Re:Balance -- Jim Peterson

A New Entry in Charlie Munger’s Daily Journal

The usually sharp-tongued Francine McKenna was the very vision of under-statement in her Market Watch for March 3, describing the auditor merry-go-round at the Daily Journal Corporation (DJCO), the odd public company controlled by Charlie Munger – himself better known as the long-time advisor, consigliere and general-purpose wheelman to investor legend Warren Buffett.

In September 2014, Munger had loudly replaced EY with BDO, intolerant of successive annual auditor letters criticizing the internal controls and identifying potential weaknesses at the Daily Journal and snarling, about what he called an “audit from hell,” that EY had been “like the doctor who wanted to cure the nosebleed by fishing around in the groin.”

BDO promptly proved itself no more tractable, in Munger’s view – sacked on this February 17 after two years of “material weakness” letters, to be replaced considerably down the audit firm food chain by the Squar Milner firm.

Slightly re-wording Oscar Wilde’s Lady Bracknell:

“To lose one auditor may be regarded as a misfortune; to lose two looks like carelessness.”

Or something else. Twice within two years, it’s a double-barreled validation of the diminished role of independent auditors, at least as seen by Munger as board chairman and major shareholder.

That is, the language of the Daily Journal’s next auditor’s report will look precisely the same, whether signed by EY, BDO or Squar, wherever they may fall on the profession’s size tables.

Of the Squar Milner firm it expresses no disrespect to note that its handful of offices in southern California (plus an outpost in the Cayman Islands showing one resident), 19 audit partners and $ 55 million in annual revenue make it approximately 1/500^th the size of EY, third largest of the global Big Four and reporting 212,000 world-wide employees and $ 29 billion in 2015 revenue.

The lack of auditor value as perceived by a company chairman as confident and self-regarding as Munger should come as no surprise. The greater point is that the public holders of the 38% of the Daily Journal’s stock not in the hands of insiders also showed their complete indifference.

That is, the company’s stock price in the week of BDO’s firing and Squar’s arrival held rock steady at the news ($ 189 - $ 190, and since risen to $ 194) – just as it had done 18 months earlier (between $ 181 and $ 182) with the firing of EY.

Put somewhat differently, the entire episode makes plain again that the identity of the audit firm placing its name to the commodity language of the traditional “pass/fail” report as required by the SEC is a matter to which investors attribute no value at all.

Those continuing to extol the value of privately-provided assurance, at least in the form currently prescribed by the world’s securities regulators, are just as entitled to their views as is Munger.

As the evidence continues to mount, however, that their position is belied by the real behavior of the participants in the capital markets – Munger providing the latest example – a more valuable exercise would involve a fundamental re-examination of the premises underlying that self-serving proposition.  

 

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And please see here for access to and a synopsis of “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”—my recently published book where these and other concerns for the large-company audit model are fully explored.  

In Print: “A Look at the Profession’s Uncertain Future” – The CPA Journal

Through 2015 The CPA Journal – published by the New York State Society of CPAs – observed its 85-year history with comprehensive exploration of the profession – past, present and future.

It was my pleasure to offer a guest editorial in the Journal’s issue for December – copied here[1] -- “A Look at the Profession’s Uncertain Future: A Rough Path Lies Ahead for ‘Big Audit’.”

The views briefly reprise the themes in my book, also released last month – “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – which explores the interrelated forces that challenge the sustainability of “Big Audit” -- the current fragile model by which assurance is delivered on the financial statements of the world’s large public companies.

Access to the Journal is either by membership in the New York society or by subscription. For the valuable insights available from this important “voice of the profession,” one choice or the other is recommended.

 

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[1] With the generous permission of The CPA Journal, Voice of the Profession, December. 2015, all rights reserved, and thanks and appreciation to Rich Kravitz, its editor-in-chief.

“Count Down” Is Published

It’s out. Emerald Publishing has this week released my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms.”

With my hearty thanks to those who voted their confidence by ordering early, and who should be expecting delivery – Amazon promptly reported itself to be “temporarily out of stock.” Based on that under-estimate, optimism seems in order, that this story -- the fragility of the Big Audit model -- will appeal across the broad audience for whom it is intended.

