Re:Balance -- Jim Peterson

De-Listing Chinese Companies – American Policy is “Ready, Fire, Aim”

The American securities regulators have a problem with China, expressed in their hand-wringing laments (e.g., here and here): their counterparts forbid inspecting the work and accessing the work papers of the auditors of Chinese public companies whose securities trade on America’s capital markets.

“Why so?” is the mystery. The SEC and the PCAOB have the effective means by which to relieve their frustrations, which – whether lacking vision, will, or coherent policy -- they have been unwilling to deploy. Instead, a “President’s Working Group” led by Secretary of the Treasury Steven Mnuchin reported on July 24 a proposal that is muddled in concept, inefficient in structure, and destined to be ineffective even if eventually put into place.  

It’s an exercise in “Potemkin regulation” – to create a façade of legitimacy, like the faux villages supposedly built by Grigory Potemkin to impress Empress Catherine II on her visit to the Crimea in 1787. Here’s why:

Empowered by the Sarbanes-Oxley law of 2002, the SEC and the PCAOB have been packing, but have kept securely holstered, a double-barreled weapon:

• Auditors of public companies whose securities trade in the US can be de-registered (Sarbanes-Oxley § 105) for failure to submit to PCAOB inspection including the obligatory production of working papers (§ 104(a)).

• Companies reporting to the SEC that fail to file accounts bearing the opinion of a registered auditor (§ 102(a) and SEC Reporting Manual § 4115.1) are subject to exclusion from issuance or sale of their securities in the US.

Only if used, these would combine in a swift and efficient two-step: the PCAOB de-registers a non-compliant auditor, then the SEC bars a company failing to file compliant financial statements. QED.  

Not so simple, in the Potemkin village. For unknown reasons, rather than break out the available armaments, the PWG proposes:

Instead of a straight-forward trading ban imposed directly by the SEC, rule-making would invite the American securities exchanges to pursue their own de-listing process (PWG report, p. 9) – an awkward and unnecessarily complex “solution” that would, among other inefficiencies, not reach the possibility that companies would simply retreat to non-exchange trading in the over-the-counter market.

To supplant a Chinese audit firm beyond the reach of PCAOB inspection, a Chinese company would obtain its audit report from the Chinese auditor’s US affiliate, deemed a “co-audit firm” – a term unknown in the professional vocabulary and having no defined scope or meaning (PWG report, p. 8). Such a process would fail, for two separate reasons:

• First, risk managers in the American firms should be aghast. Their firms are not licensed to practice in China, nor do they have the language, local technical knowledge nor cultural and political awareness to perform there. The extent of a US firm's necessary reliance on the personnel, work and documentation of its Chinese brethren would render it a “letter-box,” by which it would offer up its name, reputation and financial resources to unknown and unmeasurable exposures.

• Second, the PWG blithely assumes that in fulfillment of the PCAOB’s inspection process, the American “co-audit firm” would obtain and produce the work papers evidencing the actual work performed in China – a notion both mis-placed and naïve, given the long-standing access refusal of the Chinese regulators who would view such a ruse as risibly transparent.

To the contrary, for two decades the consistent Chinese have swaddled the American regulators in blankets of woolly rhetoric, which in their credulous diplomatic ineptitude the Americans have believed to be real and dependable promises. There is no reason to expect a fundamental change in the Chinese position.    

Nor does the PWG’s construct address the key political issue, namely the collateral effects of threatening the US listings of a roster of Chinese companies estimated at a market capitalization of $ 1.7 trillion (PWG report, p. 7).

That is, while the Chinese themselves might welcome the opportunity to capture the exchange listings of such global giants as Alibaba, PetroChina and China Life, the panjandrums of the American capital markets and the managers of the investment funds holding those companies in their portfolios might feel otherwise – as would those who believe in the desirability of promoting rather than antagonizing the enormity of the Sino-American trading relationship.

Put briefly, there is no perspective from which the PWG[1] proposal can be wrestled into rationality. Not surprisingly, it has perplexed commentators literally around the globe, from Paul Gillis’s China Accounting Blog to the Financial Times in London.

