Re:Balance -- Jim Peterson

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

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

       Tao Te Ching of Lao Tzu, Verse 15

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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The PCAOB Still Wants Audit Firms to Name Lead Partners -- The Case for Indifference

The day after Thanksgiving is known in America as Black Friday – the opening of the pre-Christmas shopping season, when merchants launch midnight sales and dubious oddball discounts, and hordes of turkey-stuffed consumers storm the malls like barbarians at the gates.

This year the 4^th of December should go down in Washington as Dull Grey Wednesday – the day that Jim Doty, chairman of the Public Company Accounting Oversight Board, hosted a public meeting to release his long-announced and little-awaited plan to require the auditors of US public companies to identify their lead partners by individual name.

By contrast to the chaos in the malls, hordes of investors and other financial information users yawned with indifference and turned back to shopping and fantasy football.

Partner naming has been simmering on the PCAOB’s burners since 2005, well before its July 2009 concept release, but has not improved with age – instead it’s an issue on which neither side of the “discussion” has a persuasive case or advocacy to be proud of.

The profession’s ongoing opposition – here summarized – quakes at the fear of heightened criticism, individual partner harassment and increased litigation exposure. But years of personal partner identification in the European environment are to the contrary, illustrating only a complete absence of concern.

Even in the UK, where partner naming is relatively new, an illustrative example is Deloitte’s report dated May 21, 2013 on Vodaphone’s March 31 year-end financial statements. There the personal signature of its lead partner has attracted not one word of commentary for his selfless if coerced beau geste – even though that report is an important early adoption of the new British requirement for the quantification of audit and reporting materiality – a topic that is evolutionary and by rights worthy of serious attention and assessment, and happily discussed in the press by the head of Deloitte’s UK practice. 

If “who cares?” should be the profession’s reaction to partner name disclosure, then, the case in its favor is no better founded.

As predictable, chairman Doty and his staff cite an academic bibliography that purports to find virtue and benefit in partner naming. But a serious dose of skepticism is indicated.

If the triviality of the issue were not compelling, it would be important to call out the confirmation bias lurking in Doty’s invocation. That’s because the scales of academic persuasion are barely quivered, much less tipped, by such “research” examples as ostensibly erroneous failures to issue going-concern opinions in Sweden, supposedly “abnormal” accruals in the UK, or a sampling of individual partners in China which credits heightened conservatism to those with Big Four experience.

It would be so dispiriting, if it mattered. Not only does recent experience with the fictive nature of Chinese financial reporting support the proposition that “quality Chinese accounting” ranks as an oxymoron up with “Italian justice system” or “Holy Roman Empire.” As well, the validity of report qualifications as a measure of auditor aggression is surely overwhelmed by the requirements of the global regulatory regimes for the anodyne language of clean opinions; witness the unqualified pre-failure reporting of the likes of GM, Fannie Mae and Lehman Brothers.

While reporters such as Edith Orenstein posted pre-release place-holders, the profession’s unremitting critics were in high dudgeon – yet the search still continues for a defensible reason to isolate the leader of an entire audit team, when any engagement of more than minimal complexity must involve a cohort of supporting personnel with distributed expertise and responsibilities sufficient to the task.

Francine McKenna, for example – endorsed by the Grumpy Old Accountant --  urged the politically unfeasible disclosure of an entire partner cohort. But few of the Big Four partners on her villains’ list were actually lead partners, which means that her argument proves too much – since listing an entire partner team plays squarely into the profession’s argument that the audit firm itself is answerable for its performance quality.

To retail investors, it would be a challenge to name the audit firms that serve their portfolio companies – much less would they register the identity of a single partner. While for those charged with decisions that matter – boards of directors, their audit committees and corporate executive leadership – the lead partner is as personally close to hand as a speed dial or a Siri instruction, and public naming is laughably irrelevant.

It may be predicted that the American regulators will have their way, by the middle of 2014 -- perhaps on partner naming, if not on a list of issues of more legitimate substance -- such as the final burial of the miserable topic of mandatory auditor rotation, or the yet-further retreat from the convergence of international accounting standards, or the PCAOB’s inconsequential steps to address the unsatisfactory state of the scope and content of the audit report itself.

Only proving yet again, that in the public evaluation of a regulator, the concept of “first, do no harm” is probably the best to be hoped for.

 

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The PCAOB's "Game Change" Proposal on the Auditors’ Report is Small Change

 Edith Orenstein’s FEI Blog is a vital resource on the antics in Washington affecting the financial sector. It was my pleasure and privilege this week to offer this guest post:  

“Audited and Approved”

Opinion of William Welch Deloitte dated 8^th February 1850, on the half-year accounts of the Great Western Railway as of December 31, 1849, in its entirety

It's been downhill for auditors' reporting ever since.(1)

Public Company Accounting Oversight Board (PCAOB) chairman James Doty described the changes proposed on August 13 to the long-standard auditors’ report to “mark a watershed moment.”

The releases from the large firms ranged from the straight-forward (PwC) to the enthusiastic (KPMG), with the expected cheer-leading coming from their flacks; muted criticism from Tony Catanach’s Grumpy Old Accountants and the corporate bar; along with a predictable flag of litigation risk from the Journal of Accountancy. 

With formal comments due to the PCAOB by December 11, and as the polite applause dies down, a cooler perspective should see this tinkering as no more a “game change” than raising the stakes from a penny to a nickel.

That’s because the PCAOB is playing it small all the way. Board member Steven Harris emphasized “the need not to change what auditors do, but to change how they report what they do” (The emphasis is his, not mine). Board member Lewis Ferguson concurred, noting that “the standard does not require the auditor to do any additional work.”

To focus on what auditors currently do, however, misses entirely the point of investor concern. The famous and misunderstood “expectations gap” has never been about what auditors do. The gap does not even exist, in the minds or the behavior of investors until it bursts forth after a major corporate fraud or failure.

Unfulfilled auditor “expectations” have emerged with every outburst of serious issuer performance, from McKesson&Robbins in 1940 to JP Morgan Chase’s “London Whale” today.