To my valued readers – if you find the themes engaging, please share with your friends and colleagues -- and a kind word or two by way of review on Amazon would be appreciated as well. If the topics are somewhat disturbing – I will take that for success, as the threats to the status quo and the complex future of Big Audit present daunting difficulties. And on the other hand, if you may feel I have got it all wrong, write to me directly – [email protected]; in due course I will be taking all reactions into the work on the paperback edition that is to come.

And by the way, receipt of your feedback will be noted and allow me to relieve your inbox by shortening the list for future mailings.

 

 

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“Count Down” – Now It’s A Matter of Proof

A stack of 240 freshly typeset pages sits on my desk. This week is fully committed to red-pencil proof-reading, for Emerald Publishing’s intended early-November release of “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”.

The task provides something to prove, in a second sense -- the first being the book itself: my take on the fundamentally threatened state of the current Big Audit model, and the broad scope of the re-engineering required to evolve a sustainable structure for privately-delivered assurance on the financial information issued by the world’s large companies.

There is resonance in reaching this final stage of a book on Big Audit. The first modern independent auditor’s report – William Welch Deloitte's on the half-yearly accounts of the Great Western Railway as of December 31, 1849 – stated, in its entirety, “Audited and approved” (my emphasis). 

From the Latin, probare, to test or to probe – the root for the English, both nouns and verbs.

Across a full range of human endeavor – proofing and proving extend from the editor’s desk to the geometrician’s theorems to the scientist’s hypotheses to the chef’s puddings. Not to offer a guaranty, or a zero-defects promise, but to test or evaluate or assess, in the quest to advance the quality of information, communication and knowledge. 

So it has been for modern auditors, over the span of 165 years -- sampling and testing and evaluating.

In none of these contexts is the process so hubristic as to presume or conclude perfection – a state of grace beyond the performance limits of auditors and proofreaders and the others alike.

Best efforts devoted, flaws will still lurk undetected in these 80,000 words. And I will not be pleased when, post-publication, they pop out into the open. But it will not be for lack of trying.

“Count Down” is now available for pre-publication ordering, direct from the Emerald Bookstore or through Amazon -- as I would be most pleased to have readers here prove for themselves.

 

 

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Specially-Designed Auditors' Reports: A Noble Gesture – If a Futile One?

Noble Group Limited, the Asian commodity trader -- based in Hong Kong, listed in Singapore and sporting a US$ 15 billion balance sheet -- has a large problem. Under serious pressure since early this year, from short-sellers and critics of its mark-to-market accounting practices, it has seen an unrelieved decline in its share price, from S$ 1.43 last September to S$ 0.41 today, with no bottom in sight.

The company took a less-than-usual step this summer. In an attempt to stop the bleeding, it reached for outside accounting expertise – going not to EY, its regular auditor whose Hong Kong firm issued its standard “pass-fail” opinion dated February 26, 2015, on Noble’s 2014 financial statements (see page 64 of Noble's annual report), but to the Singapore firm of PwC.

Whether or not Noble's maneuver can restore investor confidence, the jury is out – figuratively -- and eventually, as a fair prediction, literally as well. Either way, its enlistment of PwC illustrates two major themes:

• First, an auditor’s brief, traditional and long-familiar opinion is ineffective for credibility when issued on financial statements having the complexity, opacity and level of management estimates and judgments used by Noble.

• Second, focused accounting expertise and tailored reporting on the issues that drive investor agita can have great potential value -- only if deployed in a timely and credible fashion. 

Looking at the latter – the skepticism that met PwC’s report was altogether understandable, for several reasons:

First, PwC was able to conclude, as its report dated August 10, 2015, put it, only that Noble’s practices comported with criteria “based on the relevant requirements of (the international financial reporting standards) and standard practices in the industry.”

That might have been persuasive, in an anodyne environment. The guidance in the United Kingdom from the Financial Reporting Council on expanded detail in auditors’ reports – such as that of KPMG on the 2013 financial statements of Rolls Royce -- may show promise, although further experience and study will be needed and are called for. But once public support is eroded, a claim of virtue because “everybody does it” lacks force.

