Re:Balance -- Jim Peterson

“The Chickenshit Club,” Jesse Eisinger (Simon & Schuster 2017)

Jesse Eisinger having conclusively nailed the award for best book title of the year, for his detailed polemical history of the US Department of Justice’s timorous post-Enron retreat from the pursuit of corporate malefactors, it may seem churlish to quibble.

Nor to take away from his dispiriting story’s call for renewed vigor in the prosecution of financial criminality. But from the perspective of fifteen years of scrutinizing Big Audit and the challenges facing the large accounting firms,[1] there are issues at both ends of Eisinger’s narrative – subtle, to be sure -- on which the vigor of his arguments can stand for clarification.

Background, for those who have not yet done the reading (emphasis deliberate): after the convictions of the principals of Enron, WorldCom, Tyco and Adelphia,

“Today’s Department of Justice has lost the will and indeed the ability to go after the highest-ranking corporate wrongdoers…. Prosecutors don’t simply struggle to put executives for “Too Big to Fail” banks in prison. They also cannot hold accountable wrongdoing executives from a gamut of large corporations: from pharmaceuticals, to technology, to large industrial operations, to retail giants” (p. xvii).

His argument bases heavily on the disintegration of Arthur Andersen, Enron’s auditor and the target of the DOJ's wrath for document shredding in the fall of 2001, while the company was collapsing and law enforcement forces were gathering.[2]

Eisinger spins out the 2002 time line of Andersen’s indictment, jury trial and conviction, and cessation of business; the Supreme Court’s 2005 reversal; and the public relations campaign by which Andersen posed itself as the aggrieved victim of government over-reach. As he concludes, Andersen’s “too big/too consequential” arguments failed, but also had no observable collateral consequences:

“The Andersen case ushered in an era of prosecutorial timidity when it came to taking on the largest corporations in America. The response to the financial crisis of 2008, which took down the nation’s largest banks and put the global financial system at risk, stands in contrast to the post-NASDAQ-bubble accounting-fraud emergency…. (F)ear for the fragility of the system dominated the political discourse and tormented Department of Justice officials” (pp. 57-8).

Here’s the first problem. Eisinger is correct, but for the wrong reason, saying that, “The notion that the indictment was solely responsible for putting Andersen out of business is a myth” (p. 54).

In fact, the indictment was irrelevant. Andersen was mortally wounded by Enron, beyond salvation or recovery, simply because it lacked the financial strength and organizational cohesion to withstand the litigation shock.

Enron’s collapse was to be the first case to extract a billion dollars as the responsible auditor’s litigation exit cost. Andersen had that capacity, with its 2001 revenue of $ 9.3 billion -- but barely. It would have teetered on the brink, still facing a crushing load of claims relating to the catalog of scandals that caused Justice to view it as an unrepentant serial recidivist – the sum of which would have swiftly driven it into insolvency.

So -- arguments on both sides of the Enron indictment impact miss the misplaced nature of their premise: Andersen was dead anyway, no matter the policy decisions at Main Justice in Washington. Andersen was like a terminal patient on late-stage life support -- its death was imminent and inevitable; the tortured decision to indict only pulled the respirator plug.

Having strung so much dirty laundry on this fragile line, Eisinger works himself into a righteous froth over the government’s retreat to its pattern of settlements and corporate fines -- all to be absorbed as business costs by the corporate treasuries and shareholders’ equity of the large public corporations -- rather than devoting the time and taking the risks of seeking the higher but less certain rewards of pursuing prosecutions through to trial.

His proposition raises two concerns. The first is narrow, based on the post-Enron structure of the Big Audit model, totally dominated as it is by the surviving Big Four. Here, Eisinger’s bland observation (p. 56) about the absence of effect from Andersen’s collapse – that its “prosecution did not lead to any economic or financial crisis…. Markets didn’t crash (and) corporations just found other auditors” -- fails to meet today’s reality. Which is, loss of another of the surviving quartet would not just reduce the field to a Big Three, but would trip the entire Big Audit franchise into failure.

That’s because the four-firm model is down to a critical minimum. Unlike with the Big Four, there is no supply shortage elsewhere in the professional services sector. The clients of the recently-failed public relations firm Bell Pottinger are relocating without issue, as did those of failed law firm Dewey LeBouef. But as is currently playing out in Japan in the dysfunctional relations between Toshiba and PwC, the range of large-company auditor replacement choices is now too severely constrained to allow any margin for reduction.

So much for the sector. Closing views on Eisinger’s basic premise on criminal accountability start here: outbreaks of financial malfeasance well enough evoke spasms of cathartic retribution. Society calls for the guilty to be punished.

Any longer-term deterrent impact, however, is another matter. That is, cyclical outbreaks of financial excesses inhere in the system and are inevitable,[3] with their attendant criminality, for reasons ranging from the post-event focus of regulators and legislators on fighting the last war, to simple human credulity, greed and rapacity -- embodied in the observation of a legendary New York judge, that “from the time to which the memory of man runneth not to the contrary, the human animal has been filled with cunning and guile.”

It is simply fanciful to think that the next generation of as-yet-undiscovered white-collar successors to the current Martin Shkreli of Turing, Elizabeth Holmes of Theranos or Kweku Adoboldi of UBS will be deterred in the least by the successful but now ancient and forgotten prosecutions of Ken Lay or Jeff Skilling or Andy Fastow – any more than they would by a return to public flogging or transport to Tasmania.

In the rural countryside of my youth, it was considered a measure of perception and good judgment whether a man “had the common sense to tell gravel from chickenshit.”

At the level of fundamental law enforcement policy, that question hangs over Eisinger’s otherwise noble and illuminating work.  

 

[1] Please see my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – here at Amazon, where the “Look Inside” link gives free access to the Contents and Introduction.

[2] Disclosure: after 19 years as a senior member of Andersen’s in-house legal group, I had just left in June 2001, months ahead of the Enron debacle; intensely unpleasant events were to come, but as put by the eponymous ogre in that year’s “Shrek” -- “Better out than in, I always say!”

[3] See, for example, Benoit Mandelbrot’s brilliant “Misbehavior of Markets” (Basic Books 2004, paperback 2006).

 

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Expanded Audit Reports: Good, Bad or Ugly?

Spoiler alert from down in the weeds of accountancy regulation: readers reluctant to go there should either stop now or don’t complain that you weren’t warned.

It’s up to new SEC chairman Jay Clayton, whether audit reporting in the US will move into line with most of the world. He is to approve, or not, the PCAOB’s proposed auditing standard, The Auditor’s Report etc. etc., filed on July 19, 2017.

