Re:Balance -- Jim Peterson

Crypto-Land –- The Accountants Discover That It’s Terra Incognita

“Hic Sunt Dragones”

        --Map inscription supposed by medieval cartographers to warn of dangers in uncharted waters

 

Auditors realizing the hazards of fee-paying business? Hell freezing over!!

Perhaps the wintry bomb cyclone of this holiday weekend in the eastern United States signals a convergence of unlikely events.

With the spectacular flame-out of Sam Bankman-Fried’s crypto exchange FTX, the Armanino and Prager Metis firms have been sued over their audits of its US and international operations; Mazars pulled its “proof of reserve” report on Binance and cut ties with other crypto clients; BDO displayed its anxiety over its crypto client work; the Big Four sit in the background with little show of appetite for crypto’s possibly terminal disruption.  

That the crypto sector could be revealed as so toxic as to repel the gate-keepers of the capital markets might once have been beyond imagination –- it long having been an insiders’ wry one-liner that the short wording of a Big Audit engagement letter was, in its entirety, “Will work for food.”

Yet the profession’s retreat from crypto's trackless wilderness suggests two propositions:

• There actually are activities beyond the auditors’ capability to provide assurance within the standards developed since the invention of independent audit in the Victorian era.

• There actually are enterprises whose plans, strategies and operations, and their management competence and ethos, are so deviant as to make them unsuitably risky as clients.

It's scarcely ever been thus. A rare exception arose in my time as in-house counsel at a Big Eight firm –- olden days, very long ago, well before the company that became Enron mutated from a middle-America network of gas pipelines, and before “generally accepted” professional guidance was imposed by Washington functionaries.

(Apologies -- only with both reluctance and prudence am I still obliged to mask identities.)

One of the Big Eight was offered the first-ever audit of a global-scale cartel –- a massively complex, multi-national enterprise with pervasive presence and influence. There was no proposal process or competition –- no questions or limitations –- instead a gigantic potential fee, with no negotiations, and the work was for the taking.

The firm’s senior risk manager for the industry laid down a short, blunt, and non-negotiable refusal. “It can’t be audited. We know there are undiscovered nooks and crannies. We could never penetrate the hiding places and the dark corners. No fee is worth either the political exposure or the catastrophic risk of litigation.” 

Had only that experience been more widely applied –- how might have differed the last decades of “where were the auditors?"

Today, the audit firms that have put crypto work out to the public are already exposed and should expect to pay a price. Some number of their “proof of reserve” and actual audit reports are bound to attract the plaintiffs’ lawyers. Despite the Armanino firm’s position that its digital asset practice generated a mere one percent of its revenues, it is hostage to the “one and done” ligation impact that Enron inflicted on Arthur Andersen.

It would be encouraging to think that the profession is acting on a recognition, however belated –- like the coyote chasing the road-runner over the cliff –- that it’s a long fall to a rocky crash.

Where to from here?

Little enough should be expected from the regulators, who as usual are a day late and a dollar short. That's despite both the bold position of SEC chair Gary Gensler that, for crypto companies’ compliance, “the roadway is getting shorter,” and the speed with which the agencies of American law enforcement swooped down upon SBF, flipping his two top lieutenants and snatching him from the Bahamian authorities to face US-style justice under a $ 250 million bond and electronic monitoring in his parents’ home. There’s a fulsome discussion to be had, as Francine McKenna takes up this week at her substack, The Dig, as to how the regulators were watching the store while fictive crypto entities were allowed to grow like alien invaders into the legitimate capital markets.

Meanwhile in the marketplace itself, both the accounting firms and their clients may be choosing a cleansing re-appraisal of their activities.

It would be cause for cautious optimism if the large firms’ charting of the crypto map led them -- rather than acting as cosmeticians willing to apply lipstick to a pig -- to a simple veto message: “neither crypto nor anybody else has an entitlement to our work, name, or reputation.”   

 

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Luckin Coffee – What’s Brewing In China?