“Where were the auditors?” does not concern transparency or the disclosed detail of audit work, but the perceived dereliction of not detecting or preventing a manifest problem – whether the collapse of Enron Corp. or the thievery of Bernie Madoff.

Investors are not demanding more nuanced wordsmithing about, for example, the auditors’ attention to issuer information outside the financial statements – the impossibly elusive articulation of a distinction between “read and consider” and “read and evaluate.”

What they do want are answers to share price-moving questions that neither the auditors’ work nor the PCAOB’s changes can ever hope to reach. They include questions like these:

• Will a particular pyramid-structured company – Herbalife comes to mind -- turn out to be a Ponzi scheme?

• Can a particular company whose customer base is concentrated on a high-tech device – Blackberry, perhaps -- actually survive in a world of fast-paced and constantly evolving competition?

• Which financial institution will suffer the next rogue trader at its derivatives desk? 

Since securing the franchise to provide financial statement assurance for public companies, under the American securities laws of the 1930’s, the accounting profession has borne self-inflicted responsibility for the creation and expansion of the “expectations gap” – by such actions as:

• Over-selling the level of comfort its reports convey – going back to the inference of guaranty conveyed by the unfortunate and now-replaced terminology, “auditors’ certificate,” and the profession’s futile inability to escape its lingering shadow.

• Tolerating the misplaced label of “watchdog,” as applied by jurists and academics whose presumption of guidance exceeds their competence to pronounce.     

• Fostering the obsolete and intellectually fragile “appearance of independence” – a trope at odds with the “client pays” model in place since Mr. Deloitte’s era, which delivers neither protection for the auditors themselves nor enhanced comfort to users.

One thing is for sure – the PCAOB anxiety about creating a bull market in boilerplate language is well founded. Defensive file-stuffing will prevail, as the Big Four prepare for the double-layered second-guessing in their future PCAOB inspections. Not only “Why was this issue not deemed a ‘critical audit matter’?” – but also “How did you decide that this ‘critical’ matter did not require disclosure?”

So it may be safely predicted that every Big Four client will have some minimum number of “critical audit matters.”

Moreover, similarities across sectors and industries are far greater than individual differences between companies. Every bank has issues with provisions for non-performing loans. And the entire technology sector has been challenged by revenue recognition in all the years since IBM pioneered its manipulation.  So the pick-list of those items will quickly become standardized.

What is dispiriting is that, on such significant issues as those in the recent great collapses – think Bear Stearns and Lehman Brothers and Merrill, MF Global and Knight Capital and SAC --  it is right to question whether auditors might have contributed positively -- by way of targeted scrutiny and assurance – to management, boards and investors alike.

But it couldn’t have happened, and won’t -- not under the small-bore thinking of “no more work – only more words.”

And not so long as the assurance model is hostage to today’s binary “pass-fail” report – accurately described by PCAOB member Ferguson as something at which “they merely glance … to make sure that the opinion is unqualified….”

If anything good emerges, it is the end of the endless discussion of mandatory auditor rotation – a majority of the Board now accepting the absence of data even suggesting a relationship between auditor tenure and audit quality.

In a one-sentence summary – which propriety inhibited me from sharing with Ms Orenstein’s readers -- the PCAOB has acted on this one like the little boy in church, losing bladder control in his dark blue suit: the results don’t show very much, and he gets to feel relieved and warm all over. 

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1. Until supplanted by an earlier-dated example, this pioneering statement – which I found hiding in plain sight in the National Archives of Britain in Kew, on the outskirts of London – is the first expression of independent assurance by one of the profession’s founders, on the financial statements of a large publicly-held corporation.

Re-Writing the Auditor's Report -- The Financial Reporting Council Swings a Two-Edged Editorial Sword

 

 

Twas brillig, and the slithy toves

Did gyre and gimble in the wabe:

All mimsy were the borogroves,

And the mome raths outgrabe.

 

How fitting, that the Victorian era in which the independent auditor’s report was invented also brought forth Charles Dodgson’s unique combination of mathematical genius and – as Lewis Carroll of Jabberwocky – his verbal acrobatics.

So I thought, reading the new language requirements of the Financial Reporting Council, the British audit regulator, in its revised ISA 700, “The independent auditor’s report on financial statements”.

Life was once so straightforward. In the 19^th century, Mr. Deloitte’s pioneering report on the half-yearly accounts of the Great Western Railway at December 31, 1850 read, in its crisp entirety, “Audited and approved”.

This month, while the Public Company Audit Oversight Board in the US, the European Commission in Brussels and the International Auditing and Assurance Standards Board on the global front continue mired in endless projects aspiring to evolve the standard report, the FRC’s vorpal sword has gone snicker-snack. 

It strikes one successful blow, at least – against one of financial reporting’s great historical opacities. The new British ISA requires that the audit report’s description of the assessed risk of material misstatement must:

“Provide an explanation of how the auditor applied the concept of materiality in planning and performing the audit. Such explanation shall specify the threshold used by the auditor as being materiality for the financial statements as a whole…” (emphasis added).

It has forever been a mystery why financial statement users have tolerated a reporting and assurance model, the scope of which is designed “to give reasonable assurance that the financial statements are free from material misstatement…”, without a clue from either issuers or auditors as to the magnitude or contours of the term “material.” 

At last bringing sunlight and transparency to the question of “how big is big?”, the ISA invites specific amplification, for example, of categories of items having lower materiality levels, materiality thresholds for reporting unadjusted differences to the audit committee, and qualitative considerations relating to the auditor’s evaluation of materiality (¶ A13B). 

In the disclosure-oriented environment of the American securities laws, it would seem plain beyond ambiguity that putting such information in the hands of investors is to welcome them into the circle of the better-informed – with, no small matter, a concomitant imposition of responsibility for their own absorption and analysis of the information.

That’s on the plus side. Not so promising, the requirement that an unqualified auditor’s report – which must “clearly state that the financial statements give a true and fair view” (¶ 18) – explicate the assessed risks, materiality and audit scope, in language that must be “related directly to the specific circumstances of the audited entity and … not, therefore, generic or abstract matters expressed in standardized language” (emphasis added).  

