Re:Balance -- Jim Peterson

The Pre-Election Mood: Enervation Over Innovation

 I awoke last night in the cold sweat of nightmare terror – my own version of Bill Murray in the 1993 film, “Groundhog Day”-- that CNN moderator Candy Crowley saw her shadow, and we were cursed with six more weeks of Presidential debates.

And PCAOB chairman Jim Doty kept scheduling “public meetings” on the exhausted topic of mandatory auditor rotation – the last in Houston having dragged through October 18 with no observable contribution to our wisdom – until he held one in the junior high school gym in Punxsutawney itself.

A tour of media, commentators, and those knowledgeable, confirms the prevailing sense of lassitude and ennui – owing much to the nationwide American paralysis ahead of its November 6 elections, but also to the absence of any credible display of energy, much less urgency, around the issues overhanging the accounting profession.

The usual crabbing continues, of course – ranging from the ineffective if age-old grousing about auditor skepticism -- vented by the PCAOB chair himself, webinars from the private sector, and such bloggers as the Grumpy Old Accountants – to the commenter on my last posting, about the British regulator’s new policy on re-tendering, stating mistakenly that I “ask for ‘proof’ that lack of auditor rotation is a cause of fraud,” when I want no such impossible thing, but only recognition, as I have often said (see here) of the absence of “any evidence of a link between auditor tenure and audit quality.”

In the gathering gloom and darkness of late autumn, then:

Nothing good can be expected from the Securities and Exchange Commission in Washington, where Chairman Mary Schapiro is said to be packing for her post-election departure, having in her light-touch tenure realized nothing of effect on the structure or stability of the assurance function. 

On the globalization of accounting standards, the dialog is if anything more sterile than ever: The SEC has only an interim chief accountant in place; the griping about non-convergence includes the hand-wringing of IASB trustee chairman Michel Prada and the sideline irrelevancies of AICPA president Barry Melancon; while FASB chair Leslie Seidman should be plainly tired of the censorious Dutch-uncle utterances of her counterpart at the IASB, chairman and non-accountant Hans Hoogervorst.  

While on the auditing standards side, the intellectual heft brought by the International Auditing and Assurance Standards Board to its project on Improving the Auditor’s Report is unmatched by the political skills or horse-power necessary for action in the face of entrenched resistance. At the same time, the PCAOB’s parallel Concept Release, going back to June 2011 – which by rights should be cooperative and complementary – wallows becalmed for lack of any readiness to re-engineer a reporting system in which all interested parties are invested in preserving the status quo.

Even what should be a bright spot – the launch earlier this month by seven joint sponsors of an assessment tool for audit committees, “Annual Evaluation of the External Auditor” – designed to support “an informed recommendation to the respective board of directors whether to retain the auditor,” has the taste of very thin gruel.

That is, it says precious little about the skill level of an audit committee, to think it requires such an anodyne checklist as these “get-to-‘yes’” examples: 

• “Was the cost of the audit reasonable and sufficient for the size, complexity and risks of the company?”

• “Was the audit engagement partner able to explain accounting and auditing issues in an understandable manner?”

Enough with the softball treatment. For a committee obliged to justify itself, why are there not such substantial questions as:

• “What qualifications and training does the audit committee itself have in the exercise of skepticism and the avoidance of bias?"

• “If forced to rotate or re-tender the audit, does the company have a realistic alternative choice?” 

• “What other or different forms of assurance, beyond the current standard audit report, would company management and its community of information users find useful and valuable?”

Historians of the evolution of knowledge teach that systems on the cusp of obsolescence – inherently resistant to the disruptions of fundamental change – evolve only when those contributing to the prevailing inertia are forced into confrontation. 

But that when they are, the realignments are highly disruptive, in ways unpredictable in advance.

Meaning that the groundhog’s looming shadow is long, dark and ominous.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both on the Main page.

 

 

 

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

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

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

Nor has the decade horribilis given any reason to change.

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

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

Rather, some unasked questions should be advanced.

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

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

As for those purporting to see some claim of benefit, yet propounding no solutions to the continued eruptions of financial chicanery (here, here and here), the challenge remains that the cyclical nature of market bubbles makes inevitable a post-scandal period of cleansing and temporary return to virtue – political dynamics notwithstanding.  

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

 

 

---

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

GAAP / IFRS Convergence -- Has the SEC Finally Shut It Down At Last?

With the news on July 10 that the SEC staff’s now-published report on International Financial Reporting Standards would not include a recommendation on whether, when or how the US should get on board, I observed that the whole benighted exercise of “convergence” between IFRS and US GAAP was now, finally and deservedly, dead and buried. 

A knowledgeable reporter pushed back, writing that, “it ain’t over till it’s over.”

Let’s take a look, because it’s hard to be any more “over” than this.

My own view on the desirability of accounting standards convergence fits nowhere on the spectrum of advocacy, from David Albrecht’s “buy American” to Tom Selling’s pleas for intellectual integrity to Yale professor Shyam Sunder’s support for competing systems – much less the profession’s own hand-clapping for the endless process of inching IFRS and US GAAP together.

Rather, without a dog in the fight, I’ve long been convinced that the complexities and judgments within any of the competing sets of standards present ample opportunity for issuers’ self-service and manipulation, beyond the capability and competence of regulators and gate-keepers to achieve transparency or comparability, thus rendering the convergence debate mainly a serious distraction and waste of time and energy.

As I’ve been saying for years (e.g., May 2008), the politicized nature of the process -- including the endless maneuvering and circular finger-pointing among the Financial Accounting Standards Board, the International Accounting Standards Board, and regulators in Washington, London and Brussels -- far outstrips either the case for convergence or the vision and competence of the players to achieve it, even if they wanted to, which they don’t. There is simply neither leadership nor authority to overcome the mutually antagonistic forces – as summarized here in March 2010.

Which only becomes more pronounced with the departure of the SEC’s chief accountant, James Kroeker. As I wrote in May 2010, Chairman Mary Schapiro has shown little energy for the issue – whether from disinterest or under an agenda of more pressing concerns.

As I put it in April 2011:

“Why no-one has called the question on this endless charade reflects the two-level fantasy in the dialog: the IASB and the FASB both pretend to believe in the desirability of fully-converged accounting standards, and the community of financial statement issuers and users pretend to believe them.”  

So why the persistence of this endless exercise – so stalemated that if Saul’s trip to Damascus had depended on an SEC-like “roadmap,” his conversion would never have happened and Christianity would have remained a minor Galilean sect? 

It’s because at bottom, the situation is not so distressed as to call forth real change.

Across great arcs of history, systems degrade toward collapse – Ptolemaic astronomy, the Weimar Republic, American health care. But they only reach the point of fundamental change on two conditions:

• First, the case for change is not only recognized by its advocates, but endorsed by (or more likely, forced upon) the entrenched interests of the status quo.

