Re:Balance -- Jim Peterson

Clorox, UV and Coronavirus – Trump’s Ignorance Stirs A Toxic Cocktail

“So, supposing we hit the body with a tremendous — whether it’s ultraviolet or just very powerful light…. supposing you brought the light inside the body, which you can do either through the skin or in some other way….

 “I see the disinfectant that knocks it out in a minute, one minute. And is there a way we can do something like that by injection inside, or almost a cleaning? Because you see it gets inside the lungs, and it does a tremendous number on the lungs, so it would be interesting to check that.”

 - Remarks by President Trump, Vice President Pence, and Members of the Coronavirus Task Force in Press Briefing, April 23, 2020

 This dangerous display of the boundless ignorance of POTUS 45 was also the day of my last class for the spring semester -- “Risk Management and Decision Making,” by ZOOM with a group of smart and curious law school students at CY Cergy Université in Paris.

That coincidence lets me appreciate and say thank you to my students – the experience was as rich for me as I hope it was useful and fulfilling for them. With brief context setting, it also tees up the punch line lesson offered here.

Our course examines how humans with all our foibles and limitations make decisions under complex and uncertain conditions. The contexts are broad – personal and social, but especially professional, business and political; the processes are often sub-optimal, and the outcomes frequently somewhere between poor and disastrous.

Topping a multi-disciplinary reading list is the pioneering work of Daniel Kahneman and Amos Tversky, whose landmark 1974 paper essentially invented the field of behavioral economics – recently brought down for public accessibility by Kahneman’s own encyclopedic “Thinking, Fast and Slow” (2011) and Richard Thaler’s “Misbehaving” (2015).

Together we explore the many sources of recurrent but avoidable decision-making bias, flaws and error -- among them are herding, over-confidence, proximity bias, anchoring and frame blindness, hindsight, rationalizations, and leadership over-ride and disregard for non-confirming evidence.

Toward the end of the semester, the students take up with enthusiasm the Dunning-Kruger effect – that the less you know about a complex topic, the more likely you are to display your ignorance in flawed but over-confident actions and decisions that reveal – often with tragic and highly destructive consequences -- how little you actually know.

That trait is conspicuously displayed by POTUS 45. His egregious invitation to ingest or inject toxic household cleansers or internalize UV radiation is only the latest. Recall his allusions to nuclear weapons against hurricanes and wind turbines as cancer agents, a weather map re-drawn by sharpie, his challenges with the basics of aircraft catapults and domestic and international geography. The list seems endless of his stunning disregard and disrespect for technical, scientific and professional knowledge and expertise.    

In an affectionate joint biography of Kahneman and Tversky, “The Undoing Project” (2016), author Michael Lewis includes a version of Kahneman’s single sly metric for intelligence: “the smarter you are, the faster you realize that Amos Tversky is smarter than you are.”

To their credit, my agile students will recognize that this maxim honoring the brilliance of Kahneman’s friend and collaborator can be inverted:

“The extent of someone’s stupidity can be measured -- how long does it takes to realize how stupid Donald Trump truly is?”

 

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So What If the SEC Swallowed the PCAOB?

The proposal in the Trump administration's new budget, to roll the PCAOB up into the SEC -- likely a political non-starter -- was first reported on February 10 by Amanda Iacone at Bloomberg Tax, which this morning published my skeptical observations -- reproduced here with Bloomberg's kind permission: 

‘‘An ill-favoured thing, sir, but mine own’’

— Shakespeare’s Touchstone, on his homely Audrey (As You Like It - V, iv, 55-56).

Skepticism is called for in reaction to the budget proposal to roll up the U.S. audit regulator, the Public Company Accounting Oversight Board, into the Securities and Exchange Commission, its statutory overseer.

Do not mistake this reluctance to join the anxieties voiced by the usual suspects—among them former SEC chairman Arthur Levitt and former PCAOB chairman Jim Doty (see the Financial Times, Going Concern, and the Wall Street Journal)—as resistance to effective regulation of the capital markets.

Rather it’s that for years, neither agency has shown any real concern for the auditors or their statutory obligation to support the delivery by U.S. public companies of financial information free of material error. This latest step would only further constrain the function of an entity disfavored from the start of the Trump administration.

SEC chairman Jay Clayton, wheelman for regulatory shrinkage, is moving to ease the auditor independence rules and to reduce the disclosure obligations for smaller public companies. He purged and replaced all five members of the PCAOB, and, at the first opportunity, forced out incumbent member Kathleen Hamm in favor of ex- SEC and Treasury staffer Rebecca Goshorn Jurata.

Never in its history has the PCAOB punched even its own light weight. Nor has the case been persuasively made that the Sarbanes-Oxley Act, rushed into effect in 2002, has operated with effectiveness. Claims of improved audit quality, freely expressed by those with self-interest (e.g., here, here, and here), are never compared to what might have existed, if post-Enron politicians had not panicked into the frantic mode of ‘‘don’t just stand there. . . .’’

And evidence is to the contrary. The PCAOB had no visible effect during the 2007-2008 crisis, when cascades of companies with clean audit opinions fell into failure, take-over, or government bail-out. Nor does it inspire confidence that outbreaks of predictably doubtful behavior continue apace—recent examples include Mattel, UnderArmour, and the unattractive prospect of charges involving EY’s engagement by Sealed Air Corp., which threatens to be a reprise of the criminal scheming at KPMG to steal inspection information from the PCAOB.

The PCAOB lacked credibility from its birth—well before the current push for its demise:

• Under its founding legislation, its inspections take place in the dark, with results only emerging so old as to be stale.
• It remains conspicuously excluded from operations in China, despite continuous over-selling of progress just around the corner.
• It dealt at a glacial pace with such small-bore projects as mandatory auditor rotation and the naming of lead audit partners.
• Even its recent catch-up convergence with the global standards on extended audit reporting of ‘‘critical audit matters’’ trails experiences in other countries that have yet to demonstrate serious investor attention or value.

Currently, the departure of essentially all senior staff has hollowed out its core of experience and expertise, while the poverty of its plans and initiatives was reflected in a ‘‘strategic plan’’ of vacuous cliches.

As for the PCAOB’s fundamental mission, while the divergence expands between the content of historical financial statements and the decisions of investors, the agency’s emphasis on internal controls reporting has reduced the work of audit staff to a morale-sapping exercise in box-ticking—budget-driven and oriented to satisfying the intrusion of the government’s own inspectors.

An academic colleague recently tweeted that the KPMG/PCAOB debacle was caused by the effectiveness of PCAOB inspections, positing that if they were meaningless, there would have been no reason to steal the inspections list.