If he does, the PCAOB will conclude its long-running flirtation with this issue by aligning with the earlier movers – the Financial Reporting Council in the UK, with its standard released in June 2013, and the IAASB’s International Standard on Auditing # 701, issued January 14, 2015.

At its core, the PCAOB would require that American public company audit reports include and discuss so-called Critical Audit Matters – briefly defined as those involving “especially challenging, subjective or complex auditor judgments.” The antagonistic advocates face each other with sharpened pens locked and loaded.

In opposition, the US Chamber of Commerce rounded up 27 businesses and groups to join its letter of August 18, 2017, bolstering its own letter of August 11, which complains that “this standard will lead to the disclosure of immaterial information, increase liability costs for businesses and audit firms, and create a chilling effect on audit committee-auditor communications.” As the Chamber concludes, the standard “will obfuscate disclosures for investors and make capital formation less efficient.”

The “pro” argument is cast in terms verging on the patriotic. Caleb Newquist at Going Concern for August 24 disparages the Chamber’s opposition as “poorly written (and) wholly unconvincing,” while the editors of Bloomberg put it the same day that “so far as investors are concerned, more information is better” and that “at stake is the reputation for good governance that has made America a magnet for investors and an attractive place to list a public company.”

To express doubt on the theme of “investor protection” is as if to criticize motherhood or apple pie – perhaps only possible in a convent serving the celiac-afflicted. Of the several areas of concern, however, here are three:

First, with three years of UK experience and a great deal of self-congratulatory back-patting by the insiders, there is no actual evidence-based support for the proposition that investors’ actions are guided by expanded auditor reports – one way or the other. Writ broadly, a guaranteed PhD thesis, tenure assurance and a career annuity of publication await the ambitious doctoral student ready to crunch those numbers. Narrowly, KPMG’s landmark report on the 2013 financial statements of Rolls-Royce, in the midst of a roller-coaster of company travails and swings in its stock prices, has never – down to date since I first addressed it (here) -- been either blessed or cursed for the value of its 5400-word length.

Second, convergence of CAM language to box-ticking uniformity and a bull market in boilerplate are a certainty, to the degradation of value to information users. That is quite simply because company similarities across sectors and industries are far greater than individual differences between them, so the parade of CAMs will evolve to standardized terms: every bank has issues with its portfolio of non-performing loans; every holder of exotic financial derivatives has issues with valuation; revenue recognition has been a challenge in the technology sector since IBM invented the gaming techniques in the 1950s.

Defensive file stuffing will prevail, as the Big Four prepare for second-guessing in their future PCAOB inspections. It may be safely predicted that — as a means of fending off the PCAOB’s ticket-counting inspection process — every Big Four audit in the United States will very quickly be found to have some minimum number of CAMs.

That sets up the third issue – liability. The Chamber elides the real exposure, which is that shareholder plaintiffs’ lawyers will be salivating over the documentary record to be created under the PCAOB’s inspection process, and the four-layered mischief to be inflicted by its deficiency-seeking process.

That is, as the engagement partners are grilled in the lawsuits after the stock-price busts, hostile lawyers will have an interrogation menu to choose from:

• “Your report discusses twelve CAMs, but not the specific “complex judgment” on the matter causing the stock price collapse. How did you miss it?”

• “Why was this “complex judgment” not identified for discussion with the audit committee (assuming it was considered and passed)?”

• “You discussed this “complex judgment” with the audit committee. How could you not have identified it as a CAM?”

• “Your report discloses a CAM for the very “complex judgment” involved in the collapse, which happened anyway. How could you and the company not have solved the issue?”

Squirming in the witness chair will be equaled only by unease in the jury box and an urgent call for settlement funding.

SEC chairman Clayton may force this scenario on American public companies and their auditors. If he does, no part of the Big Audit model nor any of its players will be the better.  

 

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And for an extended examination of this and other issues threatening the viability of the Big Four and their large-company audit franchise, please see the just-released new edition of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”– its Amazon page is here.

Crowe Horwath – On The Rocks in China

In the original version of “between a rock and a hard place” -- as Homer tells the story in Book 12 of the Odyssey -- when Odysseus sailed for home through the narrow straits between Scylla the six-headed monster and the deadly whirlpool Charybdis, he escaped the twin hazards at the cost of only six of his sailors’ lives.

 No such luck for Crowe Horwath (HK) CPA Limited, the Hong Kong member firm of the eighth largest of the global accounting networks, and auditor of 22 modest-sized companies based in China and filing financial statements in the US with the Securities and Exchange Commission.

By its order dated July 27, 2017, the Public Company Accounting Oversight Board censured the firm and revoked its registration, for its refusal to produce documents to the PCAOB to enable its “access to the information that is necessary to be able to inspect (Crowe’s) audit work as required by the (Sarbanes-Oxley) Act and PCAOB rules” (¶ 2).

The audit firm defended its position based on a direction from the Chinese Ministry of Finance under that country’s laws. Sympathy is in order for Crowe Horwath’s global CEO, who Tweeted (@jkevingmcgrath), “Our Hong Kong member firm (is) caught between compliance with laws & regulations of the Chinese govt and their desire to comply with the PCAOB.”

Thus is brought forward a hostage to fortune that was embedded in the prospect of cross-border clashes of sovereign powers, immediately with the post-Enron enactment of Sarbanes-Oxley in July 2002 -- legislation that created the PCAOB and its inspection and oversight authority over the auditors of US-registered public companies.

That is, the PCAOB has been failing since 2002 to fulfill its members’ wishful promises of solutions to its inability to conduct inspections of Chinese firms – history dating to the PCAOB’s willingness to register non-US audit firms despite their explicit declarations of foreign legal impediments to compliance with its inspection regime.

The PCAOB’s revocation order made clear (¶ 10) that Crowe Horwath was to get no regulatory surcease under the May 2013 Memorandum of Understanding with the Chinese Securities Regulatory Commission and the country’s Ministry of Finance – deprecating that document (¶ 11) as a “non-binding agreement between the signing parties.” So stated, the PCAOB effectively conceded the internal inconsistency between the MOU’s “intent with regard to mutual assistance and the exchange of information for the purpose of enforcing and securing compliance with the respective Laws and Regulations of (the parties’) jurisdictions” and the bail-out that “it is ‘not intended to create legally binding obligations or…supersede domestic laws’ of the parties” (ellipsis in the order).  

The PCAOB’s slap at Crowe Horwath might demonstrate effective agency muscle – or, as likely, could be foundational for dramatically unintended consequences. While the firm’s China-based US registrants will be forced to look elsewhere for audit services, there are broader reasons to be skeptical.

