Re:Balance -- Jim Peterson

PwC’s UK Head Is Unhappy -– There Could Be Relief

“When sorrows come, they come not single spies, but in battalions.”

                    -- Claudius, Shakespeare’s Hamlet (IV, v)

How much concern do we feel for Kevin Ellis? He should sit pretty -- senior partner of the UK firm of PwC, which in 2021 clocked up record global revenue of $ 45 billion. The average profit of his UK partners was a league-leading £ 868,000, and Ellis himself in 2020 took home a handsome £ 4.4 million.

Instead, this week’s press attention finds him in a double bind, triggered by the UK’s audit regulator, the Financial Reporting Council. Even in paralysis over its structure and its remit, with the whole topic of “audit reform” on hold as the Boris Johnson government totters for survival between the fiascos of Brexit and COVID, the FRC has seen fit to widen its investigation of PwC’s audits of Babcock International –- expanding from 2017 and 2018 to sweep in the last two years before the firm was replaced by Deloitte.

In the usual grim ritual, the firm’s response was the expected if defensive pledge of obeisance and cooperation:

“We will cooperate fully with the FRC in its inquiries,” said PwC in a statement. “Audit quality is of paramount importance, and we remain committed to our ongoing program to enhance audit quality and to the delivery of consistently high-quality audits.

“The FRC’s annual reviews of our audit work, policies, and procedures show a continued trend of improvement in our work, and we use their insights, together with our own reviews, to continuously improve how we deliver high-quality audits.”

Ellis chose at the same time a gratuitous reprise of his frustration as previously aired to the Financial Times:

“(C)riticism of the audit industry from politicians and regulators was harming the profession and risked making it more difficult to attract new recruits.

“Retaining qualified auditors also ‘becomes much harder, if there’s a current of external negativity,’ he said.”

PwC’s prosperity in the COVID era considered, critics would be tempted to charge Ellis with tone-deaf ingratitude, except that his distress lies in the inability of Big Audit to accommodate two conflicting positions: The profession’s leaders self-confidently resist the recognition of atypical but inevitable instances of sub-optimal performance, while the public’s pointed question in any case of significant scandal is, “Where were the auditors?” 

Little wonder, there is skepticism about the profession’s legitimacy -- among investors and other users, with new graduates exploring their career paths, and as maturing staff decide where to commit their energies and their fortunes.

History teaches that the accounting profession has never rested easily in its relationship with its regulators. In the 1860s, the nascent profession -- counting among its leaders both Messrs. Price and Waterhouse -- fought off legislative attempts to require that government should audit the UK railroads. Its franchise of privately-provided audits of public companies was only later secured with passage of the core American securities laws of 1933 and 1934.

It’s been downhill since. Indeed, with this month’s fourth anniversary of the collapse of Carillion, Ellis might appreciate the FRC’s pointing its limited artillery at KPMG’s former partner and staff, who have turned on each other under charges of manufacturing and post-dating Carillion working papers and other engagement documentation.

Possible relief for Ellis’s dour pessimism is available, although it would require legislation, cooperation, and deep changes in attitude on the part of all the players –- starting with the auditors and including companies, information users, legislators, and regulators.

That is, it is to the profession’s discredit that Big Audit lacks a forum in which audit performance quality can with credibility be investigated, evaluated, and if necessary sanctioned. The available tools are not serving. The FRC -- derided in the post-Carillion studies as “a ramshackle house,” and “toothless and passive” -- is perceived as non-transparent, inefficient, and ineffective. And the legal systems that continue to threaten “joint and several” liability on the scale that destroyed Arthur Andersen in 2002 are seen as ponderous, erratic, and unpredictable.

To address these issues, a tribunal could be designed for “audit failure study” -– drawing on a long and successful history among the other professions. In hospital surgeries and emergency rooms, engineering studies of infrastructure collapse, assembly line disruptions and air and rail accidents, learning emerges in the study of catastrophe, from the inadequate number of lifeboats on the Titanic to the construction deficiencies in the World Trade Center.[1]  

The outputs of a well-constructed body -- given a broad remit, a legislative mandate, and the necessary expert and staff resources –- would:

• Enhance the credibility of corporate issuers’ commitments to quality reporting.
• Support the accountants’ legitimate aspirations and claims of improved performance.
• Provide guidance for standard-setters.
• Offer clarity and transparency to investors and agencies of government.

Resistance would of course be expected. Inertia and preservation of the status quo are never easy to displace. The profession’s leaders and the communities of information issuers and users would all be required as willing participants –- endorsing the value of such a tribunal as a matter of mutual trust and appreciation of its value.

As for Kevin Ellis and his concerns, a credible body for the study of his profession’s quality issues would provide a point of reference to which he would steer the interests of his audiences –- sparing himself the impossible task of preaching to the unconverted and allowing him to focus on more productive efforts. 

