Re:Balance -- Jim Peterson

Auditor Performance Metrics: The Deal Offered by the PCAOB

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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NOCLAR: The Auditors' Impossible Task Under a PCAOB Proposal

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

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Luckin Coffee – What’s Brewing In China?

With the echoes still ringing from China-based Luckin Coffee’s $ 300 million accounting scandal in 2019, the company is reportedly planning to relist its shares in the United States.

The American regulators –- the Securities and Exchange Commission and the Public Company Accounting Oversight Board –- might actually buy this remarkable assertion of restored corporate virtue. It will be a test of the policy and enforcement commitment of these erstwhile gate-keepers.

There’s ample room for doubt. My own views are well recorded: American policy toward Chinese companies has been incoherent and inconsistent for years, most recently with the Holding Foreign Companies Accountable Act of last year, with its can-kicking three year extension before Chinese companies with uninspected auditors might face de-listing.  

Looking back:

• The wave of reverse mergers by which Chinese companies gained access to US listings in this century’s first decade caught the SEC on the back foot.
• The agency was played like a chump in its 2015 smoke-and-mirrors “settlement” regarding enforcement subpoena responses by the large accounting firms.
• Meanwhile the PCAOB has been stymied since its launch in 2002 by the inability to inspect and access the working papers of auditors reporting on enterprises in China.

As for Luckin’s post-scandal history: 

• The company’s NASDAQ-traded American Depository Shares were de-listed in June 2020; its founder/controlling shareholder was forced out; and it filed for bankruptcy in February 2021.
• It was recapitalized with the injection of $ 250 million from two Chinese private equity groups, reportedly connected to the company’s earlier history, ahead of the availability of audited financial statements.
• Under an agreement announced by the SEC on December 16, 2020, the company agreed to pay $ 180 million to settle securities fraud charges based on $ 300 million of fabricated sales and $ 190 million of inflated expenses.
• In October 2021 it agreed to pay $ 175 million to settle shareholder class litigation –- with a court approval hearing scheduled for July 22, 2022.

On September 21, 2021, the company filed its annual report on SEC Form 20-F, covering the years 2019 (as re-stated) and 2020, supported by the clean audit opinion of Centurion ZD CPA & Co.  That firm, a one-office operation in Kong Kong, described on its website as formed by the April 2016 merger of Dominic K.F.Chan and AWC (CPA) Limited, succeeded Marcum Bernstein & Pinchuk, which had replaced EY post-scandal but resigned for its reported inability to audit and report on the company’s results for 2019 and 2020.

Which is where things should get interesting for the American regulators.

Centurion states that it “provides a comprehensive range of services on a global perspective,” across the range of “audit and accounting services, taxation, risk assessments services, corporate finance consultancy and business advisory services.”

To offer such a range, the demands on Centurion’s personnel and modest size are considerable. Its website names just six directors including Managing Partner Chan. Its report to the PCAOB for the year ended June 30, 2021 (Form 2), shows a total of 52 accountants of whom 18 are certified.

The Form AP filed with the PCAOB on October 26, 2021, for Luckin shows the engagement partner to be Managing Director Chan himself. Chan spreads himself widely: for the firm’s US registrant clients (see the SEC’s listing of companies for which inspection reports are not available), he and his colleague Wing Wai Lai are named as the engagement partners on 25 of the 35 Form AP reports filed with the PCAOB in the last twelve months.

As for Centurion’s capacity to handle the demands of auditing a company the size of Luckin, its resources must measure against the currently-reported size of the company: third-quarter 2021 revenue increased 106% to $ 370 million, derived from 5,671 stores, mostly on the Chinese mainland, and a market valuation above $ 2.5 billion. 