He had it wrong. Evasion and avoidance of law-making and regulation are not caused by their effectiveness or desirability, but only by the presence and effect of their malign burden. Prohibition in the 1920s and 1960s Vietnam-era conscription stand as examples.

To paraphrase baseball sage Yogi Berra’s dispirited take on the unwillingness of fans to subject themselves to the dystopia of the old Candlestick Park, ‘‘if the audit regulators don’t want to protect investors, you can’t stop them.’’

Effective government regulation, oversight, and enforcement of the operation of U.S. capital markets have been core policy aspirations for nearly 90 years. Restoration of optimism may make it so again, when—and if—public priorities become re-ordered as part of an eventual process to restore confidence in the nation’s gatekeepers.

For the moment, however, ill-motivated as may be the enthusiasm of this White House to kill off the PCAOB, the 18-year failure to justify its existence makes its proposed disappearance of too little consequence to matter.

 

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The Quality of Audit Is Strained – Sir Donald Brydon to the Rescue?

In mid-December, Sir Donald Brydon, estimable London banker and recently retired head of the London Stock Exchange, released a 135-page report, the culmination of his Independent Review Into the Quality and Effectiveness of Audit.

Tasked by the British cabinet secretary for business, his broad-ranging and insightful analysis and recommendations emerge into a UK environment of deep hostility aimed at the accounting profession. Calls for change, animated by a spate of scandals bracketed by the collapse of public contracting giant Carillion in January 2018 and travel icon Thomas Cook in September 2019, range from dissatisfaction with the Financial Reporting Council as the country’s audit regulator to proposals for the break-up or forced reduction in the dominant large-company audit market share of the Big Four.[1]  

Having no official authority of its own, the report’s prospects and impact will rest on the limited supply of political and regulatory energy to be devoted by Boris Johnson’s otherwise pre-occupied post-Brexit government.

So far, ahead of a predictable breaking wave of hostile resistance, public reaction to the substance of Sir Donald’s reasoning and advocacy has been a mild ripple of interest. There will be topics to be addressed -- most notably, his proposed new designation and certification of “corporate auditors,” and others including:

• What the report resists – e.g., mandatory joint auditors for large public companies.
• What it avoids – e.g., the financial and structural fragility and instability of the large firms.
• What it would like evolved – e.g., the current unsatisfactory form of the standard auditors’ report.

Here today, a look at the last of those, and the recommendation that the basic binary auditors’ opinion – “pass/fail,” in lay terms – be retained (¶ 2.3.7) -- although replacing the traditional British formulation that company financial statements provide a “true and fair view” with language from the global standards, that they are “presented fairly in all material respects” (¶ 2.3.2).

Herewith a dissent on the retention of “pass/fail”: As I have written elsewhere, the short-form report is an outmoded product that nobody values, at a cost that nobody wants to pay -- archaic, obsolete, unresponsive to user needs, and a candidate for the dustbin of history.[2]

Scrapped altogether, it should be replaced entirely by “bespoke” assurance – that is:

• Useful auditor reporting would be tailored in focus and content to specific user needs as determined in dialog among the company, its providers of capital, and the auditors.
• It would be sourced by the company from whichever supplier is best suited – whether a traditional audit firm, an emerging firm with a specialty niche, or a new form of provider altogether.
• Assurance engagements would be under conditions of auditor liability that allow for initiative, evolution, and appropriate measures of responsibility among the parties.  

After all, the investing public has long demonstrated disinterest in the vestigial short-form report -- whose sole surviving purpose is to satisfy the regulators of the securities markets. To make a medical comparison, its “pass/fail” language is the capital markets equivalent of the human appendix.

That is:

• Like the vermiform appendix, the “pass/fail” audit opinion serves no obvious purpose.
• Day-to-day, nobody pays it any attention.
• Very few know where it is to be found, ever seek to locate it, or understand if it actually has a function.
• Nothing in either medical science or audit capability allows for dependable predictions of failure, or the ability to prescribe preventive intervention.
• And yet, when either goes wrong – which inevitably occurs with non-zero frequency – the consequences can be grave, and even fatal.

In the end – like the human appendix that can be removed by safe and uncomplicated surgery – it could be excised and never be missed.[3]

The Brydon report’s endorsement of greatly expanded forms of assurance on publicly valued aspects of corporate performance (see generally Ch. 5) is most welcome and worthy of pursuit.

To that end, however, recognition is necessary that the narrow “pass/fail” audit opinion with its origins in the Victorian era has outlived its usefulness and stands now only as a barrier to progress.

 

[1] For a detailed view and an assessment of the UK prospects, please see my book, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon, May 2019).

[2] The theme runs through my first book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books 2d Ed. 2017) – Amazon here.  

[3] Before its exposure as a sham, the scandal-riven Theranos in California raised $ 750 million from investors without ever having an audit. In the UK, high street retailer Sports Direct was out of compliance for weeks with its obligation to replace the resigned Grant Thornton firm, all to no effect on its stock price.     

 

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RIP Paul Volcker (1927-2019) – There Was One Wreck He Couldn’t Salvage

The out-pouring of encomia for Paul Volcker, who has died at age 92, would tower over even his own formidable 6 ft. 7 in. (e.g., samples in the Financial Times and the New York Times).

His credits over more than forty years include the taming of the rampant inflation of the 1980s as Federal Reserve chairman and, post the 2007-2008 financial crisis, the articulation of an eponymous “rule” aimed at the proprietary trading excesses of the investment bankers.

One effort for which he will be little remembered was his ill-fated aspiration to forestall the Enron-driven collapse in 2002 of the Arthur Andersen accounting firm. His proposed “rescue” – floated for three months in the winter of 2002 but effectively dead in the water from the moment of its launch – would have included a cleansing replacement of its leaders with management selected by a new outside board, shrinkage of the firm to “audit only” scope, and negotiations led by his own virtuous self to resolve the Damoclean legal exposures brought by the government and civil litigants.

The Andersen drama included hubris enough to fill a Greek theater: its leaders’ cries of innocence even amid the rubble of its reputation, voracious law enforcement agents displaying their punitive prosecutorial DNA, the plaintiff’s lawyers ratcheting upward their own demands.    

And Volcker himself – boldly taking the stage to reprise a familiar role, only to discover that the script made demands beyond his repertoire.

Volcker’s quixotic effort was doomed from the outset, by a trifecta of insurmountable barriers:

• The fragility of Andersen’s organization, as a global network of national partnerships which, lacking the cohesion of a corporate structure supported by shareholder capital, was hostage to the rapid and fatal erosion of individual partner trust, confidence, and mutual commitment.
• The unwillingness of Andersen’s senior leaders to surrender their positions of stature, remuneration and accountability, to be displaced by an outsider from a different profession, however grise his éminence.  
• Above all, the unsustainable impact of the multi-billion dollar litigation exposure inflicted on Andersen’s limited capital resources – a mortal blow the instant it fell, that made futile any rescue attempt as too little and too late to stop the disintegration already begun.