 

[1] For an extended examination of the complexities, challenges, and benefits of “failure study,” please see pages 285-292 of my 2017 book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books 2d ed.)

 

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Re-Allocating the Big Audit Market in the United Kingdom – Or Perhaps Not

"Two aristocrats are out horseback riding and one challenges the other to see which can come up with the larger number. The second agrees to the contest, concentrates for a few minutes, and proudly announces, “Three.” The proposer of the game is quiet for half an hour, then finally shrugs and concedes defeat.”

     -- Mathematics professor John Allen Paulos, “Innumeracy” (Hill & Wang 1988)

Regulators and politicians in the United Kingdom may well disrupt the Big Audit model – judging from inquiries launched recently by the Financial Reporting Council and the Competition & Markets Authority. The series that began here on September 25 and October 8, started to address the misguided nature of the purported “remedies.” It is making for pretty heavy going – so with thanks for the opportunity to write this as guest for Going Concern, this to lighten things up a bit.

Grave as are the UK threats to break up the Big Four, strip them down to “audit only” or impose government appointment of large-company auditors, it would take a comedy script-writer to capture the folly by which, it is suggested, the Big Four would “voluntarily” reduce their dominant market share of the FTSE 350 from 97% to 80%.

The head of assurance for Grant Thornton in the UK offered on September 14 that a nationalized appointment authority, which “would take the buying decision from the company … could split audits, say 50 for the Big Four and 50 for the non-Big Four.”

Seriously intended or not, the idea comes oddly from those with expertise in the assessment and comprehension of quantitative information. What comes to mind instead is the stateroom scene in “Night at the Opera.”

To expand and explain -- by 2017 revenue, the ten large firms in the UK array as in the table below (in £ millions). Of their £ 13 billion total, the Big Four garnered over £ 11 billion or 86%. The trailing six firms divided the remaining 14%.  

PwC	3,598
Deloitte	3,380
EY	2,350
KPMG	2,172
Grant Thornton	500
BDO	429
RSM	320
Moore Stephens	181
Mazars	173
PKF	130

If the notion of shifting fully half of the FTSE 100 audits were apportioned by firm revenue, Grants would take fifteen, BDO twelve, RSM nine, and each of the others four or five.

Collectively, how ready and capable would they be? BDO presently has only one such engagement -- Randgold Resources Ltd – actually on the bubble at # 101 -- and that one is likely to go away with the September 25 announcement that the company is to be acquired by Barrick Gold Corp, an audit client of PwC in Toronto.

Grants itself once had a FTSE 100 client, until the stock price collapse of Sports Direct dropped its ranking to # 181. And in any event, that job is to move with the upcoming displacement of Grants thanks to the UK’s mandatory tender and replacement rules. None of the other mid-size firms audits a FTSE 100 company.

As graphically displayed here on September 25, the impact of scale is critical. No number of hours at the controls of a single-engine airplane can qualify a pilot, however skilled, to command a wide-body jet – much less a helicopter or a space shuttle or a stealth drone.

No less, and without a whisper as to the relative work quality up and down the table, the requirement of experience at the Big Four level in performing large-company audits with global footprints and necessary industry expertise is compelling.

So despite the reams of paperwork that will be generated through the inquiries of the UK regulators, it remains a solid certainty that nothing like the suggested 50/50 re-allocation of the FTSE 100 will ever happen.

Sooner the proponents, like Professor Paulos’s mounted aristocrat, eventually “shrug and concede defeat,” sooner the discussion can move to steps of possible achievability and beneficial effect.

 

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Ukraine’s Bank Regulator Whacks PwC – As For The Broader Messages?

The 103^rd anniversary on June 28 of the assassination of Archduke Ferdinand in Sarajevo, with the consequent world-wide descent into the maelstrom of warfare, should remind that under aligned conditions, “distant and obscure” does not mean “benign and inconsequential.”

 It was reported in the Financial Times on July 20 and the KyivPost on July 21, 2017, that the National Bank of Ukraine – the country’s banking authority – has struck PwC’s firm from its bank auditor registry. The alleged failure:

“to highlight the credit risk faced by PrivatBank PJSC, which led to the bank being declared insolvent and nationalized, with substantial recapitalization costs borne by the state.”

To the charge of failing to identify a $ 5.5 billion balance sheet hole, PwC issued the expected statement of disappointment: “PwC performed its audit of PrivatBank’s 2015 financial statements in accordance with international auditing standards” – typical language in private litigation, but of cold comfort as the firm faces loss of its Ukrainian bank audit franchise.

PrivatBank starkly displays the “Expectations Gap,” at its worst. That is, even a GAAS audit assumed to be immaculately compliant with professional standards would not remotely satisfy the hindsight pique and anguish of an immature small-country regulator, forced to hoover up the droppings of a political crony’s quasi-private piggy bank.