It is not impossible, of course, that Secretary Mnuchin is cranking a fog-making machine as cover for the inconsistent and unpredictable POTUS –- or that the administration is simply vamping for time through the up-coming election.

Either way, the interests of effective operation of the capital markets deserve better.

 

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[1] As a side observation for the language geeks, this body’s label joins a short list of rare three-fold oxymorons. The classic has long been “Holy Roman Empire” – a polity deserving none of those descriptions. My own offering has been “Italian justice system,” as my work experience up and down that congeries of ancient trading states showed their jurisprudence to be neither just nor systematic. Here, there is no evidence of substantive presidential guidance, and the PWG as a “group” oddly does not include the chairman of the PCAOB, the agency most involved and affected; readers are left to conclude as to the fitness of its report under the rubric of “work. ” Submissions of other such triplets are invited.    

Baseball Is Back -- Dr. Fauci Brings Some Joy to Mudville

This was drafted and ready this morning; as the footnote explains, because I paused for lunch, events overtook its prediction:

You win a few, you lose a few.

Some get rained out.

But you got to dress for all of them.

-- Satchel Paige

Dr. Anthony Fauci gave the country a lift and a smile last Thursday, when he threw out the ceremonial first pitch to open the abbreviated baseball season at Nationals Park in Washington.

Looking every inch his five-foot-seven, he shot-put an effort that at least bounced close to the first-base foul line.

A confessed Nats fan, Dr. Fauci displayed sports energy going back to his basketball days in New York, as Regis High’s plucky point guard and team captain. While his errant lob immediately earned a collectible baseball card – if not yet a Wheaties box – a grateful nation will prefer he stay focused on his day job, as America’s face of science and intelligence during the COVID-19 pandemic.

The game ended at five innings under lightning, thunder and torrential rain, with the Yankee’s own # 45, Gerrit Cole, pitching for the win. Earlier that day in Washington, even as “Fireball Fauci” was preparing to take the mound, POTUS 45 clutched for his own first-pitch publicity – a visit to Yankee Stadium on August 15.

Dr. Fauci was masked under his informed policy guidance, while also muffled under the official forces of unmasked ignorance and hostility. Here he is, sportingly enjoying himself, a picture of genuine boyish enthusiasm:

 

The same day, here is the handcuff of Mariano Rivera’s underhand toss into the ample Presidential breadbasket. Defended as if a hostile alien -- instead of a routine double-play ball, it would score an error, first-and-third, and nobody out:

 

Will August 15 actually happen? There are reasons for doubt. As heard from this White House so often and with such little effect, “We’ll know … in about two weeks.” Three seasons into this administration, the incumbent is the first non-participant in the baseball tradition started by President Taft in 1910.

On the political side:

• If not for the empty seats under the pandemic, the predictable reception by fans in New York -- the home city he forsook for Florida and one of the “Democrat” (sic) “hellholes” he so denigrates and disrespects – would have loudly reciprocated the hostility.

• Ardent animosity to Colin Kaepernick’s pre-game kneeling and bigoted militaristic reaction to all aspects of the Black Lives Matter movement would confront the banners, the ribbons and the players themselves – actions he’s claimed to mean “the game is over.”

• The mound can be even more lonely than the Oval Office. For someone eager to claim all credit but deflect all blame, there will be no subordinate or surrogate to demonize for a gaffe, nor a manager to pull him for a reliever.

• Performance anxiety will be raging under the red MAGA cap and the orange comb-over. Comes to mind the scene early in “Bull Durham,” after Crash Davis (Kevin Costner) gets into the thick head of Tim Robbins’s Nuke, whose wild throw shatters the window, and Crash calmly announces “ball four.”    

Further to the narcissistic personal vanity, POTUS would be at serious risk of being shown up by Dr. Fauci’s bouncy authenticity:

• The current major league mound was lowered years ago but is still built to the intimidating height of eight full inches – a slope that, unlike the platform at West Point on June 13, will offer neither a handrail nor a guiding elbow.