Charles Dodgson may have been able to integrate quantitative and verbal competence back in 1872. But expecting linguistic agility from today’s number-crunchers is a stretch too far.

For proof, the FRC’s own admonition on risk disclosure (¶ 19(A)(a)) is a sufficient example, as it stumbles in ponderous violation of the norms of style, punctuation and syntax:

“Describe those assessed risks of material misstatement that were identified by the auditor and which had the greatest effect on: the overall audit strategy; the allocation of resources in the audit; and directing the efforts of the engagement team…” 

A better idea would be to tap the centuries of exquisite poetry and soaring rhetoric in the country’s grand verbal heritage. The phrase “true and fair view” has always seemed, after all, to resonate in its English-ness – as if any issues of clarity or sufficiency should be subject to gentlemanly resolution on the playing fields or over brandy and cigars in the lounge back at the club.

So here would be a few precedential examples for a descriptive accounting and audit vocabulary in non-generic, non-standardized terms:

• On the deferral of executive incentive compensation: “The rule is jam tomorrow and jam yesterday but never jam today.” 

• On the difficulties of a protracted corporate reorganization: “Now is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” 

• On the impending threat of a bankruptcy filing: “It was a dark and stormy night.”

• On the choice of aggressive accounting principles by which to value a derivatives portfolio: “I know a bank where the wild thymes blow.”

• And, perhaps best of all, on the possibility of a going-concern qualification: “To be, or not to be: that is the question.”

Readers are invited and encouraged to bring forward their own suggestions.

 

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KPMG's Independence, Herbalife's Stock Price, and the Game of Name Blame

What does this say about the value placed by investors on the independence of outside auditors: 

Two trading days after KPMG withdrew its audit reports on the financial statements of its Los Angeles clients Herbalife and Skechers, because of inside information shared by its promptly sacked and criminally charged engagement partner Scott London, the stock price of both of those stocks has actually risen!

The consequences of London’s passing on, to the million-dollar benefit of his golfing pal Bryan Shaw, will be swift and nasty:

• Ratted out by Shaw, London will cut the fastest plea deal the prosecutors will offer.

• KPMG will hurl its checkbook at every dollar of costs incurred by its ex-clients to obtain replacement auditors.

• Aggressive plaintiffs’ lawyers will fashion some theory of shareholder harm – despite the stock price upticks – doubtless spinning a conspiratorial connection with the long-running spat over Herbalife between raider Carl Icahn and shortseller Bill Ackman, and eventually coercing a nuisance-level settlement.

• And the American securities and accountancy regulators – the SEC and the PCAOB – will vie with each other in a pell-mell rush, recalling the unseemly post-Enron haste with which the Sarbanes-Oxley law was passed in 2002, to push a requirement that auditors of US public companies identify by name their partners signing client audit reports.

This last has been opposed with intensity by the American accounting profession, although long in place in much of the world without measurable adverse effects.   

Nor, it should be noted, with measurable benefits either – as client managements and audit committees in the US have never lacked access to the decision-qualifying information necessary about the engagement personnel at their audit firms.

In the wishful search for magic bullets aimed at the structural weaknesses in the auditor-client business model, “partner naming” is a distinctly small-bore and ineffective weapon. 

But London’s downfall does require re-framing my opening question, this way, heretical as it may seem:

What value to the operation of the capital markets – if any -- is actually delivered by the entire structure of auditor independence? 

London’s professional position was destroyed, and his liberty put in jeopardy, not because he violated the elaborate dictates of the auditor independence rules, but because of his multi-year violations of the insider-trading prohibitions of the American securities laws.

And on the other hand, despite KPMG’s immediate and apologetic resignation and report withdrawals, the stock market has given credence to the assertions that the substantive content of the Herbalife and Skechers financial statements are unaffected (even given the charges hurled in the Icahn/Ackman dust-up).

In short, the indifference of equity investors to the state of KPMG’s independence speaks volumes.

I’ve long been saying (here and here) that – under the “client pays” business model for financial statement assurance, invented back in the Victorian era – the accounting profession has gained nothing positive for years, by way of reputation, stature or risk and exposure mitigation, from the intellectually unsatisfactory edifice of “appearance of independence.”

Now, the stock price non-event of Scott London’s misadventures equally shows the converse – that investors impose no downside price penalty on even a slam-dunk independence violation.

Conclusion: the time, energy and cost of maintaining the outmoded and anachronistic structure of “independence” should be re-directed to the long roster of topics legitimately worthy of the effort.

 

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Re:Balance Takes a Spring Time-Out -- Will the Silliness Please Take a Break Too!

For the first time since launching as a blog in 2008 after its run without a break from 2002 as “Balance Sheet” in the business section of the International Herald Tribune – “Re:Balance” is going to be dark for several weeks. 

Intense and nearly unbroken travel on three continents will impede staying current on all the mischief within the capabilities of the inter-locking participants in the structure by which assurance is provided on the financial statements of the world’s large companies: issuers, the large accounting networks themselves, users in the capital and investment markets, agencies of law enforcement and politicians and regulators.

Developments in this troubled world are likely to be consequential but cannot be predicted with any level of confidence – so there will be catching up late in the spring.

Three items in the last week head the list of topics to be monitored, however:

• The PCAOB announced consideration of a proposal for the reorganization of its auditing standards – something on absolutely nobody’s list of priorities -- while the agency has failed to get off the snide on either auditor rotation or the content of the auditor’s report – reinforcing the unavoidable conclusion that this body has lapsed into terminal inconsequence. 

• The vote of the European Parliament’s Economic and Monetary Affairs Committee to scrap a proposed requirement for mandatory auditor rotation, in favor of a less binding “directive” on periodic re-tendering, has potential to inflict a dose of reason and reality on a topic long threatening to float away on clouds of fantasy. 

• And the news from the UK -- that the move by Schroders to replace long-time auditor PwC with KPMG has foundered on the inability of the putative successor to satisfy the independence requirements -- provides early validation that even aspirations limited to periodic re-tendering are subject to the realities of a market for audit services too constrained to function under legislated mandates.