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

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

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

Looking back:

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

As for Luckin’s post-scandal history: 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

There are multiple issues:

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

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

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

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

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

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

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

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

 

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Bubble-Wrap Around Sealed Air's Auditor Change -- Punctured by the SEC's Blunt Tool

It's a pleasure to be a guest again at Bloomberg Tax, which on August 25 published my views on this topic, reproduced here with Bloomberg's kind permission:

It’s not disputed. Sealed Air Corporation’s replacement of KPMG with EY for its 2015 audit was corrupt.

The Securities and Exchange Commission so found. In proceedings dated Aug. 2, 2021 (here and here), the agency barred from practice and fined William Stiehl, the company CFO at the heart of the scheme, censured and fined EY $10 million, and imposed fines and practice bars on three of its partners (Paragraph 2):

“EY solicited and obtained from (Stiehl) competitive bid and other confidential documents and information on multiple occasions in an effort to secure the audit engagement.”

Alert to readers: This is not to question whether a selection of professional advisors should be tainted by the abuse of company confidences. It shouldn’t. This is not to defend or condone the conduct involved.

Instead, it is puzzling why the SEC should invoke its creaky, inefficient, and unpredictable rules for auditor independence (Paragraph 3):

“the manner in which EY obtained the engagement would cause a reasonable investor to conclude that EY was not capable of exercising objectivity and impartiality upon becoming (Sealed Air’s) independent auditor….”

The SEC approach was characterized as “weird” by a Bloomberg News columnist on Aug. 3, as he explored the unexceptional notion that auditors share common ground with lawyers, bankers, and other consultants:

“the actual service that these firms provide is basically ‘wise trusted advice,’ and to provide that service you really do need some relationship of personal trust.”

The columnist rightly notes that by opining on their clients’ financial statements, auditors bear a differentiating obligation from other advisors to public companies. Two observations address his perplexity:

First, consistency should matter. Both the misled but honest senior executives and directors of Sealed Air, and later the SEC alike, would have been no less insulted by a selection of lawyers, bankers, underwriters, or other advisors if perverted in the same way.

Second, which follows, the SEC had an available enforcement tool of broad and consistent application. Under its Rule of Practice 102(e)(1)(ii), it has authority to sanction any person in SEC practice, found “to be lacking in character or integrity or to have engaged in unethical or improper professional conduct.”

Full stop. Proceedings under that provision would lie, with analytic consistency, against professionals of any stripe. Putting them all on notice would spike whatever “weirdness” the columnist may find in Sealed Air.

On the flip side, the SEC’s lumbering invocation of the next provision of Rule 102)(e)—subsection (1)(iii)—goes astray, in its assumption that investors gave any importance to the Stiehl/EY machinations. Investor indifference to auditor performance in general is long-standing; the torpor is disturbed only if an outbreak of malfeasance is grave enough to animate the cry, “Where were the auditors?”

Which was not this case. On June 20, 2019, the company’s Form 8-K publicly announced Stiehl’s termination for cause, “relating to the process by which the company selected its independent audit firm for the period beginning with fiscal year 2015, and relating to the independence of that audit firm.”

So informed, the market reaction that day was a modest share price decline, from $43.67 to $41.70—just under $2 per share and less than 5% —on about four times typical volume.

Even that reaction was fleeting. By July 1—seven trading days later—the share price had recovered to $43.61—above which it stayed—while trading volume retreated to prior levels.

Put bluntly—the investor community, to whose interests the SEC is purportedly devoted, took a look for itself at the auditor environment at Sealed Air, yawned wearily, and returned to business as usual.

History provides another example—the Ventas affair of 2016. There, the SEC defined and applied the scope of Rule 102 to a “close personal and romantic relationship” between an audit partner and his client’s CFO—although, as discussed here, a senior agency official’s contemporaneous speech expressed the SEC’s lack of any appetite for rule-making to provide “bright lines and explicit guidance.”

As in Sealed Air, investor indifference to the audit turmoil at Ventas was reflected in its stock price: In the three-month period between the withdrawal of the incumbent auditor and the filing of an amended Form 10-K with the successor’s opinion, the company’s stock price increased by 3%.

