honesty of Madoff’s golf game – and the mutually corrupted readiness of his country-club set of investors to subvert the integrity of that ancient sport.

Deep in “Madoff’s World,” Mark Seal’s delicious piece in the April 2009 edition of Vanity Fair, Seal observes that in the catalog of Madoff’s obsessive-compulsive mannerisms, his golf game was as tightly managed as the rest of his life. He quotes Donald Trump: “Out of hundreds and hundreds of rounds, he never shot lower than 80 or more than 89.”

Although the former guy may not top everyone’s list of character witnesses, there’s an unmistakable clue to Madoff in his throwaway line, “Experts say he’s either the most consistent golfer in the world or he’s cheating.”

In golf as in most other endeavors, whether recreational or professional, there is simply no way to avoid the occasional bad day. A weekend duffer with no hope of approaching par will still have the rare round where the gods smile, drives are straight and every putt drops. Still, there are two tails to every bell curve. Symmetry teaches that there are days when the sand traps eat up approach shots and the cup seems to have a lid – and an honest scorecard shows it.

So the only way Madoff could have shown his reputed consistency would have been through all the available manipulative devices: improved lies, do-over shots and disregard of the whiffs and the penalties for landings in the water.

Golf being an activity where integrity relies crucially on self-reporting, that brings up the role of Madoff’s interested enablers -- the playing partners who would have seen his doubtful conduct in the bunkers and on the greens – but who if they called him, stood to lose their privileged access as early beneficiaries of his Ponzi scheme.   

Regular readers know that I have neither aptitude nor appetite for golf (here), choosing instead to keep the game safer for everyone by staying in the clubhouse. For its culture and protocols I rely on my friend Joe, who played scratch in college and still posts a handicap in the single digits.

He tells of a now-retired professional athlete of epic dimensions, who receives a guest's celebrity welcome on courses worldwide, but who will never be invited into serious club membership – because he is known to fiddle his scores, stiff his caddies and welsh on his bets.

That measure of the seriousness with which the game’s code is taken, and the apt phrase from the fractured Latin of the law schools – falsus in unum, falsus in omnibus – point the finger of accountability at Madoff’s companions. Facing the disrepute of Madoff’s violations, they evidently elected to accommodate their source, lest the promised stream of their investment returns be closed off.

Joe taught me that the dour Scots who invented the game called it “golf” because the more pungent four-letter words were already taken – “hell” or “damn” or the stronger alternatives, muttered or shouted in exasperation at the shanked drive or the malignly placed tree branch.

Would that Madoff’s blind-eyed followers had had the honesty to call “foul.”

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free, both at the Main page.

 

 

Vax Populi: A Dispatch From the VA

Yesterday morning, volunteering at the COVID vaccination center in the hulking Veterans Administration hospital on our city’s south side, I offered a supporting arm under the elbow of a bent and broken warrior.

“Vietnam” on his cap, oxygen tank in a camo backpack over his stooped shoulders, cane in a trembling hand -- he was so wracked with COPD that he could not shuffle unaided the twenty feet to the check-in desk from the arrival door – his determination to get the vaccine having brought him only that far.

Here for context:

Back in early February, the only side effect after my own first Pfizer shot was a full-body wave of relief, optimism and gratitude.

Among the very few benefits of advancing age, my priority group was right behind the first responders. That, along with the privilege of readily available medical care, put me well up the queue. After my no-wait, no-pain jab, came an emotional challenge: since we are not all safe until everyone is safe, how in good conscience could I not put some of my discretionary time into support for the broadest and fastest distribution?

A quick web search led me to the coordinator of volunteer services at the VA, where the vax site was up to speed at around 600 doses a day, and expanding its initial access for the 80-year-olds down to age seventy.

I’m now six weeks as a member of a red-shirted team of volunteers. Working in shifts of six to eight, we take stations at the corners and the corridors that are points of confusion. We answer questions, relieve anxieties, and mainly manage the traffic flow from curbside to paperwork, onward to the actual shots, the necessary recovery/waiting area and eventual discharge.

It is affecting, to be with these vets. Nearly all black and brown men, they fully display the grim array of their conditions – service-sustained as well as the obvious weight, both literal and figurative, of lifetimes of economic, educational and life-style inflictions.

They know the VA. It’s a familiar venue, for which they come fraternally dressed. Most wear caps, jackets or insignia that identify their branch and era of service; the others sport the gear of a local team. Accustomed by their military training and culture to stand or sit with patience in the inevitable waiting lines, they pass the time establishing with total strangers the instant comradeship of their shared experience.