History provides ready examples that serious financial malfeasance can be facilitated by the over-reaching of small practitioners:

• The multi-year scheme by which Rita Crundwell embezzled $ 54 million from the city coffers of Dixon, Illinois –- where a regional firm issued compilation reports, while the principal of a two-person local accounting practice signed the audit opinions (and was eventually able to contribute a modest $ 1 million in litigation settlement).
• Bernie Madoff’s flamboyant Ponzi scheme, abetted by a sole practitioner practicing out of a suburban strip mall office, who in his plea of guilty to securities fraud acknowledged simply “rubber stamping” Madoff’s fictitious filings.

Providing color to the lurking questions of Centurion’s resource and expertise adequacy are indicators that its relationship with its regulators is generously described as uneasy at best:

• On October 27, 2011, the PCAOB’s inspection report on the predecessor Chan firm found actionable audit deficiencies at two of its then four SEC-registered clients, including failures to obtain sufficient audit evidence relating to the accounting for convertible debt and preferred stock and also compensation expense –- also noting that the Chan firm did not respond when offered the opportunity to comment on a draft.
• On May 19, 2016, one month after the Chan/AWC merger that formed Centurion, the PCAOB announced sanctions against AWC and related parties, including its principal, “Albert” Wong Chi Wai. Among other things, “AWC improperly relied on management representations in auditing cash and revenue and ignored numerous red flags indicating potential fraud and undisclosed related-party transactions.” AWC and Wong were censured, each was penalized $ 10,000, the firm’s PCAOB registration was revoked, and Wong was given a two-year practice bar.
  • According to the Centurion Form 3 filed with the PCAOB on November 29, 2017, the Hong Kong Institute of Certified Public Accountants reprimanded the Centurion firm and imposed a penalty of HK$ 25,000 and costs of HK$ 10,000, apparently related to the above PCAOB proceeding.
• On September 26, 2017, Centurion reported (PCAOB Form 3) that Chan and his predecessor firm were reprimanded by the HKICPA and jointly fined HK$ 30,000 and costs of HK$ 10,000, for breach of the standards relating to non-recognition for deferred tax liabilities in connection with a client acquisition.
• On June 24, 2019, the firm reported (Form 3) the HKICPA’s personal reprimand of Chan and a penalty of HK$ 80,000 and costs of HK$ 36,630, for a client on which Chan was the engagement partner, responsible for mistakes in calculating the company’s loss per share.
• In its press release dated January 15, 2001, the HKICPA announced action against Chan as sole proprietor of the Chan firm in connection with a review report for the period ended December 31, 2018 –- two years after the Chan/AWC merger –- relating to misclassifications and related deficiencies, reprimanding Chan and the firm and imposing a penalty of HK$ 50,000 and costs of HK$ 15,000.

 If Luckin does pursue its re-listing attempt, it will rest with the SEC and the PCAOB whether all or any of this should move the agencies into action.

They could, of course, choose the passive course, deferring under the HFCAA’s three-year non-inspection trigger, leaving investors in the meantime to pour their funds into a hole as black as Luckin’s darkest expresso.  

But should they? The agencies’ tools under the Sarbanes/Oxley regime are all at hand: With its 2021 annual report in plain sight, Luckin’s business plan remains criticized -- its ambitious growth plans fueled by customer discounts at levels that guarantee long-running losses, and little chance to convert to profitability by raising prices, with competition fierce and customer loyalty fickle. 

 While the PCAOB has not reported on an inspection of Centurion since that of its predecessor in 2011, the firm if asked today would presumably deny inspection and workpaper access. De-registration could promptly follow as a matter of course. No re-listing of Luckin would happen -- instead a potential new scandal averted.

 

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

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

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

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

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

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

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

There are multiple issues:

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

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

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

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

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

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

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

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

 

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RIP Senator Paul Sarbanes

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

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

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

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

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

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

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

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

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

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

 

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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.    

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 [email protected].

 

 

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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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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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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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 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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Regulators' Re-Work of Big Audit? – “Joint Audit” Is Another Non-Starter

Today’s topic is “joint auditors for large companies” – continuing a series from September 25 through October 8 and October 16, on the issues involving Big Audit that confront the regulators and politicians in the United Kingdom who seem determined to impose disruptive change.