• And second, that an alternative paradigm is available – as evolution does not occur in a vacuum.[1]    

No less than the examples cited, there is deep and wide dissatisfaction with the current state of financial accounting, reporting and assurance. But it is also true that broad sectors remain committed, like the ancient stargazers, to structures as creaky and obsolete as geocentric models for planetary motion. Namely: 

• Financial statement issuers prefer accounting principles flexible enough to yield their preferred results.

• The first instinct of regulators is to protect and expand their limited turf.

• And the gate-keepers survive on a model unevolved since Victorian times.  

Commentators may continue to assert that there are real mileposts down a possible road to GAAP/IFRS convergence.

But from here, there is no other end: the road for this dead horse is a short haul to the knacker’s yard.

 

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

 

---

[1] See, e.g., Thomas Kuhn’s far-reaching 1962 essay, “The Structure of Scientific Revolutions”.

Watch This Space -- The Academics are Coming

 August in Washington? You’ve got to be kidding. Not even the national politicians are dumb enough to hang around that malarial swamp. 

So what could be better?

Answer: three days in a monster convention center in suburban Maryland, at the annual meeting of the American Accounting Association. At least my own registration is now in and official.

Of my two gigs there, the heavy lifting will be a panel on August 6 on “Rationalism in Accounting.”

Okay, stop the snickering! Just because such cringe-inducing pronouncements as the joint mash-up of the IASB and the FASB on lease expensing make the title of the panel sound as oxymoronic as "Jamie Dimon on risk management” or "François Hollande on French political leadership.” Teaser: leading the roster of smart people among whom I will struggle to keep up is always thoughtful Shyam Sunder of Yale – recently readable on this topic here. So at least have the good manners to hold your derision until you’ve sat in on the session.

The second should be more relaxed, and worth sticking around until the last afternoon – Dave Albrecht of The Summa hosting on the fun and games of blogging about the interesting issues that convene this group of party animals. 

Hope to see many of you there. Until then, enjoy the summer.

 

Comments and suggestions are always welcome, and subscription sign-up is easy and free -- both at the Main page.

Dixon Illinois: Fifty Three Million Dollars Go Missing -- So Who Let the Horses Out?

 

    Trust – but verify.

            -- Ronald Reagan 

The revelation of a $ 53 million embezzlement by the treasurer and comptroller of the city of Dixon Illinois – home of the 40^th American president – once again brings this to the fore:

“Why are the accountants still so bewildered that there should be an ‘expectations gap’?”

According to her criminal indictment released on May 1, Rita Crundwell went undetected since 1990 in accumulating all the appurtenances of a life of rural luxury – not only the typical clothing and jewelry, but trucks and trailers, Liberty Coach motor home and Ford Thunderbird convertible -- all supporting her sideline prominence in the boots-and-bling world of quarterhorse breeders (here).

Extractions of that magnitude, from the coffers of a city with an annual budget of only $ 8 to $ 9 million, might have required her full-time devotion to shoveling the cash with both hands. But the self-efficient Ms. Crundwell did not scruple to observe four full weeks of paid vacation each year, and was evidently only caught out when she extended her absence to an additional twelve weeks.

Separation of employees’ duties? Back-up authority that someone else should glance at the city’s checkbook? Allowing her family members to pick up the city’s mail while she was on her holidays? Could the demands of minding the city’s affairs be so simple, naive and blasé, even in the exurban Midwest?

As for the expected queries (here and here) – what about the gatekeepers at the corral?

A large regional accounting firm is reported to have done compilation services for the city since 2006, having done audits in prior years.[1] But the distinction has so far not been explored.

Which, borrowing a metaphor from Ms. Crundwell’s expensive equestrian hobby, is to beat a sad and very dead horse. Because, as the professionals are in the process of learning to their sorrow, simple proximity and association are enough to attract whole worlds of grief.

The International Auditing and Assurance Standards Board – source of auditing standards on a global basis – on March 16 issued a new version of guidance on the performance of compilations:

"Since a compilation engagement is not an assurance engagement, a compilation engagement does not require the practitioner to verify the accuracy or completeness of the information provided by management for the compilation, or otherwise to gather evidence to express an audit opinion or a review conclusion on the preparation of the financial information."

The IAASB also speaks to the intended use of compiled financial statements, however, posing the question whether: 

"External parties other than the intended users of the compiled financial information are likely to associate the practitioner with the financial information, and there is a risk that the level of the practitioner’s involvement with the information may be misunderstood …"

What the IAASB does not offer – understandably, considering the many settings in which full-blown audits are not worth the cost or effort involved – is aide to either the profession or the user community on a necessary risk-based inquiry:

“Just because a service can be done, does it make any sense and should it be done?”

The accounting profession, mistakenly relying on disclosure of the limits on what a compilation report does or does not say, has traditionally looked on that 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?

A typical compilation report – while offering no opinion – does recite that the accountant has performed with appropriate skill, ethics and the exercise of appropriate professional judgment. But that is all it takes to get burned.

I have tried to get across, both to my students in Risk Management and to my friends and clients in the profession, that for one caught holding an empty gasoline can, while standing next to a suspicious conflagration, it is not easy to avoid suspicion of arson. The explanation goes down hard, that the container was an innocent impulse purchase at the local hardware store.

As both an exercise for law and business students, and a message in the real world: there is no harm in not wearing a seatbelt, most of the time – or in not locking the barn door. Except for the rare time when it isn’t okay – and then it really matters. A long record of “being lucky” or a history of “getting by” counts for nothing when a bad event exposes the devastation wrought by casual habits.

How accountable the good townsfolk of Dixon will hold their city fathers for the quality of their stewardship – and whatever the exit cost may ultimately be, for a blinkered exercise in the assessment of risk and exposure to Crundwell’s plundering – it is once more made crystal clear that the accounting profession continues to market services that are under-comprehended and over-sold.

 

Thanks for joining this dialogue. Comments are welcome, and subscription is easy and free, both at the Main page.

---

[1] My requests to the firm’s media contact for an opportunity to converse have not been answered.

Unification of Global Accounting Standards? It's Time to Call Time

On the substance beneath the unending, noisy and fruitless wrangling over the relationship between generally accepted accounting principles in the United States and the International Financial Reporting Standards, there is no more trenchant observer than Tom Selling. 

Tom’s recent three-piece series in The Accounting Onion – “Ten Claims in Support of IFRS Adoption by the SEC – and Why They are False” -- is required reading for all who are interested in why “debits equal credits.” But while Tom is among the advocates for the superiority of American standards, my own position – agreeing with his conclusion -- is agnostic on the relative quality of the two systems.

Here’s why: It just doesn’t matter.

Even if, by whatever name, “convergence” were desirable (and Tom is persuasive that the case is not made), it is not achievable. The entire effort is massively distracting and a colossal waste of time, energy and resources.