In my youth, growing up in an agricultural village, I was schooled by mentors such as my grandfathers—a farmer and a country dentist—that a proper job requires the proper tools. For the SEC to deploy the elusive “principles” of independence in aid of its unhappiness is like weeding a field with a snow shovel, or using a spoon as a toothbrush—it could be tried, but the result would be sub-optimal in both theory and result.

It’s for fuller inquiry another time that the independence principles and rules for auditors—and their ill-formed and unloved offspring, the limitations on scope of practice for audit clients—have outlived whatever value they might once have had. Independence has no demonstrable upside; since the delivery by William Welch Deloitte of the first modern auditor’s opinion in February 1850, no companies, investors, or other sources of capital have aggrandized an auditor as an exemplar in observing the independence rules.

To the contrary, the elaborate machinery by which the “appearance of independence” is applied, regulated, and defended, becomes visible only with negative impact, in the inevitable and unpleasant handful of cases found non-compliant with hindsight.

Corporate reporting is under pressure to expand disclosures under the rubrics of environmental, social, and governance—lately extended to diversity, equity, and inclusion. Auditors will require expanded and diversified skills to offer meaningful and informative assurance. For which, the constraining influence of an archaic and obsolete independence structure is out of place at best.

In that context, the SEC’s awkward and unnecessary approach in the Sealed Air case is unfortunate.

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

For Chinese Companies -- “Double Secret Probation”?

With appreciation to my friend and colleague Francine McKenna, this guest contribution is up today on her newsletter, The Dig -- to which readers here are enthusiastically invited -- and contact her at [email protected].

 

 

When in need of street wisdom, legendary Chicago columnist Mike Royko called on his bar-stool pal Slats Grobnik.

Not even Slats could explain what has possessed the United States Senate – which on May 20 passed the Holding Foreign Companies Accountable Act – which would expel Chinese companies from the American capital markets because their auditors are shielded by the Chinese regulators from the oversight and inspection program of America’s audit regulator, the Public Company Accounting Oversight Board.

As the world’s greatest deliberative body – so goes the cliché – the fractious Senate can barely muster bi-partisan agreement on the time of day – so passage of the HFCA by unanimous resolution must elicit skepticism about whether there are adults minding the playroom.

The Act first plays to the chest-thumping China hawks – Trade Representative Robert Lighthizer and economic advisers Larry Kudlow and Peter Navarro. It would require a Chinese company seeking access to the American capital markets to certify that “it is not owned or controlled by a governmental entity….” That provision -- so susceptible to gaming that Slats would guffaw over his beer -- pictures a trench-coated character out of John le Carré, peddling a fistful of “no control” certificates -- facially valid and untraceable in provenance.

For two reasons, though, Slats would truly slap his forehead over the Act’s second bit: a Chinese company would loose its US listing and its shares would be barred from US trading, if the PCAOB were unable for three years running to access its auditor and its working papers under the auditor inspection program put into place by the Sarbanes Oxley law of 2002 and activated by extension to ex-US auditors in 2005.

For starters, even though since first requested the Chinese have consistently forbidden PCAOB auditor inspection, the enforcement armory of the American securities regulators has long had the necessary weapons locked, loaded, and zeroed in. Launch of the inevitable Chinese/American diplomatic and trade apocalypse has – at least on paper -- needed no more to pull the trigger than the order of an authorized zealot – one of the noted hawks or, even and perhaps better in these over-heated times, theocratic and rapture-ready Secretary of State Mike Pompeo.

Here’s the short guided tour through the existing arsenal:

• Sarbanes Oxley § 102(a) and PCAOB Rule 2100 require auditors reporting on an issuer’s financial statements to be registered.

• Under Sarbanes Oxley § 104(a), auditor registration includes and requires a registered firm to submit to the PCAOB’s inspection process, including access to personnel and working papers.

• Sanctions for non-compliance include revocation of a registration, under Sarbanes Oxley § 105 (see the PCAOB’s orders relating to PKF (Hong Kong) (January 12, 2016), Crowe Horwath (HK) CPA Limited (July 25, 2017), and Anthony Kam & Associates Limited (November 28, 2017).