One legacy of Volcker’s failed mis-adventure is worth recalling today, in the currently fraught environment in which the structure and business model of the surviving Big Four firms are under existential threat from politicians and regulators, particularly in the UK.[1] That is, Volcker’s ambitious but benighted initiative was incorporated into the report issued on April 1, 2008, by the US Treasury Department’s Advisory Committee on the Auditing Profession – inspiring the report’s straight-faced suggestion that the audit firms’ governance should include a mandatory management-replacement program in the event of a disintegration threat.

That the Committee’s entire body of deliberations and pronouncements promptly faded without a trace – its risible Volckeresque proposal included – suffices to capture the inadequacies that inhered in the failed attempt at Andersen.

Meanwhile in its aftermath, fresh outbreaks of financial malfeasance mark the passage of the years since the disruptions of the financial crisis of 2007-2008, with intense public criticism rather than the introduction of sustainable “solutions” dominating the debate around the fitness of the current Big Audit model.

Paul Volcker himself was never heard to admit that he lacked sufficient appreciation of the issues to comprehend the futility of his efforts. A dose of that humility would have spared him a conspicuous failure. If true for a figure of his considerable stature, the same would be prudent today for those critics tempted to prescribe impracticalities far beyond their own vision and competence.

 

[1] For which, please see my book of this May, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon 2019).

 

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Critical Audit Matters: The Games Are On

As a guest on Going Concern -- on October 27 and today -- I've been looking at the accumulating experience with extended auditors’ reports – the additional paragraphs that under international standards describe Key Audit Matters (aka Critical Audit Matters under the Public Company Accounting Oversight Board’s standards in the United States).

I'd first noted a major gap – nobody has yet asked whether investors actually pay any attention or give any value to the extra verbiage, while the evidence builds that they do not, notably the lack of indicative share price moves at Steinhoff Group in South Africa and the UK’s Thomas Cook.

If investors show no real concern for KAMs and CAMs, who does – and is auditor behavior affected?  

With those questions open, studies are emerging of the first wave of US CAMs – examples include Deloitte this summer, on 52 large companies with fiscal years ending on June 30, 2019; a second in September by Audit Analytics that looked at 65 large-company filings, followed up and expanded in November; and a third reported in November by Accountancy Europe, summarizing the recent experiences with KAMs in Europe.

The Deloitte study and its commentary focused on the substance of the CAMs – the most common are goodwill and intangibles (35%), revenue (19%), and income taxes (15%) – headline subjects also observed by Audit Analytics.

As a topic for a day to come, it may be safely predicted that another year of experience will confirm these early indications of herding toward a converged set of common CAMs, and a booming bull market in boilerplate language. Meanwhile, there are implications simply in the number of reported CAMs and the potential for gaming involved – something worthy of attention by students of the dynamics between large-company auditors and the PCAOB.

The Deloitte study reported an average of 1.8 CAMs for each reporting company, with a distribution ranging from none at all or only one to an outlying maximum of seven or eight – figures consistent with the Audit Analytics finding of 1.9 each and the average of just over two each for the twenty largest US companies reported.

For the auditors themselves, the simple question of optimal CAM frequency has salience at each of two stages – both when a company blows up in scandal, and also as the auditors go through the antagonistic process of PCAOB inspection. The first is because when challenged in a courtroom, the entire CAM process will have generated hostages to the auditors’ fortune and a litigation nightmare, with hostile lawyers pressing the perpetual question, “Where were the auditors?”

That disputing will likely trace to one of the typically common CAM topics – goodwill and intangibles (see Steinhoff), or the legitimacy of revenue (see Under Armour) or the vexed question whether and when an audit report should have been qualified (see Thomas Cook). Closing jury arguments will be built on one of two themes:

• If a CAM had been issued: “They saw it – they addressed it – and they still botched it.”
• Or if not, on the other hand, a back-footed auditor defending a report with few CAMS or none would be called to answer for a client’s fraudulent concealment: “There were billions in falsified transactions – how could they have missed them all?”

In the second case, although the level of PCAOB compliance might be thought of quotidian nuisance, there is the unfortunate frequency of inspected firms to manipulate their working paper files ahead of the inspectors – all the way to the prison-bound criminality involved in the theft of PCAOB inspection lists by personnel of KPMG.

As played straight most of the time, however, the auditors’ CAM counts will be relevant in handling inspections, where commentators since Sarbanes/Oxley’s enactment in 2002 are recognizing that box-ticking and checklist fulfillment now rule (see here and here).

In that context, “zero findings” would plainly be the wrong answer. A PCAOB inspector would be understandably incredulous over a public-company audit where nothing rose to CAM-level significance. Likewise, the presentation of only a single CAM would open the auditor to a nit-picker’s prodding – “Out of all the issues you looked at, why only this one?”

Too many CAMs, of course, would provoke a different inspection issue –-triggering the familiar maxim, “if everything is important, then nothing is important.”

A Goldilocks strategy emerges—firms will identify two CAMs at least, maybe three at most. Those numbers avoid the tail risks – too many or too few – while the inspectors can be entangled in extended discussions, over competing priorities and resources, the interest level and reading tolerance of investors, and the length and complexity of audit reports. The gaming of that process and the accompanying negotiations can be prolonged until all players are cross-eyed with boredom and fatigue.

The result? Three or four years from now, a bright young PhD candidate will have an assured research topic and a glide-path along the tenure track, by compiling experiences under the rubric, “Who ever thought CAMs were a good idea?”

 

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The Challengers’ Cup – An Auditor’s Poisoned Chalice?

Two events in the last week of October are related:

On October 25 the Financial Reporting Council, the UK’s audit regulator, released its latest “Key Facts and Trends in the Accountancy Profession.” The headline was that the Big Four had increased their market share, auditing 100% of the FTSE 100 and building their audit fee income by 1.7%, while the smaller firms doing public interest entity audits saw theirs reduced by 6.7%.

Also, high street sportswear retailer Sports Direct, owned 60% by its bumptious chief executive Mike Ashley, reported on October 23 its success after six weeks of default in replacing auditor Grant Thornton, which had resigned just before the company’s annual meeting. Although Ashley had previously insisted that only a Big Four firm would do (July 26 release of preliminary yearly results, p. 11), the willing firm was RSM – seventh by size in the UK as measured by audit fee income.[1]

For context, important developments are pending in the highly charged UK environment:

• The delivery of Sir Donald Brydon’s fulsome project on “the effectiveness and quality of audit,” expected mid-January according to his Twitter feed (@BrydonDonald).
• The uncertainty under a Brexit effect of legislation to implement the recommendations of Sir John Kingman to supplant what he called the “ramshackle” FRC with a new Audit, Reporting and Governance Authority.
• And the prospects for action on the advocacy of the Competition & Markets Authority and the BEIS committee headed by Labour MP Rachel Reeves for joint audits of the FTSE 350 with mandatory challenger participation, or other forms of coerced audit market reduction of the Big Four’s dominant share.

