Re:Balance -- Jim Peterson

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

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

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

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

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

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

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

There are multiple issues:

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

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

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

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

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

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

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

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

 

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RIP Senator Paul Sarbanes

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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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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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William McDonough: Ave Atque Vale

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

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

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

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

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

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

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

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

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

 

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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.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free – both at the Main page.

 

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.

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]

“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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A Chinese Puzzle: What If Its Auditors Really Are Barred from Practice in America?

Do you have the patience to wait until the mud settles, and the water is clear?

       Tao Te Ching of Lao Tzu, Verse 15

What will be the impact on the rickety and shambolic audit model for large global companies, if the January 22, 2014, opinion of Administrative Law Judge Cameron Elliot of the US Securities and Exchange Commission becomes final and enforceable?

That opinion would impose a six-month suspension from US public company practice on the Chinese affiliates of the Big Four audit firms – putting China-based registrants at risk of trading suspensions and de-listings, strangling the pipeline of China company IPO’s into the US, and threatening the compliance of American and other public companies having significant business presence and reportable operations in China.

As found by the ALJ, the Big Four firms had “willfully” failed and refused to produce audit work papers relating to their China-based engagements, in response to SEC enforcement subpoenas, asserting that they would be in violation of Chinese legal and state secret restrictions – positions brushed aside by the ALJ as not “in good faith” and “not sincere at all” (page 105).

Reactions and perspectives differ dramatically. To sort them out, consider the fable of Asian origin, of the committee of blind men tasked to describe an elephant:

Each feels a different part of the animal – and they variously say that for its leg it is like a column, its trunk -- a snake, its side -- a wall, its ear -- a fan, its tail -- a rope.     

Start with the Chinese themselves. Resolute optimists might see a new era of cross-border bonhomie in the China Securities Regulatory Commission’s turn-over to the SEC of documents it had received from Deloitte relating to its engagement by Longtop Financial Technologies Limited. As announced by the SEC on January 27, 2014, that supported discontinuance of the SEC’s enforcement action commended against Deloitte in 2011 – the first of the actions leading to the ALJ opinion.

Is it the start of a climb-down by the Chinese? Skepticism, caution and prudence would all advise against betting the ranch.

That’s because the behavior of the Chinese remains inconsistent, incomplete and inscrutable. Reacting to the ALJ’s decision, the CSRC issued the lofty warning that “the SEC should bear all responsibility to possible consequences arising from the decision.

And noting that the ALJ’s order is subject to appeals, first to the full SEC and then to the appellate court, Chinese analysts and corporate spokesmen took the casually sanguine view that all current reports and filings are proceeding as scheduled.

By which they failed to see two problems: First, delay through this reporting cycle is not a strategy, but only a temporary expedient; next year will arrive, all too soon and with all the same issues. Second, in any event, it should inhere in Chinese companies’ voluntary choice of American channels to the capital markets that US regulators had the right to set their rules.

As well they should, considering that effective Chinese assurance remains an elusive if needed goal. Witness the potential impact of the ALJ’s suspension order on Peoria-based Caterpillar, with fiscal 2013 revenue of $ 56 billion. Asia was its second-largest region, of which China contributed $ 3.5 billion. On this financial and geographic scale, big-firm audit support plainly is required.

Moreover, as shown by the company’s fourth-quarter write-off of $ 580 million, or some 87% of its July 2012 acquisition of Hong Kong-listed ERA Mining and Machinery Ltd for $ 653 million, the production of reliable financial information from China fell victim to “deliberate, multi-year, coordinated accounting misconduct.” 

Assertions by Caterpillar of such issues as discrepancies between physical and book inventory, at an acquired company whose major product was hydraulic roof supports to prevent rock-falls in coal mines, raise the ominous prospect that both investors and coal miners in China alike should worry about their roofs falling in.