Along with cultivation of smaller firm participation, proposals reflected in papers issued by the Financial Reporting Council and the Competition & Markets Authority and political pronouncements from both parties include break-up of the Big Four, forced separation of their non-audit services, auditor appointment by government authority, and voluntary reduction of their 97% share of the FTSE 350 market.

The optimistic case that encouraging or requiring joint audits might beneficially affect audit quality or increase the competitive access and capability of smaller firms to perform large engagements is found, e.g., in the CMA’s paper, ¶¶ 4.18-.22. There are three challenges -- each distinct and sufficient: capacity, quality and risk tolerance.

Capacity

On the ability of the smaller firms to gain market share, to affect competition and auditor choice, look to the French market, where joint auditors are required. Companies in the CAC 40, France’s large-company index, primarily choose two Big Four firms. The only smaller firm with any index-level participation is Mazars – fifth ranked in France, ninth in the UK and 14th globally. Its 2017 global revenue of $ 1.68 billion is approximately seven percent of the average revenue of the Big Four.

At that size and scope, Mazars has little reasonable prospect of taking on a FTSE 350 engagement, much less one in the FTSE 100. However beneficial its experience in France, Mazars has not grown the capability to obtain and share a joint audit with any of its smaller brethren, whose limitations would if anything be more acute.

On the capacity issue, in short, the French market experience has spoken with eloquence.

Quality

The proposition that joint audit contributes positively to audit quality suffers the familiar challenge of a small sample size and a lack of empirical support. While a research project awaits the attention of a curious scholar, historical experience supports the opposite.

Most recently, in the years under scrutiny for the € 200 billion laundered without discovery or disclosure through the Estonian branch of Danske Bank, the bank’s annual reports show that its audit was done jointly by Grants and KPMG for 2007-2010 and PwC and KPMG for 2011, before one-firm takeover by KPMG for 2012 and 2103, EY for 2014 and finally Deloitte for 2015 onwards.

Five years of joint audits, in short, were no more effective by way of detection or prevention than performance by a single firm.

As a brief sidebar on a related subject, the rotation at Danske through five different audit delivery models over nine years does no favor to the “fresh eyes benefit” urged by the proponents of frequent and mandatory auditor replacement.

There is history. Back in 2003, Deloitte and Grants had shared the audit of Italian dairy conglomerate Parmalat. Disclosure of a € 20 billion hole in its accounts revealed the mechanism: bogus contracts housed in an account labeled the “buco nero” (“black hole”) – colorfully evocative although insufficient to entice preventive inquiry by either or both.

As a precursor, the great Ponzi scheme of the 1970s run at Los Angeles-based Equity Funding involved the separation of audit responsibility between Haskins & Sells, as it was then branded in the US, and a small firm recently joining the US operation of what is now BDO. At the heart of the criminal scheme was concealment from both firms of the creation of whole ledgers of non-existent holders of fictitious life insurance policies.

To summarize, division and sharing of audit responsibility with its challenges of communication and administration brings the risk of cracks through which problems and manipulations may fall undetected.

Risk Tolerance

To conclude, the professional auditing standards permit the division of work between two or more firms (see the PCAOB’s AS 1205 in the US, and ISA 600 as widely adopted elsewhere).

In practice, the principal auditor judges whether and how to make reference to the other auditor (ISA 600.11 and AS 1205.04-.09). Either way, while the choice has implications for the level of responsibility assumed by the other auditor, the principal auditor retains responsibility for the entire scope of its own work – including the adequacy of its reliance and delegated decision-making.

There is the bind, in jurisdictions such as the US where “joint and several” legal liability exposes auditors to 100% of the potentially devastating consequences of a breakdown or failure. Inadequate as the financial resources of a Big Four firm are to protect itself from a deathblow lawsuit, the ability of a smaller firm to assume a meaningful share, monetarily or by percentage, is immaterial.