There are three reasons:

First, deferential as I am to others far more versed in the accounting literature, I rely on deep-background guidance from a friendly expert with world-class credentials. This impeccable source provides a crystal-clear message, that the manifold complexities and range of judgmental decision within either of these sets of standards are so extensive as to render illusory any sense of transparency or comparability.

We are past the point, in short, that anything in quality of standards can be gained through the wrenching process of forced amalgamation of the two.

Second, on the pure politics of convergence – whether by SEC adoption of IFRS or otherwise – the simple truth is that the American regulators lack the will, the skill and the patience to navigate the path.

Just as, ten years after the passage of Sarbanes/Oxley, the PCAOB is only now making faltering steps toward an international presence, and remains entirely shut out of China and a host of other markets, the SEC’s proposed “roadmap” to convergence is yellowed and brittle with age and disuse, while the speechmakers’ superficially supportive platitudes fail to offer any substantive indication of actual progress down the road.

Finally, it is time to acknowledge the application to the GAAP/IFRS dysfunction of a basic principle observed on large-scale projects of social and political importance.

Which is that once the timetable for a complex undertaking begins to slide, its ultimate and successful completion date only gets farther away, at ever-increasing cost and ever-higher risk of total failure.

Sketched out in Nassim Nicholas Taleb’s incisive but frustrating and much mis-understood book, “The Black Swan” (of which my May 2007 review in the International Herald Tribune is here), the proposition is readily illustrated by public works projects, diplomatic initiatives and military actions:

• The Sydney Opera House, scheduled for completion in 1963, was ten years late and fourteen times over its original $ 7 million budget.

• Peace in the Middle East, fraught enough as of the Balfour Declaration of 1917, drew further away with the creation of an independent Israel in 1948 and today is more distant than ever.

• President Bush’s 2003 announcement of the conclusion of primary hostilities in Iraq, standing on the aircraft carrier USS Abraham Lincoln under the banner “Mission Accomplished,” was cruelly premature to the extent of thousands of casualties, billions of dollars and the onward spread of violence and destruction.

To use “input measures” can be grievously misleading, in short, whether measured by budgets spent to date, diplomats’ lofty promises or the number of boots on the ground. 

The same for agency posturing on the differences between IFRS and US GAAP – on which the agenda of unfinished business grows no shorter, even as the world of financial reporting continuously presents new and challenging reasons to grind the process onward forever.

There are more than enough divergent and antagonistic interests competing in the accounting standards “debate” to drive the conclusion that reconciliation will not ever occur, even if deemed desirable by many of good will and genuine bona fides.

So – let in the fresh air of reality. Let the global markets decide – US GAAP or IFRS, or other frameworks able to compete for attention and adoption. Let the energy and intelligence currently being wasted be deployed to goals worthy of the attention of the participants and realistically susceptible to beneficial solutions.

 

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

 

 

Mandatory Auditor Rotation -- The PCAOB Bites Off More Than It Can Chew

            “The unspeakable chasing the uneatable.”

Oscar Wilde’s description of English fox-hunting captures the spirit of the two days staged in Washington on March 21-22 by the Public Company Accounting Oversight Board – in aide of illumination on mandatory auditor rotation.

(The PCAOB’s release of August 2011 announced its initiative; it links to the overwhelmingly negative public reaction. My own long-standing pessimism is partly here, here and here.)

Thankfully unable to attend, due to classroom commitments, I salute those brave and durable enough to have done – although the tedium of the webcasts accuses anyone without handsome compensation of not having enough to do.

Which is to say, the offerings from the 47 speakers crammed into the panel sessions were entirely predictable. The maxim was reinforced conclusively that the amount of intelligent substance in any agency proceeding is an upwardly-bounded constant -- the only variable being the number of witnesses among whom it is thinly spread.

Examples included the panels of academics and “investor representatives,” whose perfervid but anecdotal pro-rotation rhetoric was untroubled by the continuing absence of any relevant empirical evidence associating auditor tenure with audit quality; Paul Volcker’s plangent if irrelevant reminiscence of his brief and inconsequential association in 2002 with Arthur Andersen’s terminal state; and Jack Ciesielski’s attempt to revive the notion that insurance might backstop the auditors – a fantasy lacking credibility and long discredited (here) by the insurance industry’s manifest lack of interest.

Careful assessment of the PCAOB house-party reveals neither an empirical case for mandatory rotation nor the supportive votes among its members – leaving this question:

What will political pressure oblige the PCAOB’s members to bring forward by way of action?     

Between the poles of the speakers' antagonisms, there are the faint outlines of plausible mid-range approaches:

To start – noting a plain truth by former SEC general counsel David Becker, that individual cases for mandated auditor rotation are “intensely situational”– support now emerges for the PCAOB’s use of enforcement-based mandated rotation (e.g., Harvey Pitt).

Well -- “right on,” but also “about time.” Having written to this effect way back in August 2011 (here), I put it this way:

“…In a specific case, if the PCAOB can sustain its proof that long audit tenure was causally related to its definition of “audit failure,” it could include rotation in its toolkit of post-inspection sanctions.

“Since the PCAOB looks annually at a sampling of engagements for each of the large audit firms, and claims to target its inspections on the basis of perceived engagement risk and exposure, the agency’s experience base should bring to light cases – if any – where audit quality might be affected by length of tenure.  

“In which case, rotation could be proposed, and if necessary, imposed.” 

The other way forward comes in two flavors – either of which would allow PCAOB chairman James Doty to declare victory; would be tolerable to the profession; and, unlike mandated rotation, would actually be achievable in the large company audit market.

The first would be by way of periodic mandatory re-tender, with the incumbent auditor eligible to be re-engaged. The estimable Bob Pozen, one of chairman Doty's "rock stars," proposed 14 years (here), so as to allow for three individual partner rotations. Others proposed far shorter periods, although five or seven years would be too short, causing the profession to spend endless time and waste prodigious sums in a musical-chairs chase for business.

Compromise should be possible. If potential replacement auditors had the commercial choice of giving up ancillary services for their clients – tax, consulting, valuation – in order to be eligible to take up the audit, the market itself would determine the range of choice and competition. That has to be better than leaving such bright lines to be drawn under the dim vision of the regulators.

The second alternative places focus on the responsibilities of corporate audit committees – supported by former SEC chairmen Richard Breeden and Harvey Pitt among many others. That body would be obliged periodically to justify the continued engagement of a long tenured auditor – a process of “comply or explain” -- not difficult for a good quality committee.

Failing which the PCAOB, challenged to focus its inspection attention on long-lasting relationships, could determine that a dysfunctional audit committee amounted to a material corporate control weakness, justifying the requirement of a re-tendering.

I have crawled out on numerous shaky limbs, and survived. So I am prepared to predict here that some variant of these ideas will emerge at the seemingly endless end of the PCAOB’s process.