But there are only two equally unacceptable alternatives, if Caterpillar and other companies with significant Chinese operations are denied the services of Big Four firms there: either trading suspensions for otherwise all-American enterprises, or filing by their auditors of opinions with the deadly and impermissibly non-compliant “except for” language required by US auditing standards (see AU 508.22-26) for unresolved restrictions on the ability to perform audit work believed necessary.

In his China Accounting Blog, advantageously on the ground, academic Paul Gillis correctly observed the futility of attempts at replacement of the Big Four’s local firms: smaller firms in China would lack “the scale and skills to audit the Big Four’s clients,” and attempts to fly in non-Chinese audit personnel would fall afoul of local licensing and disclosure requirements. 

But the suggestion by Gillis that the Big Four could serve their six months in the penalty box after May 1, and then return to do 2014 audits, would be seen by the SEC and the PCAOB to show a nose-thumbing and recidivist attitude, such as fatally poisoned relations between Arthur Andersen and the Justice Department back in 2002. Fresh subpoenas and de-registration proceedings could be expected instantly, with the US regulators’ full wrath over-hanging any such evasiveness.

Meanwhile the Big Four themselves promised both full-out appeals and non-stop work for their clients, falling back on hope for a political solution and claiming to be “heartened by the significant progress on information sharing between the Chinese and US regulators over the past year.”

To which the jaundiced reaction of the ALJ must carry weight. With the negligible movement and long-term delaying capacity of the Chinese since the 2002 passage of the Sarbanes-Oxley law – Longtop developments notwithstanding -- anyone so “heartened” would have been similarly charmed back in 1912, that the lifeboat count on the RMS Titanic, cynically reduced to 20 from the planned and sufficient 64, actually exceeded maritime safety regulations.

As for the American regulators, blogger Jonathan Weil suggested that the SEC might simply back-burner the order, lacking either a deadline for action or the will to take on an issue of such intense political dimensions – an approach consistent with such persistent can-kicking as the SEC’s never-ending postponements of action on convergence of American and international accounting standards, and the PCAOB’s multi-year waving at the unproven benefits of mandatory auditor rotation.

Except that, for its very credibility, the SEC can do no less than vigorously affirm ALJ Elliot’s order. Now in the chair after making her reputation as a hard-nosed prosecutor, Mary Jo White has in two recent speeches stoutly declared the primacy of her commitment to the agency’s enforcement efforts.

Thus doubly required to show that she clanks when she walks as the meanest badge in town, she would check both reputation and priorities at the door if seen to be less than robust in support for the ALJ – to say nothing of the devastating impact of retreat on the morale and commitment of her staff.

Still, the potential for international regulatory antagonism and the likelihood of a major cross-border conflict have been in full public view, ever since Sarbanes-Oxley launched the PCAOB with its over-reaching jurisdictional aspirations and the ambition to operate internationally despite lacking the tools to do so.

And therein lies the SEC’s need to protect itself on judicial appeal. No less than the firms themselves, who in their PCAOB registrations consistently put down markers of possible conflicts among competing national regulations – the regulators accepted those markers with a blind eye to the potential for the type of stand-off now presented, leaving the SEC chargeable with a form of “agency entrapment” for its own decade of irresolution.  

Finally, as to ALJ Elliot himself – the public version of whose 112-page opinion consists of 47 pages of factual recitals followed by lengthy portions blacked out for its discussion of the Chinese laws and Chinese markets.

The ALJ plays to the five SEC commissioners who will be his initial reviewers on appeal – reciting that the audit firms’ “actions involved the flouting of the Commission’s regulatory authority” (page 102) and “failed to recognize the wrongful nature of their conduct” (page 103).

But, critically for the public assessment of his analysis, the ALJ refused to disclose much of his record, out of a seemingly punctilious concern that “some of my factual findings and legal discussion may interfere with any ongoing discussions” between the SEC and its Chinese counterpart (page 4).