Years of experience and hindsight will likely be needed, to determine whether RSM’s undertaking of an engagement shunned by all of the Big Four and other challengers will prove either very brave or very foolish.

On that, the constant business press visibility of Mike Ashley’s swashbuckling adventures suggests that RSM’s risk managers must be devoting sleepless nights to the acute recognition of the hazards of their mission – considering that, as put in the firm’s 2019 Transparency Report (p. 41) “in general (the firm) is not active in high audit risk environments.”

Perfectly understandable -- because any proceedings by investors or law enforcement arising out of Sports Direct’s accounting and public reporting would likely have a one-and-done impact on RSM’s very stability. Its audited 2018 financial information, the latest available, includes only £ 13,000 in “provisions,” none identified as litigation; it references only unspecified but “appropriate professional liability insurance;” and it indicates no financial commitment or support from the RSM network’s global structure – confirming, as put in the same Transparency Report, that the each firm in the RSM international network is “a separate and independent legal entity” and that “no single member is responsible for the services or actions of another.”

The relative size of the Sports Direct engagement matters. It is to be RSM’s only FTSE 350 engagement. With a market cap of £ 1.7 billion, it is multiples the size of RSM’s handful of AIM-listed companies. And for an extra risk factor, the company’s NASDAQ listing of its ADRs (SDISY) brings the attendant challenges of compliance with the American securities and auditor regulation regimes and exposure to the hazards of US litigation.

Returning to the broader audit market share issues – the extent of business media attention to the single event of RSM’s hiring should be a check on the CMA’s advocacy that challenger firms should take on 20% or more of the FTSE 350 work over something like a ten-year span.

That is, the CMA’s proposal would mean the migration to new auditors of some 70 companies or the equivalent in joint audit participation. If allocated to the challengers according to their 2018 audit revenues[2] -- having added one, RSM would be looking at nine more; Crowe and Mazars as the two smallest might take up ten between themselves; BDO and Grant Thornton as the two largest would look to add a couple dozen apiece.

Yet to date, neither the politicians, the regulators nor the strident critics of the profession have advanced anything like strategic plans by which those firms would succeed in developing or delivering the personnel, expertise, geographic coverage, financial resources or risk appetite upon which to scale up from RSM’s one-off.

Should Mike Ashley have been left to stew in the consequences of his own attitude? The authority of the UK business secretary to appoint an auditor only addresses a board’s failure to act, not an enforced appointment in the absence of a willing candidate – nor would an attempt at governmental conscription align with the profession’s requirements to rely upon and have a mutually trusting relationship with a client.

Put another way, and by no means impugning either the ambitions of RSM and its challenger brethren or the enthusiasm of the critics, reality intrudes. However enthusiastically a “Nirvana fallacy” may be urged, the frequency of its repetition neither adds legitimacy nor rebuts the folly of unachievability.

 

 [1] As a parenthetical, for those interested in the vexing question whether the investing public actually does value the audit function: Sports Direct’s share price on the LSE actually rose by five pence both on July 29, the day Grant Thornton announced its resignation, and September 11, the day of the annual meeting when it was conceded that no successor was engaged, and then fell by six pence on the day RSM was announced.

[2] Updating from the prior year’s figures in my recent book, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon May 2019).

 

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Critical Audit Matters: Does Anybody Care?

It's always a pleasure to be a guest on Going Concern -- with thanks to Jason, this is up there as of yesterday:

As if the standard auditor’s opinion weren’t already sleep-inducing enough.

 

Standards in the United States now require auditors to identify critical audit matters (CAMs) in their reports on the financial statements of large public companies—things that, in the language of Auditing Standard 3101.11 of the Public Company Accounting Oversight Board, involved “especially challenging, subjective, or complex auditor judgment.” Here the U.S. begins to converge—cannot say “catch up”—with the Key Audit Matters (KAMs) accumulating around the rest of the world under International Auditing Standard 701, issued in 2016.

A wealth of research opportunities is opened. A starting point is the challenge to the data miners, to discern whether this evolution from the traditional one-page “pass/fail” opinion has any actual impact on investor behavior.

Put more bluntly, “Who cares?” So far the proposition is empirically untested, in the U.S. or elsewhere. Two large-company failures, however, point to the contrary.

First was with the complete absence of share price impact when Deloitte’s Amsterdam office included five KAMs in its eight-page report dated Dec. 6, 2016, on the 2016 financial statements of South Africa’s Steinhoff International Holdings NV, the year before the revelation of massive scandal gutted that company’s value and stock price, and led Deloitte on Dec. 13, 2017, to withdraw its report.

The second is of current front-and-center attention in the U.K.—the business cessation on Sept. 23, 2019, of the venerable travel operator Thomas Cook, that country’s most recent large-company collapse.

The blame game started the next day, with the Financial Reporting Council’s indication of interest, promptly followed by the kick-off of its investigation on Oct. 1—another reprise of the perpetual cry, “Where were the auditors?” The press quickly zeroed in on the absence in Ernst & Young LLP’s opinions for 2017 and 2018 of doubts about the company’s “going concern”—not expressed until its review report of May 16, 2019, on the company’s half-year results, which stated (page 33) that “a material uncertainty exists (that) may cast significant doubt on the company’s ability to continue as a going concern.”

But let’s go back—this being about whether investors value available information.

EY’s report dated Nov. 28, 2018, on Thomas Cook’s 2018 financial statements, while not qualified, did add a new and additional KAM to the prior year’s six—an essay of over 450 words specifically labeled “Going concern basis used in preparation of the Annual Report & Accounts” (page 112).

The issue, which EY identified (page 114) as “one of the matters that had greatest impact on the allocation of partner time,” detailed at length the attention by EY itself and the company’s management and directors to the company’s ability to borrow and continue to operate within its financial covenants, which as EY put it (page 112), “remain tight, but pass under management’s severe but plausible scenarios.”

It will be for the FRC’s investigation to assess EY’s compliance with the technical and complex requirement of the professional standards.

However, those keeping track should observe the activity in the company’s stock price. That started with a drop (in pence) from 33.68 on Nov. 29 to 22.72 on Dec. 4, followed by a sharp rise to 34.40 on Dec. 5, all the way to 38.40 on Jan. 4. Not until after that five-week run-up, and five weeks after the KAM disclosures on the company’s going concern, in other words, did its share price begin its terminal decline, which extended steadily all the way to the company’s September collapse.