(Other and deeper problems would remain untouched, much less unresolved by this outcome, unfortunately, such as the basic value and usefulness of today’s accounting and reporting model itself, the relevance of audits, and the very existential viability of the private audit franchise – all subjects postponed to other days.)

Meanwhile, audit committee leadership on either re-tendering or “comply or explain” would not cause the world of audit to come crashing down. The actual effect would be modest at most.

Which in a world of knee-jerk critics and short-sighted regulators would be no small thing -- and one the community of financial statement users could very well live with.

 

Thanks for joining this dialogue. Comments are welcome, and subscription is easy and free, both at the Home page.

 

Audit Reform in the European Union -- Michel Barnier Delivers A Holiday Turkey

On November 30, European Union markets commissioner Michel Barnier released the biggest turkey of the Thanksgiving holiday. 

His “final” proposal to re-engineer the structure and business model of the large accounting firms (here) is much revised from the draft leaked in September, resembling the original no more than does turkey hash its original hormone-injected source – “fowl” though they both are.

Press reports, speculating about its parentage and legitimacy, hinted darkly that delays reflected the heavy-handed influence of the large firms or other, unnamed lobbying interests – here and here.

But the Big Four firms should only be so effective as to deserve such finger-pointing. Contrasted with lobbying experts Fannie Mae and Freddie Mac, Big Tobacco or the National Rifle Association, who have all the political access that unlimited money can buy, the poor accounting profession has been consistently rolled over – without a real legislative success since passage of the American securities laws in 1933 and 1934.

A neutral observer could only be offended by the tendentious tone of Barnier’s unsupported assertions, of which an abbreviated sample (emphasis added):

• “The lack of regular tendering of audit services and periodic rotation of audit firms has deprived audit of its key ethos: professional skepticism.”

• “(T)he prohibition of the provision of non-audit services in general would effectively address the need to reinforce independence and professional skepticism.”

• “(T)he introduction of mandatory audit firm rotation would contribute to higher quality audits.”

• “The appointment of more than one statutory auditor … would … contribute to increasing audit quality.”

A full list of the howlers in Barnier’s proposed regulation defies reasonable length limits here. But for a partial catalog: 

• No single client could sustainably represent more than 15% of a firm’s total annual fees (Art. 9) – a limitation with nasty if unanticipated potential consequences for the ability of smaller firms to ramp up their competitive scale at the upper end of the client size range.

• The broad prohibition of Article 10 on non-audit services to clients – the full range from expert services to valuation, technology consulting and legal and brokerage – would extend to network members and to client parents and foreign subsidiaries – thus clashing with permissible scope-of-services in the entire non-European world. 

• The further obligation of the large firms to hive off all their non-audit capabilities (Art. 10, § 5) would apply to their non-EU networks’ operations within the EU, thus forcing any ex-EU company to incur the cost and disruption of dividing its otherwise-permitted non-audit service engagements between a Big Four firm and another, unrelated niche provider.

• The requirement that statutory auditors provide their own annual financial reports would oblige those to be audited themselves, at both the firm and network level (Art. 26.2 and 26.3(d)).

• Not only would rotation be mandatory under Article 33 – every six years (extended to 9 years for optional joint audits). But invitations-to-tender would be required from at least two non-incumbent choices (Art. 32.2), of which one must be such a small firm that it could derive not more than 15% of its audit fees from large companies, as defined (Art. 32.3(a)).

Therein lies a recipe for paralysis for large-company audit committees. Audit competence is built on both scale and industry expertise – so the small-firm ceiling would assure that an invitee to tender would lack the size and breadth of experience to provide adequate service, while outreach to two other Big Four firms would clash against the global-level disqualifications of networks serving a client’s ex-EU needs.

• “Contingency plans” are to be required from the large firms to address life-threatening events (Art. 43) – as if there could be disruption avoidance from the impact of a “black swan” litigation or law enforcement sanction.

That’s because, unlike a corporation’s ability to continue in supervised on-going operation as debtor-in-possession, the private accounting partnerships have no retention hold on their partners or staff, whose rapid departure – proved in the case of Arthur Andersen in 2002 – would make Barnier’s “orderly failure” an oxymoron beyond his irony-deficient comprehension. 

• The revised requirements of a re-designed audit report (Art. 21) would include 23 sub-sections, adding such new information as the length of audit tenure (§ e), the extent of direct balance sheet verification (§ h), the details of materiality (§ j), and the identity of each member of the audit team (§ q).

Potentially useful and worthy of debate, some of these may be -- yet quoting § 22.4, “the audit report shall not be longer than four pages or 10,000 characters (without spaces).”

This one is a real pip – in a different league from Barnier’s quest to impose mandatory rotation. Because it is routine that a large-company audit team has a headcount above 100 members, Barnier’s four-page limit would be exceeded by a list of personnel all by itself! 

What explains Barnier’s inability to grasp the complexities of the matrix of relationships among financial statement users, auditors and users? Perhaps it’s a simple matter of provincial bias, and lack of vision flowing down to reach its own level.

Else it’s the basic principle taught in nursery schools: 

Give a toddler a hammer to play with, and expect breakage in the toy room. 

 

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

 

 

The PCAOB Wants to Name Audit Engagement Partners: Would Its "Red A" Really Matter?

As if it didn’t have real work to do, the Public Company Accounting Oversight Board in its October 11 release has revived its 2009 project, looking to require audit firms to disclose the names of their responsible engagement partners.

 With its persistent instinct for the capillary, the PCAOB presses for information that is:

•  Of no consequence to financial statement users sophisticated and informed enough to appreciate the complexity of a large audit.

• Of indifference to the bulk of the investor population already hard pressed to identify the firm auditing their portfolio companies.

•  Of interest mainly to the unremitting critics of the profession, for whom access to individual names would only fuel their continued antagonistic and unproductive axe-grinding.

Here’s a message for both sides: It’s a bogus issue, and not worth the distraction from serious matters.

Such as, first, the PCAOB’s own release of June 21, re-visiting the scope and content of the recognizably obsolete standard auditor’s report. A substantial discussion is now ready to start, that should include the responsibilities of issuers’ management and audit committees (some 150 comment letters are accumulating here). If only the PCAOB could align with the parallel undertaking of the IAASB, a truly coherent and comprehensive international dialog might constructively emerge (see here).

Second, it may be that the division in views of the PCAOB members on mandatory auditor rotation means that this time-worn subject was served up yet again, on August 16 (here), only to be killed off once for all. Here the problem is that, as selectively leaked, EU markets commissioner Michel Barnier has not only tabled mandatory rotation himself; in his enthusiasm, he threatens also to require joint audits with responsibility shared among multiple firms, and would also strip all non-audit services from the firms’ business models (here).