To start, Paul Gillis in his China Accounting Blog for July 26 calls out the agency to “pick on someone their own size” – with implications much deeper than a dig at the Big Four’s dominance of the large-company market in China.

Here is the context: at last count there were reportedly 92 Chinese companies with securities listed on the American exchanges. The upper end is totally dominated by the Big Four – of the ten largest companies in Standard & Poor’s index of the top 50 US-listed Chinese firms, PwC’s member firms audit six – Deloitte three – EY one.

Meanwhile, questions about accounting and reporting in China are fraught and persistent – the year-ago news of an SEC investigation into the accounting of Chinese giant Alibaba makes the point. An eruption of financial malfeasance in China is a simple inevitability, on a scale to have disruptive effect on the share prices of companies listed in America, to which the American regulators will be obliged to fashion a responsive strategy.

Those reactions will be intractably complicated. The SEC will be unable to secure documents and testimony, on the assumption that the Chinese securities regulator would exercise the veto granted in the largely illusory “settlement” of February 2015 – and the PCAOB will be prolonged in the paralysis of its fifteen-year inability to inspect.

Yet with its enforcement action taken against Crowe Horwath’s Hong Kong firm, the PCAOB has firmly nailed its policy colors to the mast – and (to thoroughly mix the metaphors of maritime hazard) will now, with its blind eye turned to the future, cruise merrily along until it too strikes the rocks.

That is because, to maintain any semblance of credibility as enforcer, it would seem obliged to maintain consistency with its sanction of Crowe Horwath, up the ladder of size to events involving Big Four clients. Yet – yanking the ticket of a Big Four firm in Hong Kong or China would have repercussions going to the heart of the global Big Audit model. Simply put, a regulatory deathblow against a Big Four firm in an economy the size of China would threaten the integrity and presage the collapse of a global Big Four network. And in turn, the limited range of auditor replacement choice renders impossible the functioning of a “Big Three” model – whether for the US-listed sector of large Chinese companies on its own or on the larger global stage.

Or put in Homeric terms – by pursuing Crowe Horwath between a rock and a hard place, the PCAOB may very well have sailed itself into those same troubled waters.

 

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And please also consider the comprehensive discussion of these issues in the new edition of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – just released by Emerald Books and available at Amazon.

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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Guest Op-Ed: Should FSOC Designate the Big Four As “Systemically Important”? How Not – And Yet Then What?

The question above, about the definition and scope of large bank regulation, may seem a bit wonk-ish. Unless you happen to be a large bank officer or director -- or a bank regulator – or maybe a bank client -- or a bank’s auditor or other gate-keeper.

Welcoming all readers to a new year that promises to be full of challenges, this topic kicks off 2017.

I am pleased to pose the question as co-author with Bill Kring, senior academic researcher at Boston University’s Center for Finance, Law & Policy, at today’s blog BankThink, published by The American Banker and dealing with ideas, trends and other developments in financial services:

“Efforts to mitigate the impact of systemically important nonbanks on the global economy have largely omitted a sector deeply entangled with financial institutions across the capital markets: the big accounting firms.

“The Financial Stability Oversight Council (is) mandated by the Dodd-Frank Act to designate ‘systemically important financial institutions’ for bank-like regulation….

“While FSOC’s future authority is somewhat in doubt as President-elect Trump sets to take office and the GOP has maintained control of both chambers of Congress, the work of regulators to contain systemic risks is no less important. And they should turn their attention to the ‘Big Four’ auditors that, despite being nothing like a bank or a broker-dealer, provide the audit opinions legally-mandated for all of the SIFI-designated institutions (emphasis added).

(For the entire piece, please see BankThink for January 9, 2017.)

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Non-GAAP Metrics – What Does “Generally Accepted” Really Mean?

The world of financial reporting is obsessing of late on the fixation of public companies, analysts and investors with financial reporting metrics other than those compliant with Generally Accepted Accounting Principles (GAAP).

As Den Howlett put it in his blog of June 1:

“Non-GAAP reporting has largely superseded GAAP reporting as the focus upon which management wishes analysts to pay attention. Many of those same analysts have happily fallen in line if that means the stock price can be pumped upwards.”

On July 31, Francine McKenna listed companies urging non-GAAP metrics on their followers – Brixmor, Herbalife, Apple, the New York Times, FedEx, GE and Microsoft – and a roster of regulatory functionaries wringing their collective hands – SEC Chairman Mary Jo White, Commissioner Kara Stein and chief accountant James Schnurr, and PCAOB chairman Jim Doty.

One concern was phrased in August remarks by Cindy Fornelli of the profession’s Center For Audit Quality:

“There is no authoritative framework that defines the calculation of each non-GAAP financial measure. This allows for flexibility, in that it enables non-GAAP financial measures to be tailored from one company to the next. However, the more tailored the calculation, the less comparable the measure may be across an industry….”

And yet, Francine McKenna’s blog of November 9 also put the futile issue of attempting to limit choice:

“The proliferation of non-GAAP metrics and the thousands of versions of each has made [users’] life a nightmare. It’s like standing behind the person in the Starbucks line who orders their coffee with seven different variations.”

Which of course will not do – consumers will be served. So the hard question was as put in a May speech by Hans Hoogervorst, chairman of the International Accounting Standards Board,

“whether IFRS Standards provide sufficient criteria by which performance can be judged by users of financial statements.”

As for actual abuses, the regulators will deal as best they can -- the record so far being spotty. While the SEC’s Division of Corporation Finance issued guidance in May, in practice, its review of non-GAAP filings has evidently given a pass to GE, although as reported by Dow Jones,

“the agency contended that the company’s disclosures could be unclear or confusing to investors and that its metrics may have excluded some costs they shouldn’t have.”

It is both noteworthy and unsurprising that non-GAAP measures have the unsettling tendency to favor an issuer’s desired reporting goals (see Howlett, above, and see Kevin LaCroix’s D&O Diary for August 8) -- the inevitable gaming of financial reporting being a human trait as old as the systems themselves.

So it should be timely to examine this central proposition:

If decision-making by the broad population of information users is now so focused on non-GAAP measures, does that not essentially challenge the adequacy, sufficiency and legitimacy of GAAP itself?

In other words, even though ill-founded herd behavior based on “conventional wisdom” is based on proximity, convenience and inertia, it still compels re-examination of GAAP’s basic utility – it being a core observation that even a position both long-established and intellectually robust is not immune from rejection or displacement.

Examples range from the trivial to the profound of beliefs that are “generally accepted.” Nothing abstract compels the action of a driver approaching an octagonal red sign – the expected stop is “generally accepted.” No written code obliges the congregation to stand for the bride when her father walks her to the altar.