A scrubbing of the news archives for other possible price-moving information might shed light. Until then, advocates for the proposition that KAMs and CAMs credibly attract serious investor attention must meet the serious question whether and how a sentient reader could have resisted EY’s ominous language, repeated a second time for emphasis, that the company’s survival depended on fulfillment of “severe but plausible scenarios.”

There’s more to the CAM/KAM story—but enough for today.

 

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What’s Hot in Big Audit? October 4th at the ICAEW in London

A major up-dating is set for October 4 at the London home of the Institute of Chartered Accountants in England and Wales – its 2019 Audit Conference, “Reflect, Reform, Refocus.” Proceedings will be reported in the next issue of its magazine Audit & Beyond – but live attendance on Friday will be worth it.

The context is volatile and challenging. Relevant current events include:

• The September 23 collapse of venerable travel operator Thomas Cook, this time with a gloss on the expected query -- “Where was EY?” -- that features the absence of a “going concern” qualification in its 2017 and 2018 opinions.
• The on-going noncompliance of Mike Ashley’s Sports Direct with the requirement, unfulfilled since its September 8 Annual General Meeting, that the company find an auditor willing to succeed Grant Thornton.
• And the persistent silence of the Competition & Markets Authority, following its April 18 report, which proposed that most of the FTSE 350 should be obliged to engage a second audit firm, selected from among the so-called “challengers.”

These items of immediate attention are piled on those of recent months, in addition to the CMA’s report – the report by Sir John Kingman on December 18, 2018, which set up the on-going process of rehabilitating the Financial Reporting Council into a new Audit, Reporting and Governance Authority, and the April 2, 2019, report of the Business, Energy and Industrial Strategy committee of Parliament with its calls for yet more aggressive steps to force a reduction in the near-total large company audit dominance of the Big Four, break up the Big Four, or hobble the scope and skills of their audit practices.

The morning keynote speaker at the ICAEW conference will be Sir Donald Brydon, expected to bring the world up-to-date – albeit with sensitivity and due regard for protocols and discretion – on the state of his mission, launched in December 2018 by the Business Secretary, to inquire and report on “the Quality and Effectiveness of Audit.”

Views on the broad range of concerns will be offered by speakers from practitioners, the standard-setters, and the regulators – see its programme.

I will be there, with a few words to offer. No spoiler alerts are needed – the grounds and reasons for my skepticism about the mooted “reforms” are laid out in my book of this May, short but detailed -- “DOA: Can Big Audit Survive the UK Regulators?”

For those unable to be in Chartered Accountants’ Hall on the 4^th, my perspectives on the issues derive in good part from this single graphic, showing the global accounting networks with 2018 revenue greater than $ 500 million.

Anyone paying attention to the implications of this array, and still clinging to the belief that either joint audits or forced market share re-allocation can be achieved, is invited to bring forth the arguments. Presentation space will be offered here, free and in full – fairly warned that the section will be labeled “Fiction and Fantasy.”

 

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Sports Direct’s Audit – Anyone Up For A Challenge?

If I were teaching my graduate course in Risk Management and Decision Making this summer, its final exam would pose the questions in this real-world dilemma, confronting senior management of the United Kingdom’s mid-sized accounting firms -- dubbed by the Competition & Management Authority the “challengers”:

High street retailer Sports Direct, mightily fallen from its brief stint as a FTSE large company but still listed and public, lacks a successor for long-time auditor Grant Thornton, which announced on July 29 that it would not stand for re-appointment.

The company’s CEO and largest shareholder, swash-buckling Mike Ashley, had postured, as its results were released on July 26: “we do not believe a firm outside of the Big 4 will potentially be able to cope with such an audit in the future.” Spurning Ashley’s come-hither attitude, each of those firms has explicitly demurred -- as has BDO, largest of the challengers.

First question: is another challenger willing to propose, or not? For a firm eager to push its way up the rankings, it could be a golden opportunity. Or else, the definition of a poisoned chalice, with risks and hazards of an engagement as large or larger than any in its existing client book.

Which way the reputational effect? For better or worse the company’s governance is under fire, derided as “out of control” and “a total and utter shambles;” it faces such side complexities as the delayed accounts of Ashley’s personal holdings in Sports Direct and football club Newcastle United; its stock price has tumbled below 240p, from its 2014 peak of 922p, and is now below its 2007 listing price. Its issues will be highly visible in the already-inflamed Big Audit environment.

As for the economics? Grant Thornton’s audit fee for 2017, reported in the latest Accountancy Daily survey, was £ 1.4 million-- for an estimated profit on the order of £ 200-250 thousand. A projection from that figure would be hostage, however, to the doubtful assumption of no further developments. That is, the cost to address even a modest extension of necessary extra audit work, or a lawsuit or investigative inquiry – legal fees and diverted management time alone – would swamp any engagement profit within weeks.

And that’s without thinking of the potential fines or judgments. Could the revenue justify that risk? No fee can be set and charged that would protect an auditor in the fraught context of Sports Direct -- simply impossible. On the large-company scale, Arthur Andersen disintegrated in 2002 under litigation exposure to Enron’s $ 67 billion bankruptcy; in March 2019, PwC settled its judgment of $ 625 million relating to Colonial Bank by agreeing to pay out $ 335 million.

Even much smaller companies can inflict deeply painful consequences. Grant Thornton itself is experiencing its 2019 judgment of £ 21 million plus court costs of £ 5 million related to Assetco, and has pending its day of financial reckoning arising from the indicated falsifications estimated at £ 94 million and shareholder losses of £ 446 million at Patisserie Valerie.

Further, a challenger firm’s liability insurance deductible alone would exceed its annual profit from Sports Direct, while the modest ceiling on its insurance cover would trivialize that “protection” in the face of investor and enterprise losses if Sports Direct continues on its stumbling path.

Worst case, as applied to the 2018 revenues of between £ 500 and 160 million, for the next five UK firms smaller than opt-out BDO, the behavioral model for an accounting firm’s maximum survivable litigation hit, done for the EU commissioner for markets in 2006[1] -- a blow that would fatally de-stabilize and break up a firm would range from about £ 100 million down to perhaps £ 35 million – well under the threat levels lurking at Sports Direct.

Could a firm be arm-twisted by the authorities? The ability of a professional to exercise judgment in client evaluation and acceptance would be hostage to such unseemly over-reach – as would the integrity of the firm leaders’ professed commitments to improve their quality of performance and satisfaction of user expectations.