All of these challenges reinforce the over-arching need for fundamental re-engineering of the reporting and audit functions in their entirety. But this process is unlikely to advance in any significant way during my brief absence. 

Instead, there is every reason to be confident that these problems will all be here and awaiting attention when I return.

 

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The PCAOB’s Inspection Reports Nibble at PwC -- A Reader Asks, “Where’s the Beef?”

Food beyond compare

Food beyond belief

Mix it in a mincer

And pretend it's beef

Kidney of a horse

Liver of a cat

Filling up the sausages

With this and that

-- Thénardier, “Master of the House,” Les Misérables

The Public Company Accounting Oversight Board – overseer of the accounting profession in the United States – got in a snit recently, perceiving that PwC was lax in its efforts to remediate the “significant audit performance deficiencies” that the agency asserted in its 2008 and 2009 inspection reports.

Expressing pique as it only could, on March 7, the PCAOB released to an indifferent public the previously undisclosed “Part II” portions of those reports.

Did it arouse the aforesaid public to care? Or even to notice?

A predictable handful of the large accounting firms’ most reliably ardent critics did weigh in (here and here).

Meanwhile a measured comparison comes to mind – the teapot-scale tempest aroused in Britain and Ireland this winter, over the discovery of equine DNA in samples of meatballs and ravioli – not, enforcers emphasized, because of any actual consumer health hazard, but over alleged deficiencies in labeling and transparency.

On which my perspective takes from the attitude of my daughter, a situational vegetarian who, on assignment this last year in Southeast Asia, has extended her palate and appetite to include crickets, dog conch and scorpion.

In the European kerfuffle, a libertarian-oriented omnivore – believing in both cultural differences and regulatory intervention only to the minimum necessary – would favor a simple modified label: “May contain horsemeat”. 

As for the PCAOB, the question has to be asked -- How can an oversight function claim either legitimacy or effectiveness, that:

• Decides for itself how to define and identify not a legal or professional standards failure, but an elusive “significant audit performance deficiency.”

• Keeps score under its own methods and incentives, like a traffic meter maid sent on patrol with a book of tickets and a daily quota.

• Must under cover of confidentiality conceal both the names and the detailed particulars of its self-defined offenses.

• And then in a burst of ill-temper, decides for itself whether the undisclosed substance of a remedial effort is satisfactory within unmeasured and unarticulated standards.

It’s no wonder, for two reasons, that PwC saw no reason to pursue its right of appeal to the Securities and Exchange Commission.

First, because PwC negotiated the ability to append to the PCAOB’s release a pronouncement of its commitment to virtuous conduct, positively radiant with unctuous platitudes.

But second and more especially, because under the current model for compliance with the securities laws, under which there is no available alternative, the Big Four-dominated market for large-company audit services is armor-plated against the PCAOB’s pop-gun arsenal. 

Law enforcement, rules compliance and social norm-setting in general -- in contexts that are controversial, subjective and incomprehensible to the laity -- are subject to credibility challenges and diminution of the authority of their arbiters:

• The Supreme Court’s obscure definition of obscenity, “I know it when I see it” (Stewart, J., Jacobellis v. Ohio, 1964).

• The theological search for distinctions between mortal and venial sins.

• The nuances and complexity of sport, from soccer’s off-side and cricket’s leg-before-wicket to hockey’s high-sticking and baseball’s rules on balks and infield flies.

• The subtleties of line-drawing between shrewd and informed investing and insider trading, or the bribery of officials and accepted business facilitation.

Here -- the mutual hypocrisy in the whole sorry audit regulatory environment is pervasive:

The PCAOB gets to pretend it is engaged in a meaningful exercise, worthy of being taken seriously in the capital marketplace.

The audit firms are obliged to pretend that they take the cost and impositions of the inspection process as something more than the de facto license fee paid as a nuisance to maintain their franchise.

And to the limited extent they really care, financial statement users can only search elsewhere for meaningful assurance, beyond the model unchanged since the Victorian era and long since degraded into obsolescence. 

Critics of this dysfunctional structure are entitled to their finger-pointing cynicism. But their bile is misplaced – until and unless they unite in advocating an achievable effort to re-engineer the entire system of reporting and assurance that today only fosters ambiguity, inconsequence and disrespect.

Until which, at the foot of each PCAOB inspection report should be appended an adapted version of the suggested European meat label – “May contain horse-sh*t.”

 

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Re-Structuring the Audit Profession: The UK's Competition Commission Hunts the Woozle

 After the United Kingdom’s Competition Commission issued its report on February 22, asserting that the Big-Four-dominated audit services market is non-competitive, I sought to raise a flag of warning that, unless de-railed, its rush to fait accompli would soon inflict mandatory auditor rotation or at least re-tender on global-scale companies.

Diligent digging through the Commission’s augean piles of paperwork makes clear that its ostensibly supportive “research” ranges from the shallow and irrelevant to a results-driven reflection of its confirmation bias.

Comes to mind A.A. Milne’s 1926 fable of Winnie-the-Pooh and his pal Piglet, earnest and naïve, circling their own tracks around a spinney of larch-trees, and befuddled in their speculation that they might be tracking a Woozle.

 

Despite a forthright bias in favor of “auditor switching” – reflected in the finding that “incumbent auditors … face less competition for their ongoing engagements than they would were the company more willing to switch thereby reducing rivalry” -- the Commission fails to elicit any evidence-based impact of auditor tenure on audit quality.

To be sure, the Commission’s inquiry into the rate of “switching” is voluminous – building elaborate calculations in search of relationships among such elements as client size, audit complexity, geographic spread, client evolution from private to listed status, length of tenure at the start of the measured period, etc.

Yet, it does not attempt to examine, much less resolve, these two related but distinct questions:

• With the considerable number of long-tenured auditor-client relationships where the record of non-controversial financial reporting is unbroken, is there any identifiable relationship between the length of auditor tenure and the incidence of diminished quality or “audit failure”?

• As to the extremely small population of actual “audit failures” – compared to the huge number of non-problematic audits – is there any identifiable relationship between the length of auditor tenure and such failures themselves?