If the theme has a ring of familiarity in its prim assertion – “trust me, but I won’t tell you why you should” – at least to the critics of the accounting profession – it would be in the similar opacity of the one-page standard audit report itself.

A jurist seeking credence owes a better standard of completeness, at least to the sighted if not to the blind, under the 1913 maxim of Justice Louis Brandeis, that “sunshine is said to be the best of disinfectants.”

 

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Mandatory Auditor Rotation – HR 1564’s Bump in the Road to Nowhere

  “Ancient Rome declined because it had a Senate,” the American cowboy philosopher Will Rogers querulously observed, “so what’s going to happen to us, with both a Senate and a House?” 

Consider the July 9 passage by the House of HR 1564, the “Audit Integrity and Job Protection Act.” Neither title topic is remotely addressed; instead the bill would, if fully enacted, prohibit the American audit regulator -- the Public Company Accounting Oversight Board, inflicted on the world’s oversight of financial information by the Sarbanes-Oxley law of 2002 – from acting to mandate the rotation of audit firms.

Although vigorous and unambiguous for over a decade (here to here) in my belief that mandatory auditor rotation is a flawed and unworkable idea, unsupported by any empirical showing of a relationship – causal or otherwise – between auditor tenure and audit quality – I search for any adult rationale for this goofy piece of legislation, and draw a total blank.

To start, the supportive record is bare. Whereas the primary occupation of American law-makers is the conduct of endlessly self-promoting “hearings” – exercises in vanity and posturing well deserving the description by Shakespeare’s MacBeth (V, 5) of “tales told by an idiot, full of sound and fury and signifying nothing” – the House Financial Services Committee launched HR 1564 without report, analysis or commentary.

So what reasons underlie this idiots’ tale? The PCAOB is a critic’s easy target, for sure, but any momentum there in favor of rotation has long since petered out. PCAOB Chairman Doty’s initiative of 2011 generated a series of public declamations of unsurpassed vacuity, and comment letters taking 95% unfavorable positions – and, in the event, attracted plain signals that he lacked the votes – if indeed he ever had the desire.

Across the Atlantic, committees of the European Parliament have drawn the teeth of Markets Commissioner Michel Barnier’s rotation aspirations.

And the UK’s Financial Reporting Council took an apparent deep finesse on rotation last fall, by instead requiring large public companies to put their audits out for re-tender every ten years or explain why not – a process that sources in London indicate might well see a real volume of auditor changes.

Yet, that country’s Competition Commission has just proposed a reduction to five years. The likely perverse result of which -- taking account of the huge costs for too-frequent proposals, engagement transitions and first-time learning curves -- would be these: round-robin exchanges of engagements among the Big Four; further Big Four concentration as smaller firms are squeezed out by the costs involved; replacement names on otherwise identical auditor reports; and no observable difference in innovation, performance or quality. 

So what constituencies were interested in HR 1564? The cynical view of Matt Kelly at Compliance Week is that the Big Four firms’ half-million dollars in campaign contributions to the bill’s sponsors in 2011 and 2012 bought the bill. But these amounts are merely distasteful spoonfuls in the huge cesspool of Beltway lobbying monies. And with no fear that rotation was to be forced on them, auditors in America should have been indifferent, if not resistant to a form of “protection” that could not be beneficial to their already-fragile public reputations for accountability.

The same for corporate issuers. And as noted, the PCAOB was already tied in knots, so another imposed constraint would fall somewhere between unnecessary and simply irrelevant.

In my own rather jaundiced view of the legislative process, the answer lies in Washington’s devotion to “motion” masking as “progress”. When the environment is so poisoned that such fundamental needs as immigration reform and gun control and social policy issues like food stamps and student loans are beyond the grasp of reasoned debates, legislative time and energy devoted to auditor rotation is merely wasted. 

It is thoroughly dispiriting to think that as silly and stupid a proposal as HR 1564 should have come this far under the disguise of useful law-making.