That is, the assertion of compliance with standards is of doubtful effect under stressed conditions. On April 15, 1912, it should be recalled, RMS Titanic was carrying the full number of lifeboats strictly required by the applicable maritime regulations. And in 1973, facing the public outcry that would lead to his expulsion from office, President Richard Nixon persuaded nobody at all with his claim, “I am not a crook.”

Nor does it avail much for the accountants themselves. PwC’s report is addressed strictly to the Board and management of Noble; it rigorously disavows duty, responsibility or liability to the public, and lays out strict limitations on any rights of third parties to rely.

None of these disclaimers would have been available had PwC’s work been done as part of a statutory report. Put another way, valuable as it may yet prove to be, this type of customization would have fallen outside EY's permissible scope as part of its function as the company’s regular auditor. 

Nor can PwC’s report be expected to help either Noble or EY defend against claims waiting to be asserted by shareholders – in the United States at least, where compliance with professional accounting standards has been rejected by the courts as a “safe harbor” since the 1960’s.

In any event, the confidence reposed in overly-complex accounting standards was measured by the withering criticism of one of the giants among the fraternity of white-collar courtroom lawyers, the late Peter Fleming: “Forget all the verbiage. Unless your story can persuade a jury with an average tenth-grade education, it’s worthless.”

Little wonder Noble’s share price continues to erode – dropping a further eleven percent on the day following release of PwC’s report, and still sliding.

Noble may survive this onslaught. I would not be betting on it – the portents are to the contrary – but for purposes of a “learning moment,” it doesn’t matter.

What it does drive home is a third theme – that the current model of Big Audit is antagonistic and ill-suited to the problems on display at Noble – because traditional reporting by EY observably supplied no value, while the late-arriving efforts of PwC were only in a context “too little, too late.”

 

The still-evolving Noble story is a good way to return this space toward a regular schedule. My thanks here for readers' widespread and generous reactions to my recent announcement that, scheduled for late October, Emerald Publishing will release my book, “Count Down – the Past, Present and Uncertain Future of the Big Four Accounting Firms.”

There will be interruptions, mainly for red-pencil efforts when the proofs come over from the type-setters, and to spread the word on pre-publication ordering that can now be done through either Emerald or Amazon.  But I look forward to getting back on pace. 

 

 

 

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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]

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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Around the Media – “The Economist” Gets A Good Deal Right

Recognition should be given where deserved. Mainstream media reporting on the grave challenges to the viability of the Big Audit model is typically so uneven and ill-informed that generosity favors freely extended tips of the hat.

Perhaps especially to express appreciation for the pick-up of a few choice words of my own.

So please do read the piece in the current issue of the Economist – “Accounting scandals - The dozy watchdogs”.

I had spoken at length with its author, Dan Rosenheck – with whom I am in considerable alignment, especially on our shared view that the historical “pass-fail” auditors’ opinion is sadly deficient to provide value to the complexity of today’s demanding capital markets.

Rosenheck quotes me thus:

“An auditor’s opinion really says, ‘This financial information is more or less OK, in general, so far as we can tell, most of the time’, says Jim Peterson, a former lawyer for Arthur Andersen, the now-defunct accounting firm that audited Enron. 'Nobody has paid any attention or put real value on it for about 30 years.'"

Where next? With the “expectations gap” so glaringly wide, and the perception of inadequate auditor performance so widely expressed, where does the dialog need to go?

Regular readers here will know my attention to the unachievable nature of the “magic bullet” solutions put forward by those who combine their passion for the subject with their ignorance of how Big Audit actually operates – for examples of which, see the reader comments reacting to the Economist piece as representative.

In this, I admit lack of success in calling off Rosenheck from two glaring examples:

• Selection or actual performance of audits by agencies of government – suggested by the New York Times but which I have discussed (August 20, 2014) as being so impractical as to attract and deserve nothing but howls of derision.