My response to a media inquiry on the implications in Ukraine, and more broadly for the Big Audit model, gathered these notes, here at more length than a broadcast soundbite permits:

First, as hostage to the NBU, PwC’s plight illustrates the accounting profession’s hazard where government as enforcer also has a client’s direct financial interest. That is, whatever PwC’s virtuous claim to good work, the firm cannot simply dig in and litigate, as it would against a private plaintiff, because its adversary controls its very right to practice.

Examples abound. From bygone days was Arthur Andersen’s travail with its Belfast audit client DeLorean Motor Company – because the major investor was the British government. There, HMG not only sued the audit firm when DeLorean collapsed in 1982, but it also black-listed Andersen from auditing British government enterprises and agencies, inflicting the crippling loss of a portfolio of actual and potential future work. (Full disclosure – I was a senior in-house counsel at Andersen at the time, with involvement in the unpleasantries.)

Second, there are potentially disruptive consequences to Ukraine’s banking sector – depending on the extent of PwC’s market share and the availability of replacements. (While the website of PwC Kyiv states that among its industry services, it is “particularly focused on the banking sector,” a table as of 2011 shows PwC in a fairly distant third place among the Big Four.)

Even if not an issue in Ukraine, a harbinger of potential larger concerns is the uneven distribution of audit expertise in the major economies. Consider, that is, the disruptive impact on available auditor choice in Germany if KPMG were to lose its license there, as it audits almost half of the country’s DAX 30 companies, or if PwC in the United Kingdom were excluded from auditing its 40% share of the FTSE 100.

Third, there are operating implications for PwC beyond Ukraine. It will lose whatever cross-border work it does for the subsidiaries and affiliates of home-country institutions outside Ukraine; and it will also be challenged to conduct audits for foreign banks with Ukrainian operations requiring audits under the NBU’s authority – needing to seek out the resources in-country either from the other Big Three or among whatever cross-border banking expertise may reside in other, smaller firms.

Finally, there is the large-scale question of the stability impact on the Big Audit model. In the bigger picture, Ukraine is not big enough to matter – PwC could simply shut down there without significant impact on its global business. Not so, however, if a regulator in a seriously large economy were to do the same – because loss of license in a G20 country -- on the scale of Spain or France or Italy, or surely Germany or Japan or the UK or the US – would mean a network-wide failure of client service capability. That would speedily disintegrate an entire Big Four network – with disruptive impact on the entire Big Audit model, incapable of functioning with only Three members.

Andersen’s virtually overnight downfall in 2002 is illustrative – to serve its large-company clients on a global basis, a Big Four network cannot operate anywhere if it cannot operate everywhere.

The scale and gravity of PwC’s issues in Kiev should not be under-stated. The writing on the wall may be devilish hard to read, being in Ukrainian, but its meaning is both clear and ominous.

 

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“Bonehead” – “Wrongway” – “Moonlight” : Defining Moments and Their Lessons

            “When I do good, nobody remembers; when I do bad, nobody forgets.”

This space will not use the name of the PwC partner who re-wrote the Best Picture finale of the February 26 Academy Awards ceremonies by handing the wrong envelope to Warren Beatty. That poor bastard is going through enough, and no good is served by giving the search engine voyeurs any further satisfaction.

History’s list is lengthy of accomplished, good-faith professionals whose extended records of success are instantly dissolved into public notoriety:

• Dodger pitcher Ralph Branca became defined by Bobby Thompson’s walk-off home run, the “shot heard ‘round the world,” as the Giants won the 1951 National League play-off.

• Mercury astronaut Gus Grissom was saddled thereafter with the loss of Liberty Bell on July 21, 1961 -- flooded and sunk when the explosive hatch bolts blew on landing.

• Age 19, Fred Merkle became forever “Bonehead” for his failure to tag second base and the Giants’ resulting loss to the Cubs on September 23, 1908.

• Aviator Douglas Corrigan may well have been deliberate in his 1938 solo flight from Brooklyn to Ireland, but the sobriquet “Wrongway” was applied and stuck.

Up through the ranks, a twenty-year partner with firm-wide leadership at PwC – now to be known as the guy who had an inopportune Twitter moment. It is seriously unfortunate that if past patterns hold, his career clock is ticking -- nor would it be a great surprise if he were shortly to crawl under the team bus rather than wait at risk of being thrown there.

Unfortunate, because the meticulous methodology by which PwC has for decades gathered and counted and protected the identity of the Oscar winners – including the ego-boost of blinging up and marching the briefcases down the glamorous red carpet -- was wholly irrelevant in the few seconds that demonstrated once again that any system designed and run by fallible human beings has a non-zero chance of catastrophic failure.