• That deteriorated frame shows scant evidence of enough shoulder rotation to launch a baseball the full 60’6” from mound to plate – neither two-handed water drinking nor awkwardly choppy golf swings inspire confidence.

• On my Little League team, anyway, an adolescent displaying the pain and clumsiness pictured in that close-distance game of catch on the White House lawn would have been banished to far right field and the eight-spot in the batting order.

Put another way, generously (if skeptically) accepting the claim of one-time high school level ability, decline is now on display. By comparison, Tony Fauci’s mound performance looked like Don Larsen against the Dodgers on October 8, 1956.

As a Cubs fan – anxiously noting that at this writing they have split their first two games – I have learned to my sorrow not to make predictions. Here however I hazard that by the morning of August 15, some intervening excuse will emerge to scuttle the much-ballyhooed event.

Certainly not a flair-up of the once convenient but lately unmentionable bone spurs. Nor would it be tasteful to invoke golf-induced muscle spasms.

Inclement conditions would be handy. Threats of moisture sufficed to cancel both a visit to a military cemetery outside Paris in November 2018, and the July 11 campaign event in New Hampshire. Rainout-ready Sharpies will be poised over the New York weather maps.

Or, more than likely, some staffer on the White House fringe will have gone rogue and taken a virus test with a positive return – despite the steadfastly illogical proclamations that fewer tests would mean fewer cases. That would offer an out, and finesse the prospect of an ugly and embarrassing debacle.

As often said, “We’ll see.”[1] 

[1] At 3.44 pm EDT this afternoon, POTUS tweeted a vacuous trio of reasons why he will be “unable to be in New York to throw out the opening pitch for the Yankees on August 15…” As Casey Stengel put it, “You could look it up.”     

     

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COVID-19: Florida’s Inexcusable Fiasco Goes National

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

Wirecard Crashes – And Everything Old Is New Again

German payments processor and DAX market darling Wirecard AG has been revealed to have a € 1.9 billion hole in its balance sheet. Erstwhile superstar CEO Markus Braun found himself both out of a job and into police custody.

The company’s catastrophic implosion would have been no surprise to those alert to the depth of its problems as publicized over the last 18 months – not among them the credulous at German regulator BaFin, deeply interested DeutschBank, or a group of groupies among the executive team at SoftBank.

As for the missing cash? It appears never to have been there in the first place, suggesting that the inevitable up-coming forensic exercise may not be all that complex, to unpack an extended course of malfeasance.

Professors of literature teach that there are but a handful of great plot lines. So too, there are just a few basic financial fraud schemes, repeated with minor updating variations from one decade to the next. Among them, falsified operations and fictitious assets are persistent and recurring themes – tweaked in their sordid details by each new generation of white-collar criminals.

Two examples go back a half century – the first accounting scandals on which I cut my teeth as a rookie lawyer: the Salad Oil case, in the tank farm near Newark airport where Tino De Angelis used light-weight soybean oil to top off huge tanks filled with heavier water, fooling the auditors who climbed the ladders to open the lids but neglected to tap the valves at the bottom; and the Ponzi scheme at Equity Funding, where Stanley Goldblum’s minions falsified customer ledgers to create fictitious life-insurance policy holders who went undiscovered because not directly confirmed.

Back in those old days, fraudsters did real work to cover their tracks. Barry Minkow of ZZZBest tricked up dummy customer locations to pass as real work sites. Sam Antar at Crazy Eddie dissuaded the auditors from descending into the creepy basement vaults under his boutique-sized New York shops – never large enough to hold the bulky cartons of projection televisions shown on the fanciful inventories. Head counts of phantom cattle herds were inflated by multiple cycling of the same calves through corral gates, under the noses of naïve city-bred staffers, perched on fence rails and eager to escape the dust and noise.

The evolution over five decades means that such fabrications are of less need to the malefactors. Even the revelation in 2009 that one-third of the revenue of Indian software company Satyam Computer Services was bogus involved only non-existent customer contracts, although the inexplicable absence of physical evidence for 13,000 ghost employees – such as canteen turn-over and transport allowance cards and desks and telephones – remains a puzzlement.