Time enough, when the details of Barnier’s proposals emerge for public scrutiny next month, to probe the fanciful and unrealistic nature of his expectations. That will also be the time for more vigorous and effective responses than are usual by all those concerned – large and small audit firms alike, along with their clients with whom in this area they have common cause -- to the destabilizing and dangerous effects of Barnier’s combined naïveté, ignorance and political zealotry.

Meanwhile, back to the naming of names:

Those charged with auditor selection already have access, on request, to the details of personnel identity and qualifications.

While over on the side of public “transparency,” branding individual auditors with the scarlet letter “A” might give satisfaction akin to that of the censorious townsfolk around Nathaniel Hawthorne’s Hester Prynne.

But to what end? As recognized at least by PCAOB member Lewis Ferguson (here), any engagement partner whose work is caught up in multi-year civil litigation and regulatory enforcement effectively suffers the end of his productive career – even if judgment-proof and indemnified – not only because of the overwhelmingly distracting time demands but because the emotional toll of defending even high-quality performance is ruinous to the capacity to exercise complex professional judgment.   

Which does not, on the other hand, mean that the US profession’s resistance to partner identification is a “hill worth dying on.” Partner signature is the practice around Europe, and some European filers so disclose in their NYSE filings, as chairman Doty has noted (here). As the world is not coming to an end thereby, a proof-seeking skeptic might well ask this: Are European shareholders really so “favored” over their American counterparts, as Doty suggests, or is it rather that the markets have compared the availability of partner names, and yawned with boredom?

Beyond partner names, the PCAOB goes off into another disclosure area, although reflection may suggest it has left a major hostage to fortune – namely, the proposed requirement that auditors disclose the names and work efforts of other firms, in their networks or otherwise, participating in their engagements.

Again, this is a matter on which investors have shown indifference – it being impossible to imagine that they are really engrossed on the subject, when they must suppose that local country rules on professional qualifications and rights to practice would be no less applicable for auditors than, e.g., for lawyers or doctors.

But given the back-footed positions of the SEC and the PCAOB on such matters as the recent scandals among the Chinese reverse-merger companies coming to the US capital markets, and the still-lengthy roster of ex-US firms and issuers not subject to the PCAOB’s halting efforts beyond its native soil (re-capped by Francine McKenna here), it might seem a dubious judgment for the PCAOB to encourage public airing of the gaping holes in its inspection and enforcement regime.

In other words, “be careful what you ask for” – advice perhaps not high on the list of commentary welcome in the halls of the PCAOB. But then, an agency capable of addressing mandatory auditor rotation with a straight face is equally liable elsewhere to trip onto its chin and mistake the pratfall for forward progress.

 

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

 

 

UBS: Roguery at the Bank Provides a Teaching Moment

Kweku Adoboli has done me a great favor.

Many others could not say the same. They include Oswald Grüber, Carsten Kengeter and Maureen Miskovic – the chief executive, head of investment banking and senior risk officer of UBS – whose balance sheet the 31-year-old trader has blown up to the tune of $ 2.3 billion, through the unimaginative if devastating use of fictitious customer trades to mask his massive wrong-way bets on the S&P 500 and other major indices.

While Adolboli will stay another month in custody in London, and Grüber’s team of gnomes in Zurich begin the extended process of damage assessment and control of this latest outbreak at the troubled bank, I have the privilege of bringing to a seminar at the University of Chicago Law School the MBA-level course in Risk Management I have taught at business schools these last three years.

Arrested on the third anniversary of the collapse of Lehman Brothers, Adoboli not only lets me throw out the opening pages of my introductory lecture notes, on the inevitable eruption of large-scale unmanaged risks in complex systems. He also replaces Société Générale’s Jérôme Kerviel as a final exam topic on the test question, “Where’s the rogue?” 

In the law school environment, we will explore the proposition freshly demonstrated at UBS, that compliance-oriented risk systems – limited in concept, execution and assurance to the narrow and unsatisfactory conclusion that “most things are working, most of the time” – are both wasteful and ineffective to detect or deter an existential threat.

It’s as true for a rogue trader as for a suicide terrorist: doing pat-downs or box-ticks of an entire population, whether grandmothers on airplanes or bank clerks writing customer orders, will not stop the dangerous deviant capable of causing a blow-up – however much those intrusive and costly procedures may serve the political goal of lulling both leaders and constituents into a false if harassed sense of security.

In context of Adoboli’s shenanigans, said to date back to 2008 when UBS itself was bailed out of the consequences of its ill-fated venture into subprime mortgage-backed derivatives, on through its climb-down before the Justice Department over the business of sheltering US taxpayers, there is painful irony in reading the bank’s self-congratulation on the subject of its risk management. Take, for example, excerpts from its 2010 annual report:

“Operational risk is the risk resulting from inadequate or failed internal processes, human error and systems failure, or from external causes (deliberate, accidental or natural). Events may be manifested as direct financial losses or indirectly in the form of revenue forgone as a result of business suspension. They may also result in damage to our reputation and to our franchise causing longer term financial consequences.

“Managing risk is a core element of our business activities, and operational risk is an inevitable consequence of being in business. Our aim is not to eliminate every source of operational risk, but to provide a framework that supports the identification and assessment of all material operational risks and their potential concentrations in order to achieve an appropriate balance between risk and return.

“… Management, in all functions, is responsible for establishing an appropriate operational risk management environment, including the establishment and maintenance of robust internal controls and a strong risk culture.” (All emphasis added.)

With that, a question could be posed to Mr. Grüber concerning the bank’s reported 2010 payment of fees to Ernst & Young of 67.4 million Swiss francs ($ 59 million at today’s exchange), of which CHF 58.5 million were classified as audit, to obtain the latest annual version of a standard auditor’s report:

“With hindsight, how badly would you have wished to re-direct some portion of that audit fee to an engagement to conduct a precise and effectively directed, root-and-branch scrutiny of the condition of the controls at the sections of your bank having potential to inflict multi-billion dollar harm?”

Because herein lies the puzzle, about the unavailability of such valuable assurance to replace today’s outmoded commodity product:

In launching its concept release on the auditors’ report, Public Company Accounting Oversight Board chairman James Doty’s June 21, 2011 statement acknowledged “generalized investor dissatisfaction with the pass-fail model, and generalized frustration with auditors who had issued unqualified opinions on the financial statements of banks that later failed.”

And yet -- the entire community of financial statement issuers, users, regulators and auditors remain committed to what one comment letter notes as “the PCAOB’s intent to retain the current (‘pass/fail’) form of the auditor’s report.” As stated, there is “overwhelming support from all stakeholder groups for retaining this long-standing approach to auditor reporting.”

Why?

Kweku Adoboli now stands as poster boy for the unrecognized urgency of replacing that model.