• And the fantasy of “audit insurance” – a long-discredited notion from academia that not only fails both the basic principles of insurability and the capacity of the market to provide coverage for the multi-billion dollar failures that threaten the lives of the Big Four accounting firms, but which is conclusively shown to be impractical by the simple fact that if realistic, it would already have been put in place by the insurance industry itself (see my posts going back to May 5, 2008, and July 15, 2008).    

Which does not take away from this central point:

If the dialog on the survivability of Big Audit is not treated as important and worthy of candid engagement by all the interested players, then its very viability is threatened by the kind of “Black Swan” event that would require re-design of large-company audit out of the wreckage after a catastrophic collapse.

And that threat should be appreciated as far too disruptive to be tolerable. 

 

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

“Full many a flower is born to blush unseen,

And waste its sweetness on the desert air.”

 -- Thomas Gray, 1751

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

These are, in ascending order of significance:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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Sarbox Redux: Under PCAOB Logic, the EY/Ventas Affair Will Mean Audit Partner Naming

When the Public Company Accounting Oversight Board finally votes on its long-pending requirement that auditors of US-registered public companies disclose the names of their client engagement partners, predicted for this fall – how will it come out?

In the debate on partner naming, I have been in steadfast opposition, over the years that this pointless idea has refused to die. But while I seldom make predictions, despite a successful record when I do, on this one I am expecting to lose.

That’s because, as the accountants themselves have taught over the decades, life is shaped by the accumulated impact of timing differences – frequently fortuitous.

Here, it could not have come worse for the US profession’s resistance to partner naming. On July 9, 2014, Ventas – the Chicago-based healthcare-oriented REIT – announced its replacement of EY by KPMG, and that EY's opinions on its 2011 and 2012 financial statements were withdrawn – not for any issue with their content, but because EY’s independence was impaired by what the Form 8-K ever-so-delicately called an “inappropriate personal relationship” between an EY partner and the company’s chief accounting officer and controller.

In America it’s all about the sex -- so EY’s unfortunately premature withdrawal will spill with public consequences. History suggests that snarky spasms of commentary will morph into insistence that the PCAOB now oblige lead audit partners to wear a big public “A” around their necks.

Such was the scandal impact a dozen years ago, for precedent, when Enron’s failure in the fall of 2001 and Arthur Andersen’s death spiral the following winter set in motion futile congressional efforts to legislate virtue, headed up by Senator Paul Sarbanes (D Md., ret.) and Representative Michael Oxley (R Ohio, ret.). Whether their early smolder of law-drafting might actually have ignited would have been anybody’s speculation – until later in the spring of 2002, when the spectacular flame-out that was WorldCom turned it into a conflagration of inevitability.

Reason and perspective went out the window. Sarbanes/Oxley was passed into law on July 30, 2002. And the world of financial reporting and assurance has suffered ever since -- even though as I wrote at the time, about the Senate’s unanimous vote of approval, “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

PCAOB chairman James Doty will be motivated to act -- the handle on his battle-axe lacking recent notches of success these days: His long-standing project on mandatory auditor rotation went limp last February; his efforts at meaningful re-writing of the standard auditor’s report are damply insubstantial; and on his renewed expectation of inspecting audit firms in China by the end of the year, he has been continuingly teased and titillated by the Chinese for years.

There are two aspects of Ventas that should not be submerged under the PCAOB’s grinding machinery. The first is that the EY partner involved – whose still-undisclosed name the voyeuristic must seek elsewhere, as for principle’s sake it will not appear here, but who was promptly reported to have been cashiered by the EY firm – was not the lead partner on the Ventas jobs for 2011 and 2012 – so that none of the supposedly salutary arguments in favor of naming would have been applicable.

The second is that the Ventas stock price has traded upward since EY’s departure -- $ 64.73 at this writing, compared with $ 63.91 going into the July 4th weekend. A fawning report on the company by Fitch and two by Motley Fool may have a bearing, but this uplift also confirms the indifference of the stock-buying public to an independence violation so flat-footed as to leave the company without reliable audited statements.

Which squarely poses the question – just what is the value of auditor independence? 

Those prepared to argue against my standing proposition, that 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, are invited to comment on these moves in the Ventas stock price.