In the case of Wirecard, the concentration of its business in a mere three shadowy “acquiring partners” and the ostensible location of its cash in two banks in the Philippines will figure. With their mission in hand, fraud examiners should not take long, peering at Wirecard’s business model through the guiding lens of hindsight, to reverse-engineer the plot line. Any treasure hunt is eased by having in hand a map with a large “X”.

William of Occam’s reductive principle applies no little to inform the design of a large-scale financial scam. In Wirecard, “the simpler, the better” is likely to have found a new application.

 

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For Chinese Companies -- “Double Secret Probation”?

With appreciation to my friend and colleague Francine McKenna, this guest contribution is up today on her newsletter, The Dig -- to which readers here are enthusiastically invited -- and contact her at TheDig@Substack.com.

 

 

When in need of street wisdom, legendary Chicago columnist Mike Royko called on his bar-stool pal Slats Grobnik.

Not even Slats could explain what has possessed the United States Senate – which on May 20 passed the Holding Foreign Companies Accountable Act – which would expel Chinese companies from the American capital markets because their auditors are shielded by the Chinese regulators from the oversight and inspection program of America’s audit regulator, the Public Company Accounting Oversight Board.

As the world’s greatest deliberative body – so goes the cliché – the fractious Senate can barely muster bi-partisan agreement on the time of day – so passage of the HFCA by unanimous resolution must elicit skepticism about whether there are adults minding the playroom.

The Act first plays to the chest-thumping China hawks – Trade Representative Robert Lighthizer and economic advisers Larry Kudlow and Peter Navarro. It would require a Chinese company seeking access to the American capital markets to certify that “it is not owned or controlled by a governmental entity….” That provision -- so susceptible to gaming that Slats would guffaw over his beer -- pictures a trench-coated character out of John le Carré, peddling a fistful of “no control” certificates -- facially valid and untraceable in provenance.

For two reasons, though, Slats would truly slap his forehead over the Act’s second bit: a Chinese company would loose its US listing and its shares would be barred from US trading, if the PCAOB were unable for three years running to access its auditor and its working papers under the auditor inspection program put into place by the Sarbanes Oxley law of 2002 and activated by extension to ex-US auditors in 2005.

For starters, even though since first requested the Chinese have consistently forbidden PCAOB auditor inspection, the enforcement armory of the American securities regulators has long had the necessary weapons locked, loaded, and zeroed in. Launch of the inevitable Chinese/American diplomatic and trade apocalypse has – at least on paper -- needed no more to pull the trigger than the order of an authorized zealot – one of the noted hawks or, even and perhaps better in these over-heated times, theocratic and rapture-ready Secretary of State Mike Pompeo.

Here’s the short guided tour through the existing arsenal:

• Sarbanes Oxley § 102(a) and PCAOB Rule 2100 require auditors reporting on an issuer’s financial statements to be registered.

• Under Sarbanes Oxley § 104(a), auditor registration includes and requires a registered firm to submit to the PCAOB’s inspection process, including access to personnel and working papers.

• Sanctions for non-compliance include revocation of a registration, under Sarbanes Oxley § 105 (see the PCAOB’s orders relating to PKF (Hong Kong) (January 12, 2016), Crowe Horwath (HK) CPA Limited (July 25, 2017), and Anthony Kam & Associates Limited (November 28, 2017).

• Audit reports by a de-registered firm may not thereafter be included in an issuer’s SEC filings (see the SEC’s Financial Reporting Manual § 4115.1).

• The obligations of a principal auditor using or relying on the work of another audit firm – whether or not that firm is referred to (Manual § 4104.1-.5), or must itself be registered (under the “substantial role” threshold of Rule 1001(p)(ii)) – include the production of work papers and other documents related to that firm’s work (see PCAOB Staff Questions and Answers on Audits of Mainland China Issuers By Registered Firms Outside of Mainland China, December 30, 2016).

