The Fallout from SAB 108: A Concrete Illustration of the Need for Mandatory Audit Firm Rotation

I'm going to write about auditing in this post, and my remarks are motivated by a report published by Audit Analytics on the number of restatements engendered by the adoption of SEC Staff Accounting Bulletin No. 108 (SAB 108) on materiality. 

If you're an SEC geek, you'll probably be saying to yourself that materiality in financial statements was comprehensively addressed in SAB 99.  You would be right, but the SEC nontheless was compelled to issue SAB 108 to address a specific aspect of materiality for issuers who were either too obtuse or too obdurate to apply the principles-based SAB 99 properly.  The topic of SAB 108 as stated reads as pretentiously as the title of a PhD dissertation: "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements."  But, as I'll explain below the situations it addresses are more akin to games played by mean children than graduate studies.

SAB 108 in a Nutshell

“The provisions of this Statement need not be applied to immaterial items.”  So states every Statement of Financial Accounting Standards.  If a company appeals to materiality because the cost of implementing a standard would be too burdensome, that’s OK.  But, if you are appealing to materiality to avoid implementing a standard because you don’t like the financial statement impact, principles-based SAB 99 says that’s not OK -- but who’s gonna know, just so long as you apply the rules for testing materiality as literally as you possibly can.

Here’s what can happen when you put your rose-colored materiality glasses on.  Imagine that a company has understated an expense by an ‘immaterial’ amount, say $20,000 per year for the past five years, accumulating to an understated liability of $100,000.  Now, in the fifth year, the company, having blithely ignored the pending accumulation, has a material unrecognized liability on its hands:

• Should it restate all prior periods, thereby sending an open invitation for scrutiny to the SEC and prospecting private attorneys? 
• Should it make a $100,000 correction to the income statement of the current year, and effectively compound earlier white lies with a big lie (material understatement of income) in the current year? 
• Should it do nothing -- as it has for the past five years?

In SAB 108, the SEC needed to tell everyone, as if they didn't know already, that the only way out of the pickle, once you are in it, is full restatement -- except for an amnesty to companies that cleaned up their act by a prior period adjustment to retained earnings in their annual report for fiscal years ending before November 16, 2006. 

Back to Auditing

The Audit Analytics report has a bunch of really interesting statistics about the corrections made during the SAB 108 amnesty period. There are a number of interesting statistics about the frequency (too many, including over 200 accelerated filers) of companies and the kind of accounting issues, but the juciest statistics were the distribution of error corrections over each of the Big Four auditors.   KPMG lead the way with 13.7% -- about one in seven -- of their SEC clients making corrections.  The other three weren’t even close to KPMG, all having less than 3%.  KPMG also leads the way by a fair amount in the average size of a correction.   

Perhaps too much can be made of one case, but with the KPMG's Xerox debacle fresh in my mind, I can't say that I am shocked by the results.  In the Xerox case, KPMG was found to have improperly permitted billions in earnings manipulations, and responsibility for assisting in the fraud extended to the most senior partners. 

Those of you who have had occasion to read some of my earlier posts may recall that I am an avid fan of mandatory audit firm rotation (Would Someone Please Audit the Auditor?). How many of these restatements would have been permitted or caught at an earlier stage if another firm, especially one less tolerant of the games children play, succeeded KPMG?  Would the consequences of the busted Xerox audit have been prevented, or at least mitigated?

No one can say for sure what the answers to these question are, and I am more confident that the Big Four doesn't want anyone to know.

By the way, I received a copy of the Audit Analytics report via a private email, and I have been unable to find a public URL source for it.  Therefore, I am hesitant to post it here for fear of violating copyright laws.  If anyone knows of a legitimate public source, please contact me and I'll add a link to it here.

Comments

[Independent Accountant]

Many years ago, when I was a wee little CPA I favored mandatory CPA firm rotation. I haven't for decades. Why? E&Y replaces D&T. PWC replaces E&Y. KPMG replaces PWC. What difference does it make? Do you really think E&Y is going to publicly "rat out" PWC when E&Y knows that on the ABCD audit in the say, Miami office, PWC just replaced E&Y? Be serious. My answer: lawsuits, lawsuits and more lawsuits. Indictments, indictments and more indictments. I agree with you, SOX is largely a waste of money. It's the 1995 Litigation Reform Act that should be repealed and the recent Stoneridge decision reversed by Congress.
Keep up the good work. I noticed the same changes in acquisition accounting you did when I read the opinion.