Yet beliefs evolve. It was long held that the earth was the center of the astronomical universe, a position “generally accepted” by the world’s best thinkers from the time of Ptolemy, even as the model’s complexity of deferents, epicycles, eccentrics and equants become unwieldy to the point of breakdown – eventually to be consigned to history’s dustbin with the contributions of Copernicus, Keppler and Galileo.

Social policies supported by coercive legal systems throughout history included the “general acceptance” of such inhumanities as child labor, chattel slavery and exclusion of minorities – all of them to be swept away in more enlightened eras.

As for the future of GAAP under its current challenges, theoreticians in the development of knowledge teach that the displacement of long-held paradigms happens only when two conditions are met:

• First, the necessity must come to be recognized even by those with interests in preserving the status quo.

• Second, an alternative paradigm must be available to which to migrate. (For those interested, see Thomas Kuhn, “The Structure of Scientific Revolutions” (University of Chicago Press 1962).

So if as suggested, the dialog as to non-GAAP metrics has indeed engaged the attention of a quorum of the key players, there are two next steps in the process:

• The actual if reluctant acceptance of the need to explore the supplanting of GAAP itself.

• And the convening of a far-reaching discussion of the structure by which non-GAAP measures can be identified, articulated and codified with sufficient clarity to be integrated into a reporting and assurance structure by which investor needs can be truly served.

No part of this challenge lies beyond the reach of those leaders among the community of interests that comprise the Big Audit model. What is wanting is the acknowledgement that the state of the debate has indeed come this far.

 

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The EY/Ventas Affair – In the End, Who Really Got Bonked?

“When I married an accountant, I always thought his eyes would go first.”

            -- Same Time Next Year (1975)

In the poignant Broadway play and later film, romance originating on an audit engagement could include a touching laugh line.

Less so today -- see the penalties for what the SEC’s enforcement release of September 19, 2016, delicately called the “close personal and romantic relationship” between the chief financial officer of Ventas, Inc., the Chicago-based REIT, and an audit partner on the team at Ernst & Young LLP.

Both were sacked in July 2014 when their affair became public. EY’s opinions for the two prior years were withdrawn, and it was replaced by KPMG. The recent order now censures EY, requires disgorgement of $3.2 million in fees plus interest, and adds a civil penalty of $ 1 million. The package of sanctions also includes fines of $ 25,000 each and SEC practice bans on the CFO (one year) and the EY partner (three years), with a similar ban on her superior to boot.

Time to revisit what I wrote back in 2014 – here.

First, as I predicted, the PCAOB’s then long-running project -- Docket # 029 -- at long last resulted in rules to name the lead partner, ultimately effective in May 2016. Under an awkward process satisfactory to nobody, those so inclined may now comb for the new Form AP, to obtain information of no discernible value or consequence.

A brief quibble: the EY partner involved did not lead its engagement for 2012 or 2013, so would not have been identified had the PCAOB’s rules then been in place. This annoyingly trivial regulation is not only unappealing under justifiable libertarian hostility. To the contrary, believing in the salutary role of government policies if effectively designed (see my review of the late Tony Judt’s achingly passionate 2010 book, Ill Fares the Land), I find all too depressing the ill-considered distractions of agency actions passed off under the guise of progress along with their unintended and frequently malign consequences.

Second, the Ventas action is companion to a second SEC enforcement release of the same day, under which EY and its personnel are also penalized for lack of independence – in this case based on “an inappropriate close personal relationship” between an EY partner and the client CFO – the former having generously plied the latter with “frequent social trips, gifts, and overnight out-of-town trips” along with shared family vacation trips and mutual visits.

Other commentators have risen to charge the SEC with an opaque failure of guidance on the independence impact of these personal auditor/client relations -- Matt Levine at Bloomberg and Caleb Newquist’s Going Concern; see also Tammy Whitehouse at Compliance Week and Francine McKenna at Marketwatch – beyond the high-level language of SEC Rule 2-01(b) under Regulation S-X as to what a “reasonable investor…would conclude.…”

In this area on which the SEC’s examples are silent (see Rule 2-01(c)), its senior associate chief accountant recently bailed out on an opportunity to clarify. Speaking before the American Law Institute conference on September 22, 2016, he disavowed any “appetite” for rulemaking, instead observing that, “I don’t think this is an area where you can really come up with bright lines and explicit guidance.”

Response to this default would well be that a government agency responsible to enforce rules it is unable to articulate is hardly in a position later to criticize those left in the dark, or to argue failure to comply.

Instead, the gist of the SEC’s message is that, “although we have no detailed rules, you did violate them -- so we censure and penalize you $ 9.3 million and ban your partners from practice.”

There is, however, another way to clear the SEC’s fog of uncertainty – by noting forthrightly the investor community’s clear indifference to the entire Ventas affair, including a lack of concern with bedrooms as compared with board rooms or audit rooms.

That is, between EY’s withdrawal of its opinions in July 2014 and the September 4 filing of the company’s amended 10-K with a fresh opinion by successor KPMG – in other words, while the company lacked audited financial statements – the company’s stock price actually increased by 3 %. And, flipping to the period that followed, after KPMG’s opinion became available to relieve any investor anxiety about the company’s non-compliant status, its stock price went into a brief but sharp decline, not recovering its early September price until October 17.

In brief – no stock price punishment for the absence of an independent auditor, nor any reward for re-achieving a state of virtue either. QED, the complex of rules regarding “auditor independence” is delivering nothing on which investors place value. As I put it in 2014:

The entire anachronistic edifice of “appearance of independence” rests on shifting and unstable sands, and deserves to be washed away with the tides of modernized assurance performance.

Until that day should arrive, these proceedings display once more the illusion of effective agency behavior – the infliction of penalties with only the most general guidance to the affected issuers and auditors, who are left to fulfill their compliance obligations even while forced to pretend that their regulators are offering something helpful.

 

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Fear and Loathing at the Airports – The Transportation Security Administration Brings Its Own

Which of these two scenarios at Chicago’s O’Hare Airport should be more distressing? The flight I missed by three minutes a week ago, in the midst of the nationwide chaos caused by the TSA’s managerial ineptitude and deliberate slowdown tactics, or my ten-minute breeze through their checkpoint yesterday, when a plethora of uniformed staffers were standing around giving attention so cursory as to make illusory the notion of “security.”

(A detour from my usual topics of attention? The TSA muddle offers at least a teaching moment for my graduate students in Risk Management, as well as useful “how not to” lessons in strategy, communications and client service for those in business and professional services.)