From my first day, helping the process of disciplined but slow and painful steps, I was struck to estimate that well over a third come with canes, walkers or wheel chairs, or on the arm of a spouse or child or caregiver – a proportion of mobility impairments unknown in my own daily bubble.

My puzzlement was schooled by a fellow volunteer – a steely veteran of the first Iraq war. Army Airborne, she said with pride, backing her claim of 26 jumps with a display of scars and attitude that left no room for doubt. “Unless you’ve been there, you can’t imagine,” she said. “The training alone ruins your body. Deployment in the desert—you breathe 24/7 a combination of sand and poison from the oil fields sabotaged by Saddam Hussein. These guys’ lungs and hearts are devastated.”  

The contrast was striking. In my own zip code, physical exertions at the gym or tennis court or ski slope are the antidotes to life at a desk. Orthopedic worry is whether a knee replacement induced by one too many Sunday 10K runs would be reconditioned in time for the paddle tennis season at the country club; with age-rated vax rates approaching 90%, a leading source of pandemic anxiety is the availability of a landing slot for the private jet escaping to the vacation home at the beach.

Not so at the VA, where tired and hurting heroes come for succor, having been put into uniform and harm’s way to make body-and-spirit breaking sacrifices for the sake of our country and its ideals.

They are not only our nation’s deserving – they are the exposed. Their working days are over, but their daily support is provided by children and grand-children -- themselves the central strands that weave our social and economic tapestry: the nurses and orderlies, teachers and waiters and truckers and bus drivers who put their own lives and safety on the front lines of the pandemic campaign.

The VA’s site, now open to all ages and including spouses and widows, is scheduled through the spring. By that time America will have acted according to our national character – corruptly mis-led and inept early on, roaring back with energy and commitment at an over-whelming level, only to tail off into dosage over-production and vast empty delivery sites.

As for the long process of recovery, we will by then finally reach what Winston Churchill called “the end of the beginning.” Except there will linger an unreached percentage of the population whose resistance will inflict a residual level of infections and fatalities, avoidable in theory and aspiration but tragically to be suffered out of a toxic and politicized combination of ignorance and bigotry.

The enfeebled veteran with whom this story started, along with his health-blasted comrades, placed on the altar of patriotism their youth and their healthy adulthoods, to defend principles both precious and complex -- including the right to persist in selfish disregard for the wondrous accomplishments of medical science and the collective good practices that would ameliorate our still-running miseries.  

We are obliged to respect that right – but neither its legitimacy nor those who assert it.

The good pandemic news is that not all the news is bad. Real spring has arrived in our region. Baseball is back. Six-figure vaccination doses are delivered in the state every day. At the VA, at-risk veterans are being cared for in their latter, pain-ridden years.

If you haven’t yet got your shot, you have no excuse – if for no other reason than the safety of your family and friends, colleagues and clients.

And if it’s been a while since you bumped elbows with a veteran and said “thank you,” now would be a good time.

 

Thanks for joining this dialog. Comments are invited and welcome, and subscription sign-up is easy and free – both at the Main page.  

 

    

Book Review: Tim Harford, "The Data Detective"

Released today, by Riverhead Books -- "The Data Detective" -- so titled in its American edition, the latest book from Financial Times economist Tim Harford. 

Here in the United States it is Groundhog Day. As a Brit, Harford might not appreciate my sense of deja vu. Not quite two months ago, I had written a review of the earlier version, released last May in the UK by Little Brown under the title "How to Make the World Add Up." 

As an unambiguous fan of Harford's ability to bring both clarity and entertainment to the challenges in wrestling with quantitative information, I re-publish it here for interested US readers, under the new title so as to be relieve any confusion, mis-direction or concerns about finding it.

Enjoy. I did.

 

Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free -- both at the Main page.

 

 

 

 

Is Audit Reform Truly a UK Priority? Good Luck With That

Kwasi Kwarteng wasted no time, upon taking office on January 8 as the UK’s new Secretary of State of Business, Energy and Industrial Strategy, in asserting that audit reform was “one of his initial priorities.”

The sounds of earnest innocence might be rather touching, from a government servant, freshly elevated from his Energy remit to become chief minder of the entire sprawling BEIS portfolio. Forbearance for a learning curve may be indicated, as reinforced by a CV that does not reveal experience with the issues afflicting Big Audit.