Nor is the integrity of the Commission’s history of the profession any better than that of their economic research. Their lengthy discussion of the early audit requirements, evolving from the Joint Stock Companies Act 1844 through to the superseding Act of 1856, omits essential facts:

• First, the terms of the 1844 Act were met by “auditors” chosen from among the company shareholders – non-professional co-investors engaged to examine and report on their company’s results, with interests not independent but precisely aligned economically with their fellows. 

• Second, it was not until the dawn of the next decade that these amateur “auditors” reached out to the nascent profession for assistance – e.g., William Welch Deloitte, then aged 32, joined Messrs. John Dickinson and Richard Atkinson, the shareholder auditors of the Great Western Railway’s accounts for the six months ended December 31, 1849, in the terse opinion dated February 8, 1850 – “Audited and Approved.”

• Third, therefore, by the Act of 1856, developments in the market for independent audit had surged forward, making that legislation essentially reactive, in the same manner as today for government regulators typically late to the party. 

Shortcomings in the Commission’s approach include a rose-tinted survey of the mid-tier firms’ “self appraisals of their capability and willingness to audit FTSE 350 companies” – noting, however, that as of 2010, the Big Four audited 99 companies of the FTSE 100, and 96% by number and 99% by fees of the entire FTSE 350.

In that context, asking a mid-tier business developer about his firm’s capability to audit a global-scale FTSE 100 enterprise would be like asking a sophomore in a fraternity house how he’d like a date with the Sports Illustrated swimsuit cover model. What possible response could be expected?

My graduate-level course in Risk Management uses a reading exercise in what legitimate, non-ideological research ought to look like – drawn from the very Victorian era when independent audit was invented, on whose history the Commission is so dim.

It’s the 1855 diary of physician John Snow, whose meticulous tracking of epidemic cholera cases around the publicly-accessible water pump at Broad Street in central London ranks among the origins of forensic medicine.

Dr. Snow’s techniques made inquiry in both directions: Not only who got sick, after drinking water from the pump – including both residents and casual visitors to the neighborhood. But also, who lived and worked in the vicinity and yet stayed well – such as brewery workers who preferred their own product to pump water, and factory hands in a facility with a separate and independent well.

By so doing, Snow avoided precisely the trap of disregarding the “absent evidence,” into which the Commission’s ends-serving inquiry falls headlong.

Confronted by Christopher Robin’s challenge that they had been chasing their own footsteps, rather than the imaginary Woozle, Pooh had the grace to concede:

"‘I see now,’ said Winnie-the-Pooh.

‘I have been Foolish and Deluded,’ said he, ‘and I am a Bear of No Brain at All.’

…. And then he brightened up suddenly.

‘Anyhow,’ he said, ‘it is nearly Luncheon Time.’

So he went home for it." 

 

Commission group chairman Laura Carstensen and her fellows should do no less.

 

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Mandatory Auditor Rotation: The UK's Competition Commission Stirs the Pot

For a charm of powerful trouble,

Like a hell-broth boil and bubble.

Double, double toil and trouble;

Fire burn, and caldron bubble.

            W. Shakespeare, “MacBeth,” 4.1

The simmering caldron of accountancy regulation was brought to a rolling boil in the United Kingdom on February 22, when the five-strong Audit Investigation Group of the Competition Commission issued its provisional findings.

No less sweeping than its assertion that the supply of statutory audit services to large public companies is rife with adverse effects on competition, the Group's suggested “remedies” would be draconian – among them, mandatory re-tendering for audit engagements every five to seven years, and mandatory rotation of audit firms after seven to fourteen years.

Remarkably, while the UK press treated these landscape-altering proposals as a one-day story (e.g., the Financial Times, BBC and Independent), attention in America beyond minor pick-up from the news services has included not the first word of either reporting or commentary.

Which had better change, and quickly too – not just because the basic impracticality of mandatory rotation is a long-standing barrier to its implementation (here, here and here). It’s because Group Chairman Laura Carstensen and her coven of non-accountants are working to the accelerated timetable of March 21 for comments, and publication of a final report by October 20 of this year.

By then, under the typical regulators’ effects of both momentum and inertia, their “provisional” hell-broth is likely to be fully cooked.

And a toxic brew it is indeed.

The Group did give the market-dominating Big Four tetrapoly a back-handed compliment, by exonerating them from the most malign charges of the profession’s fiercest critics:

“The CC also considered whether the market conditions are conducive to coordination or that Big 4 firms engage in tacit collusion; that they bundle audit and non-audit services together in order to raise barriers to expansion to other firms; that they target the customers of Mid Tier firms with particularly low prices; or that they are able to exercise undue influence over the formation of regulation or on regulatory bodies through their extensive alumni networks. To date, the CC has not identified sufficient evidence to support these other theories of harm.”

Scant comfort, indeed, as they went on to “find” an entire menu of ostensible reasons for a dramatic re-structuring of the audit services market:

            “Companies face significant hurdles in comparing the offerings of an incumbent auditor with those of alternative suppliers other than through a tender process.

            “It is difficult for companies to judge audit quality in advance due to the nature of audit.

            “Companies and firms invest in a relationship of mutual trust and confidence from which neither will lightly walk away as this means the loss of the benefits of continuity stemming from the relationship.

            “Company management face significant opportunity costs in the management time involved in the selection and education of a new auditor.

            “Mid Tier firms face experience and reputational barriers to expansion and selection in the FTSE 350 audit market.

            “Auditors have misaligned incentives, as between shareholders and company management, and so compete to satisfy management rather than shareholder demand, where the demands of executive management and shareholders differ.

              “Auditors face barriers to the provision of information that shareholders demand (in particular, from the reluctance of company management to permit further disclosure)."

Beyond these mostly unexceptional characteristics of a properly-functioning market for specialized professional services, of course, the unresolved and gaping logical gap in the Group’s entire approach is two-fold:

• First, Big Four dominance of large-company audit is a natural-market result of client demands for scale in geographic coverage, expertise and exposure tolerance – all of which are beyond the capabilities of the smaller firms.
• Second, at the same time, the widely-shared dissatisfaction of the user community -- that the standard and commoditized auditor’s report is grievously obsolete and provides no value -- is destined to be unrealized by the attempted re-engineering initiatives of such standard-setters as the PCAOB or the IAASB.