 

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Foreign Auditor Inspections? "China Syndrome" Strikes the SEC

 

Confidence in the American securities and accountancy regulators was not raised, when a press release on December 3 announced -- under the headline “SEC Charges China Affiliates of Big Four Accounting Firms …In Refusing to Produce Documents” – a proceeding against the five largest global networks.

For the first time in its eleven-year history, this column calls upon a graphic to illustrate the folly of a gang that couldn’t count straight:

 

   The PCAOB has been stymied for a decade in its futile attempts to enforce in China its asserted mandate under Sarbanes/Oxley to inspect and obtain working papers from auditors, including those in foreign countries, which audit more than twenty percent of a registrant’s assets or revenue (here). And the SEC itself has been piddling along with company-specific subpoena enforcement and administrative proceedings against Deloitte and its Shanghai affiliate.

So now they have called in the heavy artillery, in the person of Robert Khuzami, director of the SEC’s Division of Enforcement, who says that non-complying firms “face serious sanctions.”

Khuzami cannot be faulted for zealotry. He arrived on the scene of an agency whose Cox-era somnolence had missed not only Bernie Madoff’s predations on the domestic front but the internationally destructive tsunami of “reverse mergers” by which Chinese companies gained access to the world’s capital markets. That scorecard, a decade late and billions short, now includes more than 50 de-listings by the SEC and 40 fraud actions – and, elsewhere, a flurry of civil litigations, and most recently an agreement by Ernst & Young to settle civil litigation (but not a disciplinary proceeding) relating to Sino-Forest, by agreeing to pay C$ 117 million, the largest auditor settlement in Canadian history.  

(As an aside, those disposed to see darkly conspiratorial revolving doors in the place of Chinese fire drills will note that this is the same Khuzami whose predecessor at SEC Enforcement from 1998 to 2001, Richard Walker, thereafter went in-house at Deutsche Bank, where he hired Khuzami in 2002. So the latter, before becoming the top American securities cop in 2009, was on-scene at DB when the bank – as now reported – according to three whistle-blowers concealed losses of up to $ 12 billion for failure to “mark-to-market” the exposure gap on a notional $ 130 billion of exotic derivatives known as “leveraged super-seniors.”)  

Calling in Khuzami’s troops may look like the last act of desperate regulators – but it will actually play as the next act in “The Comedy of Errors.”

That’s not because it’s so little so late. Or because frustration of the PCAOB’s aspirations to access Chinese auditors and work papers would attract retaliation against their own ambitious plans to re-structure the global audit market by building and unleashing global-scale Chinese audit firms – an ambition otherwise unachievable both for want of competence in personnel and standards but also because, in reciprocal hostility, other countries will be no less protective of their local prerogatives.

It’s mainly that the US regulators’ only weapon of significance – banning Chinese affiliates of the large global accounting networks from qualifying to work on audits of American-listed companies – would ripple far beyond the toxic roster of China-based companies.

There are potential consequences for global-scale companies with significant operations in China that go far beyond the inability of the PCAOB to inspect their local audit firms, whether or not maneuvered to keep below the 20% threshold.

Consider just two examples: Caterpillar, whose annual filing with the SEC does not set forth results by geography but discloses total 2011 sales of over $ 60 billion and elsewhere reports its China sales to be 3% of its total. Or HSBC, which does report by region including $ 3.6 billion in profits from China in 2011 and whose mainland Chinese operations include 133 outlets including 27 branches, even after the announced sale of its interest in giant insurer Ping An.

A barrier to the use of Chinese audit firms would make it impossible for those companies to include audited results from their Chinese operations in their global accounts. The result would be top-level consolidated financial statements with a huge unaudited portion, and auditors forced in their opinions to confront the professional standards for limitations on their audit scope.