• Audit reports by a de-registered firm may not thereafter be included in an issuer’s SEC filings (see the SEC’s Financial Reporting Manual § 4115.1).

• The obligations of a principal auditor using or relying on the work of another audit firm – whether or not that firm is referred to (Manual § 4104.1-.5), or must itself be registered (under the “substantial role” threshold of Rule 1001(p)(ii)) – include the production of work papers and other documents related to that firm’s work (see PCAOB Staff Questions and Answers on Audits of Mainland China Issuers By Registered Firms Outside of Mainland China, December 30, 2016).

• Further, a non-US firm on which a principal auditor relies, whether or not registered, must under Sarbanes Oxley § 106(b)(2) produce its work papers on request and designate a US agent for service of PCAOB or SEC process.      

• Finally, because the financial statements of an issuer in the US may only be reported upon by a registered auditor (Sarbanes Oxley § 102(a)) – the consequences are as summarized in a recent blog post from the Columbia Law School (emphasis added):    

“Companies that fail to file within the allowed grace period are subject to a variety of costly penalties, including deregistration by the SEC, delisting by stock exchanges, the inability to raise capital through issuance of public securities, and potential debt covenant violations.”

With all that authority already in place to bar Chinese companies from US trading of their securities, the questions Slats Grobnik would press—caring no more about the grimy details of the law-making process than he would the ingredients in a classic Chicago hot dog – would be:

• What could they be thinking -- against the immediately predictable blowback from the Chinese securities regulator to a proposal “directly targeted at China…(that) … politicizes securities regulation”?

• Why now, having welcomed for fifteen years the listings of some of the world’s largest companies – the likes of Alibaba and PetroChina and China Life and China Telecom – while the inevitable emergence of a scandal on the order and scale of Luckin Coffee has been predictable the entire time?

• And has anyone the moxie to do it?

That last is not to be ignored -- the question who would do the dirty and disruptive work of de-registering auditors and stripping Chinese companies of their US listings. The weapons exist and are at the ready -- not so the boots on the ground. This administration’s lack of confidence in the PCAOB was manifest in its clean sweep of all five board members and the gutting of its senior staff, and this March, a budget proposal to eliminate the PCAOB altogether and roll up into the SEC whatever remaining modest scope of its politically permissible activities might survive.

Nor does SEC chairman Jay Clayton have standing as the fire-breathing regulator needed and committed to wage the hawks’ holy war. In his background is the record-breaking $ 25 billion IPO of Alibaba in 2014, featured among the big deals of his pre-SEC life as a partner in the heavyweight firm of Sullivan & Cromwell – while in his current position, he offers only frustrated reminders to investors of the limits of his agency’s timorous reactions to the on-going Chinese rebuffs.

The search for coherent thinking behind the HFCA becomes even more muddled, in looking for consistency in the justification by Senator John Kennedy (R.-La.), the bill’s principal sponsor, in the Congressional Record: “We are excruciatingly transparent. We like investors throughout the world to know what they are buying.”

Slats again – Izzat so? Then what do investors know about the operations in China of, for two quick examples:

• Caterpillar, which shows seven manufacturing and distribution locations in China in its Form 10-K for 2019, is estimated to derive some 5% of its $ 53.8 billion in global revenue from that country.

• Apple, which for the first quarter of 2020 rang up revenue in China of $ 13.6 billion -- 14.8% of its total global revenue of $ 213 billion.

High-ranking American companies – audited respectively by the US firms of the PwC and EY networks. Neither auditor explicitly shows use or reliance on the work of their colleague firms in Hong Kong or China, although both would be subject to the legal and regulatory obligations noted above – to maintain and produce information – but only if “on request.”

How long would we hold our breath, waiting to know whether Chairman Clayton’s foot soldiers might “request” access to the audit work scrutinizing those billions of China-based revenue? Slats’s lament for his beleaguered Chicago Cubs – the perennial and off-putting “just wait till next year” – extended a fulsome five score and eight years.