• Further, a non-US firm on which a principal auditor relies, whether or not registered, must under Sarbanes Oxley § 106(b)(2) produce its work papers on request and designate a US agent for service of PCAOB or SEC process.      

• Finally, because the financial statements of an issuer in the US may only be reported upon by a registered auditor (Sarbanes Oxley § 102(a)) – the consequences are as summarized in a recent blog post from the Columbia Law School (emphasis added):    

“Companies that fail to file within the allowed grace period are subject to a variety of costly penalties, including deregistration by the SEC, delisting by stock exchanges, the inability to raise capital through issuance of public securities, and potential debt covenant violations.”

With all that authority already in place to bar Chinese companies from US trading of their securities, the questions Slats Grobnik would press—caring no more about the grimy details of the law-making process than he would the ingredients in a classic Chicago hot dog – would be:

• What could they be thinking -- against the immediately predictable blowback from the Chinese securities regulator to a proposal “directly targeted at China…(that) … politicizes securities regulation”?

• Why now, having welcomed for fifteen years the listings of some of the world’s largest companies – the likes of Alibaba and PetroChina and China Life and China Telecom – while the inevitable emergence of a scandal on the order and scale of Luckin Coffee has been predictable the entire time?

• And has anyone the moxie to do it?

That last is not to be ignored -- the question who would do the dirty and disruptive work of de-registering auditors and stripping Chinese companies of their US listings. The weapons exist and are at the ready -- not so the boots on the ground. This administration’s lack of confidence in the PCAOB was manifest in its clean sweep of all five board members and the gutting of its senior staff, and this March, a budget proposal to eliminate the PCAOB altogether and roll up into the SEC whatever remaining modest scope of its politically permissible activities might survive.

Nor does SEC chairman Jay Clayton have standing as the fire-breathing regulator needed and committed to wage the hawks’ holy war. In his background is the record-breaking $ 25 billion IPO of Alibaba in 2014, featured among the big deals of his pre-SEC life as a partner in the heavyweight firm of Sullivan & Cromwell – while in his current position, he offers only frustrated reminders to investors of the limits of his agency’s timorous reactions to the on-going Chinese rebuffs.

The search for coherent thinking behind the HFCA becomes even more muddled, in looking for consistency in the justification by Senator John Kennedy (R.-La.), the bill’s principal sponsor, in the Congressional Record: “We are excruciatingly transparent. We like investors throughout the world to know what they are buying.”

Slats again – Izzat so? Then what do investors know about the operations in China of, for two quick examples:

• Caterpillar, which shows seven manufacturing and distribution locations in China in its Form 10-K for 2019, is estimated to derive some 5% of its $ 53.8 billion in global revenue from that country.

• Apple, which for the first quarter of 2020 rang up revenue in China of $ 13.6 billion -- 14.8% of its total global revenue of $ 213 billion.

High-ranking American companies – audited respectively by the US firms of the PwC and EY networks. Neither auditor explicitly shows use or reliance on the work of their colleague firms in Hong Kong or China, although both would be subject to the legal and regulatory obligations noted above – to maintain and produce information – but only if “on request.”

How long would we hold our breath, waiting to know whether Chairman Clayton’s foot soldiers might “request” access to the audit work scrutinizing those billions of China-based revenue? Slats’s lament for his beleaguered Chicago Cubs – the perennial and off-putting “just wait till next year” – extended a fulsome five score and eight years.

A long political step too far, for Senator Kennedy to extend what consistency of logic there may be in his HFCA, to benefit the investors he claims to favor, by reaching for access to the China-based audit work supporting the American firms’ reporting on the financial statements of ex-Chinese companies that include their large operations there. Nor, presumably, would it suit the China-bashers. Audits covering the operations in China of Cat or Apple are no less opaque to PCAOB inspection than those of Alibaba or PetroChina – but where would the sponsors of the HFCA see the pay-off in picking that fight?