 

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

Mandatory Auditor Rotation: If PCAOB Sanctions Were "Case-By-Case"

The Concept Release on auditor independence and mandatory rotation, issued by the Public Company Accounting Oversight Board on August 16, sought comments. Believing that those who presume to offer commentary should include potential solutions along with their griping, I put forward these thoughts: 

There is a way that rotation could be tried and tested without the cost, disruption and doubtful achievability of a wide-scale requirement – problems that leave me and most others so skeptical.

Which is that in a specific case, if the PCAOB can sustain its proof that long audit tenure was causally related to its definition of “audit failure,” it could include rotation in its toolkit of post-inspection sanctions.

Since the PCAOB looks annually at a sampling of engagements for each of the large audit firms, and claims to target its inspections on the basis of perceived engagement risk and exposure, the agency’s experience base should bring to light cases – if any – where audit quality might be affected by length of tenure.  

In which case, rotation could be proposed, and if necessary, imposed.

The sanction would not be an enforcement reach, if a credible case were made – the agency could act on its own statutory authority or in coordination with the powers of the SEC. (See the SEC’s imposition of a government-appointed monitor on KPMG as part of the 2005 resolution of the criminal investigation of its tax-shelter practice, or the six-month bar on new SEC clients imposed on Ernst & Young in 2004 for its impaired independence arising out of business relationships with its audit client PeopleSoft.)

Due process and negotiations would sort out the appropriate cases to require rotation. Many cases of financial statement failure – contrasted with the Concept Release’s definition of “audit failure” as involving alleged deficiencies in audit work alone – result in termination of the auditor/client engagement in any event, and would fall out. Other inspection cases would involve causal facts unrelated to tenure – such as personnel competence or supervision – making rotation a doubtful remedy. And since real sanctions would presumably only be applied in a publicly transparent environment, the PCAOB would achieve the disclosure it professes to desire (here) -- along with the obligation to establish the credibility of its findings.

Rotation if proposed as a sanction would allow the incumbent auditor to be heard and argue its case – or perhaps even to settle with an agreement to stand down. It would also open the record to possible resistance by a non-US regulator, in the especially challenging cross-border cases involving global companies (here) – as well as to the fact-based airing of issues of impracticality or constrained choices of successors. 

(By the way, a free-market evaluation of possible limits on alternative auditor choice could be made through the sanction of mandatory re-tender -- as opposed to the perhaps harsher remedy of outright rotation.)

The principle of “first, do no harm” was cited by PCAOB member Lewis Ferguson in his statement on the Concept Release. Case-by-case use of rotation as a sanction would satisfy the corollary: anticipate unintended consequences whenever possible, and do minimal harm in any event.

Selective required rotation would also address an emerging issue in the effectiveness of policy choices – a topic treated in my MBA-level course in Risk Management.

Namely, examples are increasingly discovered that where instances of non-compliance are serious – but rare and tightly clustered -- the deployment of a broad, sweeping enforcement program is likely to be both wasteful of scarce resources and ineffectual in achieving the desired goal.

Three examples:

• With the progress in control of automobile exhaust emissions, it is massively wasteful in administrative costs and car-owner time to require on-site tests for late model cars. The miniscule percentage of vehicles that generate most of the pollution can instead be detected by inexpensive, portable drive-by testing, with immediate ticketing and impoundment.

• The billions in costs and inconvenience inflicted on airline passengers by security programs, accomplishing only inconvenience and embarrassing privacy intrusions, have negligible anti-terrorist effect, compared with the highly sophisticated results of effective data-tracking and suspect profiling.

• And among the population of urban homeless, the great bulk of the cost of scarce resources for shelter, law enforcement and emergency medical care is consumed by a tiny fraction – who are more effectively addressed through individual identification and tailored attention.  

Mandated rotation in those rare cases where tenure length might demonstrably be an issue presents a similar environment. Audit failures being real, but also rare, across the entire time-line of auditor tenure, there has not even been a proper study, much less a showing, that length of tenure is a causal factor. 

So enforcement sanctions, including rotation, should be conserved and only deployed accordingly.

To summarize: individualized mandatory auditor/client rotation could be used as an appropriate case-by-case sanction – if but only if the PCAOB can persuasively show a basis. 

Or as Messrs. Gilbert & Sullivan’s Mikado nearly put it in 1885:

“An object all sublime

“They shall achieve in time --

“To let the punishment fit the crime.”

  

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

 

Mandatory Auditor Rotation -- The PCAOB Sails Off the Charts

“Otter: We could do it with conventional weapons, but that could take years and cost millions of lives. No, I think …that this situation absolutely requires a really futile and stupid gesture be done on somebody's part!

“Bluto: We're just the guys to do it.”

            “Animal House,” 1978

The Public Company Accounting Oversight Board's August 16 release and statements pose this central question on auditor independence and the prospect of attempted mandatory rotation:

“Will term limits, set at some appropriate length, with due regard for implementation complexities, reduce the pressures auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets?”

With all the ambiguity, nonsense and denial right there, focus on mandatory rotation. Time enough to come back to independence, when readers of stout constitution have stocked up enough antacid to alleviate their heartburn in digesting the Concept Release itself.

Consensus unhappiness with the current audit model and the historical “pass/fail” auditor’s report (alluded to by PCAOB member Jay Hanson and as I have discussed here) has, unsurprisingly, not strengthened the tissue-thin case for mandatory auditor rotation. Proof of weakness is, in this case, reciprocal with weakness of proof.

Each of the PCAOB members’ statements nods to the decades-old and too-familiar positions on rotation – Chairman Doty himself managing to mix up a metaphor that only a land-locked Texan could love:

“The learning curve, and cost-based issues involved in changing audit firms, cannot be fairly described as uncharted waters.” 

I have charted these waters, near and far (e.g., here and here) – so, not to repeat, this report from the distant end of Chairman Doty’s learning curve:

The world outside the United States is still terra incognita to the PCAOB, whose parochial approach has ignored the barriers to implementation of rotation on the large-company scale – the only sector where the issue should matter at all.

Between now and the public roundtable scheduled for March 2012, two matters of compelling impracticality should be on the table.

First is the PCAOB’s limited ex-US authority. Although the agency proclaims robust worldwide impact (e.g., the Chairman’s speech, here), its record is otherwise, and suspect.

Instead, the PCAOB has shown itself all too lacking in ability to operate effectively outside the US at all – witness the empty-handed return of its mission last month to China – a market from which the agency has been completely excluded although China has emerged in the last year as a major exporter to America of corporate malfeasance and shenanigans (tracked by Kevin LaCroix’s D&O Diary and even on the screen of researchers at the PCAOB itself).

Were the PCAOB to attempt mandated auditor rotation outside the United States, the consequences – fully foreseeable, and obnoxious -- would range from securities trading prohibitions on the American exchanges, to considerably irritated securities and accountancy regulators in countries understandably miffed at the infringements on their sovereignty.