A full hour and a quarter in the TSA scrum last week gave me ample opportunity to observe the agency's clear strategy of dilatory “work to rule.” Just one lane was open, which used the wretched scanner model that forces the emptying of pockets down to a chapstick. The single burly and surly TSA staffer had no back-up to handle any extra pat-downs, but was stripping and re-scanning frustrated would-be passengers one at a time, literally down to their cufflinks, while the waiting line stretched long enough down the concourse to deserve frequent traveler points of its own.

Yesterday, by utter contrast and at the same hour of the day, processing was so expedited that there were as many TSA personnel lounging around as there were passengers in the fast-moving queue. Three lanes were open, using the walk-through machines. The announcement was “coats and shoes stay on, computers stay in their cases.” Responding to “step right on through,” we moved so fast that the supply of plastic bins had all piled up on the other side.

Along with the rest of the flying population, I had planned ample extra time – with my own prior mis-adventure and taking seriously the reports of thousands of missed flights and rows of cots broken out for airport sleep-overs. There was one visible result of TSA’s tactical shift – the early-arriving crowds simply shifted the bottlenecks to beyond the scanners, forming lengthy queues at the Starbucks and McDonalds, and putting seats in the lounges at a premium while they waited out their now-excess margins.

Transparently displayed as was this wild variability in TSA staffing and tactics from one week to the next, the agency’s rapid ability to shift gears completely deflates the credibility of its assertion that a long-gestating problem requires long-term (and doubtless costly) fixes. To the contrary, post-9/11 inflictions at the airports have never been more than agency optics and the political manipulation of popular anxiety. Requiring plastic bags for toothpaste and hair gel has no more detected or deterred determined aggressors than has the bare-footing of grandmothers. Effective profiling and incisive algorithmic analysis have real effect; not so, the costly, annoying and pernicious disruptions of the national transportation system for the sake of TSA hiring figures or overtime budgets.  

Perhaps worst of all – when my bilious exercise of my First Amendment rights should trigger a full-body search the next time I fly, my chances of identifying the responsible bureaucrat will be the same as the utility of the entire exercise – exactly zero.

 

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Mike Oxley, RIP – Now For His Legacy…?

           “De mortuis, nil nisi bonum”

 As the bells of celebration were ringing in the New Year, they also tolled for Michael G. Oxley, retired Republican congressman from Ohio (1944-2016).

No news story failed to open with Oxley’s signature legislative accomplishment -- his co-sponsorship with now-retired Senator Paul Sarbanes (D-Md) of the 2002 law that bore their names and up-ended the regulation of public company audits and the auditing profession in the United States.

But for that bill – rushed to passage in the over-heated atmosphere of financial scandal known for short as Enron/WorldCom – Oxley’s extended career as a genial and modestly accomplished back-bencher would have been little remarked. With it, a re-visiting is possible of my observation in the International Herald Tribune on July 20, 2002, about the preliminary Senate vote, that “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

Those with interests to be served in preserving the status quo of Big Audit have been predictably bright and sunny. As SEC chairman Mary Jo White asserted on December 9, 2015, keynoting the AICPA’s annual national conference, “investor confidence in audited financial statements and independent auditors is high…. attributable, at least in part, to improvements in audit quality….”

Among those less sanguine about the persistence of the “expectations gap” would be the investors in the cascade of companies falling into disaster after the passage of Sarbanes/Oxley. They have reprised the question, “Where were the auditors?” as the list has lengthened since the debacle of 2007-2008 -- from Bear Stearns and Lehman Brothers, AIG and Fannie Mae, right down to Valeant and Martin Shkreli.

These and the many similar examples shape an understandable skepticism at the absence of convincing causation-based evidence that the American environment for reporting and auditing has been improved by Sarbanes/Oxley. And there are other grounds for doubt -- the following being tentative and incomplete:

• Start with the absence of a prosecutorial track record under the law’s new signing obligations for company officers and auditors – practical confirmation that these were hastily designed redundancies engrafted on the existing legal requirements of the core American securities laws of 1933 and 1934.

• The ability to conclude that Sarbanes/Oxley was no more than a one-off politically-motivated spasm by which the law-makers defaulted to “motion feigning as progress” is reinforced by the absence of discernible impact of the populist-oriented rhetoric from Occupy Wall Street through Elizabeth Warren to Bernie Sanders, and the lobbying-based bottle-necking of the rules by which to implement the Dodd-Frank legislation of 2010.

• Other concerns are found in the staff rooms of the large accounting firms – where straw polling among the generation of young auditors reveals deep dismay about the twin pressures of time-and-budget driven performance, and processes designed primarily to satisfy the hostile check-lists of the inspectors from the Public Company Accounting Oversight Board.

• Further, of concern to those staffers’ superiors in the ranks of the large firm partners, is the existential question whether audit quality has been improved or degraded by Sarbanes/Oxley’s injection of federal agency control over both auditing standards and quality review, and its constricting prohibitions on the scope of services permissible for audit clients.

Scholars of the human tendency to tell over-simplifying stories about complex events would caution that the supporters of Sarbanes/Oxley -- who optimistically ask, “Is the state of reporting and auditing better today than in 2002?” -- are asking the wrong question.

The more rigorous concern – therefore less appealing, and more readily denied or avoided – is this: “How would present conditions compare, if other strategies had been followed in 2002 – including, importantly, doing nothing at all but instead allowing the system to go through the inevitable period of cathartic cleansing that is part of every cycle in the financial markets?”  

That is – while Sarbanes/Oxley has plainly not achieved the Herculean task of hosing out the financial stables, neither are those edifices of capitalism equipped with self-cleansers. Rather, both periodic out-breaks of financial chicanery and the recurring resort to ineffective hindsight “solutions” are as embedded and as inevitable as the cyclical fluctuations in the world’s economies themselves.

Just so, it is a predictable certainty that the next generation of white-collar manipulators are evolving toward maturity even today – and that their unscheduled future break-outs will both surprise and evade the best efforts of earnest if out-witted gate-keepers – the SEC and the PCAOB, and Washington legislators as well.

Those would have included the well-intentioned Mike Oxley himself. All will speak well of him. But Shakespeare’s Mark Anthony expressed the darker view, at the funeral for Julius Caesar, that “the good is oft interred with their bones.”

That oration also provided a lasting reminder: even the Sarbanes/Oxley law is over-ridden by the law of unintended consequences, and “the evil that men do lives after them….”

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The PCAOB on Partner Naming – Late News from the Devil’s Playground

 

And the earth was without form, and void;

And darkness was upon the face of the deep.

-- Genesis 1:2

After His six efficient days of work, “the heavens and the earth were finished, and all the host of them” (2:1), and the great Creator took Sunday off.