Which means that – whatever his own conduct -- the potential for failure was inherent and unsolved at the firm’s level of design and execution.

Behavioral psychologists going back to the pioneering work of Daniel Kahneman and Amos Tversky in the 1970s have laid out the necessity of failure-mitigating techniques to deal specifically with the human factor – mainly by acknowledging explicitly and dealing with the inevitability of sub-optimal individual actions.

As the students in my class in Risk Management could design as a classroom exercise – the unmanaged risk of an envelope switch starts with the basic failure to recognize that the messenger should be prevented from access to more than one at a time.

“Take the one correct envelope in hand, and pass it to the ageing and near-sighted former movie idol” – who by the way was demonstrably useless as a fail-safe or means of quality control.

For which, secure and control each last-used envelope, before moving on to the next award. Get both copies out of reach and out of harm’s way. Keep the courier from touching any but the next one in the queue -- perhaps clamping a controlling minder to his elbow off-stage.

Business and industrial processes provide examples of such safety checks – physical distance between machinery switches, forcing an operator to take two separate actions to activate a hydraulic press or a cutting tool; “dead-man” cut-offs to disable a run-away vehicle; assembly lines and hospital surgeries and nuclear missile silos with dual controls to prevent a solo mishap.

Withal, there may be three sources of comfort for PwC’s sorry point man in this firm-based debacle:

First, because the delivery of audit services to the world’s large companies is completely dominated by the Big Four -- among which, with their 2016 global revenues either side of $ 36 billion, PwC vies with Deloitte as the largest -- the likelihood of negative, reputation-driven impact is constrained by the absence of client choice. And as PwC’s threatening exposures are paralleled among both the other Big Three and their smaller colleagues, that would caution against any exercise of competitive schandenfreude. In other words, to those actually choosing among the cartel of providers, the Oscars fubar is already old news.      

Second, the leader of PwC’s engagement for the Academy would not be listed on the PCAOB’s new Form AP, which identifies lead partners only on the audits of US public companies.

That exercise, in its first year, is of no use in spotting potential performance issues with large-firm personnel other than the lead partner – both because of the mobility of partners among various functions and also because of the team nature of large-company engagements – and so has yet to demonstrate any value.

And third, in any event, enjoying the handsome returns of a senior partner, when average annual Big Four partner profits are running well above $ 1 million, should cushion whatever personal impact may be imposed by the lifetime label, “Moonlight.”

 

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Gaudeamus Auditors? Instead, the Vatican Casts PwC from its Temple

Because profound issues of governance and institutional politics pervade large entities, of all types and in all locations, it’s worth noting the recent flurry of activity at the top of the Catholic Church.

To start, the news wires lit up with the May 12 announcement by Pope Francis of a commission to study the possibility of women as deacons. With this start from scratch -- while the debate on women’s participation in corporate boardrooms, legislative bodies and university faculties has long moved to questions of real progress -- optimism must be tempered. The opening of formal dialog suggests that while full clerical participation will not be available for women any time soon, a long forward step has been taken.

As for more mundane matters of Vatican governance and finance, the news was less up-beat.

That is -- since the year 313 AD, when Constantine bestowed his imperial favor and benevolence on the early Christians, the Church has managed to render successfully unto Caesar, uninhibited by the assistance of outside auditors.

So after seventeen centuries, it would have involved both a real cultural shift and considerable internal dislocation in December 2015, when the Vatican announced its engagement of PwC to perform history’s first independent audit of the Holy See.

Political reality soon intruded, however, with the unsurprising news in April 2016, that PwC’s audit was being “suspended.”

Only the most naïve and credulous would take as gospel the official Vatican version, that “issues have emerged regarding the meaning and scope of certain clauses of the contract and their methods of implementation,” or the suspiciously explicit spin that sought to disavow any “considerations linked to the integrity or quality of the work initiated by PwC, let alone the intention of one or more entities of the Holy See to block the reforms in process.”

Background first. As known to experienced auditors, “first-time-through” can make the Herculean project to hose out the stables of King Augeas look like a once-over with a handi-wipe. The international standards on auditing require in part (IAS 510(6)), in the start-up work on a client’s opening balances, that:

“The auditor shall obtain sufficient appropriate audit evidence about whether the opening balances contain misstatements that materially affect the current period’s financial statement by:

(a) Determining whether the prior period’s closing balances have been correctly brought forward to the current period or, when appropriate, have been restated;

(b) Determining whether the opening balances reflect the application of appropriate accounting policies….”

That work would be especially daunting with no predecessor auditor on which to rely. In the Vatican’s case – where never done before – there would have been no telling what financial skeletons lay deep and restive in those ancient catacombs, only waiting to be discovered and released. Small wonder that those with incentives to avoid the process would resort to postponement, denial and evasion.