Picture, for example, the situations of Deutsche Bank, audited in Germany by KPMG, or Sociéte Générale, audited jointly in France by Ernst & Young and Deloitte.

Even if replacement auditors were available, whether in the US or elsewhere – which is far from a certainty (see below) – it defies both logic and imagination to think that audit quality could be improved by obliging a German or French--based parent to engage an additional new audit firm to achieve a single opinion on its consolidated worldwide financial statements.  

As for auditor displacement at the parent level, there should be no reason to think that regulators of the securities markets and the accounting profession in those countries would tolerate, much less welcome, such an uninvited intrusion.

So the PCAOB’s ability to impose its will on major foreign regulators is comparable to the idea that audit quality requires each audit opinion to be personally signed by a Tyrannosaurus Rex – simplistic to mandate, although ill-advised, and impossible to achieve.

As for the second issue -- resource availability -- there is more than the PCAOB recognizes to the Big Four’s nearly total dominance at the global level of large-company audit – besides the awareness that mandatory rotation would only increase the tetrapoly’s hold. 

Namely – in many major economies one firm has clear leadership in large-company audits – e.g., PwC in the UK, KPMG in Germany, E&Y in France, and Deloitte in Spain.

A result is significantly lop-sided distribution of technical and industry expertise and personnel even among the Big Four, constraining rotation choices because such talent shortfalls are not readily or quickly solvable.

That is, what incentive would there be for a firm with a resource deficit to invest the time and cost to build or import the competence needed to rotate onto a complex, world-scale audit engagement – with the known prospect that its prospective new client and its stream of fees would be rotating away at the end of the cycle?

And if not, symmetrically, how does a large company rotate its auditors, if there is no place to turn?

Seekers for answers might recall the legend written on the old flat-earth maps – that beyond the horizons of ignorance, “there be dragons.”

 

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

 

 

A Prescription for What Ails Large-Company Audit: Real Medicine, for a Change

“Reality must take precedence over public relations, for nature cannot be fooled.”

            -- Physicist Richard Feynman's appendix to the Rogers Commission Report on the space shuttle Challenger disaster, January 28, 1986   

 A reader of my July 17 post acknowledged the continuing sterility of the dialog among the community of financial statement users, about the degraded status of the standard auditors’ report and the deep illness threatening the survival of the large accounting firms. But he chided me for offering only “bromides” rather than my own substantive prescription.

I felt the point of that needle – even though potential solutions have figured for the nearly ten years since this blog’s predecessor, my column "Balance Sheet," launched in the International Herald Tribune.

After the Enron debacle, the politicians’ infliction of Sarbanes/Oxley, and the many-faceted and still-unfolding events of the financial crisis, book-length treatment is surely called for -- despite the discouraging message from authors’ agents and publishers, that while the topic is worthy, the size of the interested audience would not support their investment.

Faute de mieux, I have stayed this course, appreciating the interest and support of a readership well prepared to share suggestions and criticisms.

It is a challenge to address the complex issues, within both column-length constraints and a comprehensive “holistic approach,” such as called for in June by PCAOB chairman James Doty (here), who himself lacks the vision, authority or resources to achieve it.

But by way of synthesis, a snapshot is possible of a sustainable future, using links back to the archives for detail.

First, a few background assumptions:

• A forthright reading of the projects to re-consider the scope and language of the standard auditors’ report, by the PCAOB and the IAASB among others, confirms an emerging consensus that the current “pass/fail” report is obsolete, serves no purpose other than securities laws compliance, and should be supplanted by assurance of real value.

• The existential threat hanging over the Big Four firms’ complete dominance of the large-company audit market -- the “supply side” – is simply not addressed by any of the so-called “solutions” addressed to market concentration – whether mandatory rotation, break-up or new entries, liability reforms, audit catastrophe insurance or bonds, living wills, leadership replacement, etc., etc., blah, blah, blah. As the first head of the PCAOB confirmed, regulators “don’t have a clue” – a widely shared and unchanged attitude of denial.

• There is no credible case for government-controlled delivery of audits worth the effort and expense – whether by direct execution, engagement assignments or otherwise. The output of the artificial and pathetic “profession” that would exist under such regimes would be inferior even to today’s devalued state, much less to the evolved conditions now called for.  

• And, it is time to acknowledge, the entire intellectually fragile structure of auditor independence is anachronistic, ill-suited to today’s conditions, and deleterious to both performance quality and the potential for useful change – a sacred cow that should be taken out and put to a quick and humane end (here and here).

So, now what? 

A framework does exist for regulators to license or charter sustainable audit-only firms (here). But – if and only if – a reconfigured legal and regulatory environment both permits, invites and encourages: 

• Full-service relationships between auditors and providers of other services.
• The attraction and deployment of outside capital, as would be required to support such new multi-service providers, with corresponding changes in permissible ownership structures.
• The appropriate involvement of meaningful regulatory oversight, quality enforcement and investor rights recognition.
• The emergence of geographic and industry-based new competitors.
• And, perhaps, even the return of today’s understandably reluctant insurance industry. 

Under such a fundamentally re-engineered regime, truly new and valuable forms of reporting could be designed and delivered (here and here).

These could be responsive to the needs of financial management and audit committees, welcomed by both executive teams and directors alike, and subscribed to by users under sustainable liability terms). They could be, at the same time, respectful of the value perceived by shareholders and others of the influential presence of “outside experts.” 

Simultaneous attention to all aspects of this framework is essential, however, because until then – as today’s impasse shows -- neither issuers nor auditors have any incentive to take on the increases in both cost and liability imposed under today’s exposed conditions.

I have been calling for years for an adult dialog among the inter-locking and antagonistic interests, who today are only wasting their energy in paralysis and finger-pointing. Without seeking endorsement or even agreement, I suggest that there is much more available here than “bromides.” 

Be the judges – and please let me know.   

 

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

 

The "Independent" Auditor's Real Client? Time to Re-Assess, I Kid You Not

 "Ahh, but the strawberries -- that's where I had them. They laughed at me and made jokes, but I proved beyond the shadow of a doubt and with geometric logic that a duplicate key to the wardroom icebox did exist, and I'd have produced that key if they hadn't pulled the Caine out of action"

    --Capt. Philip Francis Queeg, 1954

Comprehensive review of the scope and language of the standard auditors’ report has been long overdue. So with measured enthusiasm (here and here), the initiatives of both the Public Company Accounting Oversight Board and the International Auditing and Assurance Standards Board are welcome.

High on the list of barriers to clear thinking and potentially constructive evolution, however, is the persistent canard, renewed by PCAOB member Steven Harris at its June 21 public meeting (here), that auditors “must fully embrace the concept that the company paying their fee is not their client.”

This proposition is confusing in logic, wrong in history, and malign in its influence. Until snuffed out once for all, it will continue to deflect and distract from the achievable task of re-engineering a role for outside auditors that brings real value to the community of financial statement users.