Whereas the Public Company Accounting Oversight Board labored fully six years to issue its December 15 release – new rules and a new Form AP by which auditors of US public companies must identify their lead engagement partners.

As examined in my recently-published book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”[1], partner naming is a half-baked solution in search of a real problem. In the world of finite regulatory energy and resources, the project has never been worthy of the effort.

To start -- engagement partners in Europe and elsewhere have signed their firms’ reports for years, with no visible evidence that audit quality has been affected one way or the other – much less for the better -- and abundant examples that quality there is not demonstrably above that in America.

Conversely, for all the to-and-fro, the profession’s resistance based on liability concerns was always doubly undercut: First, by the absence of increased partner exposure outside the US. And second, by the lack of a significant history of claims against the firms themselves, under Section 11 of the Securities Act. The prospect of suits against individual partners must be remote – especially as investor plaintiffs have generally forgone those claims under other legal theories. On the other hand, partner identity has always been readily discoverable in US litigation, so the new Form AP will be insignificant in elevating whatever current exposure a partner may have.

As for this new form, rather than a forthright requirement to sign the audit opinion itself, the PCAOB takes a halfway approach that only a bureaucrat could love – a new required filing, on its own unique timetable – creating one more compliance box to tick and one more item for the inspectors’ checklist. Unmentioned in the discussion is the principle, well known to safety and compliance experts, that even the best-intended quality measures add additional complexity: “one more thing to go wrong” injects an unavoidable if unintended increase in the opportunity for cascading mistakes.

Examples are readily available. A key factor contributing to the Three Mile Island nuclear plant “accident” in 1979 was the confusion between a concealed warning light and the failure of an emergency pressure relief valve. And the highway safety studies are instructive, that while safety barriers and rumble strips may reduce the number of collisions, they also incentivize higher driver speeds, meaning that deaths and damages are greater for those that do happen.

Nor does it withstand scrutiny, that public naming somehow raises the level of partner care or concentration. As noted, Europe’s experience does not include evidence of a quality effect. Instead, partners have never lacked for adequate reasons to be focused and motivated. PCAOB member Lewis Ferguson had it right back in 2011, “As a practical matter, in larger accounting firms, a failed audit or major error in the audit of a significant client, particularly a public company, can be career ending for the audit engagement partner in charge of the audit.”

Advocates of partner naming – Re: The Auditors and Going Concern among them -- point with enthusiasm to the SEC’s orders of December 2, 2015, against the Grants firm and two of its partners – noting that one had kept active engagement responsibility after the emergence of performance quality indicators including the eruption of a major client fraud.

If not outright mistaken, this view misses the proper location of incentives and accountability. That’s because, as I was quoted in Francine McKenna’s blog, “one of the many unlearned lessons from Enron/Andersen is the hostage to fortune that a firm leaves by keeping a problem partner on-line either on the same job or as moved around.”

There’s history. Back in the Enron era of 2001, Andersen had left a senior-level audit practice partner in an on-going performance-related role, after (and in spite of) his prior SEC proceeding -- contributing to the inference drawn by law enforcement officials that the firm was an unrepentant and unresponsive repeat offender.

Further back in my own experience, my law firm defended a Big Eight firm in a whole series of lawsuits, involving the client roster of a single audit partner. He was genial but inept, a virtual Typhoid Mary of exposure – exposures that the firm could have avoided by promptly quarantining this viral at-risk partner whose every job was subject to infection.  

On top of all of these reasons, the PCAOB has long had more important fish to fry. Its own member Steven Harris flagged two of them, in his remarks in favor of partner naming – namely, “Modernizing the outdated audit report model, and improving auditor going concern reporting….” Add two more to these, at least: the persistently elusive topic of “audit quality indicators,” and the agency’s long-running exclusion from the ability to inspect audit firms in China.

Until the PCAOB acted at last to resolve the lucid question of when and how its Docket 029, pending from 2009, was ever to end – only knew God.

Now, in context of a full menu of complex tasks, six years of effort only to bring forward the new Form AP has the feel – pardon the oxymoron – of a topic deemed importantly high on a list of the inconsequential.

Perhaps more apt than the Genesis comparison, then, to the PCAOB’s misplaced aspiration, is the 1st century BCE challenge issued in Horace’s Ars Poetica:

What could he produce to match his opening promise?

Mountains will labour: what’s born? A ridiculous Mouse!

 

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Wishing a Merry Christmas to all – or whatever solstice-oriented celebration you observe – and a New Year of peace, prosperity, and compassion for those less fortunate.

 And as a holiday gift for your favorite CPA, financial officer, board or audit committee member or financial adviser – “Count Down” is available from Amazon, optimistically for delivery before the 25^th, or with only its elves’ short and manageable re-stocking.

 

[1] Available from Amazon or direct from Emerald, the publisher.

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]

Sifting the Fly Shit Out of the Pepper – The PCAOB Comes Back on Partner Naming

After eighteen months of inactivity, other than frequent promises of further action, Chairman James Doty of the Public Company Accounting Oversight Board, in a Brussels speech on June 22, 2015, announced that a release was coming, on a date still not specified, to consider a separate new form by which accounting firms would provide the name of their lead engagement partner on the audits of US public companies.

The final outcome of a yet-further comment period remains pending. But the triviality of the approach is visible in the vacuity of Doty’s announcement: rather than solve the substance of the American profession’s concern with enhanced individual partner exposure, the form would, in his words, “reduce auditors’ perception of litigation risk” (emphasis added).

Doty has trod this rocky path at tedious length for years, and the ground is familiar – see here on October 17, 2011, April 11, 2013 and December 4, 2013 – and with those references, re-plowing is not necessary. Instead, in a few words, it’s still all about the optics – and the topic is still one that diminishes the stature of the agency and distracts its energy from serious issues:

• The user community is indifferent to partner naming, as shown by the absence of distinction between practices that vary among countries.

• At the same time, audit quality differentiation based on partner naming is, to be generous, elusive. Careful reading of the “research” cited by Doty shows the “confirmation bias” built into his invocations, while there is no study at the large-company level of share price effects or financial statement quality differentiation between US-based companies that do not provide partner names and European ones, including those listed in America, that do.

• Exposure of engagement partners to real litigation will not be reduced, because their identity is readily knowable through the discovery process and complaints could, if strategic for plaintiffs, be readily amended to add them as defendants.

• But at the same time, that exposure is largely illusory. Plaintiffs’ attorneys have never made a practice of naming individual partners, because their evidence for use against their firms is always available, and their personal assets are insignificant in context of multi-million dollar damage claims.

• While cutting the other way, lead partner careers are impaired by litigation in any event, whether they are named in the suits or not, by the combination of reputational effect and protracted distraction while dealing with the time and emotional demands of participating in a large pending lawsuit.