Nor is either of these root difficulties touched at all by the asserted but unsubstantiated claims of benefit to audit quality to be wrought by mandatory tendering or rotation.

Instead, within what the FT described last fall as the Commission’s “sheaves of working papers,” there is not a single research under-taking, much less a scintilla of evidence, showing an actual link between the length of an auditor’s tenure and the quality of either its audit work or its client’s financial reporting.   

Put in summary, the fundamental dysfunctionalities in the reporting and assurance models are untouchable by the “solutions” urged by those having the authority (if not the evidentiary basis) for their mischief-making, while mandatory re-tendering and rotation remain as “remedies” in search of problems yet to be grounded in reality.

But if not stopped, the Competition Commission is likely to work its will.

A regulator on a results-oriented mission is dangerous enough. But undiluted by the flavoring effects of the facts, the Commission’s recipe for a reconstituted audit structure will leave a foul taste all around.

Those obliged to sup at this devil’s banquet are advised to bring very long-handled spoons.

 

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Standard & Poor's in the Gunsights: High Noon at the Triple-A Corral

The United States Justice Department filed a five billion dollar lawsuit on February 3 against credit-ratings agency Standard & Poor’s, over its ratings of mortgage-backed collateralized debt obligations lying at the heart of the last decade’s financial crisis (see here and here). 

Settlement talks had broken down, over S&P’s reluctance to admit to fraud charges. But the wager here is not the over/under on S&P’s eventual and inevitable settlement. Before that, there will be much posturing and a long way to run.

For sure, McGraw-Hill subsidiary S&P has lawyered up for the battle, adding to its team the trial capability of über-barrister John Keker – advocate for such luminaries of civic virtue as Enron’s Andy Fastow, Credit Suisse’s Frank Quattrone, Lance Armstrong, Eldridge Cleaver and de-frocked king of the securities class action bar Bill Lerach. 

Of concern, rather, is the longer-term impact on the roles, relationships and exposures of the various gate-keepers, ambiguously deemed critical by society to the global capital markets.

The New York Times’s Floyd Norris scratched the surface of this issue – here – but beneath lies much more.

Consider this menu of common attributes:

• A standard, commoditized report, without which financial products cannot be brought to the investor market.

• Providers not engaged by or in direct contact with investors, but competing to be engaged and paid directly by the issuers.

• Despite which, elaborate assertions of “independence” – widely criticized as resting on the intellectually shaky platform of “appearance.”

• Severely constrained choice among providers to large issuers, from a number of players limited to the low single-digits.

• Barriers to new competitive entry based on market demands for global scale, competence and resources – although tightly regulated, the provider cartel is not constrained by limits on government licenses or other franchise restrictions.

• Claims that, broadly speaking, the reports reasonably reflect reality, most of the time – except under highly stressed conditions, when they do not – a position not unlike the claim that the Boeing 787’s lithium-ion batteries work reasonably well, most of the time -- except when they catch fire.

• Provider claims to have adjusted and improved methodologies and process in light of recent criticisms – proclamations echoing those of my college era, before political correctness, that “Vassar girls don’t do those things -- and besides, the grass was wet.”

• Finally, the standard document noted at the head of this list, explicitly couched in the language of an “opinion” – as if, despite the construction of an elaborate and expensive pyramid of supportive analysis and procedures, the result were intended as a Zagats review or a “like” on Facebook.

Up to the last, this list of attributes would apply equally to the three dominant ratings agencies – S&P, Moody’s and Fitch – as to the accounting tetrapoly of Deloitte, E&Y, KPMG and PwC.

Except for the dissonance at the expectations gap, where the global accounting networks face existential litigation exposure for each large-company audit report they sign, while the ratings agencies have – until now – successfully wrapped themselves in the armored blanket of the First Amendment.

Does the government’s suit against S&P portend a realignment of the exposure realities? S&P’s free-speech advocate Floyd Abrams has forsworn a First Amendment defense (here), so a new era of litigation risk may confront S&P as well as its brethren.

From the audit firms’ perspective, though, any temptation to schadenfreude is hazardous – because of the speed and vigor with which the slightly guilty pleasure taken at another’s misfortune can turn to ashes.

Especially if there should be a contagion effect.

 

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Auditor Liability for the Dixon Fraud - Scape-Goat Hunting in the Courthouse

A nightmare of auditor litigation was predictable, when the news broke last May that the comptroller of bucolic Dixon, Illinois, had helped herself to $ 53 million dollars of city funds (here). 

Having financed her luxury-level hobby horses on an apparently modest five-figure city salary, revealed as supplanted by twenty years of hand-over-fist embezzlement, Rita Crundwell now faces twenty years of federal prison time (here).

As of December, the town added Midwestern regional accounting firm CliftonLarsonAllen as a litigation target (here) – liability being asserted for its multiple roles including Crundwell’s own tax return preparer and keeper of the city ledger, as well as auditor of the town’s financial statements until 2006 when it dialed back to “compilation services.”

A full-out courtroom scuffle would be interesting. On the one hand, the accountability of Dixon’s own city fathers over the extended looting of an annual budget of only $ 8 to $ 9 million implicates their guardianship of the municipal barn door through which Crundwell cantered away with her bags of stolen loot.

But as I wrote at the time: 

“The accounting profession, mistakenly relying on disclosure of the limits on what a compilation report does or does not say, has traditionally looked on (compilation) work as low risk – which it mostly is. But consider the environment, and the typical level and quality of competence, governance and integrity in municipal government. What level of confidence should with safety be routinely reposed in those entrusted with management of a small city’s financial resources?” 

  On the recent reporting, the Clifton firm’s reliance on the limited duties associated with a compilation is exposed to collateral arguments about its deeper involvement: emails continuing to refer to “audits,” alleged working-paper support to the local sole practitioner putting his name to the opinions, and maintenance of a steady-to-increasing stream of fees even with the reduction in its stated scope of responsibilities. 

Limited as compilation work requirements may be, they continue to require fulfillment of professional standards of quality control, ethical principles of integrity, objectivity competence and due care.