For the moment, however, and presuming good in Kwarteng’s intentions, queries on his earliest signals are in order. See his first Twitter message, following one of appreciation for his appointment – shouting out a £ 10 million investment to support carbon emissions reduction by the whiskey distillers (@kwasikwarteng), as “something we can all raise a glass to.”

Unfair to compare -- few glasses have ever been raised to salute the auditors, in the centuries since the invention of double-entry bookkeeping. But neither did audit reform rate a mention in the BEIS coverage of Kwarteng’s January 11 telephonic discussion of his priorities with five different British business organizations.

Post-Brexit trade relations with the EU and the state of the COVID vaccine roll-out naturally headed that list, on which audit reform did not appear – these having pre-occupied Kwarteng’s short-lived predecessor in office, Alok Sharma. Which said, the realities underlying the intense criticism of Big Audit in the UK that erupted with the collapse of Carillion in January 2018 now confront the anodyne language of the new Secretary’s introduction.

Government response is awaited to a quartet of reports – Sir John Kingman (December 18, 2018) on the manifold inadequacies of the Financial Reporting Council; the Competition & Markets Authority (April 18, 2019) on the Big Four’s audit market concentration at the FTSE 350 level; the BEIS select committee chaired by MP Rachel Reeves (April 2, 2019); and the extended inquiry by Sir Donald Brydon (December 2019) on the purpose of audit.

While the critics’ array of proposed “solutions” are shelved pending official response, further outbreaks of financial scandal and irregularities, litigation and regulatory impositions have added to the intensity of public interest – both in the UK (e.g., Thomas Cook, NMC Health, Patisserie Valerie, Autonomy) and globally (e.g., Gupta, Steinhoff, Wirecard).

What confronts the prospects and the credibility of Secretary Kwarteng, unhappily, is that he brings to the battle a distinct lack of weapons. As explored in detail in my 2019 book – “DOA: Can Big Audit Survive the UK Regulators?” (Amazon) – there is quite simply nothing in the legislative or regulatory armory that can be deployed to effect fundamental change in Big Audit as presently configured.

In summary:

• Re-engineering of the FRC, decried as “toothless and useless,” into the new Audit, Reporting and Governance Authority, is hostage to necessary legislation, and in any event is aimed not at auditor performance itself but at a regulator whose impact is at best secondary and retrospective.
• Attempts to expand competition with the Big Four, by injecting the so-called “challenger firms” into either joint or shared engagements or by actual forced re-distribution of audit mandates – neither ever justified on the basis of audit quality impact – more importantly confronts the reality of the smaller firms’ limitations in size, resources, geographic scope and risk-taking capacity and tolerance.
  • Auditor changes for troubled companies, in the post-Carillion era, do not indicate optimism that those limitations are subject to relief. The replacement of Grant Thornton by RSM as auditor of Sports Direct (since re-named Frasers Group) in October 2019, after weeks of non-compliance, and the December 2020 replacement by Boohoo of PwC with the much smaller Littlejohn firm of the PKF network, do not signal endorsement that the capacity of the “challengers” is adequate to the task.
• As for the ability of the Big Four to house the ancillary skills necessary to perform audits for the world’s complex companies, in the face of calls that they should be “broken up,” the UK regulators retreated to a process of “operational separation” of the audit practices – not only because full legal separation would have been a reach too far for the UK authorities, but because the negotiated optics-oriented adjustments to the large firms’ branding, governance and internal resource deployment were readily within reach.   

To emphasize – the impotence of Kwarteng and his fellows in the face of Big Audit’s intractable issues does not counsel either cynicism or despair. The world’s capital markets will continue to seek financial information assurance that is both relevant and dependable.

The Brydon report points the way, although not without heavy lifting, as Sir Donald understandably declined to wrestle with several fundamental challenges – notably the audit firms’ presently limited financial and structural stability and the related limitations of archaic rules on independence and permissible scope of practice.

One way or another, those will be solved. Perhaps by another litigation-driven collapse, as with Arthur Andersen in 2002, and replacement of the current model with newly organized and emergent suppliers. Or, desirably but much less likely, by the collective and collaborative efforts of all the relevant players to make the deep and necessary changes.

But not, it must be said, by Secretary Kwarteng. To him, as his day of reality and reckoning awaits, the best and only offer is “good luck.”

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome and invited, and subscription sign-up is easy and free – both at the Main page.

RIP Senator Paul Sarbanes

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

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

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

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

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

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

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

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

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

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

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free -- both at the Main page.