That limitation assures that the risk-management evaluation of a Big Four firm as principal auditor, persuaded or obliged to share a large audit, will include the time and attention of a full-court press on the actual performance by the smaller firm – involving substantial duplication or overlap and negative consequences for the achievability of cost efficiencies or real sharing of experience or expertise.

Conclusion

There continues to be no sign of official awareness, that none of the proposed “solutions” to the perceived issues around Big Audit is feasible, achievable or capable of affecting audit quality or competition – a fact so far without impact on the public discourse.

Joint audit, among them, is another “non-starter.” Which reinforces the suggestion here that, sooner or later, the intrusion of reality into the discussion should become compelling.

 

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The PCAOB Proposes a New Five-Year Plan – Excitement Levels are Muted

"Mann Tracht, und Gott Lacht”

            --Yiddish adage

 “Man plans -- and God laughs.” Heavenly company for bemused reactions to the draft five-year Strategic Plan exposed for public comment by the Public Company Accounting Oversight Board on August 10.

The audit regulator in the US is starting afresh. An entire slate of five new Board members was installed in December, ending the two-year extension of chairman Jim Doty’s sell-by date. A sweep of senior staff departures has included the heads of enforcement, registrations and inspection, audit and professional standards, and information technology.

Little wonder the new chairman’s Message touted the engagement of a “strategic planning consultant.” Who else was to help all the new arrivals find their desks?

The results are risibly obvious: page upon page of language so blandly generic as to be taken from available templates or cribbed from those gathering dust in corporate file bins. Mind-deadening language is strewn across an amplitude of numbers:

• Four “areas of strategic focus” in the Message itself
• Four “primary duties” in the description of the agency (p.3)
• Five “values” (p. 4)
• Three “key factors” affecting the strategic outlook (p.5)
• And five “strategic goals,” each bearing between two and four “objectives” (pp. 7-13)

All displayed under cover of five bullets in a press release, to set forth what the Board “intends” – unfortunately omitting any specifics of inter-play amongst them.

It’s a matter of perspective whether issuance of a “plan” that could have come from a desk drawer justifies such a doubtless high-priced exercise. The Board does buy itself the political benefit of a placeholder, as the absence of detail under this top-heavy verbosity will give cover for the time to provide annotations – sure to extend past this fall’s mid-term elections and well toward November 2020. And an approach of “do-nothing, and very slowly” accords with the PCAOB’s long-established tradition of releasing its modest accomplishments only after excruciating periods of contemplation: six years to consider the naming of audit partners, three years before concluding that mandatory auditor rotation was a non-starter, six years to fall in behind the IAASB in requiring extended auditors’ reports, and sixteen years and counting without resolution of its impasse with Chinese authorities over information gathering and audit firm inspections there.

(For entry to a fuller discussion of the PCAOB’s languid history, see my posts of December 21, 2015, February 11, 2014, August 29, 2017, and January 5, 2018, and Chapter Three of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (2d ed. 2017) – here.)

As for the invitation to comment on the Plan and its five Goals, some specific steps might reasonably be slotted into the Board’s aspiration to be “a trusted leader that promotes high quality auditing”:

• At the heart of the PCAOB’s public credibility issues, its objective (1:1) to provide “more timely and relevant feedback” has been frustrated from inception by the lid of confidentiality clamped on the nature and scope of information that is publicly disclosable, under the Sarbanes/Oxley law itself (see Release No. 104-2004-001, August 26, 2004). Unlikely as it would be in the current environment, a legislative initiative to permit real transparency, taken jointly with the leaders of the no-less-reluctant accounting profession itself, would be to the benefit of both. Trust and credibility require no less -- but don’t hold your breath.

• The stated objective (2:1) to “ensure that oversight activities do not impede innovations…” is not met by a plan merely to “monitor the development and implementation of emerging technologies.” Evolution to an assurance function fit for purpose, to supplant the currently low-value “true and fair view” opinion, requires the fundamental elimination of the archaic and detrimental constraints on the scope of ancillary services permissible to auditors. Again – critically necessary, although unlikely.