Meanwhile, in a world governed by principles of robust intellectual coherence, l’affaire Ventas would be no more than a blemish on the flesh with which so much human sin is committed. Instead, if the PCAOB acts in character and imposes partner naming, it is going to fester into a nasty pustule on the body of auditor regulation, to be lanced only with the blunt and painful instrument of mis-guided agency righteousness.

 

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The Rolls-Royce of Audit Reports Hits The Road: Test-Driving KPMG’s Latest Model

“So tell me what you want – what you really really want.”

            -- Spice Girls, 1996

“But if you try sometimes, you just might find, you get what you need.”

            -- Rolling Stones, 1969

Insiders within the accounting community are falling all over themselves in congratulatory admiration of the Independent Auditor’s Report signed in London on February 12, 2014, by Senior Statutory Auditor Jimmy Daboo on behalf of KPMG, on the financial statements of Rolls-Royce Holdings plc.

Running to six full pages starting at page 130 of the company’s 2013 annual report, single-spaced and double-columned, Daboo’s opinion implements with a vengeance the guidance published in June 2013 by the United Kingdom’s Financial Reporting Council, requiring auditors’ reports to describe the greatest risks to material misstatements, explain their application of materiality in audit planning and performance, and summarize their audit scope as responsive to the assessed misstatement risks.

This is not about motor cars. Rolls-Royce ranks number 28 on the FTSE 100 list of large UK companies, with £ 15.5 billion in 2013 revenue from its gas turbine and reciprocating engine sales to the civil and defense aeronautics sectors, along with marine, energy and power systems -- all spelled out in its report running a handsome 144 pages.

The interesting question is whether the world was really waiting for essays of 500-word-length on such eye-crossingly complicated topics as revenue and profit measurement, measurement of liabilities from sales financing arrangements, or the concept and presentation of non-standard “underlying” profit on foreign transactions. Or would information users have preferred the traditional, simple and comfortable anodyne opinion in the first paragraph, that a “true and fair view” was presented?

Early indications -- based on the conspicuous silence of the investor community and commentators outside the precincts of those with self-interest -- significantly suggest the latter. To be sure, the company’s stock was pounded by its largest price drop in thirteen years with the profit warning of its February 13 announcement of 2013 results, largely since recovered, but blame was placed on forecasted reductions in defense-related revenues, and the financial press made no connection with KPMG’s opinion, either then or since.   

If proved out over the rest of the annual reporting cycle for UK companies and their own broad adoption of the FRC’s requirements, the investor community’s “ho-hum” would implicate the long-running efforts to re-engineer the standard auditors’ report – by both the PCAOB in the US and the IAASB globally.

Not, as can be observed, that either of these bodies is proposing changes on the scale of the KPMG treatise – but have rather confined themselves to the identification of the kind of “critical” or “key” audit matters that may predictably elicit generic box ticking and boilerplate, rather than KPMG’s sophisticated mini-seminars delivered on Rolls-Royce.

Which would be unfortunate indeed, especially in the litigation-prone United States, the jurisdiction most likely among the world’s major large economies to inflict a death-blow jury verdict for an auditor’s “getting it wrong.” There, under the disclosure-based policies of the American securities laws, adoption of the emerging UK protocols for actually quantifying audit and reporting materiality, and for explicating the range and uncertainty of complex company decisions and judgments, would go far to draw the teeth of the beast lurking in the courthouse.

For this, those arguing for a sustainable model for privately-provided assurance could only be grateful.

But there being no sign as yet of any leadership or initiative in that direction, grounds for optimism are hard to come by.

Curious readers in the US are invited to have a look at the Rolls-Royce report including the KPMG opinion, and send in their reactions. Readers in the UK – especially actual or potential investors in Rolls-Royce, on whom the KPMG report may have made an impact or had any influence -- are invited to identify themselves and share their thoughts.

 

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Big Data: Can the Regulators Handle the Big Challenge to Big Audit

I yield to no one in my respect for the intelligence and dedication of Public Company Accounting Oversight Board member Lewis Ferguson – whose deep involvement with the accounting profession I have known for decades.