Consider the reticence and anxiety, on the part of the Vatican’s functionaries charged with the keys to its treasury, and now called upon to yield up their sacred confidences to a team of invasive outsiders.

In fact a full-blown turf battle has been revealed, since PwC’s “suspension,” between the reform-oriented Cardinal George Pell of the Vatican Secretariat for the Economy, who managed the mandate given to PwC, and the old-school leader of the Secretariat of State, Archbishop Angelo Becciu, who unilaterally and without notice to Pell informed the Vatican entities charged to cooperate in providing information that Pell’s authority was revoked.

(Developments will leak out, from day-to-day and highly managed, on these internal structural struggles; for now, see the Guardian, the Catholic News Agency, and the National Catholic Register.)

Briefly put, when he blessed PwC’s presence, Pope Francis mis-read his subordinate administrators’ readiness to cooperate -– that is, that the auditors’ archeological excavations in the Vatican’s books and records at least threatened to open ancient tombs and sarcophagi where had rested ledgers and records permeated with rot and decay.

Further at the level of actual job performance, a client so insecure and defensive as to pull the plug, at the earliest stages of the engagement, would pretty well meet an auditor’s definition of “an engagement from hell.”

To an outsider, the Vatican’s unseemly internal scrum at the foot of St. Peter's throne might not reach the scale of the Great Schism between Rome and Avignon in the Middle Ages -- perhaps more resembling the scene in Woody Allen’s 1971 “Bananas,” where rival teams of cross-bearing monks degenerate into a melee over a parking place.

In such a fragile environment, hostile factions within the client that could scupper the job at the outset would have ominous implications for PwC’s ability to report in any event. It is difficult enough to assess the veracity of client representations with the skepticism required by professional standards. More so, to raise questions of credibility when the client holds over an inquisitive auditor the potential invocation of celestial fury or the unleashing of eternal hellfire and damnation.

It would suggest no dishonor to PwC if the warfare inside the Vatican obliges them to cap their pens and close their bags and make a diplomatic retreat -- so long as their withdrawal can be sold to the waiting faithful as a professional matter, and not under the threat of excommunication or anathema.

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Book Announcement: "Count Down -- The Past, Present and Uncertain Future of the Big Four Accounting Firms"

For those who may have wondered -- my reduced schedule here in recent months had a reason: completion and readying for publication of my book, "Count Down -- The Past, Present and Uncertain Future of the Big Four Accounting Firms".

I am pleased and proud that the book is next in the Emerald Publishing Group's series, "Studies in the Development of Accounting Thought," edited by Gary Previts, E. Mandell de Windt Professor of Accountancy at Case Western Reserve University, member of the Accounting Hall of Fame and past president of the American Accounting Association.

Its scope -- bringing together themes long explored here and going back to my column in the International Herald Tribune -- is summarized in this from Emerald:

The post-Enron disintegration of Arthur Andersen in 2002 reduced to the surviving Big Four the number of international accounting firms that audit nearly all of the world’s largest public companies -- Deloitte, EY, KPMG and PwC.

 Despite their strengths -- market dominance, double-digit annual growth in non-audit services and continued revenue expansion to a global total above $ 120 billion in 2014 – the viability of the Big Four and their business model faces serious threats:

• Widespread dissatisfaction with the standard form and language of their core product -- the traditional “pass-fail” auditor’s report.

• The persistent “expectations gap” between their perceived performance quality and the stated desires of information users.

• Difficult relations with regulators and oversight agencies.

• And especially, the questionable ability of the Big Four and their partners to survive a “black swan” financial shock – a litigation judgment or law enforcement sanction on the scale that destroyed Arthur Andersen.

"Count Down" looks at the complex challenges facing the Big Four, questions the feasibility and achievability of the various proffered “solutions,” and proposes an evolved model for Big Audit that would be both sustainable for the large firms and fit to serve the capital markets of the 21^st century.

“ This book lifts the lid on the story behind the financial statements of the world’s major companies. If you want to understand the system that is allegedly validating the reported data - and why the system is a clone of the Maginot Line - expensive, obsolete and irrelevant - read on. Weak as the present system is, there is a solution. It will take a major change in regulatory attitude and a fresh approach, unfettered by history. The section on the imaginative use of Big Data is worth study by itself. “

     -- Duane R. Kullberg, Arthur Andersen & Co., S.C. Chief Executive Officer, 1980-1989

“Illusions of safety in size doomed allosaurus, empires, and auto makers. In his Count Down, Jim Peterson examines the fragility of the ineffectual audit regime, and the imminent threats to its survival. Peterson combines the insider’s knowledge with an outsider’s critical but sympathetic perspective and suggestions in this fascinating and insightful volume—a must-read for accountants and students of accounting.”