Across the globe from KPMG in London and its top-level opinion on HSBC, to PwC in Peoria, Illinois for Caterpillar – unable to rely on their excommunicated Asian brethren – auditors would have no choice but to use the dread “qualify or disclaim” language -- never seen for a public company because anathema under the rules of the SEC itself.

Or, in extremis, PCAOB de-registration of the whole of an audit network deemed non-compliant would render a company’s entire financial filing unacceptable.

Restoration of adult-level expectations and the pursuit of a non-litigated resolution process is essential, although a fading hope – since calling in the police as a last resort means an escalation of hostilities due to the one-dimensional DNA of their approach to problem-solving.

For good reason, then – under the latest blows from SEC Enforcement – the large accounting firms must feel like a bunch of nails in a hammer-testing factory.  

 

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Sarbanes-Oxley, Ten Years After -- Are We Having Fun Yet?

It has not been difficult, through this summer of discontent and turmoil in the world’s financial markets, to ignore with enthusiasm the comprehensively vacuous observations of the tenth anniversary of the Sarbanes-Oxley law. 

Readers will recall my long-held skepticism about that knee-jerk post-Enron exercise, going back to my July 20, 2002 observation in the International Herald Tribune about the preliminary Senate vote, that “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

Nor has the decade horribilis given any reason to change.

Of the smug and fatuous self-congratulations of the bill’s eponymous sponsors (webcast on July 30, 2012), the less said the better. As the English essayist Charles Lamb wrote about a blame-worthy poetic effort:

“It would be an insult to my readers’ understandings to attempt anything like a criticism on this farrago of false thoughts and nonsense.”[1]

Rather, some unasked questions should be advanced.

Regarding the self-interested back-patting of those with careers to be served by the inflictions of Sarbox –- the PCAOB’s members and staff and the spokesmen for the accounting oligopoly dependent on its compliance revenue:

“Would the elves in Santa Claus’s toy shop be expected to vote against Christmas?”

As for those purporting to see some claim of benefit, yet propounding no solutions to the continued eruptions of financial chicanery (here, here and here), 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?”

First, American law since 1934 has pronounced it illegal to make false statements in connection with the purchase or sale of securities. So – as confirmed by the absence of prosecutions under the redundant Sarbox requirements for executive certifications of financial results (summarized by Michael Rapaport and Francine McKenna) -- that exercise has from the outset never been more than optics and cosmetics.

Second, a decade of PCAOB intrusion into the relationships between auditors and clients has engulfed the corporate reporting process in cost, paperwork and degradation of the assurance function (here and here) – while, into the bargain, failing either to advance coordinated global-scale assurance regulation and oversight in most of the world’s major capital markets (here) or to prevent (among others) the wave of securities malfeasance of off-shore origin, notably from China.

Third, as to the law’s centerpiece obligations on internal controls reporting and assurance, it was always true, even pre-Sarbox, that most decently-controlled companies would do reasonably well on compliance, most of the time – while a parade of horribles since then has made it clear that, for reasons of scope limitation or plain enforcement dysfunction, the law has been ineffectual against the rare but all-too-frequent and truly consequential cases.

A brief post-Sarbox sampler illustrates that – as generally true of large-scale challenges to risk identification and management -- it is the “outlier” cases that really matter:

• The control failures that brought down Bear Stearns and Lehman Brothers

• The “buco nero” at Parmalat and the ghost employees at Satyam

• The in-house looting by the chief financial officers of Koss in Milwaukee and the city of Dixon Illinois

• The undetected Ponzi schemes of Bernie Madoff and Alan Stanford, unremarked by gate-keepers, regulators and out-of-control client advisors and abettors alike 

• The valuation fantasies behind the window-dressing at Fannie Mae and Freddie Mac

• The incentives-driven perversions in the mortgage businesses models of Washington Mutual, Countrywide and New Century

• The derivatives and trading fiascos at UBS, JP Morgan Chase, MF Global and now Knight Capital

What then is the purpose of law-making? Sarbanes-Oxley has manifestly not ameliorated the flaws persistent in the nation’s corporate reporting and assurance structures -- then of what use or benefit has it been? 