• To “expand engagement with other audit regulators around the globe” in a meaningful way (3:2) would involve actual advocacy of specific areas of desirable change. By rights this should start by the PCAOB re-visiting with its counter-parts the failure of mandatory re-tender in the UK to avoid the unintended consequence of reduced competition, and the prospect of similarly malign results under the mandatory rotation rules of the EU.

• And, on the other hand, where progress has proved futile and success elusive, namely in China, a strategic retreat is indicated, ahead of the blow-up that is otherwise a present hostage to the antagonisms between the oversight regimes of the two countries.

To close on a non-trivial quibble with the lack of a roadmap to the Plan from the Board’s press release and its five “intents,” no substance is offered on how to “reinforce the PCAOB’s culture of integrity, excellence, effectiveness, collaboration and accountability.”

On that topic, silence from this Board is no surprise, about the long-running criminal proceedings in New York, where ex-agency employees are charged with purloining and transmittal of confidential inspection information. With leadership’s heads firmly down, more impactful than lofty language and process tweaking by the agency is the prospect that the ex-employees are facing potential prison sentences of up to 65 years.

Putting that notion into a “strategic plan” would have suited Voltaire’s 18^th century comment on the state of discipline in the French navy, that hanging the occasional admiral should “encourage the others.”

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William McDonough: Ave Atque Vale

William McDonough -- president of the New York Federal Reserve Bank (1993 - 2003) and first chairman of the Public Company Accounting Oversight Board (2003 - 2005) -- died on January 22, age 83.

As a regulator he had more success with the banks than with the auditors.

In New York, he saw off the impacts of the Asian credit crisis and the bankruptcy of Long Term Capital Management, and steered the bank through the aftermath of the attacks of September 11, 2001.

In Washington, he oversaw the launch of the PCAOB under the mandate of the Sarbanes/Oxley law of 2002 – the intent of which, as put in its Board’s statement on his passing, was “to restore confidence in public accounting of American corporations.”

The success of that mission will not be debated here. Rather, for my views, see the discussions on my blog, Re:Balance, of the PCAOB’s performance in connection with, e.g., mandatory auditor rotation, independence and scope of service constraints, inspections and enforcement of auditors in China, the naming of lead partners, the incidence of audit deficiencies as observed by regulators, and extended auditors reports – along with comprehensive discussion in my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books, 2^nd edition 2017).

It is all too plain that the PCAOB and its regulatory off-spring spawned around the globe have not succeeded in quelling the periodic and repeated outbreak of large-scale financial disturbances – looking not only at the lengthy roster of failed financial and other institutions during the 2007 - 2008 financial crisis, but down through such recent examples as GE in the US, Carillion in the UK and Steinhoff in South Africa.

In this environment the public cry persists – “Where were the auditors?” – to which the measurable effectiveness and impact of the PCAOB remains as elusive as ever.

McDonough himself had the candor to concede -- when asked by a reporter in 2005 what he and his brethren would do in the event of another collapse on the scale of Enron’s fatal impact on Arthur Andersen -- that, “None of us has a clue what to do if one of the Big Four failed.”

The hazards that threaten the survival of the large accounting firms remain as grave as ever. Mr. McDonough’s terse response hangs in the air – a legacy weighty, ominous and unrebutted.

 

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While Steinhoff Teeters – Did Anyone Care What the Auditors Said?

Myths and fables are replete with urgent early warnings – only occasionally effective. The young shepherd who cried “wolf” -- the little Dutch boy plugging the dike -- the sharp-eyed lad to whom the Emperor was unclothed -- Chicken Little fearing skyfall – all the way back to poor Cassandra, doubly doomed to be disbelieved but proven right.

An emerging large-scale corporate scandal provides a vivid example – sprawling consumer conglomerate Steinhoff International NV, with its global operations based in South Africa, its principal share listing in Frankfurt, and its headquarters in the Netherlands.