All of which means that partner naming is not a real issue for most investors – in the US or elsewhere -- who could get the information if truly desired -- but only for the voyeuristic critics of the profession who want named individual villains for their finger-pointing.  

 

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“Audit Deficiency Syndrome” – IFIAR and the PCAOB Would Call It a Global Epidemic

In the panoply of clumsily identified affinity groups, the acronym for the awkwardly named International Forum of Independent Audit Regulators – IFIAR -- would surely be a top candidate for well-deserved obscurity.

IFIAR came together in 2006, one of the offspring of the Public Company Accounting Oversight Board – the American audit regulator known for short, and no more poetically, as the PCAOB.

That agency was itself born in 2002, in the post-Enron spasm of legislative righteousness that begat the Sarbanes-Oxley law and marked the end of the accounting profession’s exercise of self-inspection and quality oversight. Audit regulators were spawned around the world – the PCAOB and its children in 50 more countries now gather under the IFIAR banner with the mission of “knowledge sharing and collaboration in pursuit of its members’ shared objectives of high quality audit performance.”

That comes from the group’s press release, issued at its assembly in London earlier this month, which was led by current chair Lewis Ferguson, a member of the aforesaid PCAOB.

Bidding for media attention to its inspection and oversight programs, Ferguson’s press briefing announced the results of IFIAR’s latest survey of its members’ sampling of the work of large-company auditors:

“We continue to see high levels of inspection deficiencies in vital areas of public company audits. This is a problem for investors and stakeholders around the world.”

Numbers came with the words -- appropriate for this sector of the capital markets: the survey reported deficiencies in fully 47 % of the 948 public company audits inspected, and 41 % of the inspected audits of 148 financial institutions.

Splashed across the business and trade press, the attribution of persistent, recurring high levels of inspection deficiencies in vital audit areas was characterized as “staggering” and “chronic” in outlets such as Forbes, Economia, CFO Magazine, Financial Director, the Journal of Accountancy, Accounting Today and Accountancy Live.

Hold on a second. What of this alarmist message – a forty-plus percent deficiency rate in “vital areas of public company audits”?

On the one hand, while the IFIAR cautions against extrapolating, its findings of deficiencies:

“indicate that the audit firm did not obtain sufficient appropriate audit evidence to support its opinion … and that the audit failed to provide the level of assurance about the financial statements that it purported to do and that is required by professional standards.” (Emphasis added.)

Pass for a second the litigation implications of such charges of sub-standard performance, under the threatening regimes of legal liability in the world’s large economies. Such a failure rate in any other sector would – if credible – also be intolerable to the interested parties.

Some examples: New car warranties are now in place above and beyond 100,000 miles. Airline casualties are measured per hundred million passenger miles. Food safety and environmental pollution standards are expressed in parts per billion. Such dangerous activities as construction sites and chemical plants advertise their accident-free periods over months and years.

Even at the hands of the most casual food-safety agency, such a pervasive rate of “deficiencies in vital areas” would cost the operator’s license of a neighborhood coffee shop or a curbside taco truck in a heartbeat.

And yet – every securities trade on every stock exchange in every IFIAR country is based on financial statements audited by a firm subject to inspection by an IFIAR member. And the very raison d’être of those members is, as they put it (press release, page 3), their “mandate to improve audit quality.”

Which leads to this choice: Is the quality of the Big Audit model so fundamentally degraded that large-firm performance deserves the headline-grabbing assertion of persistent, recurring serious deficiencies?

Or – perhaps – is this global aggregation of audit regulators choosing to devise and apply the proper standards of measurement and evaluation in the first place? In other words, what counts? Who is doing the counting? And what’s the point?

After all – take the case of Andre Drummond, the 6’11” center for the Pistons, Detroit’s professional basketball team. He has the NBA’s worst current career free-throw shooting record, at less than 40 % – well below half the rate of the league’s leaders. Yet he is in his third successful year, based on his skills in rebounding and defense.

The same in professional baseball, where a batter failing to hit safely three times out of four can still achieve Hall of Fame status (see the career batting averages of Bill Mazeroski -- .260 -- Ozzie Smith -- .262 -- and Harmon Killebrew -- .256).

Properly defined measures of performance quality and rates of failure and error are not designed or intended, if legitimate, to be evaded or eroded. So IFIAR’s assertion, as Ferguson put it, that its finding of deficiencies “does not necessarily mean that the audited financial statements themselves were materially misstated,” bangs hard up against its own inability to give affirmative comfort that its findings are consistent with good reliable audit practice.  

IFIAR’s promotional efforts confront the dangerous inanity of “managing what you can measure.” So it is left not only unable to find a satisfactory answer to the wrong question – it is blinkered from even asking the right one.   

Lest we forget, there are two lessons in the legend of the shepherd boy who cried “wolf”:

The publicity-seeking little boy was met with public rejection and the lack of respect that his over-reaching deserved.

And also, when the wolf actually did show up, the villagers really did lose their sheep.

 

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The SEC Settlement with the Big Four Accounting Firms – The Chinese Puzzle Misses Some Key Pieces

On February 6, the Securities and Exchange Commission in Washington announced its order, ostensibly resolving its long-running impasse with the Chinese affiliates of the Big Four accounting networks, over working papers of the Chinese auditors demanded but not produced in response to the American agency’s investigation requests.

Is this “settlement” anything but another exercise in governmental hocus-pocus, by which the bureaucrats act as if they have delivered something real, and observers must pretend to believe them?

Reviews from the commentariat are mixed. The Corporate Counsel blog exuberantly exclaimed that the “Tug-of-War Over Audit Files Finally Ends!” By contrast, writing from over in China, Paul Gillis viewed it as the SEC’s “near complete capitulation to the Chinese.”

Let’s take a look.

First, the deal includes not a breath of reference to the perpetually frustrated aspirations of the Public Company Accounting Oversight Board to inspect the operations of China-based auditors. This hostage to fortune goes back to the launch of the PCAOB itself under the Sarbanes/Oxley law of 2002, when the PCAOB agreed to register non-US audit firms despite their explicit declarations of foreign legal impediments to compliance with its inspection regimes.

To the diminishment of the PCAOB’s modest stock of credibility, its much-vaunted “progress” against the entrenched resistance of the Chinese regulators to fall into line with its cross-border ambitions, as touted over the years by chairman James Doty and his colleagues, has proved continuingly elusive, with no real progress realistically in view.

As for the SEC itself, the devil lurking in the details of its deal with the Big Four is clutching his Satanic ribs with derisive and scarcely-suppressed hilarity. And well he might.

