Re:Balance -- Jim Peterson

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

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

What – they expected gratitude?

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

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

“Parturient montes, nascetur ridiculus mus”

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

            -- Horace, 1^st century AD Roman poet

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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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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Audit Regulation After Wirecard – Germany Marches Backwards

In French it’s déjà vu -- adopted in English, for lack of an equivalent.

The same in German, and aptly describing the behavior of the German government, dazed and confused in the fall-out of last June’s crash of erstwhile market darling Wirecard.

Confronting the familiar question -- “Where were the auditors?” –- German officials are pursuing the imperative in the DNA of regulators under stress, hoping to be seen as “doing something.” That is, heedless of the ineffectiveness or unintended consequences, they are re-cycling proposals already attempted and no more effective in other countries.

I carry no water here for Wirecard auditor EY, as it defends the enforcement scrutiny and investor lawsuits that center on the hole in the company’s cash accounts of an apparently fictitious € 1.9 billion.

Rather, as aired out in the Financial Times of November 16, a menu of German proposals have the air of familiarity and futility displayed elsewhere over the last two decades: mandatory auditor rotation, further rules on services to audit clients, tinkering with the structure and authority of the regulator, and adjustments in the standards for auditor liability.

We’ve seen these movies before. They were weak in earlier screenings, and are unimproved in this latest re-run.

In the US, Enron and WorldCom brought forth the Sarbanes/Oxley law of 2002 – which influenced neither financial reporting throughout the crisis of 2007-2008 nor such later-exposed scandals as the Ponzi scheme of Bernard Madoff or the corporate fictions of Elizabeth Holmes at Theranos.

In the EU, neither the constraints on auditor’s ancillary services to clients, the infliction of mandatory rotation, nor the introduction of extended auditors’ reports avoided the money-laundering at Danske Bank or the goodwill puffery at Steinhoff.

Mandatory ten-year rotation in Germany might be a wrinkle on the existing EU timetable – although suffering no less the absence of any credible demonstration that extended auditor tenure is in any way associated with audit quality. And the challenges to engage replacement auditors in a supply-challenged market are already on display in the region – see the compliance difficulties of Sports Direct in the UK and the pending default of Plaza Centers NV in the Netherlands.

As for further constraints on services to audit clients, those are already effectively foreclosed by existing EU rules, and in any event do not address the nature or quality of performance of the basic assurance function itself.  

In the UK, the list of recent scandals is headed by the collapse of Carillion in January 2018, with additions including Patisserie Valerie, Thomas Cook, and NMC Health among others. But Brexit and the pandemic have tossed into the ditch the perfervidly critical reports on the Big Audit model, even as the cries for disruption of the Big Four’s structures and market dominance remain untested against the inexorable impracticalities of any alternative. [1]

Broader powers are mooted for the German financial regulator – itself well deserving the opprobrious characterizations of the UK’s shambolic Financial Reporting Council as “toothless” and “useless.” Well and good, but irrelevant to concerns for actual audit performance – because it is in the very nature of a government agency to be resource constrained, limited in vision and initiative, and consistently in reactive mode after-the-fact to the speed, agility and superior imagination of new generations of white-collar malefactors.

Finally, the proposal to raise or eliminate the current auditor liability cap under certain German legal theories raises for two reasons the problem of “be careful what you wish for.”

First, given the relatively immature body of auditor liability jurisprudence in Germany compared with the major Anglo jurisdictions, there is no reason to think that a German court, if convinced that auditor malfeasance in a multi-billion euro scandal was sufficiently grave, would not readily over-ride the damages cap currently set at a negligible four million euros.

Second, the possible consequences of a “worst case” judgment in a case on the scale of Wirecard include the disintegration of the audit firm itself – it being plain, even if not widely recognized, that the Big Four lack the financial resources and organizational stability to survive claims of the magnitude of the Enron collapse that brought down Arthur Andersen in 2002.[2]

Not that any of these observations mean that the German government will find a path out of the mire. To paraphrase baseball guru Yogi Berra on those fans reluctant to visit the ballpark of a loser, “if the audit regulators don’t want to apply good judgment, you can’t stop them."

 

[1] Please see my book of last spring, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon 2019).

[2] For the particulars, please see my book, available on Amazon, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books, 2d ed. 2017), pp. 56-60.

 

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

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

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

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

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

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

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

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

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

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

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

That is:

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

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

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

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

 

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

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

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

 

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

This, then:

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

Under these unhappy conditions, barnyard metaphors are irresistible:

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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What Price Wrong-Doing? Sanctions Against KPMG Are Complicated

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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