But Ferguson recently came wrong on an issue for all parties involved with large-company financial information, that threatens to contribute to a re-ignition of the 1990’s brouhaha over the permissible scope of services deliverable by auditors.

As an adjunct to his day job in Washington, Ferguson is chair of the International Forum of Independent Audit Regulators – a global collection of bureaucrats whose agencies sprouted around the world in the post-Enron aftermath of the 2002 Sarbanes/Oxley law.

In that capacity, Ferguson was quoted recently that the auditors’ search to acquire expertise in the rapidly-evolving field of Big Data and its applicability to the practice of auditing “is a source of great concern to all regulators around the world,” and “raises serious concerns about differential levels of profitability in these businesses, differential rates of growth, where the economic incentives are and to what extent does audit quality suffer as a result”(IFIAR press conference April 10, 2014, at minute 17).

For Ferguson to suggest that auditors should be either inhibited or constrained from fully realizing the opportunities presented by Big Data is to be on the wrong side of its evolutionary trajectory.

Looking ahead today, the availability of Big Data – and the ability of management, auditors and financial information users alike to grasp and analyze all and every part of the recording and reporting of an enterprise – will shortly re-work completely the way in which assurance is performed and delivered.

With search algorithms and comprehensive analytics brought to bear, the very notion of audit by sampling – bedrock of traditional audit practice since its Victorian origins – will be rendered obsolete. Whole teams of audit staff, along with their elaborate and costly testing methodologies, will have no more raison d’être than buggy whips on an automobile, as incisive programmers scanning for irregularities will search the entirety of a massive data set with the push of a button.

A friend on the board of a global public company recently gave me a beginner’s Big Data lesson: a fraud-detection team, newly empowered with access to comprehensive data on the activities of the company’s entire employee base world-wide, was enabled through exception-searching analytics to identify – and to refer for prosecution – a manager who was routinely submitting expense claims that were both randomly different in amount and just below the policy threshold for supporting documentation – a detection task essentially impossible by traditional forensic means.

That and other extended Big Data assurance opportunities are nearly too rich to grasp – when a retail transaction at the cash register generates a stock replacement purchase order and a shipping invoice – when the nation-wide spread of epidemics is predicted not by laboratory results at the NIH but by web searches for symptoms and cures – when traffic snarls are reported not by eye-in-the-sky helicopters but by the pace of cell-phones carried by car-bound commuters.

This would not, of course, be the first time a regulator was behind the transforming consequences of change. Examples in the last decade alone included the unrestrained excesses started in the sub-prime mortgage market, and the unobserved invasion by the Chinese-based reverse mergers beneath the radar of the Securities and Exchange Commission. Most recently, regulators have been wrong-footed by the legal skimming of the high-frequency traders so entertainingly mapped in Michael Lewis’s spring book, “Flash Boys,” and the market-moving impact of Bank of America’s multi-year inability to do the sums required in the complex accounting for its capital.  

The point missed by Ferguson’s suggested handcuffs on the auditors’ ambition is typical of those failing to appreciate the implications of inevitable change: the genie of Big Data is out of the bottle, and will not be returned. If the audit firms do not develop the models and methods for its deployment in the assurance process, and re-calibrate their business models accordingly, then new players in the market surely will, with existential consequences for the viability of the audit firms and their existing franchise.

Just because Ferguson takes a retrograde view of the future of Big Data in big-firm hands, however, does not mean that the accounting profession itself has it right. At the very least, there is a huge barrier of vision to overcome, as seen in the profession’s failure to evolve the basic and obsolete “pass-fail” reporting model into assurance that the markets will actually value and be willing to pay for.

And at worst, unless the profession gains credible and active engagement in the public dialog on the compelling case to acquire and deploy the skills and practices needed to bring Big Data to bear in the next generation of Big Audit, they will be setting the stage for a reprise of the disruptions of the 1990’s that saw their unfortunate capitulation on permissible scope of ancillary services, nowhere more unfortunately exemplified than in the avoidable debacle of the Andersen/Accenture divorce.  