A long political step too far, for Senator Kennedy to extend what consistency of logic there may be in his HFCA, to benefit the investors he claims to favor, by reaching for access to the China-based audit work supporting the American firms’ reporting on the financial statements of ex-Chinese companies that include their large operations there. Nor, presumably, would it suit the China-bashers. Audits covering the operations in China of Cat or Apple are no less opaque to PCAOB inspection than those of Alibaba or PetroChina – but where would the sponsors of the HFCA see the pay-off in picking that fight?

The Senate’s headlong rush portends a reprise of the enactment of Sarbanes Oxley itself. As I wrote in the now-lamented International Herald Tribune on July 20, 2002, about that law’s equally lamentable passage, “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

That assessment has been well vindicated, by two decades of small-bore and ineffective behavior by a body whose mission would have been at least as well executed under existing laws, regulations, and behavior modification by the sector itself. As Slats would say, “here we go again.”

It does not inspire confidence that a version of the Senate-passed HFCA was promptly introduced in the lower chamber. The warning from Will Rogers is stark:

“Ancient Rome declined because it had a Senate. Now what’s going to happen to us with both a House and a Senate?”

Might good sense intrude? Elected officials definitely have the authority to inflict the HFCA – otiose and pernicious as it would be. But a strategy of “ready – fire – aim” cannot repeal the impact of the still-valid Law of Unintended Consequences.

 

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So What If the SEC Swallowed the PCAOB?

The proposal in the Trump administration's new budget, to roll the PCAOB up into the SEC -- likely a political non-starter -- was first reported on February 10 by Amanda Iacone at Bloomberg Tax, which this morning published my skeptical observations -- reproduced here with Bloomberg's kind permission: 

‘‘An ill-favoured thing, sir, but mine own’’

— Shakespeare’s Touchstone, on his homely Audrey (As You Like It - V, iv, 55-56).

Skepticism is called for in reaction to the budget proposal to roll up the U.S. audit regulator, the Public Company Accounting Oversight Board, into the Securities and Exchange Commission, its statutory overseer.

Do not mistake this reluctance to join the anxieties voiced by the usual suspects—among them former SEC chairman Arthur Levitt and former PCAOB chairman Jim Doty (see the Financial Times, Going Concern, and the Wall Street Journal)—as resistance to effective regulation of the capital markets.

Rather it’s that for years, neither agency has shown any real concern for the auditors or their statutory obligation to support the delivery by U.S. public companies of financial information free of material error. This latest step would only further constrain the function of an entity disfavored from the start of the Trump administration.

SEC chairman Jay Clayton, wheelman for regulatory shrinkage, is moving to ease the auditor independence rules and to reduce the disclosure obligations for smaller public companies. He purged and replaced all five members of the PCAOB, and, at the first opportunity, forced out incumbent member Kathleen Hamm in favor of ex- SEC and Treasury staffer Rebecca Goshorn Jurata.

Never in its history has the PCAOB punched even its own light weight. Nor has the case been persuasively made that the Sarbanes-Oxley Act, rushed into effect in 2002, has operated with effectiveness. Claims of improved audit quality, freely expressed by those with self-interest (e.g., here, here, and here), are never compared to what might have existed, if post-Enron politicians had not panicked into the frantic mode of ‘‘don’t just stand there. . . .’’

And evidence is to the contrary. The PCAOB had no visible effect during the 2007-2008 crisis, when cascades of companies with clean audit opinions fell into failure, take-over, or government bail-out. Nor does it inspire confidence that outbreaks of predictably doubtful behavior continue apace—recent examples include Mattel, UnderArmour, and the unattractive prospect of charges involving EY’s engagement by Sealed Air Corp., which threatens to be a reprise of the criminal scheming at KPMG to steal inspection information from the PCAOB.

The PCAOB lacked credibility from its birth—well before the current push for its demise:

• Under its founding legislation, its inspections take place in the dark, with results only emerging so old as to be stale.
• It remains conspicuously excluded from operations in China, despite continuous over-selling of progress just around the corner.
• It dealt at a glacial pace with such small-bore projects as mandatory auditor rotation and the naming of lead audit partners.
• Even its recent catch-up convergence with the global standards on extended audit reporting of ‘‘critical audit matters’’ trails experiences in other countries that have yet to demonstrate serious investor attention or value.