The Senate’s headlong rush portends a reprise of the enactment of Sarbanes Oxley itself. As I wrote in the now-lamented International Herald Tribune on July 20, 2002, about that law’s equally lamentable passage, “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

That assessment has been well vindicated, by two decades of small-bore and ineffective behavior by a body whose mission would have been at least as well executed under existing laws, regulations, and behavior modification by the sector itself. As Slats would say, “here we go again.”

It does not inspire confidence that a version of the Senate-passed HFCA was promptly introduced in the lower chamber. The warning from Will Rogers is stark:

“Ancient Rome declined because it had a Senate. Now what’s going to happen to us with both a House and a Senate?”

Might good sense intrude? Elected officials definitely have the authority to inflict the HFCA – otiose and pernicious as it would be. But a strategy of “ready – fire – aim” cannot repeal the impact of the still-valid Law of Unintended Consequences.

 

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A Valedictory for My Students: Keep the Bar High

My law school teaching in Paris -- “Risk Management and Decision-Making” -- is wrapping up for the spring semester. Classes at ZOOM distance are finished – final papers and grade submission await. To my regret, on-going lock-down means I will miss the students’ graduation, unable to deliver my appreciation in person.

Here is a message of congratulations and encouragement I would have offered:

“Our course sought to be a testing ground – a gathering of professionals with a performance bar as it would be in the real world. It’s now your opportunity to stand tall out there and deliver, with the same focus, energy and confidence you showed to me.”

I assume and expect excellence from students – as would a supervisor, a manager or a client. In the worlds of business and the professions, there is neither time nor tolerance for less. Just as it is not acceptable for an employee to turn in a report or a project with the preface, “I’m not sure if this is what you wanted….” – I want students to ask, if a discussion topic has been obscure or they see an ambiguity in an assignment or a test.

Clarifying questions show both curiosity and interest, and a shared commitment to the efficient use of time and energy. In both contexts: understand what’s expected – do the necessary research – draft and edit until the result is your best work.

And bring best efforts – the classroom should be preparation for the workplace. So it was, back when I was among the eighty law students who filled the old-style amphitheater of my largest first-year class. There we were obliged to recite on our feet, knees knocking, in response to the professor’s intimidating summons and pointed finger: “You – stand up and make a noise like a lawyer.”  

For a professional to do any less is to detract from stature, credibility and effectiveness. Examples abound:

Take the attempted ploy, “I’m just a small-town lawyer” and its distasteful equivalent in other fields. No perceptive adversary needs to be told. If truly the case, a real yokel will be revealed immediately. If not, the rule not to under-estimate an opponent means that while competence will be apparent, an attempt to be disarming but obviously disingenuous will be seen as insincere and untrustworthy.  

Related was my experience with a newly arrived corporate general counsel – by his admission from a transactional background and unfamiliar with disputes and litigation. His self-effacing introduction was along the lines, “I’m new here, and you know this is not my background.” He did himself no favors. Instead he invited the assessment of his peers that he had not done his work, was indeed not qualified, and never had his views given the weight and credibility he thought he deserved.

Not to suggest that there is anything wrong with an appropriate degree of restraint and humility. Boastfulness will be revealed all too soon as well, when results have spoken; as baseball legend Dizzy Dean said, “it ain’t bragging, if you can do it.” Or as the story goes of ancient Greece, you never asked a man if he was from Sparta – if he was, you’d have known it, and if not, you’d hurt his feelings by asking.

In these days of physical isolation and distance communication there’s a new form of avoidable self-inflicted wound: the footer on the message or the e-mail – “please excuse my typos” or “kindly forgive the orthography and erroneous auto-corrects.”

Don’t do it. True there are no virtue points for an error-free message – because that’s what’s expected from a professional anyway. But neither is there a license for sub-standard work. An advance disclaimer only draws attention and closer scrutiny. Put attention instead into extra editing – fix the weaknesses in logic and presentation, over-ride the errant auto-corrects, and catch the typos rather than apologize for them.    

To my smart and appealing students, then, with regret we have not been on campus together:

“Godspeed – keep it up -- all success to you, out there where a world of opportunity awaits.”

 

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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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