Questions deserving debate here are deeper and more profound than those of a narrow-focused regulator. So PCAOB member Ferguson deserves appreciation for opening a door to their exploration.

Thanks, Lew.

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Should the Big Four Have Audited Financial Statements? Should the Cobbler’s Children Have Shoes?

The Public Company Accounting Oversight Board’s member Steven Harris proposed on March 20 “that the large accounting firms make their audited financial statements available to the public.”

Harris observes that “many find it ironic that auditing firms in the United States…resist providing their own financial statements,” and sees no reason “that the auditing firms that act as gatekeepers to our securities markets should not be as transparent to investors as the companies they audit.”

“Irony spotting” not being a trait of Washington functionaries, Harris did not observe this coincidence – that he was two weeks ahead of the PCAOB’s two days of public meetings to further address its 2011 proposal for reconsideration of the manifest inadequacy of today’s auditor reporting, about which Harris himself said in September 2011:

“Investors clearly do not believe the current three paragraph, largely boilerplate, binary audit report, is either sufficiently informative or serves their needs.”

Suppose -- instead of his agency’s dreary record of spotty inspection coverage, confusing metrics and failed initiatives – that the Harris proposal to impose on the Big Four an obsolete and ineffectual assurance model were actually taken up and debated seriously.

The foxes would be truly set among the chickens.

First of all, it can be done. Some local firms of the large networks already publish IFRS-based financial statements, audited and reported on by their colleagues (in the UK, see Deloitte, EY, KPMG and PwC).

Problems of scale and substance raise immediate questions, but it’s to be noted right here – and on which more anon – that back in the late 1970’s, Arthur Andersen’s global financial statements were audited and reported on by Haskins & Sells – as the Deloitte firm in the US was then branded.

Should the Big Four voluntarily offer such disclosures and assurance? Or should they be required to do so? The cross-currents and antagonisms in those discussions would be worth the admission price.

Over the profession’s long-standing resistance, there could be considerable public education, both from the information to be disclosed, and from that not furnished.

Consider an extension to the US of the Big Four’s UK audited disclosures: for 2013, country-level revenue ranging (in millions) from £ 1,721 to £ 2,689, with UK firm profits from £ 455 to £ 740.

Those UK data mainly serve to reinforce a point urged here for years – that the Big Four’s business model, running on client receivables and egg-shell-thin capital, is not designed or robust to withstand the ten-figure financial shock that would be inflicted by a truly bad-case litigation or law enforcement outcome.

As to information that similarly-designed US disclosure would not make available – two gaping holes:

The first is that, just like the world’s other large enterprises – and noting that the Big Four’s reported aggregate global revenues for 2013 exceed $ 113 billion -- their UK statements are opaque on the extent and quantification of litigation claims and contingency exposures.

The same would be true in the US – where the modus vivendi between the accounting standards-setters and the litigation defense lawyers has forever permitted a shroud of confidentiality over the uncertainties of publicly predicted litigation outcomes.

And second, the UK experience makes clear the limited amount of world-wide information to be gleaned from country-level reporting – which offers only the most passing reference, in either words or numbers, to the local firms’ membership or participation in the business and funding of their global networks.

The Big Four continue to work the two sides of this structural issue, of course, as they are both obliged and permitted to do under the parochial nature of the profession’s organization, regulation and oversight. They proclaim both their revenues and their commitments to seamless service on a global scale, but they pull back to local-country descriptions for purposes of risk acceptance and cross-border liability.

So this point requires public acknowledgement: although Arthur Andersen was alone in ever submitting its statements to independent audit, its global network fell in 2002 like a house of cards, under the unwillingness of its ex-US firms to support the US firm in its time of Enron-based travail.

Which calls for one final and irony-tinged observation. Those urging the extension of Big Four reporting transparency would no doubt press Harris and the PCAOB to require the Big Four to follow the initiative of Andersen’s global reporting from a generation ago, as could be done, under the PCAOB’s authority over non-US audit firms participating in the audits of public companies filing in the US.

But whereas the Big Four’s UK firms are audited by firms in the next smaller tiers – who have no significant share of the market for audit services to the world’s largest global companies – the only auditors having the geographic scope and scale to report on the Big Four’s global networks would be those very four networks themselves.