And, if only the mis-leading politically-motivated placebo that it appears, what more should be expected both of our elected representatives and of those aspiring to hold them to account?

 

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---

[1] “On the Tragedies of Shakespeare,” 1811.

Will the Auditors' Real Clients Please Stand Up? You're Lost Among the Mixed Messages

I try to raise the sense of my students in Risk Management for trends, patterns and common themes – early awareness being an opportunity for effective strategy.

So when the muddied state of auditor-clients relations was twice and separately further obscured in recent days, attention should be paid.

First, a reader sent me a lament overheard at a Thanksgiving table -- a second-year audit staffer at a Big Four firm, who had been trying without success to persuade his 38-year-old supervisor that there was a defect in the results of their engagement performance. The futility of his efforts was leaving him with the dispirited feeling, as he put it, that he had become in effect an employee of the client.

The second, at the AICPA’s Washington conference on SEC and PCAOB developments, was SEC Chief Accountant James Kroeker (here) – advocating “a change to our collective vocabulary…. (D)on’t use the word ‘client’ to refer to the management of companies under audit…. (I)t is time to give serious consideration to changing the perceived ‘client’ in audit relationships.” 

The uneasy dilemma of the beleaguered young staffer is no surprise, because among the many pernicious effects of Sarbanes-Oxley has been a three-fold degrading of the auditor/client relationship. From an advisory role to one of adversity and compliance – and so forms-and-process based that young professionals lack the environment in which to learn and absorb actual client business -- under on-going stress on revenues and profitability, the firms’ clear imperative to their staff is to complete the work needed to issue another commodity report, “on time, within budget, and without making waves.”

The dynamic for an eager but career-sensitive young professional is no better put than by my senior-level friend: “When you raise a problem, then by definition you become the problem.” No wonder, then, when “client satisfaction” – the long-popular mantra across the spectrum of commercial activity – readily elides to “client capture.”

While back in Washington, the vagueness of Kroeker’s musings became truly misleading as picked up and re-broadcast under the 140-bit limits of the profession’s twittering critics – mutated to the direct question “who is the client?” as if the auditor’s “primary responsibility was to investors, not the companies they audit.” 

Kroeker and his agency are of course entitled to advocate for a nationalized audit function carried out by civil servants. If so, let them say so with candor, and let the debate be engaged – it will be revealed quickly enough how the community of financial information users would compare the value of today’s archaic and obsolete report with an equivalent document delivered by federal agencies distinguished by their inaction during the tumultuous events of the last three years.

Until then, it requires recalling that it has been a basic premise since the 1930’s passage of the American securities laws, when the profession lobbied successfully for private control of the assurance franchise, that the company under audit does the hiring and pays the bills.

Indeed, the disregarded consequences of that plain election in favor of an unambiguous definition of “client” are amply shown in the vast amount of time and energy wasted in the intellectually ineffective attempt to define with precision what constitutes an “appearance of independence,” in light of the contractual and economic linkage of direct auditor engagement.   

It is also readily recognized that important rights and obligations arise outside the strict confines of a provider-client relationship. Concepts based in agency, trust and fiduciary duty are familiar – as is legislative authority to create duties based on extra-contractual reliance and expectations, whether for investors, consumers or even innocent by-standers.

But it does no favors to the complex challenges to evolve a valuable and sustainable audit function, to blur the lines of accountability with careless invocation of an ill-defined shift in client identity.

Or as I also try to instill in my MBA students, the guidance is still relevant as laid down by 18^th century lexicographer Samuel Johnson, that “sloppy language is a mark of sloppy thinking.”

As the poor staff auditor is learning under career-threatening pressure, the issues facing the role of auditors are already sufficiently profound. From the senior regulators in Washington, they deserve clearer articulation than they now receive.

 

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