     -- Shyam Sunder, James L. Frank Professor of Accounting, Economics, and Finance, Yale School of Management

Scheduled release date is October 15. For information, and to order:

     From Emerald Books

     From Amazon

Please share with your friends and colleagues. For questions and other inquiries -- and for Emerald's pre-publication discount -- please write me: [email protected]

Government Assignment and Financing of Audits? The New York Times Offers a Poisoned Bouquet

“Full many a flower is born to blush unseen,

And waste its sweetness on the desert air.”

 -- Thomas Gray, 1751

 There are three good reasons to be both optimistic and thankful that the New York Times editorial of August 15, 2014 – calling for “a revamped system in which audits are paid for not by company management, but by fees that companies pay to a public entity for the purpose of financing audits” – will fail to achieve traction.

These are, in ascending order of significance:

First, any print release at the absolute nadir of the annual news cycle, on a Friday in the dog days of August – and on the widely-observed holiday of the Feast of the Assumption at that – is bound to be ignored as inconsequential.

Second, two key people are distracted and not listening. The Chairman of the Securities and Exchange Commission, Mary Jo White, has shown no more interest in the accounting profession than her predecessors. And in any event, White herself is teetering on her back foot; as the NYT itself only two days earlier put it, “she has disappointed a wide swath of would-be allies … whose opinions of Ms. White’s performance range from dissatisfied to infuriated.” 

While over at the Public Company Accounting Oversight Board, chairman James Doty is fully tied up with deciding whether or not audit partners should sign opinions for their firms or in their own names – a long-perplexed but basically trivial matter not worth the years of wasted effort. Meanwhile, Doty’s latest feat is an inspection protocol announced on July 18, 2014, with the audit authority in Denmark. A pleasant little country, Denmark, but so insignificant to the global capital markets that it has only five PCAOB-registered firms in all, including but three of the Big Four, while the list of countries where the PCAOB remains stymied is headed by the 46 registered but uninspected firms auditing the massive economy of China – where successfully evasive politics continue as slippery and entangled as a bowl of ramen.

Third, the NYT’s endorsement of government-administered audit assignments reflects either breath-taking naïveté or an incomprehensible and unworthy lack of understanding of the audit services market – one that has operated exclusively on the “client pays” model since privately-provided assurance was invented in the 1850’s in England and Scotland.

Not that the accountants are or should be free from critical scrutiny. Examples of legitimate current concerns include:

• The very acceptability of the accounting by Lehman Brothers and its auditors, EY, cited by the NYT editorial itself.  

• The personal conduct of a very small handful of their partners (e.g., here and here).

• The settlement announced on August 18 by the New York State Superintendent of Financial Services with PwC, imposing a $ 25 million fine and a two-year ban on certain consulting for New York-regulated banks, summarized by the NYT as a “watering down” of a report on money transfers for blacklisted companies by Bank of Tokyo-Mitsubishi (and for a considerably contrasting description, compare Matt Levine’s Bloomberg View).

The large-company audit market continues under the near-total dominance of the Big Four – whose aggregate 717,000 personnel in fiscal 2013 generated $ 114 billion in global revenue for their 38,000 partners. For a government agency to assume the administration of the greater part of that sector of professional services – hardly a mere “revamping” – would present a catalog of challenges unexamined by the NYT and unaddressed by even the profession’s most rabid critics:

• What single-country government agency could evaluate and compare the global competence, resources and freedom from conflicts of auditor candidates in every one of the several dozen countries where a global-scale company operates and would require audit services?

• What costs and disruptions would the audit networks have to incur, to tender their credentials and proposals to such a government body? And how would their business model mutate, by way of talent and audit performance, if forced to deploy their resources to such a business-seeking process.

• Because government agencies are by their very DNA unable to resist political pressures, what would be the impact of the inevitable lobbying on behalf of small and minority firms, lower-tier accounting school graduates, and population groups under-represented in the profession?

• Would auditors bid for appointments? And if so, what pricing mechanism could be functional to provide transparency and integrity?

• Or would engagement assignments be dispensed like government permits? And if so, what public confidence could be reposed in light of historical experience with the awards of broadcast licenses, mineral exploration rights and cable and mobile franchises?

• How would the constraints of government-dictated budgets and liability exposures be reconcilable with the need for engagement cost changes in light of judgmental decisions to modify or expand audit scope?

• In light of these and a host of other questions, how could a government-run process of auditor proposal, selection and monitoring possibly function on a schedule that would enable the delivery of audit reports both timely and informative to the community of interested users?

In short, what possible public legitimacy could an agency achieve, operated under the aegis of a government that has inflicted on its citizens such administrative monstrosities as the Internal Revenue Service, FEMA and healthcare.gov?

A robust public dialog has long been needed on the structure and the future of privately-provided large-company audits. Happily, with the overhang of issues like the above, if it does take place, it will not be in context of last week’s proposal by the New York Times.  