As CEO Marcus Jooste put it in resigning on December 5, “I made some big mistakes and have now caused financial loss to many innocent people” – quite an understatement, with the company’s concession of “issues concerning the validity and recoverability of certain Steinhoff Europe balance sheet assets,” reported to reach an eye-popping € 6 billion.

The latest: alleged multi-billion euro accounting irregularities, the company’s share price dropped by 90%, its credit rating cut to junk, predators circling its local operations, politicians and commentators crying for accountability, and rumblings from regulators in the three countries plus the inevitable shareholders’ lawyers.    

In this troubled context, there is this to ponder: Steinhoff’s 2015 financial statements bore the traditional and familiar “pass/fail” auditor’s report, issued by Deloitte’s Pretoria office. The next year, with the change in headquarters, the report by Deloitte’s Amsterdam office ran a full eight pages, over 3800 words with three paragraphs on “materiality” and five “key audit matters.”

Steinhoff thus offers a real-world test of the recent requirements imposed by the major regulators, that investors should receive -- and in theory might actually value -- auditor reports expanded to identify and discuss “critical” or “key” audit matters – see the IAASB’s 2015 International Standards on Auditing, and from the US audit regulator, the Public Company Accounting Review Board, its Auditing Standard on the Auditor’s Report, Docket 034, approved by the SEC on October 23, 2017.

The outgoing chairman of the PCAOB called its new standard “the first significant change to the standard form auditor's report in more than 70 years,” which will “breathe new life into a formulaic reporting model.”

Perhaps – although unlikely. My own skepticism – here – is mainly that the combination of liability anxiety and common if complex issues across companies will mean reversion to boilerplate language of anodyne simplicity.

The Steinhoff situation raises a different issue – namely, does anyone really care?

The United Kingdom is now in its third year of expanded auditor reports. While there has been a good deal of self-congratulation, the world of information users awaits an empirical study of whether extended report language in that country has had any effect on investor behavior – one way or another.

The Steinhoff saga should reinforce the doubts. From September 2015 when Deloitte South Africa issued its short report, the company stock had traded in a fairly narrow and stable range, through a series of large-scale acquisitions. The following year’s expanded report by Deloitte Amsterdam identified as two “key audit matters” the valuation of goodwill and intangible assets of over € 16 billion and the accounting for two major combinations for almost € 3 billion, and its balance sheet showed that long-term interest-bearing loans and liabilities had swelled from € 4.1 to € 7.1 billion – among the "critical" areas where the curious might have inquired for what are now the reported gaping holes.

So Deloitte’s expanded language might have been taken as cautionary. To the contrary, instead, media search fails to locate a single word on its extended opus – whether criticism, credit, or indeed comment of any kind.

Rather, impact if any among the investing public looks over-ridden by the animal spirits of the herd -- perhaps not incidentally including South Africa’s public employee pension scheme, the Public Investment Corporation – who all plunged together right up to this last December, when the bottom fell out and the company’s acknowledged if still unspecified accounting irregularities obliged Deloitte to withdraw its report altogether.

In addition to the apparent indifference of investors, history suggests that the affected legal systems will not be much impressed by protests of “we told you so.”[1]

As the blame-allocation exercise unfolds, it remains to be seen whether expanded auditor reporting will rank in importance at all – or whether defensive assertions will be credible that anyone relied on, or is bound by, the thousands of words by which Deloitte elaborated on the complexity of Steinhoff’s financial reporting.

Will it be shown that any of the expansive auditor verbiage mattered to anyone, more than the typical single paragraphs of audit scope and opinion?

The Dutch themselves would politely say, “vergeet do rest, volledig onnodig” (forget the rest, completely unnecessary). German and South African idioms would be similarly dismissive. The most printable American response would be, “couldn’t care less.”

There will be future developments -- watch this space.

 

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[1] As a model for the less-experienced jurisdictions, the American liability regime has for decades rejected the defense of compliance with professional standards. United States v. Simon (Continental Vending), 425 F.2d 796 (2d Cir., 1969).