And by way of reinforcement, commentators and standard-setters continue to press the importance of skepticism in oversight (here and here) – difficult enough to achieve, and hostage to fortune whenever tested under the harsh glare of hindsight.

However -- those expecting a shoot-out at the Dixon corral should prepare for a damp squib instead -- mainly because the prospect of an actual trial rather than an out-of-court settlement is so slight.

That’s because the Clifton firm’s exposure is life-threatening, and so unlikely to be tested in a trial.

Which is despite the fact that Dixon’s outside lawyers hold themselves out as personal injury lawyers, who do not publicize accountancy litigation as a practice area. So they are unconstrained outsiders to the culture of the traditional accountancy plaintiffs’ bar, which has long calibrated its high-end demands so as to wring only enough from the flock of Big Firm geese to enrich themselves while sustaining the steady supply of golden eggs.

Instead, using the model on which I have previously explored the shockingly small size of a litigation threat that would disintegrate a global-scale accounting firm (here), the Clifton firm’s reported $ 570 million of annual revenue is a fragile base from which to defend against a worst-case impact on the order of $ 53 million. [1]  

No management has the fortitude, much less the confidence – except under the most extreme duress -- willingly to submit the quality of its work to a civil jury for such a price.

Existential threats from litigation are an unconfronted daily reality for the Big Four firms (here). But no less for their smaller brethren, where the threat is on a “one-and-done” basis. BDO’s ability to withstand the adverse jury verdict in the Bankest case in Florida was a fortuitous combination of persistence, favorable court rulings and an eventual settlement – still not publicly disclosed (here and here). And the Baker Tilly firm’s $ 50 adverse verdict in Wisconsin in the Aqua Finance matter – unhappily including a coverage dispute with its insurance carrier (here) – surpasses its resources on a worst-case basis as well.

None of which bodes well for the strength, sustainability or long-term future of the assurance function – professed to be important to society’s ability to rely on audited financial statements.

Instead, the clock of doom ticks toward midnight.

 

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---

[1] Write me for the details if interested. My pencil pushing suggests a break point of around $ 50 million, but precision is impossible. Insurance coverage and deductibles have relevance, but only as a measure of the pain that might be inflicted on future generations of Clifton partners.

Re-Posting: Foreign Auditor Inspections? "China Syndrome" Strikes the SEC

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

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

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

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

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

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

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

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

It’s mainly that the US regulators’ only weapon of significance – banning Chinese affiliates of the large global accounting networks from qualifying to work on audits of American-listed companies – would ripple far beyond the toxic roster of China-based companies. There are potential consequences for global-scale companies with significant operations in China that go far beyond the inability of the PCAOB to inspect their local audit firms, whether or not maneuvered to keep below the 20% threshold.

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

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

Across the globe from KPMG in London and its top-level opinion on HSBC, to PwC in Peoria, Illinois for Caterpillar – unable to rely on their excommunicated Asian brethren – auditors would have no choice but to use the dread “qualify or disclaim” language -- never seen for a public company because anathema under the rules of the SEC itself. Or, in extremis, PCAOB de-registration of the whole of an audit network deemed non-compliant would render a company’s entire financial filing unacceptable.

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

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

 

My apologies for the re-posting, especially to subscription readers to whom the intended video clip did not feed -- a lesson learned in attempting to reach beyond competence with technology.

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HP-Autonomy: A Red-Ink Bath for Everyone

       “Either nobody in this deal understood the Company’s business, or someone was committing a fraud.”

-- Big Firm audit manager’s file note

Such language doubtless lurks in the working papers of the Big Four accounting firms, concerning this Thanksgiving’s biggest corporate turkey – HP’s announcement on November 20 of the whopping write-off of  $ 8.8 billion of the $ 11.1 billion paid a year earlier to acquire the UK’s FTSE 100 Autonomy.

How the blame-mongering cost of this fiasco will be allocated will depend, since each member of the large-firm tetrapoly touched the deal – Deloitte as Autonomy’s independent auditor, E&Y in the same role for HP, KPMG as part of HP’s huge buyer-side due diligence team, and finally PwC, brought in to pick over the forensic wreckage.

The quoted memo itself goes back a generation, to an investigation into sketchy high-tech revenue accounting – where it figured prominently in the investor litigation and the company’s SEC consent decree, an exhibit to the hazards of recording ideas that were both prescient and dangerous.     

That’s context for these thoughts responding to my investment banker friend and regular reader, “waiting for commentary on the Hewlett-Packard news and how it will affect Deloitte.”

Happily for the global supply of bandwidth, this story broke in a holiday week, absorbing in turkey, shopping and football the perfervid reactions of the most strident critics and their demonizing of the audit franchise as systemically venal and corrupt (e.g., here and here).

It is pointless now – time enough as the process evolves – to judge the predictable protestations of virtue of ex-CEO Mike Lynch, or Deloitte’s statement that it “categorically denies that it had any knowledge of any accounting misrepresentations….”

The Autonomy claims involve aggressions as old as IBM’s practices under the Watsons in the 1950’s – long stale and banal, and at best only interesting as an undergraduate classroom exercise in the endlessly elastic opportunities for revenue manipulation.

HP’s allegations do not, so far at least, involve such classics as the empty boxes at Miniscribe (1989) or Crazy Eddie (1987), nor yet the bogus contracts of Lernhout & Hauspie (2000) or Satyam (2009), but only the dreary familiarity of channel-stuffing and phantom contract dates – activities perpetually inviting to companies creatively striving for sweetened earnings, and elusively beyond the persistent efforts of standard-setters, regulators or law enforcement. 

More to the point, given the long-running criticism of Autonomy’s reporting by hedge funds and short sellers, is that it defies acceptable practice for HP CEO Meg Whitman to attempt the lay-off, that “the board relied on audited financials – audited by Deloitte – not Brand X accounting firm but Deloitte.”

Sorry, Meg. Not for a generation has an effective due diligence team done any more with a standard audit report than throw it onto the compost heap at the back of the document repository.