Under the agreement:

• The Big Four are to put up the trivial sum of $ 500,000 each – minor fractions and lost in the rounding errors of their fees and expenses to accomplish this four-year armistice.

• The firms concede, as they must, their refusal to comply directly with the SEC’s requests – under the arguable justification of the inhibitions of their local Chinese laws.

• But they are permitted not to admit – yes, also not to deny -- the SEC’s charges that they were law-breakers.

• Most important, they are unrestricted in any aspect of their on-going services to their Chinese clients, including those with presence in the American capital markets.

The SEC’s press release also plumps the “additional remedial measures” it might invoke in the event of future Big Four non-compliance with its further requests. But reference to the actual text of the Order (pages 21 et seq.) confirms these to be no more than the small-bore weapons the SEC has already deployed to such little effect.

The SEC may, that is, either commence new enforcement proceedings, a tool always at the ready in any event, or re-start the existing proceeding -- the final legitimacy of which is left untested by the Big Four’s pursuit of review or appeals, their rights to which are explicitly preserved (page 20).

Against which, having reached a local accommodation by giving their documents directly to the China Securities Regulatory Commission instead of to the SEC, the Big Four affiliates have inserted their home agency as a protective shield against future exposure in America.

That is, the Big Four undertake that for future SEC requests, either they will make actual production to the SEC – an unlikely prospect until and unless the recalcitrant CSRC changes its attitude -- or they will produce to the CSRC, while sending along separate logs of documents subject to claims of privilege or the constraints of Chinese rules regarding state secrets or information deemed sensitive for political or any other reasons.

The house-keeping burden of preparation and submission of these elaborate document listings, in fulfillment of the letter of the Big Four’s obligations – a cost-heavy hassle that will work primarily to the enrichment of the inevitable teams of lawyers involved – will plainly be done in Big Four dialog with the CSRC and in compliance with its views on the permissibility of onward production to the American agency.

As to the spirit, the CSRC retains unfettered authority over the ultimate release of the documents, not being a party to the Big Four’s agreement. So the SEC is left not one step further down the road to real cooperation and enforcement compliance than it was before this illusory “resolution.”

The claim by its staff in the SEC release that “the settlement is an important milestone in the SEC’s ability to obtain documents from China” would no doubt be agreed by both the Big Four and the Chinese regulators.

But they would each have their separate, distinct and antagonistic reasons, as this “milestone” sits on the berm of a pot-holed path to nowhere.

 

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Deloitte's Audit Ban in Saudi Arabia -- And Its Global Effects?

This week’s report that the Capital Market Regulator in Saudi Arabia will ban Deloitte’s firm from auditing public companies there as of next June 1, on account of its work for the targeted loss-making company MMG, will not be going down well for the largest of the global Big Four accounting networks.

Much more ominously, a collateral outcome of the Saudi black-ball may be the long-feared destabilizing of the Big Four’s trust-based franchise to audit the world’s largest companies, by a disruptive event in a location mistakenly assumed to be peripheral.

It has been well-enough recognized, since 2002 when Arthur Andersen’s leaders fatally failed to placate the US Department of Justice over conduct related to Enron, that it hurts to be on the wrong side of angry life-or-death power. Conversely, there are ample examples of the Big Four’s escape from scrutiny in settings too small to be consequential.

It’s the combination that is dangerous: an authority without a mature history of regulatory predictability, but with enough influence to unsettle the Big Audit model.

For some illustrations:

• In 2000, the Italian antitrust authority had the then-Big Six firms dead in its sights, with charges of price-fixing and other coordinated anti-competitive conduct. Lacking either the will or the motivation to push for practice prohibitions or other changed behavior, however – and who knows about “Italian justice” -- the agency was content to tap the firms gently on their wrists.

• PwC’s firm in Russia spent several years in litigation over its 2002-2004 audits of Yukos, under potential threat to its license to practice. But as now reported, PwC having remitted its fees to the government in settlement, it is comfortably persona grata, as shown by its engagements for Gazprom and Sperbank.

• PwC also suffered the inconvenient protracted incarceration of two of its Indian partners and their lengthy criminal trial, over the billion-dollar “ghost employees” scheme confessed in 2009 by Ramalinga Raju, founder and CEO of Satyam Computer Services. Results of the trial are expected at the end of this month. But it would seem unlikely that PwC‘s global chief Dennis Nally would have travelled to Delhi last month to head up his firm’s vigorous pimping a Goldilocks view of the country’s economy under Prime Minister Modi, unless he was thoroughly comfortable that the expected outcome would not disturb his firm’s presence there.

What is important is that none of these countries are large and important enough to matter. The Big Four’s global networks could survive worst-case exclusion from local practice in Russia or Italy or India.

It could have been a different and life-threatening story, by contrast, if in 2006, the sanctions imposed on PwC in Japan for its work on Kanebo had not been so flexible. With the size and global connectedness of the Japanese economy, PwC dodged a fatal bullet, permitted to survive the forced closure of its local firm by organizing a new local affiliate – which came to absorb many of its personnel and, vitally, by which it was able to continue both local work for foreign clients and ex-Japan work for its clients there.   

Which comes back to Saudi Arabia – where, incidentally or not, Deloitte also audits the Saudi-listed telephone provider Mobily, another investigation target after profit cuts, a stock price collapse and the suspension of its chief executive officer.

What is now unknowable is how far abroad the Saudi sanctions will run. In mature regulatory environments, official enforcement would not cascade into private sanctions across a Big Four client list. Leadership of a CalPers or PIMCO or Vanguard would resist imposing a ban on one of the Big Four that would cause self-inflicted disruption to the companies making up their massive fund portfolios.

Could the same be said of the global holdings of the Saudi royal family?

Demonstrably sensitive to any suggestion of lack of transparency, Prince Alwaleed Bin Talal is the chairman of the Kingdom Holding Company. On his watch, Deloitte’s consignment to pariah status in his country must be of concern, for example, to Deloitte’s firm in the UK, as auditor of one of the Kingdom’s premier real estate holdings, the massive Canary Wharf development in London.

More’s to the point, it might safely be predicted that, if the Prince has any say in the matter, only if Riyadh freezes over will Deloitte compete successfully against the incumbents for audit engagements of such prize Saudi holdings as Citigroup (KPMG), EuroDisney (PwC) or News Corp (EY).

The rippling effects of Deloitte’s Saudi-originated punishment may be grave enough. Further, with the acute pressures on auditor choice and replacement arising from mandatory re-tender requirements in the UK, and the rotations mandated under new legislation in the European Union, the structural impacts beyond a single unpredictable country can only be … well … unpredictable.

 

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