Currently, the departure of essentially all senior staff has hollowed out its core of experience and expertise, while the poverty of its plans and initiatives was reflected in a ‘‘strategic plan’’ of vacuous cliches.

As for the PCAOB’s fundamental mission, while the divergence expands between the content of historical financial statements and the decisions of investors, the agency’s emphasis on internal controls reporting has reduced the work of audit staff to a morale-sapping exercise in box-ticking—budget-driven and oriented to satisfying the intrusion of the government’s own inspectors.

An academic colleague recently tweeted that the KPMG/PCAOB debacle was caused by the effectiveness of PCAOB inspections, positing that if they were meaningless, there would have been no reason to steal the inspections list.

He had it wrong. Evasion and avoidance of law-making and regulation are not caused by their effectiveness or desirability, but only by the presence and effect of their malign burden. Prohibition in the 1920s and 1960s Vietnam-era conscription stand as examples.

To paraphrase baseball sage Yogi Berra’s dispirited take on the unwillingness of fans to subject themselves to the dystopia of the old Candlestick Park, ‘‘if the audit regulators don’t want to protect investors, you can’t stop them.’’

Effective government regulation, oversight, and enforcement of the operation of U.S. capital markets have been core policy aspirations for nearly 90 years. Restoration of optimism may make it so again, when—and if—public priorities become re-ordered as part of an eventual process to restore confidence in the nation’s gatekeepers.

For the moment, however, ill-motivated as may be the enthusiasm of this White House to kill off the PCAOB, the 18-year failure to justify its existence makes its proposed disappearance of too little consequence to matter.

 

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The Investors in Theranos – “We Don’t Need No Stinking Auditors”

 

What does the Theranos debacle teach about whether or not investors really value the opinions of independent auditors?

The question is timely, as criticism swirls around the globe about both the performance of the auditors (see the dialog I joined last week in the Financial Times, here) and the efficacy of their regulators (see here for a British MP’s call for scrutiny of the Financial Reporting Council).    

On March 19, 2018, the Securities and Exchange Commission charged that Theranos, the micro-stick blood testing enterprise started by Stanford dropout Elizabeth Holmes in 2003, was “an elaborate years-long fraud.” Law enforcement finally caught up with exposures reported back to 2015, that the entire promise of low-cost, sophisticated patient-friendly testing and analysis was built out of lies and fantasy.

As described by MarketWatch’s Francine McKenna on March 20, the erstwhile unicorn that made Holmes a Silicon Valley superstar, business media darling and temporary multi-billionaire was able to seduce $ 700 million from wealthy investors, the likes of Rupert Murdoch and Larry Ellison, “accredited investors” under the SEC rules that, instead of requiring years of audited financial statements, permitted no more information than a binder of publicity releases and unaudited spreadsheet projections, supported by a board of marquee names including Henry Kissinger, George Shultz, James Mattis and David Boies.

The entangled symbolism is positively cringe-inducing: A winsome young blonde enticed credulous, cross-generational “smart money” with a high-tech Edenic temptation. There was even an apple, invoked by her costuming in Steve Jobs’s black turtleneck. As for the sanguinary path to fall and expulsion … enough is enough.

Meanwhile the feckless “no audit – no problem” attitude of the cast of veteran investors was Shakespearean. The Bard’s own “old Adam” takes the stage in “As You Like It” just after Jaques’s reminder that in the seven ages of man, the “last scene of all, that ends their strange eventful history, is second childishness and mere oblivion.”  

Should lesser investors follow Murdoch and Ellison in their indifference to diligence? Should the regulators let them? There are reasons to resist a cynical, laissez-faire conclusion. To start, the $ 100 million said to be Murdoch’s loss on Theranos is measurable against his reported personal wealth somewhere north of $ 15 billion. Among the playthings that quantify Ellison’s readily open purse, his latest yachting adventure, the 88-meter “Mushali,” occupies a hole in the ocean reportedly valued at $ 130 million.