 

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The PCAOB's "Game Change" Proposal on the Auditors’ Report is Small Change

 Edith Orenstein’s FEI Blog is a vital resource on the antics in Washington affecting the financial sector. It was my pleasure and privilege this week to offer this guest post:  

“Audited and Approved”

Opinion of William Welch Deloitte dated 8^th February 1850, on the half-year accounts of the Great Western Railway as of December 31, 1849, in its entirety

It's been downhill for auditors' reporting ever since.(1)

Public Company Accounting Oversight Board (PCAOB) chairman James Doty described the changes proposed on August 13 to the long-standard auditors’ report to “mark a watershed moment.”

The releases from the large firms ranged from the straight-forward (PwC) to the enthusiastic (KPMG), with the expected cheer-leading coming from their flacks; muted criticism from Tony Catanach’s Grumpy Old Accountants and the corporate bar; along with a predictable flag of litigation risk from the Journal of Accountancy. 

With formal comments due to the PCAOB by December 11, and as the polite applause dies down, a cooler perspective should see this tinkering as no more a “game change” than raising the stakes from a penny to a nickel.

That’s because the PCAOB is playing it small all the way. Board member Steven Harris emphasized “the need not to change what auditors do, but to change how they report what they do” (The emphasis is his, not mine). Board member Lewis Ferguson concurred, noting that “the standard does not require the auditor to do any additional work.”

To focus on what auditors currently do, however, misses entirely the point of investor concern. The famous and misunderstood “expectations gap” has never been about what auditors do. The gap does not even exist, in the minds or the behavior of investors until it bursts forth after a major corporate fraud or failure.

Unfulfilled auditor “expectations” have emerged with every outburst of serious issuer performance, from McKesson&Robbins in 1940 to JP Morgan Chase’s “London Whale” today.

“Where were the auditors?” does not concern transparency or the disclosed detail of audit work, but the perceived dereliction of not detecting or preventing a manifest problem – whether the collapse of Enron Corp. or the thievery of Bernie Madoff.

Investors are not demanding more nuanced wordsmithing about, for example, the auditors’ attention to issuer information outside the financial statements – the impossibly elusive articulation of a distinction between “read and consider” and “read and evaluate.”

What they do want are answers to share price-moving questions that neither the auditors’ work nor the PCAOB’s changes can ever hope to reach. They include questions like these:

• Will a particular pyramid-structured company – Herbalife comes to mind -- turn out to be a Ponzi scheme?

• Can a particular company whose customer base is concentrated on a high-tech device – Blackberry, perhaps -- actually survive in a world of fast-paced and constantly evolving competition?

• Which financial institution will suffer the next rogue trader at its derivatives desk? 

Since securing the franchise to provide financial statement assurance for public companies, under the American securities laws of the 1930’s, the accounting profession has borne self-inflicted responsibility for the creation and expansion of the “expectations gap” – by such actions as:

• Over-selling the level of comfort its reports convey – going back to the inference of guaranty conveyed by the unfortunate and now-replaced terminology, “auditors’ certificate,” and the profession’s futile inability to escape its lingering shadow.

• Tolerating the misplaced label of “watchdog,” as applied by jurists and academics whose presumption of guidance exceeds their competence to pronounce.     

• Fostering the obsolete and intellectually fragile “appearance of independence” – a trope at odds with the “client pays” model in place since Mr. Deloitte’s era, which delivers neither protection for the auditors themselves nor enhanced comfort to users.

One thing is for sure – the PCAOB anxiety about creating a bull market in boilerplate language is well founded. Defensive file-stuffing will prevail, as the Big Four prepare for the double-layered second-guessing in their future PCAOB inspections. Not only “Why was this issue not deemed a ‘critical audit matter’?” – but also “How did you decide that this ‘critical’ matter did not require disclosure?”

So it may be safely predicted that every Big Four client will have some minimum number of “critical audit matters.”

Moreover, similarities across sectors and industries are far greater than individual differences between companies. Every bank has issues with provisions for non-performing loans. And the entire technology sector has been challenged by revenue recognition in all the years since IBM pioneered its manipulation.  So the pick-list of those items will quickly become standardized.

What is dispiriting is that, on such significant issues as those in the recent great collapses – think Bear Stearns and Lehman Brothers and Merrill, MF Global and Knight Capital and SAC --  it is right to question whether auditors might have contributed positively -- by way of targeted scrutiny and assurance – to management, boards and investors alike.

But it couldn’t have happened, and won’t -- not under the small-bore thinking of “no more work – only more words.”

And not so long as the assurance model is hostage to today’s binary “pass-fail” report – accurately described by PCAOB member Ferguson as something at which “they merely glance … to make sure that the opinion is unqualified….”

If anything good emerges, it is the end of the endless discussion of mandatory auditor rotation – a majority of the Board now accepting the absence of data even suggesting a relationship between auditor tenure and audit quality.