The HP team, said to comprise three hundred people from KPMG, bankers Perella Weinberg and Barclays and a quintet of law firms, surely had ample experience to sniff out any issues deemed significant. Why it did not will abide further finger-pointing.

But collective memories should not have been so short as to miss the red alert flag that the Autonomy deal was being flogged by Qatalyst Partners in the person of Frank Quattrone.

Whose earlier heady days in Silicon Valley had ended with one hung jury, a conviction reversed on appeal and a deferred prosecution agreement. So to say as did Reuters that Quattrone “specializes in tech deals” is like saying that Typhoid Mary was just going about innocently looking for work.  

Surer proof that HP will fail to spin its Autonomy debacle as an Enron-scale accounting fraud, is its assessment by Lynn Turner, who in 1998 was levitated to the post of Chief Accountant at the SEC from his position in a since-disappeared high tech company, after two decades at Coopers & Lybrand where he had emerged as national leader of its High Technology Practice.

Turner – whose background would presumably recognize dubious practices in the sector –- resisted the chance to pile on his erstwhile large-firm brethren --  for whom he forsook any affection upon his extraction from their ranks, his animosity more typically achieving the zeal of the mad monk in The DaVinci Code. Asking how the Autonomy policies “translate into a $ 5 billion write-off?” he demurred, that “the big issue isn’t the fraud they’re talking about. The big issue is that HP has made acquisitions that have turned out to be a disaster.”    

And so to my friend’s question, who might ultimately be liable to whom? The news is unhappy for HP’s long-suffering shareholders, whose claims -- either as a class (immediately launched) or on behalf of the company – under either British or American jurisprudence will offer little recourse, against HP or its management, Autonomy’s sellers or Deloitte.

Direct HP litigation against Deloitte would seem unlikely, given their existing ten-year consulting relationship as global alliance partners. Nor could Meg Whitman relish hostile courtroom scrutiny of the acquisition decision of her predecessor, Leo Apotheker, given – on her watch -- the year of pre-disclosure operating experience HP had with Autonomy, its string of prior write-offs including the $ 9.2 billion charge related to EDS, and the skeptics’ suspicion that HP’s write-off is a “big bath” overstatement of Autonomy’s illness to the forward benefit of HP’s balance sheet.   

If the impact on Deloitte and the other gate-keepers is likely “not much at all,” it is also likely not zero -- depending on where the “smoking gun” memos of the quoted variety might reside and be discovered – since a multi-billion dollar claim is beyond the Big Four firms’ financial capacity or risk tolerance to take to trial (here) – however enthusiastic their press-office protestations of innocence and scorched-earth defenses. 

What this latest dreary escapade does portend is several years of uncontrolled legal and litigation costs, and a flurry of inconclusive regulatory and oversight investigations – the end results of which will be inconsequential.

And finally, a wager is offered here, that Meg Whitman will not survive in place at HP to see it through.

 

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Ratings Agency Liability -- The Aussies Turn the World Upside Down

The litigation exposure of the Big Four accounting firms has not been made easier. 

The global networks should take no satisfaction from the field-leveling decision of Judge Jayne Jagot of the Federal Court of Australia, who on November 5 found ratings agency Standard & Poor’s (S&P) negligently liable to the purchasers of “grotesquely complicated” derivatives, designed and sold by ABN Amro. 

Schadenfreude would be wrong – and not just because it’s too hard to spell.

Consider the cries for accountability, during the recent years of financial calamity, by the auditors and the ratings agencies (e.g., here and here) – both of them, depending on one’s perspective, either vital gate-keepers to the markets, or aiders and abettors of the malefactors.

When their roles are compared, the guilty shiver of pleasure at another’s troubles would under-estimate the potential spreading of exposure. Consider the similarities: 

• Both have come to be viewed as essential functions in the world’s capital raising – chiefly by their regulatory authorities, to whom self-preservation and continuing existence are their own primary raison d’être.   

• Both are engaged and paid by their clients, upon which direct financial relationship they construct an elaborate edifice in illusory support of the intellectually unsatisfactory concept of an “appearance of independence.”

• Both seek to advance credible arguments that there is legitimate competition in their sector, despite effective barriers to entry that maintain their pass-the-parcel hegemony and an ever-tightening dominance by their respective global cartels.

• Their core products – the standard audit report and the three-letter rating – are delivered to users in prescribed and commoditized language – of which the source is a matter of consumer indifference and authorship would not be obvious absent a letterhead. 

• And finally, both couch their language in the qualified language of “opinions” and “judgment. ”

As to the last, however, the critical survivability difference emerges.

Namely, while S&P and its brethren have succeeded in wrapping themselves in the fuzzy if heretofore liability-proof blanket of the First Amendment’s free-speech protection, the auditors have long skirted disaster at the hands of a hindsight jurisprudence that threatens damages far beyond the limits of their financial tolerance or capacity. 

For the detail geeks, ABN Amro’s eye-crossingly complex derivatives, code-named “Rembrandt,” and the model-gaming involved in the rating process are laid out in overwhelming detail in the summary of Judge Jagot’s massive decision, and are thoroughly and colorfully discussed elsewhere – here and here.

The result threatens to turn topsy-turvy the ratings agencies’ comfortably protected world. Her Antipodean perspective is that S&P’s triple-A ratings were “misleading and deceptive,” involved “publication of information or statements false in material particulars,” and could not have been given by “a reasonably competent ratings agency.

For the ratings agencies themselves, the threat of worldwide contagion after the Rembrandt decision may be mitigated by both the availability of continuing scorched-earth defense strategies and the likely expiration of statutes of limitations to shield them from crisis-era claims.

For the auditors, who as noted are already far more exposed, it may be otherwise. Because -- taking cautionary note that the Rembrandt investor plaintiffs were supported by a publicly-listed company whose business is the funding and financing of large-scale class action securities litigation (here) – the investor-protection bar is a ruthlessly effective learning organism – to which the Judge’s liability language will operate like a blood-soaked invitation into a shark tank.

Even if not in the already-fraught American litigation market, should her process of hindsight negligence analysis gain traction in the courtrooms of Europe and elsewhere, the large accounting firms will find no ready firewall against the spreading conflagration.

 

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