The funding of Theranos, privately placed and speedily lost in “childishness and oblivion,” in chunks of a size on which the vast majority of investors would happily live forever after, was relative lunch money – a small-change bagatelle -- to the cohort of those succumbing to the Holmsean blandishments.

It could be tempting to invert the old cliché – “If you’re so smart, why aren’t you rich?” – to ask, “If that’s how smart you are, how have you stayed so rich?” Except that schadenfreude is pointless. The Theranos investors will survive untouched and unmarked by the public’s lack of sympathy.

The SEC’s metrics for “accredited investor” set minimum thresholds based on income and net worth, rather than requiring demonstrable acuity of judgment or the ability to resist a compelling sales pitch. And a good thing too, herd behavior being what it is. Consider the likelihood that the roster of luminaries marshaled at Theranos by Holmes would – if allowed by more generous regulation – have passed out offering binders to the faithful, acting as bell-goats leading flocks of eager lambs to their shearing if not all the way to slaughter.

For investors aspiring to achieve reasonable and legitimate growth and safety in their Keogh plans, investment accounts and retirement funds, and also for the gate-keepers and enforcers charged to look after the public interest in the capital markets, Ronald Reagan’s old maxim still holds:

“Trust – but verify.”

 

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“Count Down” – The Second Edition Is Published

The second edition of my book -- “Count Down: The Past, Present and Uncertain Future of The Big Four Accounting Firms” -- is, to my pleasure, just released by Emerald Books.

Deliveries are available – see Amazon. Up-dated, revised and extended, this trade edition is now designed -- and priced --  for readers in accounting and other professions, corporate management and governance, finance and investing.

The new “Count Down” brings into its updated narrative important developments since publication of the December 2015 first edition, affecting the Big Four and the threats facing their business model:

The Big Four’s growth to collective global 2016 revenue of $ 128 billion, and the structural implications of the continued growth disparities between their Audit and Advisory practices.

The imposition and implications of mandatory auditor rotation under legislation and regulation in the European Union; and in the US, the PCAOB’s requirement to name lead partners on public company audits.

New examples of corporate financial malfeasance, regulatory and law enforcement proceedings and potentially disruptive auditor litigation, involving each of the Big Four and their large global clients – of which a partial sample here:

• Deloitte’s Brazil firm in December 2016 incurred an eight million dollar penalty, the largest ever imposed by the PCAOB, and practice bars and other sanctions against twelve partners and employees, over confessed alteration of documents, false testimony and lack of cooperation with the PCAOB’s inspections and investigations.
• EY in September 2016 was the target of two SEC enforcement actions, involving censures, fee disgorgements, fines and practice bars against its personnel, over charges of loss of independence based on “close personal relationships” between engagement partners and client personnel -- in one case a romantic relationship and in the other, significant expenses paid for travel, entertainment, sporting events tickets and family vacations for the client CFO and his family.
• KPMG in April 2017 fired five partners and an employee, including its Vice Chair of Audit and its head of Audit Quality and Professional Practice, over its receipt and handling of advance inspection information leaked by an employee of the PCAOB.
• PwC’s delivery of the wrong “best picture” envelope, and the resulting tumultuous ending to the February 2017 broadcast of the Academy Awards, evoked public ridicule -- although the significance of the debacle was pale compared with the potentially fatal financial impact of two multi-billion dollar lawsuits, relating to its audits of Colonial Bank and MF Global, where jury trials in process in August 2016 and March 2017, respectively, were discontinued in favor of settlements for confidential amounts.

This new edition also expands in scope and detail on the required re-engineering by which – with the necessary but unlikely mutual cooperation among financial statement issuers and users, the accounting profession, legislators, regulators and agencies of law enforcement – a sustainable structure for financial reporting and assurance might emerge -- that is, a Big Audit model truly fit to serve today’s global capital markets.

The issues here have meaning and impact not only for professionals in the Big Four and the smaller but no less affected firms, but also for those working with and for public companies and their clients, and investors who rely on robust audited financial statements, as well as individuals and institutions holding the securities of public companies in their savings and retirement funds, Keoghs and IRAs, pension and endowment funds.