If put in place, that round-robin of mutual examination and reporting would not find favor, it could be surmised, among the unremitting critics of the accounting profession who see malign cartel behavior at every turn.

So – bravo for the Steve Harris initiative. Let both the hand-wringing and the stone-throwing begin at once. And see who comes out on the other side.

 

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Previewing the PCAOB’s Public Meetings on the Auditor’s Report – Where Can We Find the Bar?

How high should the bar of expectations be set, ahead of the meetings of the Public Company Accounting Oversight Board set for April 2-3, where a series of panels are to consider its proposal of last August addressed to the auditors’ reporting model?

Based on the modest heights scaled by the agency over the course of its dozen-year history, shin guards are recommended.

 Consider these steps, halting and slow:

• The PCAOB admits that its audit firm inspections are still barred by unresolved claims of confidentiality or national sovereignty in some 15 countries, importantly including China, Hong Kong, Ireland and Italy. 

• It also lists affiliated firms of the largest global audit networks that have not been inspected in these and such other major economies as France, Germany and Spain, for four or more years.

• Three years after re-launching its elaborate series of proposals, hearings and road-shows on the never-supported proposition for mandatory limits on auditor tenure, PCAOB chairman James Doty finally folded his losing hand in February – not with a forthright admission that the notion was ill-founded from the outset, but with the budgetary cavil that “We don’t have an active project or work going on within the board to move forward on a term limit for auditors.”

• The entire edifice of auditor quality evaluation lies exposed to PCAOB member Jay Hanson’s trenchant criticism of the agency’s basic measuring stick – its own peculiar definition of an “audit failure” – that is, in the agency’s view only, if “the auditor did not do enough to know whether (financial statements were fairly stated).”

As Hanson diplomatically summarized in his March 18 speech, the agency’s self-referential definition “appears to have caused confusion among investors, audit committees and others…,” because it is neither consistent with the same term as used, e.g., by the US Government Accountability Office, nor are its “findings”  causally related to actual problems in an issuer’s financial statements or restatements.

• And finally, the PCAOB shows such disrespect for the memory and acuity of its audience that its March 20 release actually touts the participation of members of the Bush-era’s long discredited Advisory Committee on the Auditing Profession. That callous exercise in political spin, by US Treasury Secretary Henry Paulson, yielded up a final report in October 2008, so tangled in internal posturing that it was unable even to achieve consensus on the existence of a stability threat to the very model for audit services to the world’s largest companies.

Instead, the Treasury Committee’s lack of credibility was measurable by its straight-faced but ludicrous suggestion that the partners of the large audit networks would, if facing existential threats from litigation or law enforcement, stabilize their firms by abdication -- surrendering their leadership to rescue teams of replacement management standing by in the wings.  

• Aside: to its modest credit, the Committee was not altogether lacking in substantive insights – high-lighting, for example, the stunning short-coming in the oversight of the audit profession, that “No formal forum currently exists where auditors and other market participants regularly share their views and experiences relating to fraud prevention and detection in the context of fraudulent financial reporting.”

Other significant business and professional sectors provide effective models for the opportunity to engage and learn from “failure study” – engineers, air traffic safety, emergency hospital procedures, for example. The crying absence of such a forum around the subject of “audit failure” dooms the entire community of financial statement users to the blinkered limitation that “You can’t hope to improve, if you can’t tell whether you’re good or not.”

At the core of the PCAOB’s current audit report initiative is its proposal that auditors should discuss so-called “Critical Audit Matters.” The main effects of this marginal exercise – as abundantly spelled out in comment letters already in the PCAOB’s hands -- would be disruption of the appropriate allocation of reporting and disclosure responsibility resting on public-company management teams and their boards and audit committees, the fostering of further boilerplate reporting language, and the propagation of hindsight second-guessing by regulators and litigants about whether a particular matter was indeed “critical.”  

Under all these conditions, those seeking to locate the expectations bar for the upcoming PCAOB meetings are best advised to approach it on hands and knees.

 

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