Meanwhile, the UK regulators are in no position to use force. Not only is it inapposite to consider the suggested but untested authority under Section 490 of the Companies Act 2006 to appoint an auditor if a company fails to act. Any official attempt to press-gang a reluctant firm into an unwanted audit engagement would further the diminishment of the profession’s stature and legitimacy that goes back to the inflictions of Sarbanes/Oxley in 2002.

This, then:

• The adverse consequences of mandatory auditor replacement and constraints on the scope of permissible auditor services are manifest.
• Equally apparent is the insufficiency of long-argued but unachievable “solutions.”
• Regulators and politicians are effectively helpless to impose non-consensual audit assignments.

Under these unhappy conditions, barnyard metaphors are irresistible:

• The chickens have come home to roost.
• The foxes have invaded the henhouse.
• And the capons are squawking around with their heads lopped off.

Students undertaking this examination are reminded that their analysis and answers to these questions are due before the company’s September 11 annual general meeting.

[1] Discussed in detail in my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (2d ed. 2017) at pp. 45 et seq., and a central theme of my recent book on the volatile state of the UK environment, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon May 2019).

 

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Grant Thornton Quits as Auditor of Sports Direct – Why It Matters

“Oh they’ll find some dumb son of a bitch….”

 -- Fire Chief Mike O’Hallorhan (Steve McQueen) to architect Doug Roberts (Paul Newman) – before volunteering to dynamite the water tanks atop the eponymous “Towering Inferno” (1974)

 In an ordinary mid-summer news slump, only yawning disinterest would greet the July 29 news of Grant Thornton’s notice to the UK authorities of its intent to resign as auditor of troubled retailer Sports Direct International plc.

The times are not ordinary; the cauldron of auditor criticism has bubbled since the collapse of Carillion in January 2018. No firm has appeared as a willing successor to Grant Thornton – opening a gap with globally far-reaching implications for the entire Big Audit model.

For context, the parties’ relationship was fraught. The Financial Reporting Council had started an investigation of Grant’s work in 2018, the company’s July 26 release of preliminary results showed performance and stock price in a tail-spin, and the reportedly long-running search for a successor had failed to identify a candidate.

Deflating the posturing confidence of CEO Mike Ashley’s letter in the company’s release, that “we do not believe a firm outside of the Big 4 will potentially be able to cope with such an audit in the future,” none of those firms has taken the bait.

Neither have any of the next tier –- BDO, RSM or Mazars –- unfortunately identified by the Competition & Markets Authority as “challengers.” As for the prospect of a candidate from the still-smaller ranks, the latest Accountancy survey conveys the telling message of scale:

• No firm smaller than Mazars audits a single company in the FTSE 350.
• Of the smaller AIM-100 companies, third-tier firms audit only five, none of which approaches the size of the Sports Direct engagement.

So the day may have arrived when a large public company is unable to secure the services of a qualified auditor. At least three observations are in order:

First, the barren results of Sports Direct’s auditor search reveals the fictive nature of the CMA’s April proposal that all but the largest of the FTSE 350 should be obliged to have “joint auditors,” one of which must be a “challenger” and expected to take up a significant percentage of the actual work.[1]

No criticism of quality, but a quick glance at capacity – if deterred by the scale of the Sports Direct job with its £ 966 thousand fee, “challengers” would even more surely blink at the constraints of expertise, financial resources and risk tolerance involved in taking joint responsibility for the audits of companies larger by several orders of magnitude.

Second, as the Financial Times reported, “under UK rules, the Department for Business has the power to make an appointment if a company cannot appoint an auditor.” The reference is presumably to Section 490 of the Companies Act 2006 – “If a public company fails to appoint an auditor or auditors in accordance with Section 489, the Secretary of State may appoint one or more persons to fill the vacancy.”

That provision aims at a failure of corporate governance, however, not the unavailability of a candidate. At the company level, regulators could hardly force such a result upon a board and management – whose agreement should clearly be essential, the prospect of a hostile and antagonistic auditor presence being unthinkable.

Even less could the FRC presume to force an engagement onto an audit firm reluctant to accept. Professional standards require that the auditor be able and willing to rely on the truthfulness and credibility of evidence and representations from a client and its management – see, e.g., ISA 580 on written representations – making essential the existence and maintenance of mutual trust and confidence.    

Third, the large accounting firms’ vigorously professed dedication to quality has long failed one empirical test. Namely -- no matter how degraded the financial condition or reporting quality or how questionable the character or credibility of management, some pliable audit firm has always been available and willing to engage with any large-company leadership sufficiently sentient to sign an agreement and a retainer check.

So if Sports Direct is indeed left high and dry, it would mark a small but significantly positive step in the profession’s willingness to draw a line for the sake of improved client quality. Putting to rest the behind-doors belief that “Will work for food” is the standard opening message of any audit proposal, that progress should be applauded.

The context of the Sports Direct paralysis being the politically charged evolution of the FRC into the newly constituted Audit Reporting and Governance Authority, it is not hard to envision some serious political arm-twisting of the Big Four, that one of them should relent and take up the poisoned chalice. For the firms, the necessity to resist that pressure would put at stake their very professional integrity.

Whatever political and regulatory energy may survive the Halloween deadline for a Brexit resolution, it is within optimistic expectations that the “purpose of audit” review now in process under the leadership of Sir Donald Brydon will bring clarity of analysis and reasonableness of vision to the challenges of evolving today’s Big Audit model to one fit for future purpose.

Figuring in that project, Sports Direct may well be left orphaned, to bear the consequences of its regulatory non-compliance. If so, that would be a tentative but real demonstration of the gravity of the issues requiring resolution in bringing about the necessary changes.

 

[1] For a detailed exploration of the various official proposals pending in the UK, please see my new book – “DOA: Can Big Audit Survive the UK Regulators?” – available through Amazon in paperback and e-reader formats.

 

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A Taxman Cometh – The United Kingdom Gets a New Audit Regulator

London continues the center of political and regulatory threats to the Big Audit model – there being no way to tell the difference between Washington’s summer torpor and the chronic somnolence at the SEC and the PCAOB:

 “Cometh the hour, cometh the man”? Perhaps – although not clear.

Whitehall’s July 18 announcement is that career civil servant Sir Jonathan Michael Thompson – “Jon” yclept – will leave his post as chief executive of HM Revenue and Customs, succeeding Steven Haddrill, the lame-duck chief executive of the Financial Reporting Council.

He will arrive in interesting times. The FRC – “toothless and passive” as described by Labour MP Rachel Reeves, and in City grandee Sir John Kingman’s December 18, 2018, report (¶ 4) “a rather ramshackle house … built on weak foundations” – is to mutate into a newly configured Audit Reporting and Governance Authority.