The story of the fragility of the business model of the Big Four retains its importance. In that spirit, I hope it is worthy of your attention. I invite you to order -- read -- enjoy (or at least be stimulated). Reactions are invited. Comments on Amazon are welcome and encouraged -- as are "likes," "shares" and RTs on Facebook and Twitter, messages on LinkedIn, and especially, recommendations to friends and colleagues. As for any disagreements or criticisms -- feel free to write me directly at [email protected].

.

 

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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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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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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]

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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Alibaba: Jack Ma Cried Out “Open Sesame” – And They All Opened Their Wallets

The modern story of Alibaba Group Holding Limited (NYSE: BABA) may be just as “fabulous” as the ancient Persian version in the 1001 Nights (for which, see Burton’s colorful if quaint 1886 translation).

In what ways?

It makes for quite a tale: launched by a school teacher with $ 4000 – explosive growth – reported yearly revenue now $ 5.55 billion – potential as limitless as that of the combined Chinese consumer and business economies on which it feeds.

As a regular part of my graduate-level course in Risk Management, we examine how language can be manipulative or revealing – how names and labels can mis-lead or inform.

Why is it clichéd nonsense, for example, that “Even a broken clock is right twice a day”? How reliable is the maxim, “Buy on the dips”? What is the best reaction to “This time it’s different”?

So the public reaction is interesting to Alibaba’s initial public offering – Jack Ma’s globe-spanning sales tour, the company’s early closure of its order book, the offering price raised to $ 68, and the first-day price pop to $ 92.70 on September 18. With the underwriters’ exercise of their “green shoe” option to sell extra shares, Alibaba raised $ 25 billion and became the largest IPO in history.

All in the face of such darker elements of the “fable” as:

• A governance structure that captures and traps investor equity by lodging control in a circle of insiders.
• An opaque business model based in the Cayman Islands, operating through a network of separate businesses in the hands of Mr. Ma and his coterie.
• A home country distinguished by its resistance to corporate or regulatory visibility – see both the decade-long auditor inspection impotence of the PCAOB and the teeth-gnashing enforcement attempts at work-paper access by the securities regulators of both the US and Hong Kong – and a history of exporting financial chicanery into the world’s capital markets – see the major Canadian regulatory and civil litigation settlements related to Sino-Forest Corp., and the rash of dubious reverse mergers of Chinese companies into partners listed in other markets. 

History provides casebook examples of revealing terminology that might have alerted the sharp-eyed, but missed in the credulous buy-in of investors and gate-keepers to the stories of the flim-flam artists:

• At Parmalat, the recording of bogus transactions in an account called the “buco nero” might have been suggestive – the Italian equivalent of “black hole” not being immediately obvious for its legitimacy.

• A high-tech company in Silicon Valley engaged in that industry’s all-too-familiar practice of recording revenue on transactions not completed at year-end, keeping a separate ledger called the “oven list” – jargon for “half-baked” but booked early nevertheless.

• With a thesaurus full of kinder and gentler terms available, Enron’s use of special purpose vehicles denominated the “Raptors” might, for the curious, have suggested their predatory nature and raised the question, “Just who is the prey?”

As for Alibaba – which in its first trading week failed on any day to close above its opening price – there is more to compare with the old story than the image of an open-faced and humble wood-cutter, who by alert if simple eaves-dropping heard the magic phrase that opened the cave of the forty thieves.

As that version played out, AliBaba first concealed and disguised the thieves’ murder of his avaricious brother. And after the dead man’s cold-blooded slave girl had boiled in oil the thieves who came for revenge, and then knifed their chieftain while he sat as AliBaba’s guest at dinner, this superficially callow and guileless peasant looted their treasure trove for the life-time enrichment of himself and his family circle.

Not exactly a model for hospitality, openness or transparency.

So – for the huge herd of investors who rushed to buy Alibaba’s sizzle – in heedless disregard of the quality or even the existence of the steak – the future will soon tell whether, in their collective enthusiasm, they blinked and missed the unsubtle message in Jack Ma’s audacious branding choice.

 

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