Since the middle of the 19^th century, when Mr. Deloitte and his pioneering colleagues were first engaged to assist the “auditors” of Victorian-era public companies – themselves selected from among the body of corporate shareholders, to advise their fellows in their shared financial interests – the auditor/client relationship has been contractual, consensual and private.

The appliqué of “public interest” has been allowed not only to stick, but to become an incrustation on the auditors’ appropriate functions. Fostered since its infancy by the newly-invented profession itself, to its discredit and lately to its mortal threat, the label did fend off – if only temporarily – the prospect of government-provided assurance – but at high cost and under the now-realized hazard of exaggeration and misapprehension of its capacities.

The shaky structure on which Harris bases his claim, that “the ultimate client of an auditor of any publicly traded company must be investors” is the 1984 case of United States v. Arthur Young. There, perpetuating the unfortunately long tradition of judicial malappreciation of the auditors’ role, Chief Justice Burger invoked the inapposite image of the “public watchdog” -- that “the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.”

As a matter of jurisprudence, Burger’s gratuitous dictum was unnecessary to the Court’s holding that tax accrual working papers could be reached by IRS subpoena.

And as a matter of unexamined rhetoric, Burger defied the logic of canine behavior, by expecting even the most vigilant watchdog to bite the very hand that feeds it.  

Events have now shown that on such a tenuous rationale, the bulky but fragile edifice of constrained client service and “appearance of independence” cannot stand. 

Critics such as Harris of the “pass/fail” audit report model have much to complain of – but there will be no solutions in shooting at the messengers, for continuing to deliver this outdated and devalued commodity product. 

Instead, history provides many examples of the dangers that lurk in broadening the distance that separates the payor of fees or benefits from the subsidized interests ostensibly served:

• Raising the limits on depositors’ insurance incentivized the reckless behavior of the American savings and loan institutions in the 1980’s, underlying their ruinous boom-and-bust.

• Lodging the management of health care cost reimbursement decisions with self-interested insurers has opened the doors to the waste, abuse and mis-allocations in the pricing and delivery of medical services.

• And most recently, requiring an issuer-paid rating agency’s report as a “green light” to sell complex derivatives was a central element in the inflation of the subprime-mortgage driven crisis that has plagued the financial markets for four years and counting.

None of which is to say that the “agency problem” of close auditor relationships with corporate boards and managements can be addressed successfully by the further intrusion of government. The prospect that an audit regulator could take on and satisfy the task of providing even today’s out-dated “pass/fail” assurance is beyond Panglossian fantasy or imagination. 

Rather, hope for progress lies in a realistic re-framing of the results that can reasonably be expected from the auditors, in an environment where legitimate and valuable new forms of assurance can be designed and delivered.

Which requires putting aside inflated language, moderating unrealistic expectations, and nurturing the profession’s acknowledged and considerable expertise.

 

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

The PCAOB's Concept Release: What Might a Truly Useful Auditors' Report Actually Say?

First reaction to the Public Company Accounting Oversight Board’s Concept Release of June 21 (here), which puts on the table a buffet of possible revisions to the long-standing commodity language of the standard auditors’ report: 

It’s like Bob Dylan’s observation on the twelve-string guitar – you spend half your time tuning the damned thing, and the other half playing out of tune.

Thanks to readers for asking – more will be coming, through the comment period ending September 30.

A second reaction should be positive, since the project puts the US regulator’s stamp on a vital question, posed by Chairman James Doty during the public meeting (here), “how audit reports can be more useful to society?” 

But optimism should be carefully tempered. This is only the latest in the cyclical spasms of user dissatisfaction, going back to such barely-remembered efforts as the Cohen Commission of 1974 and the Treadway Commission of 1985. Vision and will have consistently turned to failure, over-taken by the return of bubbly investor enthusiasm, and this spring’s exuberant reception of the new media IPO’s (here), during which rational attention to the boundaries of quality accounting and reporting has been blinkered by investor frenzy, does not bode well.  

Researchers in group psychology have long known that human attitudes are asymmetrical towards rewards and detriments: people are risk-seeking on the upside, but risk averse on the downside.

Which means that the pain of a losing investment will more than outweigh the pleasure of a similar gain.

And therein lies the fallacy behind the traditional “pass-fail” audit report. As shown by recent behavior, investors will ignore all cautionary limitations within a clean report on such recent bubble companies as LinkedIn or Pandora – or the sketchy accounting proffered ahead of the upcoming launches of Facebook or Groupon. But on the other hand, they will never be satisfied – whatever the PCAOB staff may think they have accomplished with their “outreach” – absent an advance “fail” signal on a company poised to fall – Lehman, Bear, Countrywide, AIG, Fannie, and so on – not because the real desire is for a coherent and comprehensible articulation of a business model destined to failure, but to avoid the failure itself, at all.

What this “second-order” disconnect means, then, is that the auditor is truly at one remove from the core issue in today’s world of short-term score-keeping -- financial reporting is, essentially if emotionally, only a proxy for investors on the ultimate future success of the reporting enterprise. So it misses the point to keep belaboring the messenger.

Resolution is ready to hand, right within the framework of the Concept Release itself. But radical adjustment will be required, both to the reporting by issuers themselves and in the auditors’ report language.

That is, it must be for the company, not the auditors, to fully satisfy the regulators’ disclosure goals regarding, for example, the achievability of results dependent on management’s judgments, critical estimates, and difficult choices among permissible or alternative accounting policies – all of which contain and reflect the company’s business, operational and strategic risks, on which actual results depend.

The accountants then have two socially useful but limited roles:

First, to provide the necessary technical and professional competence to assist issuers in navigating through their many politicized and judgmental reporting choices – a process, by the way, which brings to the fore the many irrationalities involved in the unending fables of “convergence” among standards and the essentially irreconcilable inconsistencies between and among IFRS and the various versions of GAAP (for which, as always, see The Accounting Onion).

Second, the assurance role: to support – to the extent possible -- the clarity and transparency of the representations made in the financial statements to the community of users.

And that’s it – so much, and no more.

What may this mean for legitimately useful audit report language? Messages are required like, “We don’t know …. we cannot tell from the evidence …. we cannot test or provide a meaningful comment ….”  These, with some work on the drafting, can be properly articulated under several of the Concept Release’s rubrics -- whether Auditor Discussion & Analysis or Emphasis Paragraphs or Clarification of Language.

The profession’s leaders have been leery of any such rationalization of their role – a fear driven by economic self-interest and their unwillingness to confront the fragility of their business model.

Staying the present course to nowhere, however, risks their being revealed, like the Wizard of Oz, as little figures behind the curtain, puffing smoke and noise of no value or significance.

It needn’t come to that. Stay tuned – the upcoming months may tell.

 

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