Or not. Housekeeping adjustments at the FRC began with uptake of the Kingman report by Greg Clarke, cabinet secretary for Business, Energy and Industrial Strategy. More serious changes require legislation, although whether any law-making energy survives the Keystone Kops environment of Brexit will abide – as will, indeed, any policy initiatives that may outlive the dubious tenure of a Tory government predicted to be led by Boris Johnson.

To fulfill ARGA’s charge, described in the July 18 Financial Times as “restoring confidence in the quality of the audit work in the UK after scandals at companies such as Carillion, the outsourcing group,” Thompson steps into fraught conditions.

First, as addressed in detail in my new book – “DOA: Can Big Audit Survive the UK Regulators?” – he will find his regulatory cookbook lacking achievable recipes:

• The headline recommendation in the April report of the Competition and Markets Authority was that all but the largest of the FTSE 350 companies should engage two audit firms. The problem is that if enacted, a requirement that second auditors be selected from the ranks of the “challengers” would suffer irredeemable impracticality based on those firms’ limited scale, capacity, financial resources and risk tolerance.
• The CMA’s other proposals -- that there be “organizational separation” of the Big Four’s audit practices, and that they should foreswear all ancillary services to audit clients -- were already either fait accompli or well capable of adoption, yet are of dubious and unproven impact on the quality of auditor performance.

Second, the more aggressive actions urged by press and academic critics as well as the April 2019 report of the Reeves committee -- such as enforced reduction of the Big Four’s market dominance, actual break-up, or shrinkage of the large firms to “audit only” -- have failed to acquire traction.

Third, presuming the best of regulatory intentions at the new ARGA, reality will intrude to impose practical limits on the scope of any enforcement penalties -- the head-on hazard that the failure of another Big Four firm, in a reprise of the 2002 litigation-driven collapse of Arthur Andersen, would disintegrate the entire model.

Last and most important, ARGA will inherit two of the FRC’s structural handicaps – that by the nature of its auditor oversight remit it is distant by two removes from the machinations of corporate malefactors; and that, like any enforcer, it will be under-resourced, politically stressed, and consistently late to arrive on the scene of the next and inevitable outbreak of scandal.    

In this less-than-optimistic setting, Sir Jon brings to his new task a CV in government accounting and finance and a career-long string of civil service postings – none relating to the profession of public accounting or, in particular, the national and global complexities of the Big Four networks’ provision of audits for the world’s large public companies.

Rather, as the FT observed, his tenure at HMRC included “controversy over staff bullying” and “an independent review (that) found that abrasive behavior was prevalent.”

Context affects the prospects for success. “Horses for courses,” as the English put it. Or in the tactics manual of the American mob, “don’t bring a knife to a gun fight.”

Is a bare-knuckled bureaucrat well suited to the UK’s multi-party bun-fight over its audit model? Critical public reaction to the evidence given in last January’s committee hearings by non-auditor representatives of the large accounting firms suggests the importance for credibility’s sake of detailed experience and communication capability.

Credit Sir Jon with the energy and skill set of an experienced civil servant –- whether or not transferable to a radically different context, where both enthusiasm and ideology may well be sucked into the vortex of Big Audit’s technical, professional and business structure and culture – enough to smother the best of intentions.

One risk is clear: his initiatives will be hostage to the Dunning-Kruger effect – the prospect that inexperienced decision-makers will suffer all-too-human over-confidence and fail to recognize the limits of their capabilities in a complex field.

As the current occupant of the White House in Washington has been fond of saying since 2016, about his own ad lib initiatives that so often dissolve into thin air or inaction, “We’ll see.”

 

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What Price Wrong-Doing? Sanctions Against KPMG Are Complicated

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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My New Book -- "DOA: Can Big Audit Survive the UK Regulators?"

It is a pleasure to announce the availability of my new book -- "DOA: Can Big Audit Survive the UK Regulators?" -- now available in paperback and e-reader versions through Amazon -- here. 

To summarize the story, which is little enough comprehended even in the United Kingdom, and both seriously under-reported and much misunderstood in the United States and elsewhere:

"The collapse of Arthur Andersen in 2002 reduced the large accounting networks to the Big Four – Deloitte, EY, KPMG and PwC. Can they survive, in a model fit for purpose?

 "Public criticism and the hostility of regulators and politicians are intense, especially in the United Kingdom since the January 2018 collapse of contracting giant Carillion. The debate is joined, the outcome is uncertain, and the consequences to the capital markets will be profoundly disturbing.

"The issues are complex: audit quality, the 'expectations gap,' competition and choice. Disruptive 'solutions' include breaking up the Big Four, stripping their people and services back to 'audit only,' and even nationalizing audit assignments. 

"DOA surveys the background to the current UK environment, examines the possible actions, and assesses the doubtful prospects for beneficial change." 

By its focus, in the current volatile British environment, on the political, regulatory and litigation risks that swirl globally around the Big Four, DOA is a sequel to the detailed scrutiny of these issues in my earlier and still-relevant book, "Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms" (Emerald Books, 1st ed. 2015, revised and extended paperback edition 2017 -- also on Amazon).  

The certainty of global implications for the continuing availability of assurance on the financial information of the world's large public companies, including the stability and viability of the Big Four themselves, makes broadly relevant the actions and decisions of the regulators and politicians in the UK. 

I invite your attention to the examination in DOA of these important issues. Please share with friends and colleagues. Comments here via the Main page, and reactions and suggestions to me at jrpllc@mac.com, are invited and most welcome.

 

Failure Study: Can Auditors Get Better?

“How can you hope to improve, if you can’t tell whether you’re good or not?”

My article, Failure Study: A Needed Addition to the Accounting Toolkit, is just out in the March edition of the CPA Journal, published by the New York State Society of CPAs.

With my thanks to editor-in-chief Rick Kravitz and his team, a direct link is here. And because not all readers here would have the Journal on their lists, it’s my pleasure to offer it in PDF below.

Here's the theme: the accounting profession lacks a forum by which to examine its instances of questionable performance, for lessons to be learned and opportunities to improve.

While “failure study” is an article of faith, deeply embedded and pursued in many other sectors – medical care, engineering, aviation safety and operations, manufacturing processes – the accounting profession has found reasons, if not justifications, not to join.    

For context, recent months have seen refreshed examples, circling the globe with intensified criticism, that repeat the invariable question – “Where were the auditors”:

• The January 2018 collapse of contracting giant Carillion in the United Kingdom, arousing regulators, politicians and media alike.
• Money laundering through the Estonian branch of Danske Bank.
• Falsified transactions at South Africa–based Steinhoff.
• The looting of Malaysia’s 1MDB fund.
• Litigation in Japan by shareholders of Toshiba.
• In the US, criminal proceedings relating to information theft and mis-use by PCAOB employees and senior personnel at KPMG, and PwC’s settlement of the FDIC’s judgment relating to Colonial Bank.