In a one-sentence summary – which propriety inhibited me from sharing with Ms Orenstein’s readers -- the PCAOB has acted on this one like the little boy in church, losing bladder control in his dark blue suit: the results don’t show very much, and he gets to feel relieved and warm all over. 

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1. Until supplanted by an earlier-dated example, this pioneering statement – which I found hiding in plain sight in the National Archives of Britain in Kew, on the outskirts of London – is the first expression of independent assurance by one of the profession’s founders, on the financial statements of a large publicly-held corporation.

Auditor Re-Tender Every Five Years? Concentration in the UK Gets a Fresh Squeeze

 Attitudes differ about the ingredients in a ham-and-eggs breakfast. To a chicken, it’s a matter of interest. To a pig, it’s a matter of life and death. 

Which makes puzzling the reactions of the accounting firms to the provisional decision of the Competition Commission in the United Kingdom, that public company audits should be put out for mandatory re-tender every five years – which would halve the doubly permissive ten-year “re-tender or at least explain” promulgated last fall by the Financial Reporting Council.

The large firms complained that the five-year period is too short, while others argue that the provision is still too soft. 

Considering the interests of the chicken and the pig, these reactions of both the Big Four and the next smaller firms seem wrong-footed. Regulators being masterful at failing to identify the likelihood of highly-disruptive unintended consequences – of which the statement of the Chairman of the Competition Commission’s Investigative Group, that “the audit function is too important to be left undisturbed for longer than five years” will likely prove an example -- here’s why:

Although there is no research or empirical evidence to indicate any causal relationship between lengthened auditor tenure and audit quality, there is wide and credible belief and research that the early years of an auditor-client relationship, on the steep slope of the learning curve, are fraught for issues of risk and irregularity.

So what is to happen in – say – years three and four, just ahead of the expensive and demanding re-tender process in year five.

A Big Four firm, prepared (and obliged) to invest both time and personnel, as either incumbent or outside competitor, would draw on its depth, from its broad client roster and its ranks of people and industry resources.  

Indeed, an incumbent Big Four firm’s tactic would implement its obligatory engagement partner rotation in about year three -- providing that new partner with experience and seasoning, and selling its then-familiarized engagement leadership as a stability message in the re-tender competition in year five.

By contrast, a smaller firm would be hobbled in a five-year regime as either incumbent or as outsider. As incumbent, its profitability would have suffered – like a Big Four firm, to be sure -- from the first-time costs of a new engagement, against fee levels influenced by a multi-firm competition. Then, instead of benefitting from the stable middle years of a ten-year incumbency, firms would immediately face the costly defense of the engagement – against Big Four competitors assembling competitive proposal resources from available stock.

And as an outsider, a smaller firm – by definition lacking the “bench strength” in personnel and industry competence that only a Big Four’s roster of Footsie-350 clients provides – must, for each potential but very uncertain potential proposal target, find and marshal the people and invest the costs of proposing – not once but twice each decade.  

Unhappy consequences can well be imagined for budget-cutting, ever-higher pressures of time and execution on engagement personnel, and threats to performance quality – with the associated prospects of audit breakdown and failure.

Defenders of the five-year timetable assert that the re-tender process could become routinized, and the costs therefore mitigated – an anodyne position that is wrong for two reasons:

First, the assumption is fragile. The pace of change in the global large-company environment will demand fresh, detailed and widely-researched attention every year. Attempted “off-the-shelf” proposal methodologies will obsolesce with the relentless speed of the business cycle.

Second, audit committees offered the easy default of incumbent retention would only be persuaded to change on the basis of compelling and well-customized advocacy. A box-ticking proposal process would only reinforce and increase an incumbent’s advantage.

In summary, five-year re-tender as proposed by the Competition Commission would portend these results:

• Even less auditor switching than under the FRC’s ten-year cycle.

• Mid-tier firms withdrawing from tenders for inability or unwillingness to sustain the impact on their personnel and their business models. 

• Further intrusion of the Big Four into the client lists of the mid-tier firms, with resulting increase in the market concentration among that tetrapoly, based on their ability to deploy superior resources against uncertain defenses.

On top of all of this, the FRC’s ten-year rule seems already to be generating increased auditor switching – as I predicted last fall it might – with such large UK parcels reportedly to be passed as Unilever and the London Stock Exchange (both PwC), and PwC replaced by EY at both Land Securities and BG Group (here) – the discomfort of which no doubt being eased by PwC’s capture from KPMG of banking giant HSBC, the UK’s most lucrative audit engagement. 

On the race-track of an August 13 deadline for comments, and with conditions in place not manifestly broken, Chairman Carstensen and her colleagues should re-think with care the warning to “be very careful what you wish for.”

 

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