As spelled out in the Journal article, the structure and remit of an effective failure study forum are available, for the value it could bring to an assurance model now under challenges – from these examples and any number of others -- of trustworthiness, stability and fitness for purpose.

The conceded difficulty would be one of implementation, involving all the participants in the Big Audit model. Nothing less would be required than broad cooperation and buy-in -- from issuers of financial information, users in the capital markets, the accounting firms providing assurance, standard setters, legislators, and regulators and law enforcement agencies.

Discussion and debate – reactions and comments – are invited and welcome.

Download CPAJFailureStudy

 

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Facing the British Politicians – A Strategy for the Big Four

The Big Four accounting firms, under intense pressure in London and with their business model at risk, have at most limited influence. A possible strategy in the face of political and regulatory animosity lies in the folk tale found in many cultures -- the clever rabbit, who evades his dire fate at the hands of the voracious fox by pleading not to be thrown into the briar patch.

It would seem so, watching the televised January 30 session of Parliament’s Business, Energy and Industrial Strategy Committee, on “The Future of Audit.”

The Committee focused on the recommendations in the market study by the Competition & Markets Authority and the review led by Sir John Kingman. While other ideas were tabled, the two headline prospects seem to be: (i) mandatory “joint auditors,” for all but the largest of the FTSE 350 companies, to include the “challengers” – firms below the size of the Big Four – or (ii) compelled reduction of the Big Four’s dominant 97% market share.

Passed over here for possible later attention is the genial shared attitude toward the Kingman recommendations to replace and re-engineer the Financial Reporting Council (see the hearing broadcast at 10.51, 11.04). The track record of the profession’s regulators considered – and images of the crew re-arranging deck chairs on the Titanic are difficult to resist -- supplanting one bureaucratic structure with another appeared not important enough to be worth resisting.

With the Committee’s eager desire to “get on with it” (see 10.59, 11.59), either of these options would have fundamental impact. So it is worth a comparison, from the perspective of the firms both large and smaller.

Witnesses from the Big Four all expressed opposition to a regime of mandatory joint audits, citing:

• The absence of evidence that participation of a second audit firm actually achieves an improvement in audit quality (11.08, 11.29).
• The absence of joint auditor value as shown by the lack of uptake in markets where it is an available but unused option (11.29).
• The record of joint audits in France, the single country where local politics creates particular conditions in the legal and governance regimes (10.50, 11.29), and where it has not opened that market beyond the limited share of a single challenger firm (11.29).

In addition, as a risk issue for Big Four incumbents but also a Trojan Horse for the challengers expected to act jointly, the prospect cannot be avoided of added cost, complexity and performance quality risk (10.46, 11.11). Two reasons:

• First, while the challengers asserted their professional capability to perform, they admitted to significant issues with the expansion to scale of their personnel and expertise capacity (10.01, 10.48).
• Second, under the CMA’s proposal the challengers would not only take on significant basic audit work. They would also conclude and opine separately on an issuer’s top-level financial statement consolidation (see 10.04) – a risk with particular liability implications for audit opinions issued into the litigation-prone Anglo securities markets, the US in particular.

For purposes here and absent satisfactory research either way, the challengers’ position on capability may be taken on faith – although the UK record-setting judgment of £ 21 million awarded on January 31 against Grant Thornton over its audits of Assetco, along with the furor over Grant client Patisserie Valerie’s apparent £ 40 million in falsifications and irregularities, serve the point that audit performance by the challengers is not demonstrably superior to that of the Big Four.

With the steely cynicism expressed by Rachel Reeves as Committee chair, on the expectation of fraud detection in the audit of “a shop that sells tea and cakes” (10.32), the Committee did introduce a new cliché into the never-ending antagonism between auditors and information users.  

As noted, and as against the unanimity of Big Four opposition to mandatory joint audits, the large firms’ attitude toward market caps and the surrender of some significant portion of their large-company clients seemed almost benign (11.07-.08, 11.11, 11.28) – for which there are also several reasons:

First, a share reduction from 97% to around 75% might contemplate the shifting of perhaps 60 to 70 engagements over several years time -- each of the Big Four giving up some 15 to 20 jobs.

That’s a modest enough number, especially since the specifics would involve the complex gamesmanship of a four-way dialog among (i) an incumbent Big Four auditor; (ii) the companies identified as candidates, whose audit committees would have to be satisfied with the adequacy of a replacement; (iii) one or more tendering challengers, who would have to demonstrate both the ability to present a satisfactory tender in the first place and execution capability and capacity in the event of success; and (iv) the newly-constituted agency supplanting the current FRC, which itself would be required to ramp up to evaluate and approve the entire process (see 11.09, 11.12).

From the Big Four perspective, the unlikelihood that such a multi-party exercise could be launched and effectively operational within a time span measured in less than a generation would make participation an option with modest risk and more than adequate opportunities to manage to advantage.

All the more, as the Committee seemed to use a metric for selected movement based on head-count (11.07, 11.11), with the consequence that the companies selected for shifting would concentrate at the bottom end of the FTSE 350 scale.

Such a metric might raise an issue of optics and political acceptability, as the companies comprising the bottom quintile of the index by size account for only about 2.5% of its total £ 2.45 trillion in market capitalization. On the other hand, the question is daunting whether the challenger firms could, over any reasonable time span, ever build the capacity or assume the risk profile to take on the company population necessary to represent 20% of the FTSE 350 by capitalization.

To summarize the risk evaluation of a Big Four firm as between the options: A market cap would mean shedding 100% of the liability and exposure involved in the audits of a score or so of smaller-company engagements – with those devolved to challengers willing to accept that start-up issues in the first years of new engagements are well-recognized for maximum risk of failure. Offered a choice, for the Big Four, that risk-mitigating option would seem preferred over the intrusion into their entire portfolios of mandated joint auditors.

Why a challenger firm would want such a supposedly positive opportunity is another matter. Competing each year for the chance to take on an additional half dozen new jobs apiece – all of them larger than anything presently done – with the “early years” challenges and the prospect that any single blow-up on the scale of a Patisserie Valerie could be fatal to their limited financial resources – leadership would need to be bold indeed.

Forced to choose between unattractive options, in short, the Big Four’s strategy to support market caps would adapt from the animal kingdom the rabbit’s view of the briar patch.

Different for the challengers, for whom perhaps better suited is the supposed advice to her daughter by the wife of Prime Minister Stanley Baldwin, on managing a young suitor’s predatory advances. Drawing on her own experience, Lucy Baldwin is quoted:

“Just close your eyes and think of England.”

 

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